10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2004

OR

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

FOR THE TRANSITION PERIOD FROM              TO             .

Commission File Number : 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, including zip code)

Registrant’s telephone number, including area code:

(650) 603-5200

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

None

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

Common Stock, $0.002 par value

Preferred Stock Purchase Rights

(Title of class)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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 aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $3,500,862,858 as of June 30, 2004, based upon the closing sale price reported for that date on the NASDAQ National Market. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily conclusive for other purposes.

The number of shares of Registrant’s Common Stock outstanding as of March 4, 2005 was 86,199,828.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for Registrant’s 2005 Annual Meeting of Stockholders to be held May 19, 2005 are incorporated by reference in Part II and III of this Annual Report on Form 10-K.

TABLE OF CONTENTS

		Page
PART I
Item 1.	Business	1
	General	1
	Products and Services	2
	Research and Development	8
	Sales, Marketing, and Alliance Partners	8
	Licensing, Pricing, Deferred Revenue, and Seasonality	9
	Financial Information About Geographical Areas	10
	Competition	10
	Patents, Trademarks, and Licenses	11
	Personnel	11
	Available Information	12
Item 2.	Properties	12
Item 3.	Legal Proceedings	13
Item 4.	Submission of Matters to a Vote of Security Holders	13
PART II
Item 5.	Market for the Registrant’s Common Equity and Related Stockholder Matters	14
Item 6.	Selected Consolidated Financial Data	15
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	50
Item 8.	Financial Statements and Supplementary Data	52
Item 9.	Changes in and Disagreements with Accountants On Accounting and Financial Disclosures	52
Item 9A.	Controls and Procedures	53
Item 9B.	Other Information	53
PART III
Item 10.	Directors and Executive Officers of the Registrant	54
Item 11.	Executive Compensation	55
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	56
Item 13.	Certain Relationships and Related Transactions	56
Item 14.	Principal Accountant Fees and Services	56
PART IV
Item 15.	Exhibits and Financial Statement Schedules	57
Signatures		62

This Annual Report on Form 10-K 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 the forward-looking statements in this Annual Report on Form 10-K.

Mercury, Mercury Interactive, the Mercury logo, LoadRunner, ProTune, QuickTest Professional, SiteScope, TestDirector, and WinRunner are trademarks of Mercury Interactive Corporation in the United States and may be registered in certain jurisdictions. The absence of a trademark from this list does not constitute a waiver of Mercury’s intellectual property rights concerning that trademark.

This Annual Report on Form 10-K contains references to other company, brand, and product names. These company, brand, and product names are used herein for identification purposes only and may be the trademarks of their respective owners. Mercury Interactive Corporation disclaims any responsibility for specifying which marks are owned by which companies or which organizations.

PART I

Item 1. Business

General

Industry Overview

The importance of enterprise software applications in today’s business environment cannot be overstated. Some analysts project that up to 90-percent of business processes are automated in enterprise applications. As a result, maximizing the value of enterprise software applications is a critical factor in overall business success. Yet it is increasingly difficult for chief information officers (CIOs) to deliver business value while managing costs, risks, and compliance against a changing backdrop of increasing business and technology complexity. To address these challenges, many of our global customers are turning to business technology optimization (BTO), the industry strategy for maximizing the business value of Information Technology (IT). BTO applies business and quality management practices coupled with software to optimize the business results of IT. Global 2000 companies use the principles and practices of BTO to automate and optimize IT itself. BTO is about ensuring that every dollar invested in IT, every resource allocated, and every application in development or in production is fully aligned towards business goals. BTO helps CIOs and IT executives achieve their top priorities, which include:

• maximize and demonstrate the business value of IT;

• align IT strategy with business priorities;

• reduce IT spending; and

• control risks and improve regulatory compliance.

Company Overview

We are a leading provider of software and services for the BTO marketplace. Mercury was incorporated in 1989, and began shipping software quality testing products in 1991. Since 1991, we have introduced a variety of BTO software and service offerings, including offerings in application delivery for testing software quality and

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performance in pre-production, application management for monitoring and managing application availability in production, and IT governance for managing IT’s portfolio of projects, processes, priorities, and resources.

Our BTO offerings for application delivery, application management, and IT governance help customers maximize the business value of IT by optimizing application quality and performance as well as managing IT costs, risks, and compliance. The Mercury BTO offerings include:

• Our IT governance offerings help customers govern and manage the priorities, people, and processes required to run an IT organization like a business.

• Our application delivery offerings help customers optimize their custom and packaged business applications by improving the quality and performance of those applications, while reducing the time and costs required to deploy them.

• Our application management offerings help customers optimize the performance and availability of applications in production and resolve problems quickly and proactively.

• Most of our offerings are available as a managed service over the Internet. Our managed service is a “software as a service” offering that allows our customers have the flexibility of choosing which Mercury software to run themselves and which software will be outsourced to us.

• We also provide a wide range of customer support and professional service offerings that enable our global partners and customers to implement, customize, manage, and extend our BTO offerings.

2004 Business Acquisitions and Technology License Agreement

On July 1, 2004, we acquired Appilog, Inc., a privately-held company. The acquisition of Appilog, a leading provider of auto-discovery and application mapping software, extended our capabilities in application management and BTO. Appilog’s products, now marketed and sold as Mercury Application Mapping, automatically manage the complex and dynamic relationships between enterprise applications and their supporting infrastructure. This technology helps customers to discover application dependencies on infrastructure, automatically detect and visually depict changes to applications and infrastructure, and visualize the business impact of planned and unplanned changes and infrastructure failures.

On November 16, 2004, we announced an OEM relationship with HyPerformix to enhance our capacity planning offering. The new offering, Mercury Capacity Planning (Powered by HyPerformix), allows IT teams to make the right tradeoffs between the performance and scalability of mission-critical business applications and the costs of their underlying infrastructure.

Products and Services

Our portfolio of BTO products and services is strategically organized around three product lines: IT governance, application delivery, and application management. Our BTO offerings, called Mercury Optimization Centers, consist of integrated software, services, and best practices within each center that enable companies to use a center of excellence approach to govern the priorities, processes, and people of IT, while maximizing the quality, performance, and availability of software applications. These Optimization Centers allow our existing customers to expand from tactical initiatives to an enterprise approach to BTO.

IT Governance Offerings

Our IT Governance offerings are used by CIOs and IT executives to prioritize and automate IT business processes from demand through production. These IT Governance offerings help customers optimize and align IT strategy and execution with business goals, reduce the cost of day to day operations, and improve business value and competitiveness.

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Mercury IT Governance Center

Mercury IT Governance Center provides integrated capabilities for managing the strategic components of IT. It provides real-time data to consolidate key governance functions such as demand management, portfolio and project management, resource management, and a comprehensive system to help comply with regulations such as the Sarbanes-Oxley Act of 2002. It offers support for quality programs and process control frameworks such as Six-Sigma, CMMI, ITIL, ISO-9000, and COBiT. In addition, it integrates workflow, security, execution, and reporting services.

Mercury IT Governance Center core products include:

• Mercury IT Governance Dashboard provides visibility into IT trends, status, and deliverables so that customers can make and execute real-time decisions. It provides a comprehensive real-time view of all IT initiatives and operations through a single point of access, and provides the centralized visibility and control essential to building a high-performance IT organization.

• Mercury Demand Management is used to manage all the demand placed on IT. It allows customers to consolidate, prioritize, and fulfill both strategic projects and day-to-day activities. It also allows customers to manage service levels.

• Mercury Portfolio Management is used to govern IT portfolios by evaluating, prioritizing, balancing, and approving both new initiatives and customers’ existing portfolio; analyzing different what-if scenarios, and ensuring alignment with business strategy and IT resource constraints. It lets business and IT stakeholders collaboratively govern their entire IT portfolio, with “apples-to-apples” comparisons and multiple levels of input, review, and approval.

• Mercury Program Management is used to collaboratively manage IT programs from concept to completion. It allows customers to automate and align processes for managing scope, risk, quality, issues, and schedules. Customers can deliver complex programs with the highest quality and capabilities, on time and on budget.

• Mercury Project Management enables collaborative project management for both repetitive projects, such as installing a new release of an HRMS application, and one-time projects, such as developing a new e-commerce capability. It allows customers to accelerate project delivery while reducing project costs.

• Mercury Change Management is used to plan, package, release, and deploy changes to customers’ applications portfolios. It delivers best practice software change management processes across platforms (mainframe, UNIX, NT, Linux), types of change (code, configurations, content), environments (Java, C, COBOL), or applications (Oracle, PeopleSoft, SAP, Siebel, custom, legacy).

• Mercury Financial Management is used to manage IT portfolios with real-time visibility into financial performance. It offers automatic real-time calculations of costs and variances, giving customers detailed comparisons of project health. It also provides real-time visibility into budgets, costs (both labor and non-labor), programs, projects, and overall IT demand—without costly integrations to multiple data sources.

• Mercury Resource Management is used to manage resource capacity and allocation. It balances resource supply, including both staffing levels and skill base, with incoming demand, giving full visibility and control over project demand, such as deploying new web-based services, as well as day-to-day demand, such as provisioning new employees and installing vendor patches.

• Mercury Time Management helps customers focus on value-added activities by streamlining time collection and improving accuracy across the wide range of work performed by IT.

• Mercury Object Migrator automates the deployment of AOL (Application Object Library) setups between Oracle E-Business Suite instances—saving time, money, and reducing errors.

• Mercury IT Governance Foundation enables customers to efficiently implement, protect, scale, and administer their Mercury IT Governance Center. It provides an integrated transaction processing architecture with shared services available across all IT Governance applications. IT Governance

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Foundation enables customers to minimize the total cost of ownership of their IT management applications. By sharing common services across Mercury IT Governance Center, our Foundation is less costly to administer and easier to learn and use.

Application Delivery Offerings

Our application delivery offerings help customers to optimize the quality and performance of both custom-built and pre-packaged software applications before they go into production. We offer two Mercury Optimization Centers for application delivery that automate critical delivery functions, including test management, business-process test design, functional and regression testing, load-testing, performance tuning, capacity planning, and diagnostics. These products and technologies are used to optimize the pre-production software development, customization, and integration processes. Our application delivery offerings enable customers to make informed “go live” decisions, decrease software defects, reduce the time and cost of deploying new software or software upgrades, and help ensure that software applications will produce their intended business results. In addition, certain of the capabilities of our two optimization centers are available through a managed service as application delivery services.

Mercury Quality Center

Mercury Quality Center is used by developers, quality assurance teams, and business analysts to perform automated software testing and quality assurance across a range of IT and application environments. It combines a suite of role-based applications, a business dashboard, and an application delivery foundation to optimize and automate key quality activities, including test management, requirements and defects tracking, functional and regression testing, and business process design validation. In addition, customers can choose to have Mercury Quality Center delivered as a managed service.

Mercury Quality Center core software products include:

• Mercury TestDirector is our global test management product that helps organizations deploy high-quality applications more quickly and effectively. Mercury TestDirector software integrates requirements management with test planning, test scheduling, test execution, and defect tracking in a single application to accelerate the quality testing process. Customers can leverage Mercury TestDirector’s core modules either as a standalone solution or integrated within a global Quality Center of Excellence.

• Mercury QuickTest Professional is our automated testing solution for building functional and regression test suites. It provides a keyword-driven approach to structured automation, so customers can use natural language to build tests that verify user interactions and ensure business processes work as designed. Mercury QuickTest Professional supports a range of enterprise IT environments, including Web (HTML/DHTML), ..NET, Java/J2EE, ERP/CRM, client/server, mainframe, and multimedia.

• Mercury WinRunner is our standard functional testing solution for enterprise IT applications. It captures, verifies, and replays user interactions automatically, so customers can identify defects and ensure that business processes, which might span across multiple applications and databases, work as designed upon deployment and remain reliable.

• Mercury Functional Testing combines our functional testing products, Mercury QuickTest Professional and Mercury WinRunner, to deliver a complete solution for functional test and regression test automation—with support for nearly every software application and environment.

• Mercury Business Process Testing provides our automated functional testing capabilities to business analysts—enabling those people who are most knowledgeable about business process and application functionality to become an integral part of the quality optimization process. Mercury Business Process Testing is a web-based test automation solution designed to enable subject matter experts to build and execute test automation without any programming knowledge.

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Mercury Performance Center

Mercury Performance Center is used by developers and performance testing teams to optimize application performance in pre-production. It helps to ensure applications will scale to support the right number of users, transaction volumes, and performance levels. Mercury Performance Center combines integrated software, services, best practices, and a business dashboard for key performance optimization activities, including load-testing, performance tuning, capacity planning, and diagnostics across complex, heterogeneous computing environments. In addition, customers can choose to have Mercury Performance Center delivered as a managed service.

Mercury Performance Center core software products include:

• Mercury LoadRunner is our industry-leading load-testing solution for predicting system scalability, behavior, and performance. Mercury LoadRunner is used to obtain an accurate picture of end-to-end system performance, verify that new or upgraded applications meet specified performance requirements, and identify and eliminate performance bottlenecks during the development lifecycle. It exercises an entire application infrastructure by emulating thousands of virtual users and employs performance monitors to identify and isolate performance bottlenecks across and within each tier. By using Mercury LoadRunner, customers can minimize testing cycles, reduce defects, optimize application performance, and accelerate application deployment.

• Mercury Tuning (formerly ProTune) helps isolate and resolve infrastructure bottlenecks. It takes customers through a structured methodology to determine where the faults might be within the system, and then provides a centralized console to look across the system configuration to resolve problems. Mercury Tuning extends Mercury LoadRunner’s capabilities through the Safe Deployment System, allowing customers to systematically identify, isolate, and resolve infrastructure performance bottlenecks by modifying the system configuration settings.

• Mercury Capacity Planning provides simulation modeling of real-world production environments to help customers make informed decisions about the optimal infrastructure requirements from an application end-user perspective, before going live. Mercury Capacity Planning uses HyPerformix’s Integrated Performance Suite^™ technology with Mercury LoadRunner, to build models of existing or future production environments and create “what-if” scenarios of infrastructure deployment alternatives. This helps customers forecast and plan the types and quantities of key IT resources required to meet cost, performance, and utilization objectives.

• Mercury Diagnostics is our lifecycle application diagnostics solution for J2EE, .NET, and ERP/CRM environments. It can be used in both pre- and post-production environments to find deep code and configuration level issues in enterprise applications environments, including intermittent problems, memory leaks, synchronization, deadlocks, and data dependent issues. In pre-production, Mercury Diagnostics allows customers to identify, diagnose, and resolve application problems prior to deployment.

Application Management Offerings

Our application management offerings help customers optimize business availability and problem resolution. We offer one Mercury Optimization Center as well as a managed service for application management that facilitates a strategic, business-centric approach to ensuring that production software performs at the levels required to meet business goals. Additionally, our application management offerings enable customers to proactively manage and automate the repair of production problems, which reduces the business ramifications of downtime.

Mercury Business Availability Center

Mercury Business Availability Center is used by IT operations teams to maximize business availability, manage IT operations from a business perspective, minimize downtime, and ensure applications are meeting established service levels with customers. Comprised of integrated applications, a business dashboard, and an application management foundation, Mercury Business Availability Center is used to manage application

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performance and availability according to service levels and business priorities, automatically discover and map the dynamic relationships between applications and underlying infrastructure, quantify the business impact of application downtime, and prioritize problem resolution based on business impact and service-level compliance. In addition, customers can choose to have Mercury Business Availability Center delivered as a managed service.

Mercury Business Availability Center core software products include:

• Mercury Application Management Dashboard (formerly Topaz Business Availability) is our interactive dashboard that provides real-time visibility into key application-enabled business processes. By monitoring application performance and availability in real time, Mercury Application Management Dashboard helps IT and business executives measure the results delivered by production applications.

• Mercury Service Level Management (formerly Topaz for Service Level Management SLM) enables customers to proactively manage service levels from the business perspective. It provides service level reporting for enterprises and service providers to measure application service levels against business objectives. By using Mercury Service Level Management, customers can define realistic, quantifiable service level objectives that reflect business goals, and track performance both on a real-time basis and for offline planning purposes.

• Mercury System Availability Management, in conjunction with Mercury SiteScope, enables customers to seamlessly deploy and maintain an enterprise infrastructure monitoring solution to achieve 100-percent coverage. It connects to existing Enterprise Management System (EMS) products or uses SiteScope to collect and monitor system availability and performance data from across the entire enterprise. Mercury System Availability Management, using SiteScope as its data collection engine, is based on a unique agentless architecture that enables centralized management, configuration, and management, which ultimately lowers the total cost of ownership.

• Mercury Application Mapping provides real-time visibility into the dynamic relationships between enterprise applications and their underlying infrastructure. It continuously updates and maintains this topology map within a common relationship model, enabling customers to quickly assess business impact of IT issues. As a result, customers can reduce the costs and risks of managing new services and making changes to existing services.

• Mercury End User Management proactively monitors application availability in real-time and from the end-user perspective, so customers can fix issues before end-users experience problems. It proactively emulates end-user business processes against applications on a 24x7 basis. Plus, it enables customers to assess business impact on real users across multiple domains and geographies, and manage end-user performance from a wide number of supported desktops, and handheld devices.

• Mercury Diagnostics is our lifecycle application diagnostics solution for J2EE, .NET, and ERP/CRM environments. It can be used in both pre-production and production environments to find deep code and configuration level issues in enterprise applications environments, including intermittent problems, memory leaks, synchronization, deadlocks, and data dependent issues. In production, Mercury Diagnostics allows customers to manage, monitor, diagnose, and resolve critical application problems before they impact business or end-user performance.

• Mercury Application Management Foundation(formerly Topaz Platform) offers an “agentless” monitoring architecture that includes our business process and end-user monitoring infrastructure, as well as an infrastructure monitoring solution. Key components include:

• Mercury Business Process Monitor (formerly Topaz Business Process Monitor) proactively monitors enterprise applications in real-time and alerts IT Operations groups to performance problems before users experience them. Customers can monitor sites from various locations to accurately assess site performance from the perspective of different users.

• Mercury Client Monitor (formerly Topaz Observer) gathers performance data directly from the client machine and measures the experience of real end-users as they utilize business processes. It

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provides unique client-monitoring capabilities to work through issues that affect inconsistently, and correlate them to failure points in the backend, network and all the way to the client’s “last mile” connection or even the desktop system itself, whether the user resides inside or outside the firewall.

• Mercury Global Monitor (formerly Topaz Monitor) is the only solution that provides a monitoring infrastructure that allows a customer to gain insight into the end-user experience both inside and outside the firewall, from a single source. We maintain a network of host machines, or agents, to help our customers measure their end-user performance experience at any time, from anywhere.

• Mercury Real User Monitor (formerly Topaz Prism) is a central solution for measuring the online experience of every user, from every location, all the time. With Real User Monitor, customers can quantify the business impact of performance problems and effectively prioritize resolution efforts. By providing visibility outside of the datacenter into all users, it enables customers to isolate inconsistent issues which impact individuals or groups of users.

Mercury BTO Services

Mercury Services provides a wide range of professional and educational services as well as customer support offerings that enable global partners and customers to implement, customize, manage, and extend our BTO offerings. Many of our software offerings are available as a managed service over the Internet—giving customers the flexibility of choosing to deploy Mercury software in-house, and/or outsourced to us.

Mercury Professional and Educational Services

Our professional services organization offers the expertise, knowledge, and practices to help the customer implement an enterprise-wide BTO strategy. We help the customer measure the quality of their applications and automated business processes from a business perspective, maximize technology and business performance at each stage of the application lifecycle, and use effective governance strategies to manage IT operations for continuous improvement. Post-sales support is provided by our professional services organization through training and consulting engagements. Our educational services provide a comprehensive curriculum for all our products, using different methods of delivery at multiple locations in the U.S. and worldwide. Customers must take rigorous certifications to obtain “Mercury Certified Product Consultant” and “Mercury Certified Instructor” titles. As of December 31, 2004, our professional and educational services organization consisted of 244 employees.

Mercury Customer Support

Our customer support organization provides post-sales support through renewable maintenance contracts. These contracts provide for technical support as well as software upgrades on an “if and when available” basis. Our customer support organization offers different customer support programs to suit varying needs of our global customers. Our development teams in Israel serve as an extension of our customer support organization to assist when local support centers are unable to solve a problem. We believe that a strong customer support organization is integral to both the initial marketing of our products and maintenance of customer satisfaction, which in turn enhances our brand and improves opportunity for repeat orders. In addition, the customer feedback received through our ongoing support function provides us with information on market trends and customer requirements that are strategic to ongoing product development efforts. As of December 31, 2004, our customer support organization consisted of 262 employees.

Mercury Managed Services

Our managed services offerings are a critical part of our strategy to deliver rapid time to value for our customers. These services offer customers the choice to run our software in-house or have us provide them with an outsourced offering. By deploying our software as a service over the Internet, our managed services help our customers rapidly derive more value from their IT investments while minimizing costs and risks. Our managed

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services provide an infrastructure that consists of server farms, a robust infrastructure for managing data, and more than 300 agent machines located in 80 cities around the world. In addition, to help customers be successful in implementing our BTO products, our managed services can be augmented with on-going knowledge transfer from our professional services. We believe that offering our customers the choice of whether to run our software internally or have us provide it as a managed service is a significant competitive advantage over vendors who only offer one or the other option. As of December 31, 2004, our managed services organization consisted of 111 employees.

Research and Development

Since our inception in 1989, we have made significant investments in research and product development. We believe that our success will depend in large part on our ability to maintain and enhance our current product lines, develop new products and solutions, maintain technological competitiveness, extend our technological leadership, and meet changing customer requirements. Our research and development organization maintains relationships with third-party software vendors and with many major hardware vendors on whose platforms our products operate.

Our primary research and development facility is located near Tel Aviv, Israel. Performing research and development in Israel offers a lower cost structure than in the U.S. Operating in Israel has also allowed us to receive tax incentives from the government of Israel (see Note 12 to the consolidated financial statements for additional information regarding our income tax provision).

We also have engineering facilities in Boulder, Colorado; Bellevue, Washington; and Mountain View, California that were acquired in conjunction with our acquisitions of Freshwater in May 2001, Performant in May 2003, and Kintana in August 2003, respectively.

For the years ended December 31, 2004, 2003, and 2002, we incurred $73.5 million, $55.6 million, and $42.2 million in research and development expenses, excluding stock-based compensation of $0.3 million, $0.3 million, and $0.5 million, respectively. As of December 31, 2004, our research and development organization consisted of 602 employees.

Sales, Marketing, and Alliance Partners

Sales

We employ highly skilled enterprise sales professionals and systems engineers to understand our customers’ needs and to explain and demonstrate the value of our products and services. We sell our products primarily through our direct sales organization, which is supported by our pre-sales systems engineers. Our sales organization also includes our inside corporate sales professionals, who are primarily responsible for smaller transactions with existing customers. As of December 31, 2004, our sales organization consisted of 945 employees.

Our subsidiaries and branches operate sales and support 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, Poland, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore.

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Marketing

Our marketing organization is primarily responsible for aligning the needs of our customers and partners with our BTO strategy, building the value of the Mercury brand, marketing our product and service offerings, differentiating us from competitors, and enabling our global channel to sell and service our customers. Our marketing activities include integrated marketing campaigns, BTO executive summits, business and trade press tours, industry analyst briefings, global advertising, and lead generation campaigns targeted at senior IT executives. Marketing activities included direct mailings to customers and prospects, as well as attendance and sponsorship at strategic industry events and tradeshows. We also share BTO best practices with partners, existing customers and prospects through a series of events, publications, and hosting a series of Internet seminars. These activities are designed to familiarize the market with the capabilities of BTO and Mercury Optimization Center offerings. As of December 31, 2004, our marketing organization consisted of 149 employees.

Alliance Partners

We work with a wide range of partners around the globe. Our strategy is to partner with global software vendors, systems integrators, and hardware and software vendors to provide our customers with a wide breadth and depth of leading software and services to get the most value out of their initiatives. These companies include:

• global software vendors that provide enterprise applications, such as Oracle, SAP AG, and Siebel Systems; and

• major systems integrators, including Accenture and BearingPoint.

We derive a portion of our business from sales of our products through our alliance partners. We normally pay our alliance partners through our channel business in the form of a discount or a fee for the referral of business, which is netted against the revenue we recognize.

Licensing, Pricing, Deferred Revenue, and Seasonality

We license our software to customers under non-exclusive license agreements on either subscription, perpetual, or multiple year term bases that generally restrict use of the products to internal purposes at a specified site. We typically license software products to either allow up to a set number of users to access the software on a network at any one time, using any workstation attached to that network, or to allow use of the software on designated computers or workstations. In addition, our managed services, our application management products, and some of our application delivery and IT governance products are licensed and priced based on usage, such as the number of transactions monitored, number of virtual users emulated per day, or period of usage.

We believe that offering customers the option to license our software using term and subscription contracts provides us with an unique differentiator. Term and subscription licensing enable our customers to license the software they need for the time period they use it, while providing us with the opportunity to earn renewals and expand contracts over time.

Our products are priced to encourage customers to purchase multiple products and licenses and expand the usage of our technology. License fees depend on the product licensed, the term of the license, the number of users for the product licensed, and the locations in which such licenses are sold, as international prices tend to be higher than U.S. prices. Sales to our indirect sales channels, which are intended for resale to end-users, are made at discounts from our list prices based on the sales volume of the indirect sales channels. Original purchases of maintenance and renewal maintenance sales are priced at specified percentages of the related license fees. Training and consulting revenues are generally generated on a time and expense basis.

We recognize revenue ratably from subscription contracts whose terms generally range over a period of one to three years. Recognized revenue from these contracts was $152.1 million, $98.9 million, and $53.0 million for the years ended December 31, 2004, 2003, and 2002, respectively. Our total deferred revenue balance was $414.3

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million at December 31, 2004. We expect $102.2 million of this balance to be recognized in periods after 2005. In addition, we enter into a small number of maintenance contracts that have terms greater than one year. Recognized revenue from these contracts was $28.8 million, $15.3 million, and $11.2 million for the years ended December 31, 2004, 2003, and 2002, respectively.

We do not have any sales contracts that obligate our customers to buy any material products or services over future periods other than those sales recorded as either revenues or deferred revenues.

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 fiscal quarters, from our application management and application delivery businesses being typically strongest in the fourth fiscal quarter and weakest in the first fiscal quarter, and to a lesser extent, from the structure of our sales commission program. We expect this seasonality to continue in the future.

Financial Information About Geographical Areas

Financial information about geographical areas is included in Note 17 to the consolidated financial statements.

Competition

We believe that we compete favorably in each of the key components of BTO. However, 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, Parasoft, Worksoft, and Segue Software. In the new and rapidly changing market for application management solutions, our principal competitors include BMC Software, Computer Associates, Compuware, HP OpenView (a division of Hewlett-Packard), Keynote Systems, Segue Software, Tivoli (a division of IBM), Wily Technologies, and Veritas. In the market for IT governance solutions, our principal competitors include enterprise application vendors such as SAP AG, Oracle, Lawson, and Compuware (with its acquisition of Changepoint), as well as point tool vendors such as Niku and Primavera.

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.

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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 IT governance competitor, PeopleSoft, was acquired by Oracle, 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. We anticipate the market for our software and services to become increasingly more competitive over time.

Patents, Trademarks, and Licenses

We rely on a combination of patents, copyrights, trademarks, service marks, trade secret laws, and contractual restrictions to establish and protect proprietary rights in our products and services. The source code for our products is protected both as a trade secret and as an unpublished copyrighted work. Despite our precautions, it may be possible for a third party to copy or otherwise obtain and use our products or technology without authorization. In addition, the laws of various countries in which our products may be sold may not protect our products and intellectual property rights to the same extent as the laws of the U.S. Our competitors may independently develop technologies that are substantially equivalent or superior to our technology.

We rely on software that we license from third parties for certain components of our products and services including the technology we licensed from Hyperformix. In the future, we may license other third party technologies to enhance our products and services and meet evolving customer needs. The failure to license any necessary technology, or to maintain our existing licenses, could result in reduced demand for our products.

Because the software industry is characterized by rapid technological change, we believe that factors such as the technological and creative skills of our personnel, new product developments, frequent product enhancements, name recognition, and reliable product maintenance are more important to establishing and maintaining a technology leadership position than the various legal protections of our technology.

As of February 1, 2005, we have been granted or own by assignment 27 patents issued in the United States and have 10 patent applications on file with the United States Patent and Trademark Office (including continuation and divisional applications) for elements contained in our products and services. Once granted, we expect the duration of each patent will be up to 20 years from the effective date of filing of the applications. Our earliest issued patents can remain effective until April 23, 2013. In addition, we have three patents issued in Australia. We intend to continue to file patent applications as appropriate in the future. We cannot be sure, however, that any of our pending patent applications will be allowed, that any issued patents will protect our intellectual property or will not be challenged by third parties, or that the patents of others will not seriously harm our ability to do business. In addition, others may independently develop similar or competing technologies or design around any of our patents. We do not believe we are 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.

Although we believe that our products and services and other proprietary rights do not infringe upon the proprietary rights of third parties, third parties may assert intellectual property infringement claims against us in the future. Any such claims may result in costly, time-consuming litigation and may require us to enter into royalty or cross-license arrangements.

Personnel

As of December 31, 2004, we had a total of 2,659 employees, of which 1,307 were based in the Americas and 1,352 were based outside the Americas. Of the total, 1,094 were engaged in marketing and selling, 617 were in services and support, 602 were in research and development, and 346 were in general and administrative

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functions. Our success depends in significant part upon the performance of our senior management and certain key employees. Competition for highly skilled employees, including sales, technical, and management personnel, is strong in the software and technology industry. We may not be able to recruit and retain key sales, technical, and managerial employees. Our failure to attract, assimilate, or retain highly qualified sales, technical, and managerial personnel could seriously harm our business. Additionally, during 2004 we had changes in the roles, responsibilities, and personnel in our executive management. Any failures of our executive team to adopt and change to these new roles and responsibilities could have an adverse affect on our business. None of our employees are represented by a labor union, we have never experienced any work stoppages, and we believe that our employee relations are in good standing.

Available Information

We are subject to the informational requirements of the Securities Exchange Act of 1934 (the Exchange Act). Therefore, we file periodic reports, proxy statements, and other information with the Securities and Exchange Commission (the SEC). Such reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street, NW, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet website at http://www.sec.gov that contains reports, proxy, and information statements and other information regarding issuers that file electronically.

You can access financial and other information on our website at www.mercury.com/us/company/ir/. We have made all reports and amendments to reports from December 31, 2002 to December 31, 2004, available on our website. We also make available, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the SEC.

Item 2. Properties

In the second quarter of 2004, we moved into four buildings in Mountain View, California that we leased in October 2003. The four leased buildings, with a total square footage of approximately 253,000, became our new headquarters. Prior to the move, we were headquartered in Sunnyvale, California in four buildings that we owned with a total square footage of approximately 156,000. In January 2004, we sold two of the three vacant buildings in Sunnyvale, California with a total square footage of approximately 50,000. As of December 31, 2004, we owned two buildings with a total square footage of approximately 106,000. On January 7, 2005, we sold one of the two buildings in Sunnyvale, California that became vacant since April 2004 with a total square footage of approximately 55,000. In addition, we lease office buildings in other locations within the Americas. As of December 31, 2004, we leased approximately 171,000 square feet of office buildings in other locations within the Americas.

Our primary research and development activities are conducted by our subsidiary in Israel in two buildings that we own with a total square footage of 255,000. We also lease two other buildings, one of which is used for research and development activities and the other of which is used for manufacturing activities. In February 2004, we purchased approximately 30,000 square feet of land near our existing offices in Israel to accommodate future expansion in research and development activities.

As of December 31, 2004, we had a total of 72 sales and support offices throughout the world, of which 38 were in the Americas, 23 were in EMEA, 9 were in APAC, and 2 were in Japan.

As of December 31, 2004, we leased office buildings in EMEA, APAC, and Japan with a total square footage of approximately 180,000, 36,000, and 7,000, respectively.

We believe that our existing facilities are adequate for our current needs.

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Item 3. Legal Proceedings

There are presently no material legal proceedings pending, other than routine litigation incidental to our business, to which we are a party or to which any of our properties is subject. It is common in our industry to experience legal disputes with customers, shareholders, partners, and/or employees. This type of legal action could significantly harm our business.

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

No matters were submitted during the fourth quarter of 2004 to a vote of the holders of our common stock through the solicitation of proxies or otherwise.

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PART II

Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters

(a) Market for Common Stock

Our common stock is traded publicly on the NASDAQ National Market under the trading symbol “MERQ.” The following table presents, for the periods indicated, the high and low intra-day sale price per share of our common stock as reported on the NASDAQ National Market.

	High		Low
Year Ended December 31, 2003:
First Quarter	$	38.63	$	29.28
Second Quarter	$	44.20	$	29.24
Third Quarter	$	52.16	$	37.25
Fourth Quarter	$	52.43	$	42.01
Year Ended December 31, 2004:
First Quarter	$	54.25	$	41.21
Second Quarter	$	50.94	$	42.53
Third Quarter	$	50.08	$	31.05
Fourth Quarter	$	47.44	$	35.55

Holders of Record

As of March 4, 2005, there were approximately 301 holders of record of our common stock.

Dividends

We have never declared or paid any cash dividends on our common stock. We currently intend to retain earnings for use in our business and do not anticipate paying any cash dividends in the foreseeable future.

(b) None.

(c) None.

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Item 6. Selected Consolidated Financial Data

	Year ended December 31,
	2004			2003			2002			2001			2000
	(in thousands, except per share amounts)
Consolidated Statements of Operations Data:
Revenues:
License fees	$	261,306		$	201,047		$	192,212		$	203,817		$	206,835
Subscription fees		152,064			98,858			53,024			32,783			9,265
Total product revenues		413,370			299,905			245,236			236,600			216,100
Maintenance fees		196,141			159,030			122,343			98,536			64,250
Professional service fees		76,036			47,538			32,543			25,864			26,650
Total revenues		685,547			506,473			400,122			361,000			307,000
Costs and expenses:
Cost of license and subscription		40,344			29,056			24,804			23,915			15,626
Cost of maintenance		15,583			11,880			11,662			10,712			4,969
Cost of professional services (excluding stock-based compensation)		62,726			36,889			24,334			20,396			21,359
Cost of revenue - amortization of intangible assets		10,019			5,189			1,833			1,118			—
Marketing and selling (excluding stock-based compensation)		314,463			238,765			193,775			182,682			147,077
Research and development (excluding stock-based compensation)		73,469			55,608			42,246			40,726			35,282
General and administrative (excluding stock-based compensation)		55,987			40,000			32,407			24,806			19,274
Stock-based compensation		821			5,992			1,163			1,999			—
Acquisition-related charges		900			11,968			—			—			—
Restructuring, integration, and other related charges		3,088			3,389			(537	)		5,361			—
Amortization of intangible assets		5,544			2,281			542			29,007			—
Excess facilities charge		8,943			16,882			—			—			—
Total costs and expenses		591,887			457,899			332,229			340,722			243,587
Income from operations		93,660			48,574			67,893			20,278			63,413
Interest income		38,614			36,077			35,119			36,981			30,526
Interest expense		(20,292	)		(19,551	)		(23,370	)		(23,636	)		(11,775	)
Other income (expense), net		(4,837	)		(7,405	)		2,747			17,113			(1,289	)
Income before provision for income taxes		107,145			57,695			82,389			50,736			80,875
Provision for income taxes		22,545			16,182			17,185			16,582			16,175
Net income	$	84,600		$	41,513		$	65,204		$	34,154		$	64,700
Net income per share (basic)	$	0.95		$	0.48		$	0.78		$	0.41		$	0.81
Net income per share (diluted) *	$	0.83		$	0.41		$	0.74		$	0.39		$	0.73
Weighted average common shares (basic)		89,060			87,124			83,938			82,559			79,927
Weighted average common shares and equivalents (diluted) *		103,207			102,401			87,640			88,567			88,745

* Diluted net income per share and diluted common shares and equivalent for 2004 and 2003 include the effect of common stock issuable upon the conversion of the Zero Coupon Senior Convertible Notes due 2008 issued in 2003. The 2003 diluted net income per share has been retroactively adjusted to reflect the adoption of Emerging Issue Task Force No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share. See Note 1 to the consolidated financial statements for the basic and diluted net income per share computation for these periods.

Certain reclassifications have been made to the consolidated statements of operations for the years ended December 31, 2003 and 2002 to conform to the presentation adopted for the year ended December 31, 2004. These reclassifications had an immaterial impact on the prior reported balances and no impact on total revenues, income from operations, or net income. See Note 1 to the consolidated financial statements for additional information on the reclassifications.

	Year ended December 31,
	2004		2003		2002		2001		2000
	(in thousands)
Consolidated Balance Sheet Data:
Cash, cash equivalents, and short-term investments	$	630,321	$	717,360	$	527,246	$	427,781	$	628,743
Working capital		422,851		534,045		377,343		342,724		556,821
Total assets		2,019,950		1,970,952		1,075,283		927,625		976,375
Convertible notes		804,483		811,159		316,972		377,480		500,000
Stockholders' equity		580,986		700,369		445,168		354,345		303,032

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Item 7. 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

We are 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 BTO offerings for application delivery, application management, and IT governance products and services, and the Mercury Optimization Centers are designed to help our customers maximize the business value of IT by optimizing application quality and performance as well as managing IT costs, risks, and compliance.

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 have the choice between running our 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 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 a majority of our IT governance products and our application delivery products, on a perpetual license basis. We have in the past expanded the number of offerings structured as subscription based contracts. The majority of these subscription 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 undelivered items such as 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 customer 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

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customer support, which are determinable based upon substantive 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, the fair value of which is determinable based upon separate sales of these services to other customers without the 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), all license revenue is recognized in the quarter that the product is delivered, with only the unused term of maintenance revenue 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. Furthermore, if a perpetual license is sold at the same time as a subscription-based license to the same customer, then generally the two become bundled together and are recognized over the term of the contract.

Our product revenues in any given quarter are 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 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. Conversely, if our overall level of orders is below the target level but our license mix is above our targets (if we deliver more-than-expected perpetual licenses), our revenues may still meet or even exceed 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 the related infrastructure, and depreciation expense of managed services equipment. Cost of maintenance includes direct costs of providing product customer support, largely consisting of personnel-related costs, 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 reasonably 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-related costs and costs of outsourcing service. License and subscription, maintenance, and professional services costs also include allocated facility expenses and allocated IT infrastructure expenses. Cost of revenue also includes a portion of amortization expenses for intangible assets that are associated to our current products. These amortization expenses were recorded as “Cost of revenue—amortization of intangible assets” in our consolidated income statement.

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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 a portion of our commission expense related to subscription licenses and maintenance contracts and amortize the expense over the term of the subscription or maintenance contract. See “Critical Accounting Policies and Estimates” for a full description of our estimation process for accrued liabilities.

Results of Operations

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

	Year ended December 31,
	2004		2003		2002
Revenues:
License fees	38	%	40	%	48	%
Subscription fees	22		20		13
Total product revenues	60		60		61
Maintenance fees	29		31		31
Professional service fees	11		9		8
Total revenues	100		100		100
Costs and expenses:
Cost of license and subscription	6		6		6
Cost of maintenance	2		3		3
Cost of professional services (excluding stock-based compensation)	9		7		6
Cost of revenue - amortization of intangible assets	2		1		1
Marketing and selling (excluding stock-based compensation)	46		47		48
Research and development (excluding stock-based compensation)	11		11		11
General and administrative (excluding stock-based compensation)	8		8		8
Stock-based compensation	—		1		—
Acquisition-related charges	—		2		—
Restructuring, integration, and other related charges	—		1		—
Amortization of intangible assets	1		—		—
Excess facilities charge	1		3		—
Total costs and expenses	86		90		83
Income from operations	14		10		17
Interest income	6		6		9
Interest expense	(3	)	(4	)	(6	)
Other income (expense), net	(1	)	(1	)	—
Income before provision for income taxes	16		11		20
Provision for income taxes	4		3		4
Net income	12	%	8	%	16	%

Certain reclassifications have been made to the consolidated statements of operations for the years ended December 31, 2003 and 2002 in order to conform to the presentation adopted in the current year. These reclassifications had an immaterial impact on the prior reported balances and no impact on total revenues, income from operations, or net income.

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Revenues

License fees

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

	Year ended December 31,				Increase				Year ended December 31,				Increase
	2004		2003		in Dollars		in Percentage		2003		2002		in Dollars		in Percentage
Revenues:
License fees	$	261,306	$	201,047	$	60,259	30	%	$	201,047	$	192,212	$	8,835	5	%
Subscription fees		152,064		98,858		53,206	54	%		98,858		53,024		45,834	86	%
Maintenance fees		196,141		159,030		37,111	23	%		159,030		122,343		36,687	30	%
Professional service fees		76,036		47,538		28,498	60	%		47,538		32,543		14,995	46	%
Total revenues	$	685,547	$	506,473	$	179,074	35	%	$	506,473	$	400,122	$	106,351	27	%

The increase in license fee revenue for the year ended December 31, 2004 was primarily due to an increase in license sales of application delivery products of $28.8 million. The increase in license fee revenue was also attributable to an increase in IT governance license sales of $19.4 million and an increase in application management license sales of $12.1 million. We expect our license fee revenues to increase in absolute dollars for 2005.

The increase in license fee revenue for the year ended December 31, 2003 was primarily attributable to the sale of IT governance products acquired through the acquisition of Kintana and an increase of $2.7 million in application management license fees, mainly due to an increase in sales of our application management licenses. IT governance license fee revenue was $7.6 million in 2003. The increase of license fee revenue was partially offset by a decrease of $1.5 million in application delivery license fee revenue due to more customers licensing our products on a subscription basis.

Subscription fees

The increase in subscription fee revenue for the year ended December 31, 2004 was primarily due to a continuous growth in license sales of application delivery products on a subscription basis and an increase over the past two years in the license sales of our application management products. Our application management products are mainly offered on a subscription basis. The increase in license sales of application delivery products was $30.5 million while the increase in the license sales of our application management products was $20.9 million. The increase was also attributable to an increase in IT governance license sales of $1.8 million. In the event that more customers license our products on a subscription basis, we expect sales of our subscription licenses and services to continue to increase in absolute dollars in for 2005.

The increase in subscription fee revenue for the year ended December 31, 2003 was primarily attributable to an increase in license sales of $22.9 million in both application management subscription products and services and application delivery subscription due to more products being offered and more customers licensing our products on a subscription basis.

Maintenance fees

The increase in maintenance fee revenue for the year ended December 31, 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. The increase of maintenance fee revenue

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related to application delivery products, IT governance products, and application management products was $24.6 million, $10.1 million, and $2.4 million, respectively. We expect that maintenance fee revenue will continue to increase in absolute dollars for 2005.

The increase in maintenance fee revenue for the year ended December 31, 2003 was primarily attributable to an increase of $32.8 million in application delivery maintenance fee revenue due to renewals of existing maintenance contracts, an increase of $2.2 million in application management maintenance fee revenue due to renewals of maintenance contracts for products including those acquired through the acquisition of Freshwater, and $1.7 million in maintenance fee revenue from the sale of IT governance products acquired through the acquisition of Kintana.

Professional service fees

The increase in professional service fee revenue for the year ended December 31, 2004 was primarily attributable to $12.8 million in professional service fees for service engagements related to IT governance products and an increase in professional service fees of $9.7 million and $6.0 million associated with application management products and application delivery products, respectively. The professional service fee revenue grew as a result of our continuous effort to offer more 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 2005.

The increase in professional service fee revenue for the year ended December 31, 2003 was attributable to $6.6 million consulting fees for service engagements related to the sale of IT governance products acquired through the acquisition of Kintana. The increase was also attributable to an increase of $5.5 million in professional service fees associated with application delivery products and an increase of $2.9 million in professional service fees associated with application management products due to a continuous growth in both of our application delivery and application management product offerings and an effort to increase our professional service offerings to our customers.

International revenues

International revenues include sales from Europe, the Middle East, and Africa (EMEA), Asia Pacific (APAC), and Japan. International revenues for the year ended December 31, 2004, compared to the year ended December 31, 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 year ended December 31, 2004 were $262.1 million, an increase of $77.6 million or 42%, compared to $184.5 million for the year ended December 31, 2003. The increase was primarily attributable to increased sales in EMEA of $40.0 million and APAC and Japan of $15.4 million as well as fluctuations in foreign exchange rates of $22.2 million. International revenues represented 38% and 36% of our total revenues for the years ended December 31, 2004 and 2003, respectively.

International revenues for the year ended December 31, 2003, compared to the year ended December 31, 2002, 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 year ended December 31, 2003 were $184.5 million, an increase of $46.9 million or 34%, compared to $137.6 million for the year ended December 31, 2002. The increase was primarily attributable to increased sales in EMEA of $18.4 million and APAC and Japan of $6.8 million as well as fluctuations in foreign exchange rates of $21.7 million. International revenues represented 36% and 34% of our total revenues for the years ended December 31, 2003 and 2002, respectively.

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Costs of revenues and operating expenses

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

	Year ended December 31,						Increase				Year ended December 31,						Increase
	2004			2003			in Dollars		in Percent- age		2003			2002			in Dollars		in Percent- age
Costs of revenues:
Cost of license and subscription	$	40,344		$	29,056		$	11,288	39	%	$	29,056		$	24,804		$	4,252	17	%
Cost of maintenance		15,583			11,880			3,703	31	%		11,880			11,662			218	2	%
Cost of professional services		62,726			36,889			25,837	70	%		36,889			24,334			12,555	52	%
Cost of revenue-amortization of intangible assets		10,019			5,189			4,830	93	%		5,189			1,833			3,356	183	%
Total cost of revenues	$	128,672		$	83,014		$	45,658	55	%	$	83,014		$	62,633		$	20,381	33	%
Percentage of total revenues		19	%		17	%						17	%		16	%

Cost of license and subscription

The increase in cost of license and subscription for the year ended December 31, 2004 was primarily attributable to higher personnel-related costs, an increase in outsourcing expense, an increase in royalty expense, and higher allocated facility expenses. Personnel-related costs increased by $6.9 million as a result of growth in headcount. The increase was also attributable to an increase of $1.3 million in outsourcing expense related to delivery of one of our application delivery offerings and an increase of $1.2 million in royalty expense primarily associated with license agreements signed in 2004 for current products. Allocated IT infrastructure expenses increased by $0.6 million primarily due to the lease for our new headquarters. Based upon our revenue growth as described in “Revenues,” we expect cost of license and subscription to continue to increase in absolute dollars for fiscal 2005.

The increase in cost of license and subscription for the year ended December 31, 2003 was primarily attributable to an increase of $5.2 million in personnel-related costs due to an increased number of employees and an increase of $0.7 million in professional service costs related to outsourcing expense related to delivery of our application delivery offerings. The increase was partially offset by a decrease of $0.9 million in allocated facility expenses.

Cost of maintenance

The increase in cost of maintenance for the year ended December 31, 2004 was primarily due to higher personnel-related costs as a result of additional headcount to support our overall growth in business, higher consulting fees for our global expansion assessment project, higher allocated facility expenses, and higher allocated IT infrastructure expenses. Personnel-related costs, allocated facility expenses, allocated IT infrastructure expenses, and consulting fees increased by $1.1 million, $0.9 million, $0.8 million, and $0.5 million, respectively. Facility expenses and IT infrastructure expenses increased primarily due to the lease for our new headquarters. Based upon our revenue growth as described in “Revenues,” we expect cost of maintenance to increase in absolute dollars for 2005.

The increase in cost of maintenance for the year ended December 2003 was primarily due to higher personnel-related costs as a result of additional headcount to support our overall growth in business, higher consulting fees for our global expansion assessment project, higher allocated facility expenses, and higher allocated IT infrastructure expenses.

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Cost of professional services

The increase in cost of professional services for the year ended December 31, 2004 was primarily attributable to higher personnel-related costs as a result of growth in headcount, an increase in outsourcing expense, higher allocated facility expenses, higher allocated IT infrastructure expenses, and to a lesser extent, an increase in consulting fees. Personnel-related costs increased by $13.3 million, of which $7.7 million was related to Kintana employees who joined us as part of that acquisition in 2003. The increase in outsourcing expense of $10.1 million was primarily due to the growth in professional services and our continuous effort to offer more training and consulting services to our customers who license our products. The increase was also attributable to higher allocated facility expenses of $1.6 million and higher allocated IT infrastructure expenses of $1.0 million. Facility expenses and IT infrastructure expenses increased primarily due to the lease for our new headquarters. Based upon our revenue growth as described in “Revenues,” we expect cost of professional services to continue to increase in absolute dollars for fiscal 2005.

The increase in cost of professional service for the year ended December 31, 2003 was primarily due to an increase of $11.0 million in personnel-related costs due to an increased number of employees, of which $3.5 million was related to Kintana employees who joined us as part of that acquisition, an increase of $0.9 million in allocated facility expenses, and an increase of $0.9 million in allocated IT infrastructure expenses. These increases were partially offset by a decrease of $0.6 million in outsourcing expense due to a higher utilization of our internal professional services group, resulting in less outsourcing activities.

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

	Year ended December 31,						Increase/ (Decrease)					Year ended December 31,						Increase/ (Decrease)
	2004			2003			in Dollars			in Percent -age		2003			2002			in Dollars		in Percent -age
Operating expenses:
Marketing and selling	$	314,463		$	238,765		$	75,698		32	%	$	238,765		$	193,775		$	44,990	23	%
Research and development		73,469			55,608			17,861		32	%		55,608			42,246			13,362	32	%
General and administrative		55,987			40,000			15,987		40	%		40,000			32,407			7,593	23	%
Stock-based compensation		821			5,992			(5,171	)	(86	)%		5,992			1,163			4,829	415	%
Acquisition-related charges		900			11,968			(11,068	)	(92	)%		11,968			—			11,968	*	%
Restructuring, integration, and other related charges		3,088			3,389			(301	)	(9	)%		3,389			(537	)		3,926	731	%
Amortization of intangible assets		5,544			2,281			3,263		143	%		2,281			542			1,739	321	%
Excess facilities charge		8,943			16,882			(7,939	)	(47	)%		16,882			—			16,882	*	%
Total operating expenses	$	463,215		$	374,885		$	88,330		24	%	$	374,885		$	269,596		$	105,289	39	%
Percentage of total revenues		67	%		73	%							73	%		67	%

* Percentage is not meaningful.

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Marketing and selling

Marketing and selling expense consists of employee salaries and the related costs, sales commissions, marketing programs, sales training, campaigns, allocated facility expenses, and allocated IT infrastructure expenses.

The increase in marketing and selling expense for the year ended December 31, 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 an increase in consulting fees for recruiting activities and other business development activities. 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 primarily due to the lease for our new headquarters. The increase in the spending on marketing programs was primarily related to an increase in marketing research and brand building campaigns. Personnel-related costs and commission expense increased by $35.8 million and $21.5 million, respectively, of which personnel-related costs of $8.8 million and commission expense of $3.9 million were related to Kintana employees who joined us as part of that acquisition in 2003. In addition, consulting fees, spending on marketing programs, and sales training fees increased by $3.7 million, $2.8 million, and $1.0 million, respectively. Allocated IT infrastructure expenses and allocated facility expenses increased by $4.9 million and $3.5 million, respectively. We expect marketing and selling expense to continue to increase in absolute dollars for 2005.

The increase in marketing and selling expense for the year ended December 31, 2003 was primarily attributable to an increase of $30.5 million in personnel-related costs due to an increased number of employees and an increase of $3.7 million in commission expense due to an increase in sales revenue and the number of sales employees. This increase included personnel-related costs of $4.2 million and commission expenses of $1.0 million related to Kintana employees who joined us as part of that acquisition. The increase was also attributable to an increase of $5.5 million in marketing programs to promote our BTO initiative through a number of campaigns, an increase of $2.9 million in allocated IT infrastructure expenses, a severance charge of $1.5 million, and an increase of $1.0 million in professional services. The severance charge of $1.5 million was related to accrued salaries and bonuses for a former executive officer. In December 2003, we entered into a severance agreement with a former executive officer. In accordance with the agreement, he is entitled to salary and bonus through October 3, 2005. We also modified the terms of certain options granted to this former officer (see further discussion under stock-based compensation below). These increases were partially offset by a decrease of $0.9 million in allocated facility expenses due to a slight decrease in the headcount percentage in marketing and selling department relative to our total employees in 2003.

Research and development

Research and development expense consists of employee salaries and the 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.

The increase in research and development expense for the year end December 31, 2004 was primarily attributable to higher personnel-related costs of $10.6 million as a result of growth in headcount, of which $5.8 million was related to Kintana employees who joined us as part of that acquisition in 2003. The increase was also attributable to higher allocated IT infrastructure expenses of $2.2 million, higher allocated facility expenses of $2.0 million, and higher consulting fees for research and development projects of $0.7 million. Facility expenses and IT infrastructure expenses increased primarily due to the lease for our new headquarters. The increase was also attributable to a $1.0 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 upon our product development plan, we expect research and development expense to continue to increase in absolute dollars for 2005.

The increase in research and development expense for the year ended December 31, 2003 was primarily attributable to an increase of $9.8 million in personnel-related costs due to an increased number of employees, of

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which $3.0 million was related to Kintana employees who joined us as part of that acquisition, an increase of $1.8 million in allocated facility expenses, and an increase of $1.7 million in allocated IT infrastructure expenses. The increase was also attributable to a $1.8 million devaluation of the U.S. dollar to the Israeli Shekel as a substantial portion of our research and development expenses were in Israeli Shekel.

General and administrative

General and administrative expense consists of employee salaries and the related costs associated with administration and management, allocated facility expenses, and IT infrastructure expenses. It also consists of fees for audit, tax, legal, and consulting services primarily for the compliance with Section 404 of the Sarbanes-Oxley Act of 2002.

The increase in general and administrative expenses for the year ended December 31, 2004 was primarily attributable to higher personnel-related costs of $5.4 million as a result of growth in headcount and additional fees for audit, tax, and other consulting services of $6.9 million, of which $3.3 million were fees related to projects for the compliance with Section 404 of the Sarbanes-Oxley Act of 2002. The increase was also attributable to higher allocated facility expenses of $0.9 million and higher allocated IT infrastructure expenses of $0.6 million. Facility expenses and IT infrastructure expenses increased primarily due to the lease for our new headquarters. We expect general and administrative expenses to continue to increase in absolute dollars for 2005 due to a projected increase in headcount and the implementation of a new operational and financial reporting system.

The increase in general and administrative expense for the year ended December 31, 2003 was primarily attributable to an increase of $5.8 million in personnel-related costs due to an increased number of employees, an increase of $1.2 million in professional services due to increased audit, tax and other consulting fees, and an increase of $0.9 million in allocated IT infrastructure expenses.

Stock-based compensation

Stock-based compensation for the year ended December 31, 2004 primarily consisted of amortization of unearned stock-based compensation associated with assumed options from acquisitions of Kintana and Performant in 2003. We expect to record amortization of unearned stock-based compensation of $0.3 million for 2005, $0.2 million for 2006, and less than $0.1 million for 2007.

The increase in stock-based compensation for the year ended December 2003 was primarily attributable to a one-time stock-based compensation charge related to a former executive officer. In December 2003, in connection with a severance agreement with a former executive officer, we 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. As a result of the modification of stock options, we recorded a stock-based compensation charge of $5.1 million based on the fair value of Mercury common stock on the date of the modification. In addition, we recorded amortization of unearned stock-based compensation totaling $0.2 million related to assumed options as a result of the acquisitions of Performant and Kintana in 2003. Amortization of unearned stock-based compensation related to assumed options from the acquisition Freshwater in 2001 was $0.6 million. Unearned stock-based compensation is amortized over the remaining vesting period of the related options on a straight-line basis.

Also, see Note 5 to the consolidated financial statements for additional information regarding the acquisitions completed in 2003 and the unearned stock-based compensation recorded in each acquisition.

Acquisition-related charges

Acquisition-related charges for the year ended December 31, 2004 of $0.9 million were related to acquired in-process research and development (IPR&D) from the acquisition of Appilog in July 2004.

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Acquisition related charges of $12.0 million for the year ended December 31, 2003, were related to acquired in-process research and development from acquisitions of Performant in May 2003 and Kintana in August 2003. We recorded acquired in-process research and development because technological feasibility of Performant’s and Kintana’s in-process technology had not been established and no future alternative uses existed upon the acquisitions. No in-process research and development was recorded in 2002.

The fair value of in-process research and development was determined through the discounted cash flow approach using key assumptions for percentage of completion, future market demand, and product life cycle. Actual results from the purchase acquisitions to date did not have a material adverse impact on our business and operating results. Acquired IPR&D projects from the Appilog, Kintana, and Performant acquisitions were completed as of December 31, 2004.

Also, see Notes 5 and 6 to the consolidated financial statements for additional information regarding the acquisitions completed in 2003 and 2004 and the acquired in-process research and development recorded in each acquisition.

Restructuring, integration, and other related charges

The integration and other related charges for the year ended December 31, 2004 were primarily attributable to a milestone bonus plan associated with 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 as earned. The maximum total payment under the plan is $5.5 million, of which $5.2 million has been paid through December 31, 2004. On July 1, 2004, we completed the acquisition of Appilog. As of December 31, 2004, we had not incurred significant integration costs associated with the Appilog acquisition. We do not expect the integration costs related to the Appilog integration to be significant in future periods. We did not record any restructuring charges in 2004 and 2003.

The integration and other related charges for the year ended December 31, 2003 were primarily due to a charge of $2.8 million related to the milestone bonus plan signed in conjunction with the acquisition of Performant and integration costs of $0.6 million associated with the Kintana acquisition, primarily for employee severance and consulting services.

We did not record any integration costs for the year ended December 31, 2002. We recognized a benefit of $0.5 million for a reversal of cash charges associated with the cancellation of a marketing event for which we were able to use the deposit toward another event during 2002. The charge was originally recorded as part of the restructuring charge in 2001.

Amortization of intangible assets

The increase in amortization of intangible assets for the year ended December 31, 2004 was primarily due to the full year amortization of intangible assets related to the acquisitions of Performant in May 2003 and Kintana in August 2003, the purchase of existing technology in the third quarter of 2003, and the acquisition of a domain name in the fourth quarter of 2003. The increase was also attributable to amortization of expenses associated with intangible assets of $8.9 million acquired from the Appilog acquisition in July 2004.

The increase in amortization of intangible assets for the year ended December 31, 2003 was primarily due to the amortization of intangible assets related to the acquisitions of Performant in May 2003 and Kintana in August 2003, purchase of existing technology in the third quarter of 2003, and the acquisition of a domain name in the fourth quarter of 2003.

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We amortize intangible assets 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.

For the years ended December 31, 2004, 2003 and 2002, $10.0 million, $5.2 million, and $1.8 million, respectively, in intangible assets were amortized to expenses related to our current products. The following table summarizes amortization of intangible assets recorded as cost of revenue for the periods indicated (in thousands):

	Year ended December 31,
	2004		2003		2002
Cost of license and subscription	$	8,882	$	4,808	$	1,833
Cost of maintenance		1,137		381		—
	$	10,019	$	5,189	$	1,833

Future amortization of intangible assets at December 31, 2004 is as follows (in thousands):

Year Ending December 31,
2005	$	15,436
2006		11,764
2007		5,516
2008		4,253
Thereafter		1,483
	$	38,452

Also see Notes 5 and 6 to the consolidated financial statements for additional information regarding the acquisitions completed in 2004 and 2003 and the intangible assets acquired in each acquisition.

Excess facilities charge

Excess facilities charge for the years ended December 31, 2004 and 2003, was $8.9 million and $16.9 million, respectively, were primarily related to the write-down of three vacant buildings we owned in our Sunnyvale headquarters that had been placed for sale. In July 2003, the Board of Directors approved a plan to lease a new headquarters facility and to sell the existing buildings we owned in our Sunnyvale headquarters. In September 2003, as a result of our decision to move to a new headquarters facility and to sell two vacant buildings, we performed an impairment analysis of the vacant buildings. In the third quarter of 2003, we recognized a non-cash charge of $16.9 million to write down the net book value of the two vacant buildings that were held for sale to their appraised market value. We considered the cost to maintain the facilities until sold and sales commissions related to the sale of the buildings when we calculated the charge. On January 30, 2004, we sold the two vacant buildings in Sunnyvale, California at carrying value to a third party for $2.5 million in cash, net of $0.2 million in transaction fees.

In April 2004, we completed the move from one of the two remaining buildings we owned and we placed the vacant building for sale. We recognized a non-cash charge to write down the net book value of the vacant building that was held for sale to it appraised market value. We considered the cost to maintain the facility until sold and sales commissions related to the sale of the building when we calculated the charge. On January 7, 2005, we completed the sale of the third vacant building at carrying value to a third party for $4.9 million in cash, net of $0.3 million in transaction fees. As such, we will not record any additional impairment charge on this vacant building.

Excess facilities charge for the year ended December 31, 2004 was also related to the remaining lease payments for two leased facilities from the Kintana acquisition. In connection with our move into our

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consolidated headquarters, we also vacated two leased facilities from the Kintana acquisition. We recognized a non-cash charge for the remaining lease payments, as well as the associated costs to protect and maintain the leased facilities prior to returning these leased facilities to the lessor. One of these lease agreements expired in September 2004 and the other expires in 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 to these facilities.

Non-operating income (expense)

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

	Year ended December 31,						Increase/ (Decrease)					Year ended December 31,						Increase/ (Decrease)
							in			in								in			in
	2004			2003			Dollars			Percent -age		2003			2002			Dollars			Percent -age
Other income (expenses):
Interest income	$	38,614		$	36,077		$	2,537		7	%	$	36,077		$	35,119		$	958		3	%
Interest expense		(20,292	)		(19,551	)		(741	)	4	%		(19,551	)		(23,370	)		3,819		(16	)%
Other expense, net		(4,837	)		(7,405	)		2,568		(35	)%		(7,405	)		2,747			(10,152	)	(370	)%
Total other income, net	$	13,485		$	9,121		$	4,364		48	%	$	9,121		$	14,496		$	(5,375	)	(37	)%
Percentage of total revenues		2	%		1	%							1	%		3	%

Interest income

The increase in interest income for the year ended December 31, 2004 was attributable to an improvement in the average yields for our investments during 2004 compared to 2003, partially offset by a decrease in cash balances. The increase in interest income for the year ended December 31, 2003 was primarily attributable to an increase in cash balances, offset by a decline in interest rates in 2003 and a reduction of interest income associated with our February 2002 interest rate swap, which was included in interest income until the January and February 2002 swaps were merged into one in November 2002.

Interest expense

Interest expense for the year ended December 31, 2004 and 2003 primarily consisted of interest expense associated with the interest rate swap and the 4.75% Convertible Subordinated Notes due July 2007 (2000 Notes) which we issued in July 2000. The increase in interest expense in 2004 was due to an increase in the London Interbank Offering Rate (LIBOR) associated with our interest rate swap agreement. The decrease in interest expense in 2003 was primarily attributable to a decrease of $2.6 million in interest expense associated with our interest rate swap as a result of lower LIBOR and a change in the interest rate spread between the January 2002 swap and the November 2002 swap. The decrease was also attributable to a full year interest expense of $1.2 million associated with the portion of our 2000 Notes that were retired early in 2002.

In 2002, we entered into an interest rate swap arrangement with Goldman Sachs Capital Markets, L.P. (GSCM). The interest rate swap is designated as an effective hedge of the change in the fair value attributed 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 our 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.

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Also, see Notes 7 and 13 to the consolidated financial statements for additional information regarding our 2000 Notes and the related interest rate swap activities.

Other income (expense), net

Other expense, net primarily consists of net gain or loss on investments in non-consolidated companies and a warrant to purchase common stock of Motive, amortization of debt issuance costs associated with the issuance of our Zero Coupon Convertible Notes due 2008 (2003 Notes) and 2000 Notes, and currency gains or losses. The decrease in other expense, net for the year ended December 31, 2004 was primarily attributable to a decrease of $2.9 million in losses on our investments in privately-held companies and a private equity fund and a realized gain of $0.3 million on the sale of available-for-sale securities. The decrease was partially offset by the full year amortization of debt issuance costs associated with our 2003 Notes issued in April 2003. Additional debt issuance costs related to the 2003 Notes was $0.7 million.

The increase in other expense, net for the year ended December 31, 2003 was attributable to an increase of $1.6 million in amortization of debt issuance costs associated with the issuance of our 2003 Notes. During 2002, we recognized a gain of $11.6 million on early retirement of our 2000 Notes. Since we did not retire any portion of our 2000 or 2003 Notes during 2003, there was no gain associated with early retirement of our Notes to reduce other expense in 2003. The increase in other expense, net was partially offset by a decrease of $1.7 million in foreign exchange losses due to a devaluation of the U.S. dollar, a decrease of $1.4 million in losses on our investments in privately-held companies and a private equity fund, and an unrealized gain of $0.4 million for the initial fair value of the Motive warrant.

The fair value of the Motive warrant was calculated using the Black-Scholes option-pricing model, which requires subjective assumptions including 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. In calculating the loss to be recorded 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 and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months.

Also, see Notes 7 and 13 to the consolidated financial statements for additional information regarding our 2000 and 2003 Notes and the related interest rate swap activities.

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 in 2005 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 years ended December 31, 2004, 2003, and 2002 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 rates 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.

Our effective tax rate decreased in 2004 compared to 2003 primarily due to an increase in the proportion of worldwide income subject to lower tax rates associated with our Israeli tax holiday.

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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, to be amortized to income tax expense in our consolidated statements of operations over eight years, which approximates the period over which the expected benefit is expected to be realized. At December 31, 2004 and 2003, the prepaid tax asset was $15.9 million and $19.1 million, respectively. We are currently evaluating the migration of the economic ownership of the technology acquired from Performant and Kintana to our Israeli subsidiary in 2005. This migration may lead to an increase in our effective tax rate. In the event that we do not migrate the technology, our effective tax rate may also increase due to a greater portion of U.S. source income associated with the technology acquired from Performant and Kintana.

Liquidity and Capital Resources

At December 31, 2004, our principal source of liquidity consisted of $1,138.4 million of cash and investments, compared to $1,233.7 million and $665.2 million at December 31, 2003 and 2002, respectively. The December 31, 2004 balance included $447.5 million of short-term and $508.1 million of long-term investments, compared to $589.4 million and $422.6 million of short-term and $516.3 million and $138.0 million of long-term investments in the December 31, 2003 and 2002 balances, respectively. We invested in high quality financial, government, corporate, and auction rate securities in 2004, 2003, and 2002. The overall decrease in cash and investments from December 31, 2003 was primarily due to cash used in purchase of treasury stock and capital expenditures partially offset by positive cash generated from operating activities and cash received from issuance of common stock under our stock option and employee stock purchase plans. During the year ended December 31, 2004, we generated $212.8 million of cash from operating activities, compared to $180.5 million during the year ended December 31, 2003. The increase in cash from operations during 2004, compared to 2003, was due primarily to an overall growth in our business.

During the year ended December 31, 2004, cash provided by our investing activities was $71.3 million, compared to $724.0 million cash used in investing activities during the year ended December 31, 2003. Cash proceeds from investing activities in 2004 consisted of net proceeds of $152.1 million from transactions related to our marketable securities, the sale of assets and vacant facilities of $2.7 million, and return on investment in one of the privately-held companies of $1.5 million. Cash used for investing activities during the year ended December 31, 2004 primarily consisted of net cash paid for the Appilog acquisition of $49.5 million, including $50.8 million paid in accordance with the acquisition agreement, $0.7 million paid for direct acquisition costs, less $2.0 million cash acquired from Appilog. Cash was also used in the acquisition of property and equipment of $32.7 million and additional investment in a private equity fund of $2.6 million. Cash spent on the acquisition of property and equipment was primarily attributable to leasehold improvements and IT infrastructure for our new headquarters in Mountain View, California and new foreign offices. In addition, we paid $2.2 million in cash to purchase land in Israel in February 2004.

During the year ended December 31, 2004, our financing activities primary consisted of $332.2 million cash used to repurchase 9,675,000 shares of our common stock at an average price of $34.33 per share under the stock repurchase program approved by our Board of Directors on July 27, 2004. In addition, we received $104.0 million cash proceeds from common stock issued under our employee stock option and stock purchase plans.

In June 2003, we entered into a non-exclusive agreement 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 products, which should be generally available in early 2006. The agreement is in effect until December 31, 2006 with the 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 balance of $7.0 million was accelerated and was paid in February 2004. We recorded such payments as prepaid royalties.

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As of December 31, 2004, we are committed to make additional capital contributions to a private equity fund totaling $6.0 million.

We have entered into four irrevocable letters of credit agreements totaling $1.4 million with Wells Fargo & Company (Wells Fargo). Three of the agreements totaling $1.2 million remained outstanding at December 31, 2004. Two of the agreements were related to facility lease agreements assumed by us in conjunction with the acquisition of Kintana in 2003. One of these agreements remains intact and has an automatic annual renewal provision under which the expiration date cannot be extended beyond March 1, 2006 and the other agreement expired in September 2004. A 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. This agreement is automatically extended after January 1, 2005 unless we provide a termination notice to Wells Fargo. At December 31, 2004, no amounts had been drawn on the letters of credit. Wells Fargo is a related party to us as one of the members of Board of Directors is an executive officer of Wells Fargo.

We lease our headquarters facility and 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. In April 2004, we moved from the two Kintana facilities to our new headquarters in Mountain View, California. Future payments for leases with non-cancelable terms, including leases of the two vacant facilities from the Kintana acquisition, are included in the following table.

Future payments due under debt, lease, royalty, and license agreements at December 31, 2004 are as follows (in thousands):

	Due in
	2005		2006		2007		2008		2009		Thereafter		Total
Zero Coupon Senior Convertible Notes due 2008 (2003 Notes)	$	—	$	—	$	—	$	500,000	$	—	$	—	$	500,000
4.75% Convertible Subordinated Notes due 2007 (2000 Notes) (a)		—		—		300,000		—		—		—		300,000
Non-cancelable operating leases		20,532		14,178		10,330		6,700		5,876		21,186		78,802
Royalty and license agreements		2,335		1,615		1,615		160		10		90		5,825
	$	22,867	$	15,793	$	311,945	$	506,860	$	5,886	$	21,276	$	884,627

The above table does not include contractual interest payments on the 2000 Notes.

(a) Assuming we do not retire additional 2000 Notes during 2005 and interest rates stay constant, we estimate that we will make interest payments net of our interest rate swap of approximately $9.8 million during each of 2005 and 2006, and approximately $4.9 million during 2007. The face value of our 2000 Notes differs from our book value. See Note 7 to the consolidated financial statements for a full description of our long-term debt activities and related accounting policy.

As of December 31, 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.

In July 2000, we issued $500.0 million in 4.75% Subordinated Convertible Notes due 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

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approximately $111.25 per share, subject to adjustment under certain conditions. From December 2001 through December 31, 2004, we retired $200.0 million face value of the 2000 Notes. We may redeem the 2000 Notes, in whole or in part, at any time on or after July 1, 2003. If we redeem the 2000 Notes, we will pay accrued interest up to the redemption date. We did not redeem any portion of the 2000 Notes in 2004.

In 2002, we entered into an interest rate swap agreement of $300.0 million with Goldman Sachs Capital Markets, L.P. (GSCM) to hedge the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) of our 2000 Notes. The interest rate swap matures in July 2007. The value of the interest rate swap is determined using various inputs, including forward interest rates, and time to maturity. Under the terms of the swap, we provided 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. Our interest rate swap was recorded as an asset in our consolidated balance sheets as of December 31, 2004 and 2003, but continues to decrease in value as interest rates rise. 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 a liability due to an unfavorable value, we would be obligated to pay to our counterparty the market value of the swap at termination date.

In April 2003, we issued $500.0 million of Zero Coupon Senior Convertible Notes due 2008 in a private offering. The 2003 Notes mature on May 1, 2008, do not bear interest, have a zero yield to maturity and may be converted 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 consolidated financial statements for further details on the conversion provisions for the 2003 Notes.

See Notes 7 and 13 to the consolidated financial statements for additional information regarding the 2000 and 2003 Notes and the related interest rate swap activities.

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, 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.

For the years ended December 31, 2004, 2003, and 2002, our source of funding was mainly from cash generated by our operations and from the issuance of convertible notes. 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.

In addition, we continue to derive a portion of our overall business growth through the growth of our application management product offerings which are primarily offered on a subscription basis. This 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. Our quarterly operating results are affected by 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 in the past expanded the number of offerings structured as subscription contracts. Furthermore, if a perpetual license is sold at the same time as a subscription-based license to the same customer, then the two generally become bundled together and are recognized over the term of the contract. This shift may cause us to experience a decrease or a

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lower rate of growth in recognized revenue, in a given period, as well as continued growth in deferred revenue. Deferred revenue at December 31, 2004 was $414.3 million compared to $280.6 million as of December 31, 2003. Of this increase, $56.2 million was attributable to the increase of subscription fees and $50.7 million was attributable to the increase of maintenance fees. We expect the mix of license to continue to fluctuate.

In the future, we expect cash will continue to be generated from our operations. For the year ending December 31, 2005, we expect to spend approximately $5.0 to $8.0 million on our customer management database and $3.2 million for a license and the related first year maintenance service of a new operational and financial reporting system that we purchased in December 2004. We expect to spend an additional $12.0 to $17.0 million in 2005 for the implementation of this new operational and financial reporting system. Except for cash spent for our customer management database, the license and the related maintenance of the new financial reporting system, we do not expect the level of cash used in investing activities to acquire property and equipment in 2005 to change significantly from 2004. 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. Cash could also be used to repurchase additional equity or retire or redeem additional debt. For example, since the inception of the stock repurchase program on July 27, 2004 through March 4, 2005, cash used to repurchase our common stock under the stock repurchase program was $332.2 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 January 7, 2005, we completed the sale of the vacant building in Sunnyvale, California that was classified as held for sale in April 2004 at carrying value to a third party for $4.9 million in cash, net of $0.3 million in transaction fees.

In February 2005, we entered into a sublease agreement to lease additional buildings at our headquarters in Mountain View, California. The lease begins in May 2005 and July 2005. The agreement expires in March 2013.

In February 2005, we entered into a letter of credit line with Wells Fargo Bank for $5.0 million, of which $2.2 million has been utilized. $1.2 million is related to previously issued letters of credit associated with certain facilities we lease in California and a $1.0 million newly issued letter of credit is related to the new sublease agreement we executed for the additional building leases at our Mountain View headquarters.

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 consolidated 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 assets and intangible assets;

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• valuation of goodwill;

• accounting for income taxes;

• accounting for investments in non-consolidated companies;

• accounting for stock options.

We further discuss these policies as well as the estimates and judgments involved below. In addition, we also have other significant 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. See Note 1 to the consolidated financial statements for the significant accounting policies used in the preparation of the consolidated financial statements.

Revenue recognition

Our revenue recognition policy is detailed in Note 1 to the 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 determine 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 based on our revenue recognition policy.

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. 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

In order 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.

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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, and 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 sales reserve provision. As a percentage of current period revenues, charges against the sales reserves were insignificant in the years ended December 31, 2004, 2003, and 2002. 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 December 31, 2004 and 2003, the provision for sales reserves was $5.2 million and $6.1 million, respectively.

We are required to make significant judgments and estimates in connection with establishing prepaid commissions associated with revenues that will be recognized in future periods. Estimates made by us include the composition of future revenues, timing of revenue recognition and the extent to which sales quotas and commission accelerators are achieved. Commissions are paid to employees in the month after we receive an order. Commissions are calculated as a percentage of the value of an order. We analyze historical commission rates, composition of the future revenues, and the expected timing of revenue recognition related to the commissions earned by our employees. We recognize the commission expense ratably over the same period when the related revenues are recognized. The future revenues and timing of revenue recognition may change significantly from period to period based on our ability to address those items which prevent us from recognizing revenue. As a result, we are required to use estimates. Material differences may result in the amount and timing of our sales commission expense recognized for any period if we make different judgments or use different estimates.

At December 31, 2004 and 2003, prepaid commissions were $33.9 million and $23.4 million, respectively.

Valuation of long-lived assets and other 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:

• 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. During the year ended December 31, 2004, we recorded an impairment charge of $6.7 million associated with the remaining vacant

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building we owned that had been placed for sale. During the year ended December 31, 2003, we recorded an impairment charge of $16.9 million associated with our two vacant buildings we owned. During the year ended December 31, 2002, we did not record any impairment charges on long-lived assets or certain intangible assets. 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 $116.9 million and $118.3 million at December 31, 2004 and 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 in the fourth quarter of 2004, 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 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. To the extent that we are able to continue to reinvest a substantial portion of our profits in lower tax jurisdictions, our tax rate may decrease in the future.

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 entire 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.

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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 fund. 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 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 an investment loss in our consolidated statement of operations. Estimating the fair value of non-marketable equity investments in 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 December 31, 2004, our equity investments in non-consolidated companies were composed of investments in privately-held companies of $4.1 million, a private equity fund of $8.0 million, and a warrant to purchase of common stock of Motive of $0.9 million. At December 31, 2004, our total capital contributions to this private equity fund were $9.0 million. We have committed to make additional capital contributions to this private equity fund up to $6.0 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 year ended December 31, 2004, we recorded losses of $0.5 million on one of our investments in privately-held companies and a loss of $0.6 million on our investment in the private equity fund. The losses for the year ended December 31, 2004 were partially offset by unrealized gains of $0.5 million related to a change in fair value of the Motive warrant. For the year ended December 31, 2003, we recorded losses of $2.4 million, $0.6 million, and $0.5 million on three of our investments in privately-held companies and a loss of $0.4 million on our investment in the private equity fund. The losses on our investments in privately-held companies and private equity fund for the year ended December 31, 2003 were partially offset by an unrealized gain of $0.4 million for the initial value of the Motive warrant. For the year ended December 31, 2002, we recorded losses of $3.4 million, $1.5 million, and $0.4 million on three of our investments in privately-held companies. In calculating the loss to be recorded, we took into account the latest valuation of each of the portfolio companies based on recent sales of equity securities to unrelated third party investors and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months.

The Motive warrant is treated as a derivative instrument due to a net settlement provision and it is recorded at its fair value on each reporting period. We calculate the fair value of the Motive warrant using the Black-Scholes option-pricing model. The option-pricing model requires the input of highly subjective assumptions such as the expected stock price volatility. In June 2004, Motive completed an initial public offering and is listed in

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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 fair market value 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.

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 December 15, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No.123R, Shared-Based Payment, that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. The standard requires public companies to value employee stock options and stock issued under employee stock purchase plans using fair value based method on the option grant date and record it as a stock-based compensation expense. Fair value based model such as the Black-Scholes option-pricing model requires the input of highly subjective assumptions and does not necessarily provide a reliable single measure of the fair value of our stock options. Assumptions used under the Black-Scholes option-pricing model that are highly subjective include the expected stock price volatility and expected life of an option. We currently use the Black-Scholes option-pricing model to calculate the pro forma effect on net income and net income per share if we had applied SFAS No. 123 to employee option grants. (See Note 1 to our consolidated financial statements for the disclosure of the pro forma information for the years ended December 31, 2004, 2003 and 2002, if we had applied SFAS No. 123.) However, the actual impact to our results of operations upon adoption of the new standard could be materially different from the pro forma information included in Note 1 to our consolidated financial statements due to variations in estimates, assumptions, and valuation model used in the calculation. The effective date of the standard is for interim or annual periods beginning after June 15, 2005. Since we currently account for equity awards granted to our employees using the intrinsic value method under APB No. 25, we expect the adoption of SFAS No. 123R will have a significant impact on our financial position and results of operations.

Recent Accounting Pronouncements

In March 2004, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF No. 03-1. 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

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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. In September 2004, the FASB issued a final FASB Staff Position that delays the effective date for the measurement and recognition guidance for all investments within the scope of EITF No. 03-1. We will evaluate the effect of adopting the recognition and measurement guidance when the final consensus is reached. The consensus reached in March 2004 also provided for certain annual disclosure requirements associated with cost method investments that were effective for fiscal years ending after June 15, 2004. We adopted the annual disclosure requirements in 2004.

In June 2004, the EITF reached a consensus on EITF No. 02-14, Whether an Investor Should Apply Equity Method of Accounting to Investments Other Than Common Stock. EITF No. 02-14 states that an investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. EITF No. 02-14 was effective for periods beginning after September 15, 2004. The adoption of EITF No. 02-14 did not have any impact on our consolidated financial position, results of operations, or cash flows.

In September 2004, the EITF reached a consensus on EITF No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share. In accordance with EITF No. 04-8, potential shares issuable under contingently convertible securities with a market price trigger should be accounted for the same way as other convertible securities and included in the diluted earnings per share computation, regardless of whether the market price trigger has been met. Potential shares should be calculated using the if-converted method or the net share settlement method. EITF No. 04-8 was effective for periods ending after December 15, 2004 and should be applied by retroactively adjusting previously reported diluted earnings per share. We adopted EITF No. 04-8 in the fourth quarter of 2004 and have included 9,673,050 shares issuable upon the conversion of our 2003 Notes in the diluted earnings per share computation, unless these shares are deemed to be anti-dilutive. Diluted earnings per share for the years ended December 31, 2003 has been retroactively adjusted to conform to the methodology used for the current period. See Note 7 to the consolidated financial statements for additional information regarding our 2000 and 2003 Notes.

In December 2004, the Financial Accounting Standard Board issued Statement No.123 (revised 2004) (SFAS No. 123R), Shared-Based Payment, that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. The 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 over the service period or the vesting period. The standard also requires public companies to initially measure the cost of liability based service awards based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. We are required to adopt the new standard for interim or annual periods beginning after June 15, 2005. Upon the adoption of SFAS No. 123R, we can elect to recognize stock-based compensation related to employees equity awards in our consolidated statements of operations using fair value based method on a modified prospective basis and disclose the pro forma effect on net income or loss assuming the use of fair value based method in the notes to the consolidated financial statements for periods prior to the adoption. Since we currently account for equity awards granted to our employees using the intrinsic value method under APB No. 25, we expect our adoption of SFAS No. 123R will have a significant impact on our financial position and results of operations.

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Risk Factors

In addition to the other information included in this Annual Report on Form 10-K, 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;

• consolidation of the software industry;

• 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, 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, and order realization;

• our ability to keep a sales force organization with adequate number of sales and services personnel;

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• 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;

• 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;

• the continuing relationships with alliance partners; 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 and application delivery businesses 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 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

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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 may not meet our revenue targets which may adversely affect our operating results. Conversely, if our overall level of orders is below the target level but our license mix is above our targets (if we deliver more-than-expected perpetual licenses), our revenues may still meet or even exceed our revenue targets. 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 may continue in the future in the event that more of our customers license our products on a subscription basis. Furthermore, if a perpetual license is sold at the same time as a subscription based license to the same customer, then the two generally 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 and term based 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, Parasoft, Worksoft, and Segue Software. In the new and rapidly changing market for application management solutions, our principal competitors include BMC Software, Computer Associates, Compuware, HP OpenView (a division of Hewlett-Packard), Keynote Systems, Segue Software, Tivoli (a division of IBM), Wily Technologies, and Veritas. In the market for IT governance solutions, our principal competitors include enterprise application vendors such as SAP AG, Oracle, Lawson, and Compuware (with its acquisition of Changepoint), as well as point tool vendors such as Niku and Primavera.

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

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offerings. For example, our former IT governance competitor, PeopleSoft, was acquired by Oracle, 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. We anticipate the market for our software and services to become increasingly more competitive over time.

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 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 system and process. 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. As a result, we have

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licensed software from SAP AG and have begun a process to expand and upgrade our operational and financial systems. Any delay in the implementation of, or disruption in the transition to, our new or enhanced systems, procedures or controls, could harm our ability to accurately forecast sales demand, manage our supply chain, achieve accuracy in the conversion of electronic data and record and report financial and management information on a timely and accurate basis. In addition, as we add additional functionality, new problems could arise that we have not foreseen. Such problems could adversely impact our ability to do the following in a timely manner: provide quotes; take customer orders; ship products; provide services and support to our customers; bill and track our customers; fulfill contractual obligations; and otherwise run our business. Failure to properly or adequately address these issues could result in the diversion of management’s attention and resources, impact our ability to manage our business and our results of operations, cash flows, and stock price could be negatively impacted.

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, in addition to 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 and even in the last few days 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 revenues were 38%, 36%, and 34% for the years ended December 31, 2004, 2003, and 2002, respectively. We face risks associated with our international operations, including:

• changes in tax laws and regulatory requirements;

• difficulties in staffing and managing foreign operations;

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• 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;

• 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 are currently evaluating the migration of the economic ownership of the technology acquired from Performant and Kintana to our Israeli subsidiary in 2005. The migration may lead to an increase in our effective tax rate. In the event that we do not migrate the technology, our effective tax rate may also increase due to a greater portion of U.S. source income associated with the technology acquired from Performant and Kintana.

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

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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, Poland, 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 and deferred revenue, as we generate sales 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.

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 approximate the intercompany balances. 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. 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 be negatively impacted.

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;

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• 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.

Future changes in financial accounting standards may adversely affect our reports results of operations.    For example, under the newly-issued Statement of Financial Accounting Standards No.123 (revised 2004) (SFAS No. 123R), Shared-Based Payment, we will be required to account for equity under our stock plans using fair value based model on the option grant date and record it as a stock-based compensation expense. Our net income and our earnings per share will be significantly reduced or may reflect a loss. 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 consolidated financial statements for the years ended December 31, 2004, 2003, and 2002. A fair value based model such as the Black-Scholes option-pricing model requires the input of highly subjective assumptions and does not necessarily provide a reliable single measure of the fair value of our stock options. Assumptions used under the Black-Scholes option-pricing model that are highly subjective include the expected stock price volatility and expected life of an option. SFAS No. 123R requires us to adopt the new accounting provisions beginning in our third quarter of 2005, and will require us to expense shares issued under employee stock purchase plans and stock options as a stock-based compensation expense using a fair value based model.

Investments may become impaired and require us to take a charge against earnings.    At December 31, 2004, our equity investments in non-consolidated companies were composed of investments in privately-held companies of $4.1 million, a private equity fund of $8.0 million and a warrant to purchase common stock of Motive of $0.9 million. At December 31, 2004, our total capital contributions to this private equity fund were $9.0 million. We have committed to make additional capital contributions to this private equity fund up to $6.0 million in the future. We may be required to incur charges for the impairment of value of our investments. For the year ended December 31, 2004, we recorded losses of $0.5 million on one of our investments in privately-held companies and a loss of $0.6 million on our investment in the private equity fund. Unrealized gain related to a change in fair value of the Motive warrant was $0.5 million for the year ended December 31, 2004. For the year ended December 31, 2003, we recorded losses of $2.4 million, $0.6 million, and $0.5 million on three of our investments in privately-held companies, and a loss of $0.4 million on our investment in the private equity fund. The losses on our investments in privately-held companies and private equity fund for the year ended December 31, 2003 were partially offset by an unrealized gain of $0.4 million for the initial value of the Motive warrant. For the year ended December 31, 2002, we recorded losses of $3.4 million, $1.5 million and $0.4 million on three 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 and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months. 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

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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 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.

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

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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 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 and operational results.    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 December 31, 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. 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.

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In addition, 9,673,050 shares issuable upon the conversion of our 2003 Notes are included in our diluted net income per share calculation upon the adoption of Emerging Issues Task Force No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share in the fourth quarter of 2004. As required by EITF No. 04-8, we also retroactively adjusted previously reported diluted earnings per share.

Finally, our stock repurchase program was approved by the Board of Directors on July 27, 2004, which permits us to repurchase up to $400.0 million of our common stock may leave us with less cash to repay our 2000 Notes and 2003 Notes. Since inception of the stock repurchase program through March 4, 2005, we have repurchased 9,675,000 shares of our common stock at an average price of $34.33 per share for an aggregate purchase price of $332.2 million.

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 although the economy and business conditions appear to be improving, customers may continue 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, 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 February 18, 2005, the closing sale prices of our common stock as reported on the NASDAQ National Market ranged from a high of $50.60 to a low of $32.36. 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 and/or quarterly guidance;

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

• announcements by us or our competitors relating to strategic relationships, acquisitions or investments;

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

• changes in general economic conditions;

• consolidation in the software industry;

• 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

49

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.

Item 7A. 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. We have classified all of our debt securities investments as either held-to-maturity or available-for-sale. Marketable equity securities are classified as short-term investments. At December 31, 2004, we did not hold any marketable equity securities. At December 31, 2004, $182.9 million, or 16.1% of our cash, cash equivalents, and investment portfolio have original maturities of less than 90 days, and an additional $447.5 million, or 39.3% of our cash, cash investment portfolio had original maturities of less than one year. All debt securities classified as held-to-maturity investments mature in less than three years from the date of purchase as required by our policy. From time to time, we also invest in auction rate securities, which we classify as available-for-sale investments. Information about our investment portfolio in debt securities is presented in the table below which states notional amounts and the related weighted-average interest rates. Amounts represent contractual maturities from the reporting date to the dates shown below for each of the twelve-month periods (in thousands):

	December 31,
	2005			2006			2007 and thereafter			Total			Fair Value
Investments maturing within 30 days at December 31, 2004:
Fixed rate	$	212,620		$	—		$	—		$	212,620		$	212,620
Weighted average rate		2.30	%		—			—			2.30	%		—
Investments maturing 30 days after December 31, 2004:
Fixed rate	$	228,620		$	223,576		$	399,669		$	851,865		$	849,021
Weighted average rate		2.21	%		2.57	%		1.74	%		2.08	%		—
Total investments	$	441,240		$	223,576		$	399,669		$	1,064,485		$	1,061,641
Weighted average rate		2.25	%		2.57	%		1.74	%		2.13	%		—

Our long-term investments include $532.2 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 December 31, 2004 was $301.5 million while the face value and book value was $300.0 million and $304.5 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 December 31, 2004 was $525.2 million while the face value and the book value was $500.0 million. See Note 7 to the consolidated financial statements for transactions regarding our 2000 and 2003 Notes.

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In January and February, 2002, we entered into two interest rate swaps with respect to $300.0 million of our 2000 Notes. In November 2002, we merged the two 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 maturing 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. Under the terms of the swap, we provided 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. Our interest rate swap was recorded as an asset in our consolidated balance sheets as of December 31, 2004 and 2003, but continues to decrease in value as interest rates rise. 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 was a liability due to an unfavorable value, we would be obligated to pay to our counterparty the market value of the swap at the termination date.

We classified the initial collateral and will classify any additional collateral as restricted cash in 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 obligations under the swap are guaranteed by the Goldman Sachs Group L.P.

Also, see Notes 7 and 13 to the 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, Poland, 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 $31.2 million and $31.5 million at December 31, 2004 and 2003, respectively. The forward contracts in effect at December 31, 2004 matured on January 31, 2005 and were hedges of certain foreign currency exposures in the Australian Dollar, British Pound, Danish Kroner, Euro, Indian Rupee, Japanese Yen, Korean Won, Norwegian Kroner, South African Rand, Swedish Kroner, and Swiss Franc.

51

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 $23.7 million and $42.6 million at December 31, 2004 and 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 revaluation of intercompany balances and non-functional currency balances. Net gains or losses on forward contracts and the underlying balances 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 make equity investments in public companies, privately-held companies, and private equity funds for business and strategic purposes. At December 31, 2004, our investments in privately-held companies and a private equity fund were $4.1 million and $8.0 million respectively. Through December 31, 2004, we made capital contributions to the private equity fund totaling $9.0 million and we have committed to pay up to $6.0 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. The 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 year ended December 31, 2004, we recorded losses of $0.5 million on one of our investments in privately-held companies and a loss of $0.6 million on our investment in the private equity fund. For the year ended December 31, 2003, we recorded losses of $2.4 million, $0.6 million, and $0.5 million on three of our investments in privately-held companies and a loss of $0.4 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 new unrelated third party investors, and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months.

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 $0.9 million and $0.4 million as of December 31, 2004 and 2003, respectively.

Item 8. Financial Statements and Supplementary Data

Financial statements required pursuant to this Item are presented beginning on page 63 of this report.

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

None.

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Item 9A. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act). Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Our management, including our CEO and CFO, conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2004. In making our evaluation, we used the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework.

Based on our evaluation, under the framework set forth by the COSO in Internal Control—Integrated Framework, we concluded that, as of December 31, 2004, our internal control over financial reporting was effective. Our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report on page 63.

Our management, including our CEO and CFO, acknowledge that because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal controls over financial reporting during the quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect our internal controls over financial reporting.

Item 9B. Other Information

None.

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PART III

Certain information required by Part III is omitted from this Annual Report on Form 10-K because we will file a definitive proxy statement within 120 days after the end of our fiscal year pursuant to Regulation 14A for our annual meeting of stockholders, currently scheduled for May 19, 2005, and the information included in the proxy statement is incorporated herein by reference.

Item 10. Directors and Executive Officers of the Registrant

Our executive officers as of February 28, 2005 are as follows:

Name	Age	Position
Amnon Landan	46	Chief Executive Officer and Chairman of the Board of Directors
Anthony Zingale	49	President, Chief Operating Officer, and Director
Douglas P. Smith	53	Executive Vice President and Chief Financial Officer
James Larson	46	Senior Vice President of Worldwide Field Operations
David Murphy	42	Senior Vice President, Corporate Development and Business Transformation
Yuval Scarlat	41	Senior Vice President, Products
Bryan J. LeBlanc	38	Vice President, Finance and Operations
Susan J. Skaer	41	Vice President, General Counsel and Secretary

Mr. Amnon Landan has served as our Chief Executive Officer since February 1997 and as our President from February 1997 to December 2004, has served as Chairman of the Board of Directors since July 1999, and has been a director since February 1996. From October 1995 to January 1997, he served as President, and from March 1995 to September 1995, he served as President of North American Operations. He served as Chief Operating Officer from August 1993 until March 1995. From December 1992 to August 1993, he served as our Vice President of Operations and from June 1991 to December 1992, he served as Vice President of Research and Development. From November 1989 to June 1991, he served with us in various technical positions.

Mr. Anthony Zingale joined us as our President and Chief Operating Officer on December 1, 2004 and has been a member of our Board of Directors since July 2002. Mr. Zingale was retired from April 2001 to November 2004. Prior to joining us, he served as the President and Chief Executive Officer of Clarify, a publicly traded enterprise technology company that was a leader in the customer relationship management market from March 1998 until it was acquired by Nortel Networks, Inc. in March 2000. Following the acquisition, he served as President of Nortel’s billion-dollar eBusiness Solutions Group from March 2000 to March 2001. From 1989 to December 1997 Mr. Zingale held various executive management positions at Cadence Design Systems, Inc., a leading supplier of electronic design products and services, leading to his role as Senior Vice President of Worldwide Marketing.

Mr. Douglas Smith has served as our Executive Vice President and Chief Financial Officer since November 2001. He served as our Executive Vice President of Corporate Development from May 2000 until November 2001. From September 1996 to May 2000, he served in various positions with Hambrecht & Quist, most recently as Managing Director and co-head of the Internet Group. From September 1994 to September 1996, he was the Chief Financial Officer and Executive Vice President of Strategy for ComputerVision Corporation.

Mr. James Larson has served as our Senior Vice President of Worldwide Field Operations since January 2005. From March 2004 to December 2004, Mr. Larson served as Vice President of Americas’ Field Operations and from July 2000 to February 2004, he served as Vice President, Americas’ Sales. From October 1998 to December 1999 Mr. Larson was Vice President, Western Area and from January 2000 to June 2000 he was Vice President, U.S. Sales, PGP Security Division for Network Associates. Prior to that Mr. Larson held various sales and management positions at various technology companies, including Siebel Systems and Oracle.

Mr. David Murphy has served as our Senior Vice President, Corporate Development and Business Transformation since January 2005, and from January 2003 to December 2004 he served as our Vice President of

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Corporation Development and Business Transformation. From May 2001 to December 2002, he was President and Chief Executive Officer of Asera, a provider of business process enterprise solutions. Before joining Asera, from March 1998 to May 2001 Mr. Murphy was President and General Manager of Tivoli Systems at IBM, a division of IBM, and leading provider of systems management solutions. Prior to joining Tivoli, he was head of the private equity investments group at Perot Systems and a partner at McKinsey & Company.

Mr. Yuval Scarlat has served as our Senior Vice President, Products since January 2005 and from January 2004 to December 2004 he served as our Vice President of Products. From January 2002 to January 2004, he was Vice President and General Manager of Testing & Deployment. From January 2000 to January 2002, he served as our President of Managed Services. From July 1996 to December 2000, he served as our Vice President of Technical Services. From 1990 to July 1996, he served with us in various technical and marketing positions.

Mr. Bryan LeBlanc has served as our Vice President, Finance and Operations since March 2004 and from May 2002 to February 2004 he served as our Vice President of Finance. Prior to joining the company, he served as Executive Vice President and Chief Financial Officer for inSilicon Inc., a software company developing intellectual property for semiconductor communication, from March 2001 to May 2002. From March 2000 to March 2001, Mr. LeBlanc was Vice President of Finance and Chief Financial Officer of Fogdog, Inc., an online retailer of sports equipment, and from November 1999 to March 2000, he was the Director of Finance of Fogdog. From April 1997 to November 1999, Mr. LeBlanc was the Director of Corporate Finance for Documentum, Inc., an enterprise content management software development company. Prior to that, between 1988 and 1997, he held various financial management positions with Cadence Design Systems, Inc., an electronic design automation software company.

Ms. Susan Skaer has served as our Vice President, General Counsel and Secretary since November 2000. From October 1996 to November 2000, Ms. Skaer was a partner with the law firm GCA Law Partners LLP (formerly General Counsel Associates LLP). From September 1990 to October 1996, Ms. Skaer was an associate with the law firm Wilson Sonsini Goodrich & Rosati.

The information concerning our directors required by this Item is incorporated by reference to our proxy statement under the heading “Election of Directors – Nominees” in our proxy statement.

The information concerning our audit committee financial expert and our audit committee required by this Item is incorporated by reference to our proxy statement under the “Audit Committee” under the heading “Board Structure and Compensation.”

The information concerning compliance with Section 16(a) of the Exchange Act required by this Item is incorporated by reference to our proxy statement under the heading “Section 16(a) Beneficial Ownership Reporting Compliance.”

Our Code of Business Conduct and Ethics (including code of ethics provisions that apply to our principal executive officer, principal financial officer, controller and senior financial officers) is available on our website at www.mercury.com/us/company/ir/corp-governance/ under “Code of Business Conduct and Ethics.” We will post amendments to or waivers from a provision of the Code of Business Conduct and Ethics on our website at www.mercury.com/us/company/ir/corp-governance under “Code of Business Conduct and Ethics.”

Item 11. Executive Compensation

The information required by this Item is incorporated by reference to our proxy statement under the heading “Executive Compensation.”

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Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information regarding securities authorized for issuance under equity compensation plans required by this Item is incorporated by reference to our proxy statement under the heading “Equity Compensation Plan Information.”

The information regarding securities authorized for issuance under equity compensation plans required by this Item is incorporated by reference to our proxy statement under the heading “Equity Compensation Plan Information.”

Item 13. Certain Relationships and Related Transactions

The information required by this Item is incorporated by reference to our proxy statement under the heading “Certain Transactions.”

Item 14. Principal Accountant Fees and Services

The information required by this Item is incorporated by reference to our proxy statement under the heading “Principal Auditor Fees and Services.”

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PART IV

Item 15. Exhibits, Financial Statement Schedules

(a) The following documents are filed as a part of this report:

1. Financial Statements.

The following financial statements of Mercury Interactive Corporation are filed as a part of this report:

	Page
Report of Independent Registered Public Accounting Firm	63
Consolidated Balance Sheets at December 31, 2004 and 2003	65
Consolidated Statements of Operations for the years ended December 31, 2004, 2003, and 2002	66
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2004, 2003, and 2002	67
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003, and 2002	68
Notes to Consolidated Financial Statements	69

2. Schedules

Financial statement schedules not listed above have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.

3. Exhibits

Exhibit Number	Description	Incorporated by Reference
		Form	File No.	Exhibit(s)	Filing Date
3.1	Certificate of Incorporation of Mercury, as amended and restated to date.	S-1	33-68554	3.3	October 29, 1993
3.2	Certificate of Amendment of Restated Certificate of Incorporation dated May 20, 1998.	10Q	000-22350	3.1	November 16, 1998
3.3	Certificate of Amendment of Restated Certificate of Incorporation dated May 26, 1999.	S-3	333-95097	4.1	January 20, 2000
3.4	Certificate of Amendment of Restated Certificate of Incorporation dated May 24, 2000.	10-K	000-22350	3.2	March 29, 2001
3.5	Certificate of Amendment of Restated Certificate of Incorporation dated May 19, 2004.	10-Q	000-22350	3.1	August 9, 2004
3.6	Corrected Certificate of Amendment of Restated Certificate of Incorporation dated June 4, 2004.	10-Q	000-22350	3.2	August 9, 2004
3.7	Amended and Restated Bylaws of Mercury.	10-K	000-22350	3.3	March 5, 2004
10.1*	Form of Directors’ and Officers’ Indemnification Agreement.	10-Q	000-22350	10.2	August 14, 2003

57

Exhibit Number	Description	Incorporated by Reference
		Form	File No.	Exhibit(s)	Filing Date
10.2*	Form of Change of Control Agreement entered into by Mercury with the President of European Operations.	10-K	000-22350	10.26	March 31, 1999
10.3*	Form of Amended and Restated Change of Control Agreement entered into by Mercury with the Chief Financial Officer and certain other officers.	8-K	000-22350	10.2	December 21, 2004
10.4*	Amended and Restated Change of Control Agreement by and between Mercury and Anthony Zingale dated December 15, 2004.	8-K	000-22350	10.3	December 21, 2004
10.5	Preferred Shares Rights Agreement dated July 5, 1996.	8-A12G	000-22350	1	July 9, 1996
10.6	Amendment to Rights Agreement dated March 31, 1999.	8-A12G/A	000-22350	1	April 2, 1999
10.7	Amendment No. Two to Rights Agreement, dated May 19, 2000.	8-A12G/A	000-22350	1	May 22, 2000
10.8	Amendment No. 3 to Preferred Shares Rights Agreement dated April 23, 2003.	10-Q	000-22350	4.3	April 30, 2003
10.9	Purchase and Sale Agreement by and between WHSUM Real Estate Limited Partnership and Mercury dated December 1, 2000.	10-K	000-22350	10.12	March 29, 2001
10.10	Form of Note for Mercury 4.75% Convertible Subordinated Notes due July 1, 2007.	10-Q	000-22350	4.1	August 14, 2000
10.11	Indenture between Mercury, as Issuer and Chase Manhattan Bank and Trust Company, National Association, as Trustee dated July 3, 2000 related to Mercury 4.75% Convertible Subordinated Notes due July 1, 2007.	10-Q	000-22350	4.2	August 14, 2000
10.12	Registration Rights Agreement among Mercury and Goldman, Sachs & Chase Securities Inc. and Deutsche Banc Securities Inc. dated July 3, 2000 related to the Mercury 4.75% Convertible Subordinated Notes due July 1, 2007.	10-Q	000-22350	4.3	August 14, 2000

58

Exhibit Number	Description	Incorporated by Reference
		Form	File No.	Exhibit(s)	Filing Date
10.13	Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated January 17, 2002 (as revised on January 31, 2002), and Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated February 26, 2002.	10-K	000-22350	10.18	March 27, 2002
10.14	Indenture, dated as of April 29, 2003, by and between Mercury Corporation and U.S. Bank National Association related to Zero Coupon Senior Convertible Notes due 2008.	10-Q	000-22350	4.1	April 30, 2003
10.15	Form of Note for the Company’s Zero Coupon Senior Convertible Notes due 2008.	10-Q	000-22350	4.1	April 30, 2003
10.16	Registration Rights Agreement, dated as of April 23, 2003, by and between Mercury Corporation and UBS Warburg LLC related to Zero Coupon Senior Convertible Notes due 2008.	10-Q	000-22350	4.2	April 30, 2003
10.17	Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated November 5, 2002.	10-Q	000-22350	10.1	April 30, 2003
10.18	Agreement and Plan of Merger among Freshwater Software, Inc., Mercury and Aqua Merger Company dated as of May 21, 2001.	10-Q	000-22350	10.1	August 14, 2001
10.19	Agreement and Plan of Merger dated as of June 9, 2003, among Kintana, Inc., Mercury, Kanga Merger Corporation, Kanga Acquisition LLC and Raj Jain as Stockholders’ Representative.	10-Q	000-22350	10.1	August 14, 2003
10.20	Lease Agreement by and between 369 Whisman Associates, L.P. and Mercury, dated as of December 15, 2003.	10-K	000-22350	10.19	March 5, 2004
10.21*	Mercury Long-Term Incentive Plan.	8-K	000-22350	10.1	December 21, 2004
10.22*	401(k) Plan.	S-1	33-68554	10.12	October 29, 1993
10.23*	Amended and Restated 1989 Stock Option Plan.	S-8	333-62125	4.1	August 24, 1998
10.24*	1994 Directors’ Stock Option Plan and Forms of Notice of Grant and Stock Option Agreement.	S-8	33-95178	10.1	July 31, 1995

59

Exhibit Number	Description	Incorporated by Reference
		Form	File No.	Exhibit(s)	Filing Date
10.25*	Amended and Restated 2000 Supplemental Stock Option Plan and Forms of Notice of Grant and Stock Option Agreement.	S-8	333-56316	4.2	February 28, 2001
10.26*	Form of 1998 Employee Stock Purchase Plan and Form of Subscription Agreement.	S-8	333-111915	4.2	January 14, 2004
10.27*	Amended and Restated 1999 Stock Option Plan and Forms of Notice of Grant and Stock Option Agreement.	S-8	333-111915	4.1	January 14, 2004
10.28*	Conduct Ltd. 1998 Share Option Plan.	S-8	333-94837	4.1	January 18, 2000
10.29*	Freshwater Software, Inc. 1997 Stock Plan.	S-8	333-61786	4.1	May 29, 2001
10.30*	Performant, Inc. 2000 Stock Option/Restricted Stock Plan.	S-8	333-106646	4.1	June 30, 2003
10.31*	Kintana, Inc. 1997 Equity Incentive Plan.	S-8	333-108266	4.1	August 27, 2003
10.32*	Chain Link Technologies Limited Company Share Option Scheme.	S-8	333-108266	4.2	August 27, 2003
10.33*	Appilog, Inc. 2003 Stock Option Plan.	S-8	333-117599	4.1	July 23, 2004
10.34*	Letter Agreement by and between Mercury and Kenneth Klein, effective as of December 30, 2003.	10-K	000-22350	10.20	March 5, 2004
10.35*	Employment Agreement dated December 1, 2004 by and between Mercury and Anthony Zingale.	8-K	000-22350	10.1	December 3, 2004
10.36*	Amended and Restated Employment Agreement dated August 28, 2000 by and between Mercury and Douglas Smith.	8-K	000-22350	10.3	December 3, 2004
10.37*‡	Employment Agreement dated February 11, 2005 by and between Mercury and Amnon Landan.
10.38*	Form of Notice of Grant and Stock Option Agreement between Mercury and Anthony Zingale.	8-K	000-22350	10.3	December 3, 2004
10.39*	Form of Notice of Grant and Stock Option Agreement between Mercury and Amnon Landan	8-K	000-22350	10.2	February 9, 2005
10.40*	Form of Notice of Grant and Stock Option Agreement between Mercury and Executive Officers	8-K	000-22350	10.3	February 9, 2005
10.41*	Form of Mercury Long-Term Incentive Plan Participation Notice	8-K	000-22350	10.1	February 9, 2005

60

Exhibit Number	Description	Incorporated by Reference
		Form	File No.	Exhibit(s)	Filing Date
10.42*‡	Amended and Restated Mercury Long-Term Incentive Plan
10.43*‡	Mercury 2005 Annual Executive Incentive Plan
10.44‡	Agreement of Sublease dated February 28, 2005, by and between Netscape Communications Corporation and Mercury
14.1**	Code of Business Conduct and Ethics.
21.1‡	Subsidiaries of Mercury.
23.1‡	Consent of Independent Registered Public Accounting Firm.
	Power of Attorney (see page 62)
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.

* Designates management contract or compensatory plan arrangements required to be filed as an exhibit of this Annual Report on Form 10-K.

** See Item 10, Directors and Executive Officers of Registrant of this Annual Report on Form 10-K.

‡ Filed herewith.

† Furnished herewith.

61

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.

Dated: March 14, 2005

MERCURY INTERACTIVE CORPORATION (Registrant)
By:	/s/    DOUGLAS P. SMITH
	Douglas P. Smith, Executive Vice President and Chief Financial Officer
By:	/s/    BRYAN J. LEBLANC
	Bryan J. LeBlanc Vice President, Finance and Operations Principal Accounting Officer

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints jointly and severally, Amnon Landan, Susan J. Skaer and/or Douglas P. Smith and each one of them, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.

Signature	Title	Date
/s/    AMNON LANDAN         Amnon Landan	Chief Executive Officer (Principal Executive Officer) and Chairman of the Board of Directors	March 14, 2005
/s/    DOUGLAS P. SMITH         Douglas P. Smith	Executive Vice President and Chief Finance Officer (Principal Financial Officer)	March 14, 2005
/s/    BRYAN J. LEBLANC         Bryan J. LeBlanc	Vice President, Finance and Operations (Principal Accounting Officer)	March 14, 2005
/s/    BRAD BOSTON         Brad Boston	Director	March 14, 2005
/s/    IGAL KOHAVI         Igal Kohavi	Director	March 14, 2005
/s/    CLYDE OSTLER         Clyde Ostler	Director	March 14, 2005
/s/    YAIR SHAMIR         Yair Shamir	Director	March 14, 2005
/s/    GIORA YARON         Giora Yaron	Director	March 14, 2005
/s/    ANTHONY ZINGALE         Anthony Zingale	Director	March 14, 2005

62

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Mercury Interactive Corporation:

We have completed an integrated audit of Mercury Interactive Corporation’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements

In our opinion, the consolidated financial statements listed in the index appearing under item 15, present fairly, in all material respects, the financial position of Mercury Interactive Corporation and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 1 to the consolidated financial statements, effective October 1, 2004, the Company changed its method of accounting for contingently convertible equity securities in accordance with Emerging Issues Task Force Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings Per Share.

Internal control over financial reporting

Also, in our opinion, management’s assessment, included in “Management’s Report on Internal Control Over Financial Reporting,” appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in

63

accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/    PRICEWATERHOUSECOOPERS LLP

San Jose, California

March 14, 2005

64

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

	December 31,
	2004			2003
A S S E T S
Current assets:
Cash and cash equivalents	$	182,868		$	127,971
Short-term investments		447,453			589,389
Trade accounts receivable, net of sales reserve of $5,167 and $6,117, respectively		224,011			142,908
Deferred tax assets, net		10,140			442
Prepaid expenses and other assets		85,077			64,043
Total current assets		949,549			924,753
Long-term investments		508,120			516,348
Property and equipment, net		78,415			73,203
Investments in non-consolidated companies		13,031			13,928
Debt issuance costs, net		11,258			14,965
Goodwill		395,439			347,616
Intangible assets, net		38,452			45,126
Restricted cash		6,000			6,000
Interest rate swap		4,832			11,557
Other assets		14,854			17,456
Total assets	$	2,019,950		$	1,970,952
L I A B I L I T I E S  A N D  S T O C K H O L D E R S’  E Q U I T Y
Current liabilities:
Accounts payable	$	20,008		$	17,584
Accrued liabilities		128,997			96,637
Income taxes, net		65,578			63,771
Short-term deferred revenue		312,115			212,716
Total current liabilities		526,698			390,708
Convertible notes		804,483			811,159
Long-term deferred revenue		102,205			67,909
Long-term deferred tax liabilities, net		3,192			266
Other long-term payables, net		2,386			541
Total liabilities		1,438,964			1,270,583
Commitments and contingencies (Notes 8 and 9)
Stockholders’ equity:
Preferred stock: par value $0.002 per share, 5,000 shares authorized; no shares issued and outstanding		—			—
Common stock: par value $0.002 per share, 560,000 shares authorized; 84,990 and 90,481 shares issued and outstanding, respectively		170			181
Additional paid-in capital		599,976			468,150
Treasury stock: at cost; 10,459 shares and 784 shares, respectively		(348,249	)		(16,082	)
Notes receivable from issuance of common stock		(4,173	)		(6,580	)
Unearned stock-based compensation		(608	)		(1,533	)
Accumulated other comprehensive loss		(13,182	)		(6,219	)
Retained earnings		347,052			262,452
Total stockholders’ equity		580,986			700,369
Total liabilities and stockholders’ equity	$	2,019,950		$	1,970,952

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

65

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

	Year ended December 31,
	2004			2003			2002
Revenues:
License fees	$	261,306		$	201,047		$	192,212
Subscription fees		152,064			98,858			53,024
Total product revenues		413,370			299,905			245,236
Maintenance fees		196,141			159,030			122,343
Professional service fees		76,036			47,538			32,543
Total revenues		685,547			506,473			400,122
Costs and expenses:
Cost of license and subscription		40,344			29,056			24,804
Cost of maintenance		15,583			11,880			11,662
Cost of professional services (excluding stock-based compensation)		62,726			36,889			24,334
Cost of revenue - amortization of intangible assets		10,019			5,189			1,833
Marketing and selling (excluding stock-based compensation)		314,463			238,765			193,775
Research and development (excluding stock-based compensation)		73,469			55,608			42,246
General and administrative (excluding stock-based compensation)		55,987			40,000			32,407
Stock-based compensation *		821			5,992			1,163
Acquisition-related charges		900			11,968			—
Restructuring, integration, and other related charges		3,088			3,389			(537	)
Amortization of intangible assets		5,544			2,281			542
Excess facilities charge		8,943			16,882			—
Total costs and expenses		591,887			457,899			332,229
Income from operations		93,660			48,574			67,893
Interest income		38,614			36,077			35,119
Interest expense		(20,292	)		(19,551	)		(23,370	)
Other income (expense), net		(4,837	)		(7,405	)		2,747
Income before provision for income taxes		107,145			57,695			82,389
Provision for income taxes		22,545			16,182			17,185
Net income	$	84,600		$	41,513		$	65,204
Net income per share (basic)	$	0.95		$	0.48		$	0.78
Net income per share (diluted)	$	0.83		$	0.41		$	0.74
Weighted average common shares (basic)		89,060			87,124			83,938
Weighted average common shares and equivalents (diluted)		103,207			102,401			87,640
* Stock-based compensation:
Cost of professional services	$	108		$	53		$	—
Marketing and selling		437			5,609			643
Research and development		255			296			453
General and administrative		21			34			67
	$	821		$	5,992		$	1,163

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

66

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)

	Common stock					Additional paid-in Capital			Treasury stock			Notes receivable from issuance of common stock			Unearned stock-based compensation			Accumulated other comprehensive loss			Retained earnings		Total stockholders’ equity			Comprehensive income
	Shares		Amount
Balance at December 31, 2001	82,849		$	166		$	232,750		$	(16,082	)	$	(11,164	)	$	(4,795	)	$	(2,265	)	$	155,735	$	354,345
Amortization of unearned stock-based compensation	—			—			—			—			—			1,163			—			—		1,163
Reversal of unearned stock-based compensation	—			—			(2,336	)		—			—			2,336			—			—		—
Collection of notes receivable	—			—			—			—			878			—			—			—		878
Stock issued under stock option and employee stock purchase plans	1,845			3			23,804			—			(769	)		—			—			—		23,038
Currency translation adjustments	—			—			—			—			—			—			540			—		540		$	540
Net income	—			—			—			—			—			—			—			65,204		65,204			65,204
Balance at December 31, 2002	84,694			169			254,218			(16,082	)		(11,055	)		(1,296	)		(1,725	)		220,939		445,168		$	65,744
Unearned stock-based compensation	—			—			1,571			—			—			(1,571	)		—			—		—
Amortization of stock-based compensation	—			—			—			—			—			787			—			—		787
Stock-based compensation for modification of stock options	—			—			5,205			—			—			—			—			—		5,205
Reversal of unearned stock-based compensation	—			—			(547	)		—			—			547			—			—		—
Tax benefit from stock options	—			—			6,367			—			—			—			—			—		6,367
Collection of notes receivable from officers	—			—			—			—			2,856			—			—			—		2,856
Collection of notes receivable from foreign employees	—			—			—			—			1,330			—			—			—		1,330
Repurchase of shares upon cancellation of notes receivable	(10	)		—			(289	)		—			289			—			—			—		—
Vested stock options assumed in conjunction with Kintana acquisition	—			—			38,325			—			—			—			—			—		38,325
Issuance of stock in conjunction with Kintana acquisition	2,237			5			88,528			—			—			—			—			—		88,533
Stock issued under stock option and employee stock purchase plans	3,560			7			74,772			—			—			—			—			—		74,779
Currency translation adjustments	—			—			—			—			—			—			(4,494	)		—		(4,494	)	$	(4,494	)
Net income	—			—			—			—			—			—			—			41,513		41,513			41,513
Balance at December 31, 2003	90,481			181			468,150			(16,082	)		(6,580	)		(1,533	)		(6,219	)		262,452		700,369		$	37,019
Amortization of stock-based compensation	—			—			—			—			—			686			—			—		686
Stock-based compensation for modification of stock options	—			—			135			—			—			—			—			—		135
Reversal of unearned stock-based compensation	—			—			(239	)		—			—			239			—			—		—
Tax benefit from stock options	—			—			17,964			—			—			—			—			—		17,964
Collection of notes receivable from foreign employees	—			—			—			—			1,689			—			—			—		1,689
Repurchase of shares upon cancellation of notes receivable	(12	)		—			(718	)		—			718			—			—			—		—
Purchase of treasury stock	(9,675	)		(19	)		—			(332,167	)		—			—			—			—		(332,186	)
Vested stock options assumed in conjunction with Appilog acquisition	—			—			10,401			—			—			—			—			—		10,401
Stock issued under stock option and employee stock purchase plans	4,196			8			104,283			—			—			—			—			—		104,291
Currency translation adjustments	—			—			—			—			—			—			(6,963	)		—		(6,963	)	$	(6,963	)
Net income	—			—			—			—			—			—			—			84,600		84,600			84,600
Balance at December 31, 2004	84,990		$	170		$	599,976		$	(348,249	)	$	(4,173	)	$	(608	)	$	(13,182	)	$	347,052	$	580,986		$	77,637

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

67

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

	Year ended December 31,
	2004			2003			2002
Cash flows from operating activities:
Net income	$	84,600		$	41,513		$	65,204
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		21,697			17,869			14,704
Sales reserve		1,873			1,193			3,342
Unrealized (gain) loss on interest rate swap		51			8			(406	)
Amortization of intangible assets		15,563			7,470			2,375
Stock-based compensation		821			5,992			1,163
Gain on early retirement of debt		—			—			(11,610	)
Loss on investments in non-consolidated companies		1,138			3,959			5,296
Loss on disposals of assets		454			—			—
Gain on sale of available-for-sale securities		(336	)		—			—
Unrealized gain on warrant		(502	)		(435	)		—
Write-off of in-process research and development		900			11,968			—
Excess facilities charge		8,943			16,882			—
Tax benefit from employee stock options		17,964			6,367			—
Deferred income taxes		(7,214	)		13,517			(6,595	)
Changes in assets and liabilities, net of effect of acquisitions:
Trade accounts receivable		(76,787	)		(40,878	)		(28,288	)
Prepaid expenses and other assets		(14,350	)		(20,808	)		(27,498	)
Accounts payable		1,152			3,167			(451	)
Accrued liabilities		23,142			12,927			11,443
Income taxes		5,216			(12,681	)		38,492
Deferred revenue		126,627			111,944			65,002
Other long-term payables		1,845			541			—
Net cash provided by operating activities		212,797			180,515			132,173
Cash flows from investing activities:
Maturities of investments		544,135			453,142			382,261
Purchases of held-to-maturity investments		(481,887	)		(809,395	)		(303,427	)
Increase in restricted cash		—			—			(6,000	)
Proceeds from sale of available-for-sale investments		1,124,255			1,498,549			637,635
Purchases of available-for-sale investments		(1,034,438	)		(1,687,095	)		(871,973	)
Proceeds from return on investment in non-consolidated company		1,525			—			—
Purchases of investments in non-consolidated companies		(2,625	)		(1,500	)		(2,244	)
Cash paid in conjunction with the acquisition of Performant, net		—			(22,028	)		—
Cash paid in conjunction with the acquisition of Kintana, net		(163	)		(136,653	)		—
Cash paid in conjunction with a technology purchase from Allerez		—			(1,270	)		—
Cash paid in conjunction with a domain name purchase		—			(650	)		—
Cash paid in conjunction with the acquisition of Appilog, net		(49,543	)		—			—
Net proceeds from sale of assets and vacant facilities		2,684			—			—
Acquisition of property and equipment, net		(32,684	)		(17,093	)		(8,164	)
Net cash provided by (used in) investing activities		71,259			(723,993	)		(171,912	)
Cash flows from financing activities:
Proceeds from issuance of convertible notes, net		—			488,056			—
Proceeds from issuance of common stock under stock option and employee stock purchase plans		103,981			74,779			23,038
Purchase of treasury stock		(332,186	)		—			—
Retirement of convertible subordinated notes		—			—			(64,640	)
Collection of notes receivable from issuance of common stock		1,689			4,186			878
Net cash provided by (used in) financing activities		(226,516	)		567,021			(40,724	)
Effect of exchange rate changes on cash		(2,643	)		(194	)		1,287
Net increase (decrease) in cash and cash equivalents		54,897			23,349			(79,176	)
Cash and cash equivalents at beginning of year		127,971			104,622			183,798
Cash and cash equivalents at end of period	$	182,868		$	127,971		$	104,622

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

68

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1—OUR SIGNIFICANT ACCOUNTING POLICIES

We were incorporated in 1989 and began shipping testing products in 1991. Since 1991, we have introduced a variety of software products and services for Business Technology Optimization (BTO) including application delivery and application management. With our acquisition of Kintana in August 2003, we commenced sales of Information Technology (IT) governance products. Our software products and services for BTO help customers maximize the business value of IT by optimizing application quality and performance as well as managing IT costs, risks, and compliance.

In July 2004, we acquired Appilog, Inc. In May and August of 2003, we acquired Performant, Inc. and Kintana, Inc., respectively. These transactions were accounted for as purchases, and accordingly, the operating results Performant, Kintana, and Appilog have been included in our consolidated financial statements since the date of the acquisitions. See Note 5 for a full description of the acquisitions.

Basis of presentation

We have wholly-owned sales subsidiaries in the Americas; Europe, the Middle East and Africa (EMEA); Asia Pacific (APAC); and Japan for marketing, distribution and support of products and services. The Americas includes Brazil, Canada, Mexico, and the United States of America (the U.S.). EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, Poland, South Africa, Spain, Sweden, Switzerland, and the United Kingdom (the U.K.). APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. Research and development activities are primarily conducted in our Israel subsidiary. The consolidated financial statements include our accounts and those of our wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Use of estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Foreign currency translation

In preparing our consolidated financial statements, we are required to translate the financial statements of the foreign subsidiaries from the functional currency, generally the local currency, into U.S. dollars, the reporting currency. This process results in exchange gains or losses which, under the relevant accounting guidance are either included within the consolidated statements of operations or as a separate part of our net equity under the caption “Accumulated other comprehensive loss.” If any subsidiary’s functional currency is deemed to be the local currency, then any gain or loss associated with the translation of that subsidiary’s financial statements is reflected as cumulative translation adjustments included in accumulated other comprehensive income (loss). However, if the functional currency is deemed to be the U.S. dollar, any gain or loss associated with the translation of these financial statements is recorded as “Other income (expense), net” in our consolidated statements of operations.

The functional currency of our subsidiary in Israel is the U.S. dollar. Assets and liabilities in Israel are translated at year-end exchange rates, except for property and equipment, which is translated at historical rates. Revenues and expenses are translated at average exchange rates in effect during the year. Foreign currency translation gains or losses are included in the consolidated statements of operations. See Note 2 for foreign currency translation gains or losses recognized in 2004, 2003, and 2002.

69

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The functional currencies of all other subsidiaries are the local currencies. Accordingly, all assets and liabilities of these subsidiaries are translated at the current exchange rate at the end of the period and revenues and expenses at average exchange rates in effect during the period. The gains or losses from translation of these subsidiaries’ financial statements are recorded as accumulated other comprehensive income or loss and included as a separate component of stockholders’ equity.

Derivative financial instruments

We enter into derivative financial instrument contracts to hedge certain foreign exchange and interest rate exposures in accordance with Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities and SFAS No. 149, Amendment of Statement 133 on Derivative Instruments Hedging Activities.

Under SFAS No. 133, as amended, we are required to recognize all derivatives on the consolidated balance sheets at fair value. Derivatives that are not hedges must be adjusted to fair value through the consolidated 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. See Note 13 for a full description of our derivative financial instruments and related accounting policies.

Cash and cash equivalents

We consider all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.

Short-term and long-term investments

We have categorized our debt securities as either held-to-maturity or available-for-sale investments in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. We classify all held-to-maturity securities with remaining maturities of less than one year to be short-term investments and all held-to-maturity securities with remaining maturities greater than one year to be long-term investments. As required by our policy, debt securities categorized as held-to-maturity have contractual maturities of less than three years and are stated at amortized cost. We categorize auction rate securities as available-for-sale short-term investments. Auction rate securities are reported at cost, which approximates fair market value due to the interest rate reset feature of these securities. As such, no unrealized gains or losses related to these securities were recognized during the years ended December 31, 2004, 2003, and 2002. Gross realized gains and losses on sales of available-for-sale debt securities were not material for the years ended December 31, 2004, 2003, and 2002. The cost of securities sold is based on the specific identification method. See “Reclassifications” in Note 1 for information regarding prior period adjustments to the classification of auction rate securities.

We review our investments in debt securities for potential impairment on a regular basis. As part of the evaluation process, we consider the credit ratings of these securities and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated improvement of the investee financial condition. We will record an impairment loss on investments for any other-than-temporary decline in fair value of these debt securities below their cost basis. For the years ended December 31, 2004, 2003, and 2002, we did not record any impairment losses that were related to other-than-temporary decline in fair value of our debt

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securities. At December 31, 2004, we did not record any unrealized losses on our debt securities related to an impairment determined to be temporary.

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 such gains are realized. At December 31, 2004 and 2003, we did not have any marketable equity securities.

The portfolio of short-term and long-term investments (including cash and cash equivalents) consisted of the following (in thousands):

	December 31,
Available-for-Sale Securities		2004		2003
Auction rate securities	$	371,001	$	519,959
	$	371,001	$	519,959
Held-to-Maturity Securities
Cash and interest bearing demand deposits	$	107,589	$	113,670
Corporate debt securities		127,626		121,489
Municipal and tax-advantaged securities		—		3,000
U.S. treasury and agency securities		532,225		475,590
	$	767,440	$	713,749
Investments in marketable securities	$	1,138,441	$	1,233,708

The portfolio of short-term and long-term investments (including cash balance of $74.0 million) by their contractual maturities as of December 31, 2004 was included in the following captions in the consolidated balance sheet (in thousands):

	December 31,
Available-for-Sale Securities		2005		2006		2007 and thereafter		Total		Fair Value
Investments	$	255,876	$	—	$	115,125	$	371,001	$	371,001
Held-to-Maturity Securities
Cash and cash equivalents	$	182,868	$	—	$	—	$	182,868	$	182,863
Investments		76,452		223,576		284,544		584,572		581,733
	$	259,320	$	223,576	$	284,544	$	767,440	$	764,596

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Concentration of credit risks

Financial instruments, which potentially subject us to concentrations of credit risk, consist principally of cash, cash equivalents, investments, and accounts receivable. We invest primarily in marketable securities and place our investments with high quality financial, government, or corporate institutions. Accounts receivable are derived from sales to customers located primarily in the U.S., EMEA, and APAC. We perform ongoing credit evaluations of our customers and to date have not experienced any material losses. For the years ended December 31, 2004, 2003, and 2002, no customer accounted for more than 10% individually of revenue.

Fair value of financial instruments

The carrying amount of our financial instruments, including cash, cash equivalents, investments, accounts receivable, and accounts payable approximates their respective fair values due to the short maturities of these financial instruments. The fair value of foreign currency forward contracts has been estimated using market quoted rates of foreign currencies at the applicable balance sheet dates. The value of the interest rate swap is determined using various inputs, including forward interest rates and time to maturity. Warrants are valued using the Black-Scholes option-pricing model.

The fair market value of our 4.75% Convertible Subordinated Notes due July 1, 2007 issued in 2000 (2000 Notes) was $301.5 million and $297.4 million at December 31, 2004 and 2003, respectively, based on the quoted market price. The fair market value of our Zero Coupon Senior Convertible Notes due 2008 issued in 2003 (2003 Notes) was $525.2 million and $574.5 million at December 31, 2004 and 2003 based on the quoted market price.

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, 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.

Internal use software

We recognize software development costs in accordance with the Statement of Position (SOP) No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Software development costs, including costs incurred to purchase third party software, are capitalized beginning when we have determined certain factors are present including, among others, that technology exists to achieve the performance requirements, and/or buy versus internal development decisions have been made. Capitalization of software costs ceases when the software is substantially complete, is ready for its intended use, and is amortized over its estimated useful life of generally three years using the straight-line method. At December 31, 2004 and 2003, we have capitalized internal use software of $24.9 million and $16.2 million, respectively. For the years ended December 31, 2004, 2003, and 2002, we incurred amortization expense of $4.8 million, $2.8 million, and $1.9 million, respectively.

When events or circumstances indicate the carrying value of internal use software might not be recoverable, we assess the recoverability of these assets by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is recognized to the extent that the carrying value exceeds the projected discounted future operating cash

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flows and is recognized as a write down of the asset. In addition, when it is no longer probable that computer software being developed will be placed in service, the asset will be recorded at the lower of its carrying value or fair value, if any, less direct selling costs. We did not write down any internal use software during the years ended December 31, 2004, 2003, and 2002.

Software costs

We account for research and development costs in accordance with SFAS No. 86, Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed. Costs incurred in the research and development of new software products are expensed as incurred until technological feasibility is established. Development costs are capitalized beginning when a product’s technological feasibility has been established and ending when the product is available for general release to customers. Technological feasibility is reached when the product reaches the working model stage. To date, products and enhancements have generally reached technological feasibility and have been released for sale at substantially the same time and all research and development costs have been expensed. Consequently, no research and development costs have been capitalized in 2004, 2003, and 2002.

Investments in non-consolidated companies

Investments in non-consolidated companies consist of a warrant to purchase common stock of a publicly traded company, minority equity investments in privately-held companies, and private equity funds. We make these investments for business and strategic purposes. Investments in privately-held companies and private equity funds are accounted for under the cost method, as we do not have the ability to exercise significant influence over these companies’ operations. We record the warrant at its fair value at each reporting date using Black-Scholes option-pricing model because it is considered a derivative instrument under SFAS No. 133. 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 its estimated 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 deemed to be 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 and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months.

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

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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 any impact on our financial position or results of operations.

Goodwill

Goodwill represents the excess of purchase price over fair value of tangible and intangible assets acquired in an acquisition. In January 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets, and as a result, we ceased to amortize goodwill and reclassified certain intangible assets to goodwill. We are also required to perform an impairment review of goodwill on an annual basis or more frequently if circumstances change.

The impairment review involves a two-step process as follows:

• Step 1—We compare the fair value of our reporting units to the carrying value, including goodwill of each of these units. For each reporting unit where the carrying value, including goodwill, exceeded the unit’s fair value, we move on to Step 2. If the unit’s fair value exceeds the carrying value, no further work would be performed and no impairment charge would be necessary.

• Step 2—If we determine in Step 1 that the carrying value of a reporting unit exceeded our fair value, we would perform an allocation of the fair value of the reporting unit to our identifiable tangible and non-goodwill intangible assets and liabilities. This would derive an implied fair value for the reporting unit’s goodwill. We would then compare the implied fair value of the reporting unit’s goodwill with the carrying amount of the reporting unit’s goodwill. If the carrying amount of the reporting unit’s goodwill is greater than the implied fair value of our goodwill, an impairment loss would be recognized for the excess.

Intangible assets

Intangible assets, including purchased technology and other intangible assets, are carried at cost less accumulated amortization. We amortize intangible assets on a straight-line basis over their estimated useful lives. The range of estimated useful lives on our identifiable intangible assets is three months to six years.

Impairment of long-lived assets

We assess the recoverability of long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. The impairment of long-lived assets held for sale is measured at the lower of book value or fair value less cost to sell. The recoverability of long-lived assets held and used is assessed based on the carrying amount of the asset and its fair value, which is generally determined based on the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset, as well as specific appraisal in certain instances. Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction.

We assess the impairment of long-lived assets 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:

• 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;

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• 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.

See Note 3 for excess facilities charges recorded during the years ended December 31, 2004 and 2003. No excess facilities charge was recorded in the year ended December 31, 2002.

Income taxes

We account for income taxes in accordance with the liability method of accounting for income taxes. Under the liability method, deferred assets and liabilities are recognized based upon anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. The provision for income taxes is comprised of the current tax liability and the change in deferred tax assets and liabilities. We have recorded a valuation allowance for the entire portion of the net operating losses related to the income tax benefits arising from the exercise of employees’ stock options.

Treasury stock

We account for treasury stock under the cost method. To date, we have not reissued or retired our treasury stock.

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 was 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. See Note 10 for discussion of unearned stock-based compensation. 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 the Board of Directors. For options granted to our non-employee members of the Board of Directors, we account for the stock-based compensation using intrinsic value method under 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, in accordance with FIN No. 44, Accounting for Certain Transactions Involving Stock Compensation, an interpretation of APB No. 25. 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

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stock-based compensation and amortized over the remaining vesting period of the stock options. During the third quarter of 2003, we recorded a one-time stock-based compensation charge of $0.1 million as we modified original terms of certain options.

Pro forma information regarding net income (loss) and net income (loss) per share is required by SFAS No. 123, as amended by SFAS No. 148. This information is required to be determined as if we had accounted for our employee stock option and employee 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):

	Year ended December 31,
	2004			2003			2002
Net income, as reported	$	84,600		$	41,513		$	65,204
Add:
Stock-based employee compensation expense included in reported net income		821			5,917			1,163
Deduct:
Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(106,889	)		(141,723	)		(122,206	)
Pro forma net loss	$	(21,468	)	$	(94,293	)	$	(55,839	)
Net income per share (basic), as reported	$	0.95		$	0.48		$	0.78
Net loss per share (basic), pro forma	$	(0.24	)	$	(1.08	)	$	(0.67	)
Net income per share (diluted), as reported	$	0.83		$	0.41		$	0.74
Net loss per share (diluted), pro forma	$	(0.24	)	$	(1.08	)	$	(0.67	)

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 August 2004. We estimate the number of shares issuable under the 1998 ESPP based upon actual contributions made by employees for the period from August 16 through December 31, 2004 and the lower of the fair market value of our common stock on August 16 and December 31, 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 are tax effected as stock-based compensation charges associated to these options are generally deductible on our income tax returns. 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 are not tax effected as stock-based compensation charges associated to these options are not deductible on our income tax returns. See Note 11 for assumptions used in the option-pricing model and estimated fair value of employee stock options and shares issued under the 1998 ESPP.

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Comprehensive income (loss)

We comply with SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 requires that all items recognized under accounting standards as components of comprehensive earnings be reported in an annual financial statement that is displayed with the same prominence as other annual financial statements. Comprehensive income has been included in the consolidated statements of stockholders’ equity for all periods presented.

Revenue recognition

Revenue consists of fees for license and subscription licenses of our software products, maintenance fees, and professional service fees. We apply the provisions of 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 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 transaction related sales incentives.

In the second quarter of 2003, we adopted EITF No. 00-21, Revenue Arrangements with Multiple Deliverables. EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue-generating activities. The adoption of this EITF did not have a material impact on our consolidated financial statements and we continue to account for our revenues in accordance with SOP 97-2, Software Revenue Recognition.

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/or 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 or the software is made available for download. At the time of the transaction, we assess whether the fee associated with our revenue transaction 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, 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 the probability of 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 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, consists of license fees to use one or more software products, and to receive maintenance support (such as customer 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 licence 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. Furthermore, if a perpetual license is sold at the same time as a subscription-based license to the same customer, then the two generally become bundled together and are recognized over the term of the contract.

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Maintenance revenue consists of fees charged for post-contract customer support, which are determinable based upon vendor specific evidence of fair value. Maintenance fee arrangements include ongoing customer support and rights to product updates if and when available. 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 evidence of fair value. Professional service revenue is recognized as the professional services are delivered provided all other revenue recognition requirements are met.

For arrangements with multiple elements (for example, 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 substantive renewal rates quoted in the 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 of these services to other customers without the bundling of other elements. 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.

Sales commissions

Commissions are paid to employees in the month after we receive an order. We sell our products under non-cancelable perpetual, subscription, or term contracts. Commissions are calculated as a percentage of the value of an order. Commission rates vary by position, title, and the extent that employees may exceed their quotas. Once earned there is no ongoing performance obligation by the employees. Our policy is that commissions paid to employees are only refundable when we have to write off a customer receivable because it is uncollectible. We have historically enforced this refund right and will continue to enforce this policy in the future.

Prepaid commissions represent deferred cost related to revenues that will be recognized in future periods. We classify such amounts as “Prepaid commissions” in our consolidated balance sheet since the commission expense is directly related to revenues that are partially or entirely deferred in accordance with our revenue recognition policy. We recognize the deferred commission expense because there is future economic benefit in the form of future revenue and we have the ability to recoup or seek restitution for commissions paid within our stated policy.

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, and changes in customer demand, and

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acceptance of our products when evaluating the adequacy of the sales reserve. Revenues for the period are reduced to reflect the sales reserve provision. See Note 2 for a summary of changes in our sales reserve during the years ended December 31, 2004, 2003, and 2002.

Cost of license and subscription, maintenance, and professional services

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, and 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 the related infrastructure, and depreciation expense of managed services equipment. Cost of maintenance includes direct costs of providing product customer support, largely consisting of personnel-related costs, 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 reasonably 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-related costs and outsourcing service costs. License and subscription, maintenance, and professional services costs also include allocated facility expenses and allocated IT infrastructure expenses. Cost of revenue also includes a portion of amortization expenses for intangible assets that are associated to our current products. These amortization expenses were recorded as “Cost of revenue—amortization of intangible assets” in our consolidated income statement. See Note 6 for amortization expenses related to cost of license and subscription and cost of maintenance.

Research and development

Research and development costs are expensed as incurred.

Acquisition-related charges

We expense as incurred all costs associated with in-process research and development (IPR&D), provided that technological feasibility of IPR&D has not been established and no future alternative uses of the technology exist.

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 years ended December 31, 2004, 2003, and 2002, advertising expenses totaled $8.3 million, $9.2 million, and $5.9 million, respectively.

Net income per share

Net income per share is calculated in accordance with the provisions of SFAS No. 128, Earnings per Share and EITF No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share. Under these accounting standards, public companies are required to report both basic and diluted net income per share. Basic net income per share consists of the weighted-average number of common shares outstanding, excluding unvested restricted common stock. Diluted net income per share includes the weighted-average number of common shares outstanding, incremental common stock from assumed exercise of dilutive stock options and unvested restricted common stock, and dilutive common stock issuable upon the conversion of our 2003 Notes as required by EITF 04-8. The inclusion of these shares resulted in a decrease of $0.04 to previously reported diluted earnings per share for the year ended December 31, 2003.

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The following table summarizes our net income per share computations for the years ended December 31, 2004, 2003, and 2002 (in thousands, except per share amounts):

	Income		Shares	Per Share Amount
Year ended December 31, 2004
Basic net income per share:
Net income	$	84,600	89,060	$	0.95
Effect of dilutive securities:
Incremental common shares attributable to shares issuable under employee stock option plans and unvested restricted common stock		—	4,474
Potential common stock issuable upon conversion of the 2003 Notes		1,434	9,673
	$	86,034	103,207	$	0.83
Year ended December 31, 2003
Basic net income per share:
Net income	$	41,513	87,124	$	0.48
Effect of dilutive securities:
Incremental common shares attributable to shares issuable under employee stock option plans and unvested restricted common stock		—	5,604
Potential common stock issuable upon conversion of the 2003 Notes		956	9,673
	$	42,469	102,401	$	0.41
Year ended December 31, 2002
Basic net income per share:
Net income	$	65,204	83,938	$	0.78
Effect of dilutive securities:
Incremental common shares attributable to shares issuable under employee stock option plans and unvested restricted common stock		—	3,702
	$	65,204	87,640	$	0.74

For the years ended December 31, 2004, 2003, and 2002, options to purchase 8,031,000 shares, 8,372,000 shares, and 15,483,000 shares of common stock, respectively, with a weighted average price of $56.92, $55.40, and $44.73, respectively, were considered anti-dilutive because the options’ exercise price was greater than the average fair market value of our common stock for the years then ended. For the years ended December 31, 2004, 2003, and 2002, common stock reserved for issuance upon conversion of the outstanding 2000 Notes for 2,697,000, were not included in diluted earnings per share because the conversion would be anti-dilutive. Upon our adoption of EITF No. 04-8 in the fourth quarter of 2004, 9,673,050 shares issuable from the conversion of the 2003 Notes are included in the diluted net income per share computation, unless these shares are deemed to be anti-dilutive. Diluted share and per share amounts for the year ended December 31, 2003 have been retroactively adjusted to reflect the inclusion of the 9,673,050 shares related to the conversion of our 2003 Notes.

Segment reporting

We comply with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. SFAS No. 131 establishes standards for the manner in which public companies report information about operating segments in annual and interim financial statements. 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,

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application management, and IT governance solutions. Our chief decision makers make financial decisions and allocate resources based on internal management reports with financial information presented by geographic locations. Information related to geographic segments is included in Note 17.

Reclassifications

Certain reclassifications have been made to the December 31, 2003 balances to conform to the December 31, 2004 presentation, namely the netting of deferred tax assets and deferred tax liabilities from the same jurisdiction, netting of short-term deferred tax liabilities with income tax payables, and the reclassification of auction rate securities from cash and cash equivalents and long-term investments to short-term investments. Certain reclassifications have been made to the consolidated statements of operations for the years ended December 31, 2003 and 2002 presentations, namely the reclassification of certain amortization of intangible assets to cost of revenue and interest income to conform to the presentation adopted for the year ended December 31, 2004. These reclassifications had an immaterial impact on the prior reported balances and no impact on total revenues, income from operations, or net income.

In connection with the preparation of this report, we concluded that it was appropriate to classify auction rate securities as short-term investments. These investments had been classified as cash and cash equivalents, short- and long-term investments in our consolidated balance sheets prior to 2004. Accordingly, we have revised the classification of these investments as short-term investments in our consolidated balance sheet as of December 31, 2003. We have also made corresponding adjustments to our consolidated statements of cash flows for the years ended December 31, 2003 and 2002 to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents. This change in classification does not affect previously reported cash flows from operations or from financing activities in our previously reported consolidated statements of cash flows, or our previously reported consolidated statements of operations for any periods.

As of December 31, 2003, prior to this classification adjustment, $421.3 million and $11.0 million of these investments were classified as cash and cash equivalents and long-term investments, respectively, in our consolidated balance sheet. For the year ended December 31, 2003 and 2002, prior to this classification adjustment, net cash used in investing activities related to these investments of $176.8 million and $180.0 million, respectively, were included in cash and cash equivalents in our consolidated statement of cash flows.

Recent accounting pronouncements

In March 2004, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF No. 03-1. 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. In September 2004, the FASB issued a final FASB Staff Position that delays the effective date for the measurement and recognition guidance for all investments within the scope of EITF No. 03-1. We will evaluate the effect of adopting the recognition and measurement guidance when the final consensus is reached. The consensus reached in March 2004 also provided for certain annual disclosure requirements associated with cost method investments that were effective for fiscal years ending after June 15, 2004. We adopted the annual disclosure requirements in 2004.

In June 2004, the EITF reached a consensus on EITF No. 02-14, Whether an Investor Should Apply Equity Method of Accounting to Investments Other Than Common Stock. EITF No. 02-14 states that an investor should

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only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. EITF No. 02-14 was effective for periods beginning after September 15, 2004. The adoption of EITF No. 02-14 did not have any impact on our consolidated financial position, results of operations, or cash flows.

In September 2004, the EITF reached a consensus on EITF No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share. In accordance with EITF No. 04-8, potential shares issuable under contingently convertible securities with a market price trigger should be accounted for the same way as other convertible securities and included in the diluted earnings per share computation, regardless of whether the market price trigger has been met. Potential shares should be calculated using the if-converted method or the net share settlement method. EITF No. 04-8 was effective for periods ending after December 15, 2004 and should be applied by retroactively adjusting previously reported diluted earnings per share. We adopted EITF No. 04-8 in the fourth quarter of 2004 and have included 9,673,050 shares issuable upon the conversion of our 2003 Notes in the diluted earnings per share computation, unless these shares are deemed to be anti-dilutive. Diluted earnings per share for the year ended December 31, 2003 has been retroactively adjusted to conform to the methodology used for the current period. See Note 7 to the consolidated financial statements for additional information regarding our 2000 and 2003 Notes.

In December 2004, the FASB issued SFAS No.123 (revised 2004) (SFAS No. 123R), Shared-Based Payment, that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. The standard requires public companies to value employee stock options and stock issued under employee stock purchase plans using fair value based method on the grant date and record stock-based compensation expense over the service period or the vesting period. The standard also requires public companies to initially measure the cost of liability based service awards based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. We are required to adopt the new standard for interim or annual periods beginning after June 15, 2005. Upon the adoption of SFAS No. 123R, we can elect to recognize stock-based compensation related to employees equity awards in our consolidated statements of operations using fair value based method on a modified prospective basis and disclose the pro forma effect on net income or loss assuming the use of fair value based method in the notes to the consolidated financial statements for periods prior to the adoption. Since we currently account for equity awards granted to our employees using the intrinsic value method under APB No. 25, we expect the adoption of SFAS No. 123R will have a significant impact on our financial position and results of operations.

NOTE 2—FINANCIAL STATEMENT COMPONENTS

	Year Ended December 31,
	2004			2003			2002
	(in thousands)
Sales reserve:
Beginning balance	$	6,117		$	7,431		$	6,334
Increase in sales reserve		1,873			1,193			3,342
Write-off of accounts receivable		(2,843	)		(2,619	)		(2,370	)
Currency translation adjustments		20			112			125
Ending balance	$	5,167		$	6,117		$	7,431

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	December 31,
	2004			2003
	(in thousands)
Property and equipment, net:
Land and buildings	$	44,296		$	55,272
Computers and equipment		43,067			44,668
Internal use software		24,887			16,194
Office furniture and equipment		20,041			13,747
Leasehold improvements		11,320			8,864
		143,611			138,745
Less: Accumulated depreciation and amortization		(68,849	)		(67,378	)
		74,762			71,367
Construction in progress		3,653			1,836
	$	78,415		$	73,203

Depreciation and amortization expense of property and equipment for the three years ended December 31, 2004, 2003, and 2002 was $17.6 million, $14.4 million, and $13.7 million, respectively. For the years ended December 31, 2003, 2002, and 2001, property and equipment acquired under capital leases were insignificant.

	December 31,
	2004		2003
	(in thousands)
Accrued liabilities:
Payroll and related	$	75,049	$	58,144
Interest on convertible subordinated notes		7,125		7,125
Sales tax and related		13,007		9,358
Unfavorable lease liabilities		2,714		4,284
Swap interest expense		1,929		1,174
Other		29,173		16,552
	$	128,997	$	96,637

	Year ended December 31,
	2004			2003			2002
	(in thousands)
Other income (expense), net:
Gain on early retirement of debt	$	—		$	—		$	11,610
Amortization of debt issuance costs		(3,707	)		(3,018	)		(1,562	)
Foreign exchange gains (losses)		85			(214	)		(1,867	)
Gain on sale of available-for-sale securities		336			—			—
Loss on disposals of assets and other		(466	)		(98	)		—
Gain on interest rate swap		—			—			406
Net loss on investments in non-consolidated companies and warrant		(636	)		(3,524	)		(5,296	)
Other		(449	)		(551	)		(544	)
	$	(4,837	)	$	(7,405	)	$	2,747

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NOTE 3—CONSOLIDATION OF FACILITIES

In July 2003, the Board of Directors approved a plan to lease a new headquarters facility and to sell the existing buildings we owned in our Sunnyvale headquarters. In September 2003, as a result of our decision to move to a new headquarters facility and to sell the two vacant buildings, we performed an impairment analysis of the vacant buildings. In the third quarter of 2003, we recognized a non-cash charge of $16.9 million to write down the net book value of the two vacant buildings that were held for sale to their appraised market value. We considered the cost to maintain the facilities until sold and sales commissions related to the sale of the buildings when we calculated the charge. Accordingly, we reclassified these two vacant buildings as assets held for sale. The assets held for sale were included in “Prepaid expenses and other assets” in our consolidated balance sheet as of December 31, 2003. On January 30, 2004, we sold the two vacant buildings in Sunnyvale, California at the carrying value to a third party for $2.5 million in cash, net of $0.2 million in transaction fees.

In April 2004, we completed our move from one of the two remaining buildings. As such, we placed the vacant building we owned for sale. As a result of our move and our decision to sell the vacant building, we recognized a non-cash charge to write down the net book value of the building that is held for sale to its appraised market value. We considered 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. The asset held for sale was included in “Prepaid expenses and other assets” in our consolidated balance sheet as of December 31, 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 recognized a non-cash charge for the remaining lease payments, as well as the associated costs to protect and maintain the leased facilities prior to returning these leased facilities to the lessor. One of these lease agreements expired in September 2004 and the other expires in 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 to these facilities. The total excess facilities charge recorded in 2004 was $8.9 million.

On October 18, 2004, we entered into an agreement with a third party to sell the vacant building that had been previously written down to its fair value. We completed the sale in January 2005 and sold the vacant building to a third party at carrying value. As such, no additional impairment charge will be recorded on this vacant building. See Note 18 for additional information regarding to the sale.

NOTE 4—INVESTMENTS IN NON-CONSOLIDATED COMPANIES

At December 31, 2004, our equity investments in non-consolidated companies were composed of investments in privately-held companies of $4.1 million, a private equity fund of $8.0 million, and a warrant to purchase common stock of Motive, Inc. of $0.9 million. At December 31, 2003, our equity investments in non-consolidated companies were composed of investments in privately-held companies of $7.5 million, a private equity fund of $6.0 million, and the Motive warrant of $0.4 million. Through December 31, 2004, we have made capital contributions to a private equity fund totaling $9.0 million. We have committed to make additional capital contributions up to $6.0 million in the future.

As of December 31, 2004, there were no impairment losses that were considered to be temporary and as such, there were no unrealized losses associated with our investments in privately-held companies and the private equity fund as of such date. Based on our review of the investments in privately-held companies and the private equity fund for the years ended December 31, 2004, 2003, and 2002, impairment losses were considered to be other-than temporary. For the year ended December 31, 2004, we recorded losses of $0.5 million on one of our investments in privately-held companies and a loss of $0.6 million on our investment in the private equity fund.

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The losses for the year ended December 31, 2004 were partially offset by unrealized gains of $0.5 million related to a change in fair value of the Motive warrant. For the year ended December 31, 2003, we recorded losses of $2.4 million, $0.6 million, and $0.5 million on three of our investments in privately-held companies and a loss of $0.4 million on our investment in the private equity fund. The losses on our investments in privately-held companies and private equity fund for the year ended December 31, 2003 were partially offset by an unrealized gain of $0.4 million for the initial value of the Motive warrant. For the year ended December 31, 2002, we recorded losses of $3.4 million, $1.5 million, and $0.4 million on three 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 and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months. We believe that the carrying value of our investments in non-consolidated companies approximated their fair value at December 31, 2004 and 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 securities. Unrealized gains related to the available-for-sale 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.

We had not exercised the Motive warrant as of December 31, 2004. The fair value of the Motive warrant was calculated using the Black-Scholes option-pricing model with the following inputs:

	December 31,
	2004		2003
Contractual life (years)	5.0		5.0
Risk-free interest rate	3.69	%	3.25	%
Volatility	75.0	%	53.7	%
Dividend yield	0.0	%	0.0	%

NOTE 5—ACQUISITIONS

2004

Appilog

On July 1, 2004, we completed the acquisition of all capital stock of Appilog, a provider of auto-discovery and application mapping software. Appilog’s advanced technology automatically manages the complex and dynamic dependencies between enterprise applications and their supporting infrastructure. Appilog’s technology, when combined with our application management products, optimizes business results from applications by managing relationships between users, applications, and the supporting infrastructures for the applications. The value of combining the auto-discovery technology acquired from Appilog with our existing application management products contributed to a purchase price in excess of the fair market value of Appilog’s net tangible and amortizable intangible assets acquired, and as such, we have recorded goodwill associated with the transaction in the amount of $51.8 million. The goodwill is not deductible for tax purpose and will not be amortized. We will test the goodwill for impairment at least annually.

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The total preliminary purchase price of the Appilog acquisition was as follows (in thousands):

Cash	$	50,791
Fair value of Appilog options assumed by Mercury		10,401
Direct acquisition costs incurred by Mercury		725
Total purchase price	$	61,917

We also assumed all Appilog options outstanding and fully vested as of the date of the acquisition, which were converted into options to purchase approximately 229,000 shares of our common stock. The fair value of Appilog options assumed by us was determined using the Black-Scholes option-pricing model with the following inputs: risk-free interest rate of 3.74%, expected life of 4 years, volatility of 84%, zero dividend rate, and the fair value of our common stock as of July 1, 2004. The purchase price is allocated to the following tangible and intangible assets acquired and liabilities assumed (in thousands):

Cash	$	1,973
Tangible assets		489
In-process Research and Development (IPR&D)		900
Non-compete agreements		400
Patents/core technology		1,200
Maintenance contracts		1,200
Customer relationships		1,300
Existing technology		4,800
Goodwill		51,835
Total assets acquired		64,097
Liabilities assumed		(2,180	)
	$	61,917

The purchase price allocation is preliminary and it may be changed based upon additional information related to the fair values of certain tangible assets and liabilities of Appilog as well as the total direct acquisition costs incurred by us.

We recorded deferred tax assets to the extent of deferred tax liabilities. The remaining deferred tax assets were fully reserved due to uncertainty regarding their realization.

We recognized intangible assets acquired from the Appilog acquisition as assets apart from goodwill because they arose either from contractual or other legal rights, or they were separable from the acquired entity and they could be sold or licensed separately. These intangible assets were identified through interviews with Appilog management and our analysis of financial information provided by Appilog. We valued identifiable assets related to non-compete agreements, patents or core technology, maintenance contracts, and existing technology using the discounted cash flow as estimated by management knowledgeable in the technologies and commercial applications of these assets with discount rates of 21%, 21%, 19%, and 19%, respectively. To value patents or core technology, maintenance contracts, and existing technology, we took into account the projected revenues and expenses that could be generated over the estimated useful life of the technologies or contracts. To value the acquired non-compete agreements, we took into account the potential loss in revenues and additional expenses to Mercury if the signatories to the agreements were to enter into competition. We valued identifiable asset related to customer relationships using the cost approach under which the fair value of the identified asset was estimated based on the cost to replace the existing customer relationships established by Appilog management.

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The weighted average amortization period of non-compete agreements is 18 months, patents/core technology, maintenance contracts, customer relationships, and existing technology are 60 months. The weighted average amortization period of all intangible assets is 58 months. All intangible assets are amortized on a straight-line basis over their useful lives which best represents the distribution of the economic value of the intangible assets. Amortization expense for the year ended December 31, 2004 was $1.0 million.

In conjunction with the acquisition of Appilog, we recorded a $0.9 million charge for acquired IPR&D during the third quarter of 2004 because feasibility of the acquired technology had not been established and no future alternative uses existed. The acquired IPR&D charge is included as “Acquisition-related charges” in our consolidated statements of operation for the year ended December 31, 2004. The acquired IPR&D is related to the development of a more advanced version of auto discovery and application mapping software. The value of acquired IPR&D was determined through the discounted cash flow approach. The expected future cash flow attributable to the in-process technology was discounted at approximately 30%, taking into account the percentage of completion of approximately 87%, the rate technology changes in the industry, the future markets, and the risk that the technology is not competitive with other products using alternative technologies with comparable functionalities. As of December 31, 2004, acquired IPR&D projects were completed.

The results of operations of Appilog have been included in our consolidated statements of operations since the completion of the acquisition on July 1, 2004. Results of operations for Appilog for periods prior to the acquisition were not material to us and accordingly pro forma results of operations have not been presented.

2003

Kintana

On August 15, 2003, we acquired Kintana, a leading provider of IT governance software and services. Kintana’s IT governance software and services expands our product line to include products which enable our customers to improve the management of information technology performance. The ability to offer additional products to our customers contributed to a purchase price in excess of the fair market value of Kintana’s net tangible assets acquired, and as such, we have recorded goodwill associated with the transaction of $214.0 million. The goodwill is not deductible for tax purpose and will not be amortized. We will test the goodwill for impairment at least annually.

The total purchase price of the Kintana merger was as follows (in thousands):

Cash	$	130,900
Fair value of Mercury common stock issued		88,533
Fair value of Mercury options issued		39,641
Direct merger costs incurred by Mercury		3,714
Direct merger costs incurred by Kintana paid by Mercury		4,646
Total purchase price	$	267,434

The fair value of our common stock issued was determined using the average closing price of our common stock for the 15 trading days up to and including August 13, 2003. The fair value of our options issued was determined using the Black-Scholes option-pricing model with the following inputs: risk-free interest rate of 3.37%, expected life of 4 years, volatility of 89%, zero dividend rate, and the fair value of our common stock as of August 14, 2003. We issued 2,236,926 shares of common stock based upon the number of shares of Kintana stock outstanding as of August 15, 2003, and the exchange ratio in accordance with the merger agreement. We

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also issued options to purchase 1,493,066 shares of our common stock in exchange for all Kintana options outstanding as of August 15, 2003.

The purchase price is allocated to the following tangible and intangible assets acquired and liabilities assumed (in thousands):

Cash	$	1,283
Tangible assets		10,182
Deferred tax asset		14,909
IPR&D		10,688
Non-compete agreements		13,863
Current products and technology		13,376
Core technology		10,930
Maintenance and support contracts		6,106
Goodwill		213,982
Total assets acquired		295,319
Liabilities assumed		(11,492	)
Deferred tax liability		(17,710	)
Unearned stock-based compensation		1,317
	$	267,434

We recorded total deferred tax asset of $14.9 million primarily relating to net operating loss and tax credit carryforwards acquired as part of the acquisition. In conjunction with the filing of Kintana’s 2003 income tax return in 2004, we recorded additional deferred tax assets of $2.1 million and we reduced goodwill by the same amount accordingly. In addition, a deferred tax liability of $17.7 million was recorded for the difference between the assigned values and the tax bases of the intellectual property assets acquired in the acquisition.

In 2004, we increased accounts receivable balance acquired from Kintana by $1.2 million since, based on additional information requested and received by management, we collected payments from customers of these accounts receivable. We reduced goodwill by $1.2 million accordingly.

We recognized intangible assets acquired from the Kintana acquisition as assets apart from goodwill because they arose either from contractual or other legal rights, or they were separable from the acquired entity and they could be sold or licensed separately. These intangible assets were identified through interviews with Kintana management. We valued these identifiable intangible assets using the discounted cash flow as estimated by management knowledgeable in the technologies and commercial applications of these assets with a discount rate of 20%. To value current product and technology, core technology, and maintenance and support contracts, we took into account the projected revenues and expenses that could be generated over the estimated useful life of the technologies or contracts. To value the acquired non-compete agreements, we took into account the impact on our earnings if the signatories to the agreements were to enter into competition.

The weighted average amortization period of non-compete agreements and current products and technology are 36 months, core technology is 60 months, and maintenance and support contracts are 72 months. The total weighted average amortization period of all intangible assets is 47 months. All intangible assets are amortized on a straight-line basis over their useful lives which best represents the distribution of the economic value of the intangible assets. Amortization expense for intangible assets acquired from Kintana for the years ended December 31, 2004 and 2003 was $12.3 million and $4.6 million, respectively.

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In conjunction with the acquisition of Kintana, we recorded a $10.7 million charge for acquired IPR&D during the third quarter of 2003 because technological feasibility of the IPR&D had not been established and no future alternative uses existed. The acquired IPR&D charge was recorded as “Acquisition-related charges” in our consolidated statement of operations for the year ended December 31, 2003. 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 acquired IPR&D was determined using 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 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 December 31, 2004, the acquired IPR&D projects were completed.

In conjunction with the acquisition of Kintana, we recorded unearned stock-based compensation totaling $1.3 million, which represents the intrinsic value of 1,493,066 options to purchase our common stock that we issued in exchange for Kintana unvested stock options. This amount is included in the total fair value of our options issued of $39.6 million. Unearned stock-based compensation is amortized over the remaining vesting period of the related options on a straight-line basis. During the years ended December 31, 2004 and 2003, amortization of unearned stock-based compensation associated with these options was $0.4 million and $0.2 million, respectively.

We did not record any integration costs related to the Kintana acquisition during the year ended December 31, 2004. During the year ended December 31, 2003, we recorded $0.6 million in integration costs related to the Kintana acquisition, primarily for severance and consulting services.

The transaction was accounted for as a purchase and, accordingly, the operating results of Kintana have been included in our accompanying 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 and 2002, 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. The acquired 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):

	Year Ended December 31,
	2003		2002
	(unaudited)
Net revenues	$	534,914	$	444,647
Net income	$	38,441	$	53,900
Net income per share (basic)	$	0.44	$	0.63
Net income per share (diluted) *	$	0.39	$	0.60

* In accordance with EITF No. 04-8, 2003 net income has been retroactively adjusted to include debt expense, net of tax, of $1.0 million and 2003 diluted net income per share has been retroactively adjusted to include 9.7 million shares of common stock issuable upon the conversion of the 2003 Notes.

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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. 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 management cycle from pre-production testing to production operations. The ability to offer our customers software products with additional functions contributed to a purchase price in excess of the fair market value of Performant’s net tangible assets acquired, and as such, we have recorded goodwill associated with the transaction of $16.3 million. The goodwill is not deductible for tax purpose and will not be amortized. We will test the goodwill for impairment at least annually.

The fair value of our options issued was determined using the Black-Scholes option-pricing model with the following inputs: risk-free interest rate of 1.99%, expected life of 4 years, volatility of 89%, zero dividend rate, and the fair value of our common stock as of May 5, 2003. We also issued options to purchase approximately 9,300 shares of our common stock in exchange for all Performant unvested options outstanding as of May 2, 2003.

The total purchase price was $22.5 million and consisted of cash consideration of $21.9 million, net of cash acquired of $0.3 million, and transaction costs of $0.6 million. The purchase price is allocated to the following tangible and intangible assets acquired and liabilities assumed (in thousands):

Tangible assets (net of cash acquired)	$	270
Deferred tax asset		3,658
IPR&D		1,280
Existing technology		1,620
Patents and core technology		800
Employment agreements		720
Customer contracts and related relationships		150
Order backlog		80
Goodwill		16,296
Total assets acquired		24,874
Liabilities assumed		(1,190	)
Deferred tax liability		(1,180	)
	$	22,504

We recorded a deferred tax asset of $3.7 million relating to net operating loss and tax credit carryforwards acquired as part of the acquisition. In conjunction with the filing of Performant’s 2003 income tax return in 2004, we recorded additional deferred tax asset of $0.9 million and we reduced goodwill by the same amount accordingly. In addition, a deferred tax liability of $1.2 million was recorded for the difference between the assigned values and the tax bases of the intellectual property assets acquired in the acquisition.

We recognized intangible assets acquired from the Performant acquisition as assets apart from goodwill because they arose either from contractual or other legal rights, or they were separable from the acquired entity and they could be sold or licensed separately. These intangible assets were identified through interviews with Performant management and our analysis of financial information provided by Performant. We valued identifiable assets related to existing technology and patents and core technology using the discounted cash flow as estimated by management knowledgeable in the technologies and commercial applications of these assets with discount rates of 17% and 22%, respectively. To value these identified intangible assets, we took into account the

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projected revenues and expenses that could be generated over the estimated useful life of the technologies or contracts. We valued identifiable asset related to employment agreements, customer contract and related relationships, and order backlog using the cost approach under which the fair value of the identified assets were estimated based on the cost to replace the existing agreements, relationships or transactions previously established by Performant management.

The weighted average amortization period of existing technology, patents and core technology, and customer contracts and related relationships are 48 months, employment agreements are 18 months, and order backlog is 3 months. The total weighted average amortization period of all intangible assets is 41 months. All intangible assets are amortized on a straight-line basis over their useful lives. Amortization expense for intangible assets acquired from Performant for the years ended December 31, 2004 and 2003 was $1.0 million and $0.8 million, respectively.

In conjunction with the acquisition of Performant, we recorded a $1.3 million charge for acquired IPR&D during the second quarter of 2003 because feasibility of the acquired technology had not been established and no future alternative uses of the technology existed. The acquired IPR&D charge was recorded as “Acquisition-related charges” in our consolidated statement of operations for the year ended December 31, 2003. The acquired IPR&D is related to the development of the Microsoft version of the diagnostics software or .NET version. 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. As of December 31, 2004, the acquired IPR&D projects were completed.

In conjunction with the acquisition of Performant, we recorded unearned stock-based compensation totaling $0.3 million associated with approximately 9,300 unvested stock options that we assumed. The options assumed were valued using the Black- Scholes option-pricing model. During the years ended December 31, 2004 and 2003, amortization of unearned stock-based compensation associated with these options was less than $0.1 million.

The transaction was accounted for as a purchase and, accordingly, the operating results of Performant have been included in our accompanying consolidated statement 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 and 2002, after applying certain adjustments, including amortization of intangible assets and amortization of unearned stock-based compensation and interest income, net of related tax effects. The acquired IPR&D of $1.3 million has been excluded from the following presentation as it is non-recurring charge (in thousands, except per share amounts):

	Year Ended December 31,
	2003		2002
	(unaudited)
Net revenues	$	506,604	$	400,653
Net income	$	40,152	$	58,928
Net income per share (basic)	$	0.46	$	0.70
Net income per share (diluted) *	$	0.40	$	0.67

* In accordance with EITF No. 04-8, 2003 net income has been retroactively adjusted to include debt expense, net of tax, of $1.0 million and 2003 diluted net income per share has been retroactively adjusted to include 9.7 million shares of common stock issuable upon the conversion of the 2003 Notes.

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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 December 31, 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 earned. The maximum total payment under the plan is $5.5 million, of which $5.2 million has been paid through December 31, 2004. For the years ended December 31, 2004 and 2003, we recorded $3.1 million and $2.8 million, respectively as “Restructuring, integration and other related charges” in our consolidated statements of operations associated with the milestone bonus plan.

2002

There were no business acquisitions during 2002.

NOTE 6—GOODWILL AND OTHER INTANGIBLE ASSETS

In July 2004, we acquired goodwill and intangible assets in conjunction with our acquisition of Appilog. In May and August 2003, in conjunction with our acquisitions of Performant and Kintana, respectively, we acquired goodwill and intangible assets. See Note 5 for a full description of our acquisition activities. In addition, we purchased existing technology from Allerez in July 2003 and the Mercury.com domain name in October 2003.

The changes in the carrying amount of goodwill are as follows (in thousands):

Balance at December 31, 2002	$	113,327
Acquisition of Performant		17,154
Acquisition of Kintana		217,135
Balance at December 31, 2003		347,616
Additional goodwill amount for acquisition of Kintana		163
Additional goodwill amount for acquisition of Appilog		51,835
Adjustment to goodwill amount related to Kintana		(3,317	)
Adjustment to goodwill amount related to Performant		(858	)
Balance at December 31, 2004	$	395,439

In 2004, we increased our goodwill from Kintana acquisition by $0.2 million, due to additional liabilities. We reduced our goodwill from the Kintana acquisition by $3.3 million as a result of additional deferred tax assets of $2.1 million realizable from the Kintana acquisition based on the filing of Kintana’s 2003 income tax return in 2004 and an adjustment to accounts receivable acquired from Kintana of $1.2 million. In 2004, we also reduced our goodwill from the Performant acquisition by $0.9 million as a result of additional deferred tax assets realizable from the Performant acquisition based on the filing of Performant’s 2003 income tax return in 2004.

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The changes in the carrying amount of intangible assets are as follows (in thousands):

	December 31, 2004						December 31, 2003
	Gross Carrying Amount		Accumulated Amortization		Net		Gross Carrying Amount		Accumulated Amortization		Net
Intangible assets:
Existing technology	$	24,966	$	11,649	$	13,317	$	20,166	$	5,481	$	14,685
Patents and core technology		14,530		5,059		9,471		13,330		2,345		10,985
Maintenance and support contracts		7,306		1,519		5,787		6,106		382		5,724
Employment agreements		1,120		853		267		720		320		400
Customer contracts and other		15,393		6,626		8,767		14,093		1,838		12,255
Domain name		1,124		281		843		1,135		58		1,077
	$	64,439	$	25,987	$	38,452	$	55,550	$	10,424	$	45,126

In July 2003, we purchased existing technology from Allerez for $1.3 million. This technology enables our customers to leverage their investment in their existing information technology infrastructure. The valuation of the intangible assets acquired was based upon our estimates. The intangible assets are amortized on a straight-line basis over their useful lives which best represent the distribution of the economic value of the intangible assets.

In October 2003, we purchased the Mercury.com domain name for $1.1 million. The total consideration consisted of $0.7 million in cash and $0.4 million in costs to provide certain customer support service and sales and technical training to the seller. The non-cash consideration was determined based upon our estimated costs to provide such services to third parties. The intangible assets will be amortized on straight-line basis or when services are performed.

The weighted average amortization period of existing technology is 42 months, patents and core technology is 57 months, employment agreements is 18 months, maintenance and support contracts is 70 months, customer contracts and other intangible assets are 38 months, and domain name is 60 months. The total weighted average amortization period of all intangible assets is 47 months. The aggregate amortization expense of intangible assets was $15.6 million, $7.5 million, and $2.4 million for the years ended December 31, 2004, 2003, and 2002, respectively. Amortization of intangible assets related to our current products are recorded as “Cost of revenue—amortization of intangible assets” in our consolidated statements of operations. The following table shows the breakdown of amortization of intangible assets recorded in the consolidated statements of operations for the periods indicated (in thousands):

	Year ended December 31,
	2004		2003		2002
Cost of license and subscription	$	8,882	$	4,808	$	1,833
Cost of maintenance		1,137		381		—
Total cost of revenue		10,019		5,189		1,833
Operating expenses		5,544		2,281		542
	$	15,563	$	7,470	$	2,375

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Future amortization of intangible assets at December 31, 2004 is as follows (in thousands):

Year Ending December 31,
2005	$	15,436
2006		11,764
2007		5,516
2008		4,253
Thereafter		1,483
	$	38,452

NOTE 7—LONG-TERM DEBT

In July 2000, we issued $500.0 million in 4.75% Convertible Subordinated Notes due July 1, 2007. The 2000 Notes 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. If we redeem the 2000 Notes, we will pay accrued interest up to the redemption date. We did not redeem any portion of the 2000 Notes in 2004, 2003, or 2002. During the year ended December 31, 2002, we paid $65.8 million including accrued interest of $1.2 million to retire $77.5 million face value of the Notes, which resulted in a gain on early retirement of debt of $11.6 million. From December 2001 through December 31, 2004, we retired $200.0 million face value of the 2000 Notes.

In connection with the issuance of our 2000 Notes, we incurred $14.6 million of issuance costs, which primarily consisted of investment banker fees, 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 the straight-line method over the remaining term of the 2000 Notes. Amortization expense related to the issuance costs was $1.3 million, $1.4 million, and $1.6 million for the years ended December 31, 2004, 2003, and 2002, respectively. At December 31, 2004 and 2003, net debt issuance costs associated with our 2000 Notes were $3.3 million and $4.6 million, respectively.

In 2002, we entered into two interest rate swaps with respect to $300.0 million of our 2000 Notes. See Note 13 for a full description of our derivative financial instruments and related accounting policies.

In April 2003, we issued $500.0 million of Zero Coupon Senior Notes due 2008 in a private offering. The 2003 Notes mature on May 1, 2008, 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 fiscal quarter (beginning with the third fiscal 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 fiscal quarter exceeds 110% of the conversion price of the 2003 Notes on that 30^th trading day;

• if 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

• if 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

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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. in addition and not withstanding, if 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 fees, legal, and other professional fees. These costs are being amortized using straight-line method over the term of the 2003 Notes. Amortization expense related to the issuance costs was $2.4 million and $1.6 million for the years ended December 31, 2004 and 2003. At December 31, 2004 and 2003, net debt issuance costs associated with our 2003 Notes were $8.0 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 early 2006. 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. Prepaid royalties are included as “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 forecasted revenue or straight line over the estimated useful life.

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. 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

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through October 3, 2005 (See Note 10). Severance charge related to accrued salaries and bonuses of $1.5 million was recorded as “Marketing and selling expense” in our consolidated statement of operations for the year ended December 31, 2003.

Lease commitments

We lease our headquarters facility and 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 leases agreements with lease terms ranging from month-to-month up to one year. Future minimum payments under the facilities, including the two vacant facilities from the Kintana acquisition, equipment, and other leases with non-cancelable terms in excess of one year are as follows at December 31, 2004 (in thousands):

Year ending December 31,
2005	$	20,532
2006		14,178
2007		10,330
2008		6,700
2009		5,876
Thereafter		21,186
	$	78,802

Total rent expense under operating leases amounted to $13.7 million, $8.4 million, and $6.9 million for the years ended December 31, 2004, 2003, and 2002, respectively.

Letters of credit

As of December 31, 2004, we had three irrevocable letters of credit agreements totaling $1.2 million in conjunction with our facility leases. See Note 16 for a full description of 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 in our financial position, results of operations, or cash flows.

NOTE 9—GUARANTEES

FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an Interpretation of FASB Statements No. 5, 57, and 107 and rescission of FIN No. 34 (FIN No. 45) requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken by issuing the guarantee. FIN No. 45 also requires additional disclosures to be made by a guarantor in its interim and annual financial statements about its

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obligations under certain guarantees it has issued. The accounting requirements for the initial recognition of guarantees are applicable on a prospective basis for guarantees issued or modified after December 31, 2002. The following is a summary of the agreements that we have determined are within the scope of FIN No. 45:

We warrant 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 as of December 31, 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 completed prior to December 31, 2004 that were not included in the purchase price.

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 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. We have a director and officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid. 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. Accordingly, we have no liabilities recorded for these agreements as of December 31, 2004.

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 as of December 31, 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 our customers 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 excess 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 as of December 31, 2004.

We also 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

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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 indemnification agreements 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 as of December 31, 2004.

NOTE 10—STOCKHOLDERS’ EQUITY

Preferred Stock

Under the terms of our Amended and Restated Certificate of Incorporation, the Board of Directors may determine the rights, preferences, and terms of our authorized but unissued shares of preferred stock.

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.

In accordance with a Preferred Shares Rights Agreement or Shareholder Rights Plan, as amended, which we adopted on July 5, 1996, our common stockholders receive a preferred stock purchase right for each share of common stock issued after July 15, 1996.

Stock Repurchase Programs

During the third quarter of 2001, the Board authorized the repurchase of 1 million shares of our common stock in the open market, subject to normal trading restrictions, at a price no greater than $25.00. At December 31, 2004 and 2003, we had 0.8 million shares of treasury stock at a cost of $16.1 million for both years under this stock repurchase program.

On July 27, 2004, our Board of Directors approved a 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. During 2004, we have repurchased 9,675,000 shares of our common stock at an average price of $34.33 for an aggregate purchase price of $332.2 million. December 31, 2004, we had 9.7 million shares of treasury stock at a cost of $332.2 million under this stock repurchase program.

The repurchased shares under our stock repurchase programs will be used for general corporate purposes, including the share issuance requirements under our employee stock option and purchase plans. Treasury stock is accounted for under cost method. To date, we have not reissued or retired our treasury stock.

Unearned Stock-Based Compensation

Unearned stock-based compensation was related to assumed stock options in conjunction with the acquisitions of Kintana and Performant in 2003 and Freshwater in 2001. Acquisition-related unearned stock-based compensation includes the intrinsic value of stock options assumed in conjunction with the acquisitions that is earned as the employees provide future services. Unearned stock-based compensation is amortized to expense over the remaining vesting period of the related options on a straight-line basis. Through December 31, 2004, we reduced unearned stock-based compensation by $7.1 million due to the termination of certain employees. For the years ended December 2004, 2003, and 2002, stock-based compensation expense related to our acquisitions totaling $0.7 million, $0.8 million, and $1.2 million, respectively. The estimated amortization of unearned stock-based compensation is $0.3 million for 2005, $0.2 million for 2006, and less than $0.1 million for 2007.

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In December 2003, in connection with a severance agreement with a former executive officer, we 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. As of result of the modification of stock options, we recorded a one-time stock-based compensation charge of $5.1 million based on the fair value of our common stock on the date of the modification.

During 2004 and 2003, we recorded a one-time stock-based compensation charge of $0.1 million in each respective year which was associated with modification of original terms of certain options.

NOTE 11—EMPLOYEE BENEFIT PLANS

1989 Plan

In August 1989, we adopted a stock option plan (1989 Plan). Options granted under the 1989 Plan are for periods not to exceed ten years. For holders of 10% or more of the total combined voting power of all classes of our stock, options may not be granted at less than 110% of the fair value of the common stock at the date of grant and the option term may not exceed 5 years. Incentive stock option grants under the 1989 Plan must be at exercise prices not less than 100% of the fair market value and non-statutory stock option grants under the 1989 Plan must be at exercise prices not less than 85% of the fair market value of the stock on the date of grant. Options are immediately exercisable but all shares purchased upon exercise of options are subject to repurchase by us until vested. Options generally vest over a period of four years. Options are no longer granted under this plan.

1994 Director Plan

On August 3, 1994, the Board of Directors (Board) adopted the 1994 Directors’ Stock Option Plan (Directors’ Plan). We reserved 2,000,000 shares of common stock for issuance upon exercise of stock options to be granted during the ten-year term of the Directors’ Plan. Only members of the Board may be granted options under the Directors’ Plan. The plan provided for an initial option grant of 25,000 shares to our outside directors as of August 3, 1994 or upon initial election to the Board after August 3, 1994. In addition, the Directors’ Plan provided for automatic annual grants of 5,000 shares upon re-election of the individual to the Board. In August 1998, the stockholders agreed to amend the Directors’ Plan to increase the number of shares granted to 50,000 shares as an initial grant to new non-employee directors, 10,000 shares as the annual grant to continuing non-employee directors, and to provide for a one-time grant of 100,000 shares to our non-employee directors who were serving as our directors as of August 14, 1998. The option term is ten years, and options are exercisable while such person remains a director. The exercise price is not less than 100% of fair market value on the date of grant. The initial option grants and the one-time grants vest 20% annually for each director on the date of each Annual Meeting of Stockholders after the date of grant of such option. The annual option grants shall vest in full on the fifth anniversary following each individual’s re-election to the Board.

1996 Supplemental Plan

In May 1996, we adopted a stock option plan solely for grants to employees of our subsidiaries located outside the U.S. (Supplemental Plan). The provisions of the Supplemental Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the 1989 Plan. Options are no longer granted under this plan.

1999 Plan

In August 1998, the stockholders adopted the 1999 Stock Option Plan (1999 Plan) to replace the 1989 Plan, effective on the expiration of the term of such plan in August 1999. Since adoption, an aggregate of

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19,506,527 shares of common stock have been reserved for issuance upon exercise of stock options to be granted under this plan. The provisions of the 1999 Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the 1989 Plan except that all options granted under the 1999 Plan must be at exercise prices not less than 100% of the fair market value.

2000 Plan

In July 2000, we adopted the 2000 Supplemental Stock Option Plan (2000 Plan) which allows options to be granted to any employee who is not a U.S. citizen or resident and who is not an executive officer or director. Since adoption, an aggregate of 6,000,000 shares of common stock have been reserved for issuance upon exercise of stock options to be granted under the 2000 Plan. In November 2000, the Board amended and restated the 2000 Plan to better address our tax issues and our employees in countries other than the U.S. The provisions of the 2000 Plan regarding option term, grant price, and exercise price are identical to those of the 1999 Plan except that all the terms of options granted in certain EMEA countries may be different and the 2000 Plan provides for the grant of stock purchase rights.

1997 Freshwater Plan

In May 2001, in conjunction with the acquisition of Freshwater, we assumed the 1997 Freshwater Stock Option Plan (1997 Freshwater Plan). The provisions of the 1997 Freshwater Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the 1999 Plan. Freshwater vested and unvested options were converted to our shares at a conversion ratio of 0.1326. Options are no longer granted under this plan.

Kintana Plans

In August 2003, in conjunction with the acquisition of Kintana, we assumed the Kintana 1997 Equity Incentive Plan in the U.S. and Share Option Scheme in the United Kingdom (Kintana Plans). The provisions of the Kintana Plans regarding option term, grant price, exercise price, and vesting period are identical to those of the 1999 Plan except for stock options granted under the Share Option Scheme are not exercisable immediately. Kintana vested and unvested options were converted to options to purchase our shares at a conversion ratio of 0.0951. Options are no longer granted under these plans.

2000 Performant Plan

In May 2003, in conjunction with the acquisition of Performant, we assumed the 2000 Performant Stock Option Plan (2000 Performant Plan). The provisions of the 2000 Performant Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the 1999 Plan. Performant unvested options were converted to options to purchase our shares at a conversion ratio of 0.0099. Options are no longer granted under this plan.

2003 Appilog Plan

In July 2004, in conjunction with the acquisition of Appilog, we assumed the 2003 Appilog Stock Option Plan (2003 Appilog Plan). The provisions of the 2003 Appilog Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the 1999 Plan. Appilog unvested options were converted to options to purchase our shares at a conversion ratio of 0.0081. Options are no longer granted under this plan.

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Option plans summary

The following table presents the combined activity of all our option plans for the years ended December 31, 2004, 2003, and 2002 (shares in thousands):

			Options outstanding
	Options available for grant		Number of shares		Weighted average exercise price
Balance outstanding at December 31, 2001	5,895		19,591		$	35.32
Additional shares authorized	3,996		—		$	—
Options granted	(6,113	)	6,113		$	29.33
Options canceled	1,447		(1,587	)	$	45.21
Options exercised	—		(1,456	)	$	10.11
Balance outstanding at December 31, 2002	5,225		22,661		$	34.62
Additional shares authorized	7,126		—		$	—
Options assumed in acquisitions	—		1,502		$	36.42
Options granted	(6,232	)	6,232		$	34.43
Options canceled	1,501		(1,771	)	$	40.29
Options exercised	—		(3,034	)	$	20.97
Balance outstanding at December 31, 2003	7,620		25,590		$	35.90
Options assumed in acquisition	271		229		$	4.82
Options granted	(3,367	)	3,367		$	45.60
Options canceled	1,517		(1,890	)	$	41.49
Options exercised	—		(3,490	)	$	24.98
Balance outstanding at December 31, 2004	6,041		23,806		$	38.14

The following table presents weighted average price and remaining contractual life information about significant option groups outstanding under the above plans at December 31, 2004 (shares in thousands):

	Options outstanding				Options vested
Range of exercise prices	Number outstanding	Weighted average remaining contractual life (years)	Weighted average exercise price		Number exercisable	Weighted average exercise price
$    0.13–$  18.74	3,345	3.99	$	9.98	3,240	$	9.72
$  21.03–$  29.29	3,276	6.72		28.33	2,159		28.44
$  29.65–$  31.41	3,287	7.66		31.25	1,450		31.33
$  31.55–$  39.81	3,684	7.80		36.04	1,814		34.80
$  40.72–$  45.50	3,133	6.44		42.00	2,196		40.89
$  45.55–$  60.88	4,467	7.36		53.06	2,071		59.48
$  63.06–$  89.00	2,424	5.74		64.79	2,392		64.75
$103.44–$125.44	190	5.66		107.80	190		107.80
$    0.13–$125.44	23,806	6.61		38.14	15,512		38.03

Employee Stock Purchase Plan

In August 1998, the stockholders adopted the 1998 Employee Stock Purchase Plan (1998 ESPP). Since adoption, an aggregate of 7,300,000 shares of common stock have been reserved for issuance thereunder. Under the 1998 ESPP, employees are granted the right to purchase shares of common stock at a price per share that is

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the lesser of (i) 85% of the fair market value of the shares at the participant’s entry date into the offering period, or (ii) 85% of the fair market value of the shares at the end of the offering period. In August 2001, the Board changed the offering period from six months to two years. During 2004, 2003, and 2002, 707,000, 526,000, and 389,000 shares, respectively, were purchased under the 1998 ESPP at an average purchase price of $24.22, $21.23, and $23.81, respectively.

Fair Value and Assumptions for SFAS No. 123 Pro Forma Disclosures

The fair value of 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 years ended December 31, 2004, 2003, and 2002:

	Option plans						ESPP
	2004		2003		2002		2004		2003		2002
Expected life (years)	4.28		3.98		4.00		0.50		0.50		0.50
Risk-free interest rate	3.30	%	3.05	%	4.18	%	1.62	%	1.64	%	3.84	%
Volatility	82	%	89	%	90	%	81	%	89	%	90	%
Dividend yield	0.0	%	0.0	%	0.0	%	0.0	%	0.0	%	0.0	%

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 and expected life of an option. We use projected volatility rates, which are based upon historical volatility rates trended into future years. 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 valuation per share of options granted under the option plans during the years ended December 31, 2004, 2003, and 2002 was $28.73, $22.52, and $19.44, respectively. The weighted average fair valuation per share of stock granted under the 1998 ESPP during the years ended December 31, 2004, 2003, and 2002 was $13.66, $12.70 and $13.54, respectively.

Long-Term Incentive Plan

On December 15, 2004, the Compensation Committee of our Board of Directors adopted the Mercury Long-Term Incentive Plan (Incentive Plan) which provides cash-based and equity-based incentives to our eligible employees, including executive officers designated by the Compensation Committee. Payment of the cash awards is generally based upon the attainment of financial goals over a particular performance period. The Compensation Committee may specify a vesting period for payment of the cash awards that may be longer than the performance period. We will recognize expense related to the cash awards over the performance period or the vesting period, whichever longer on straight line basis. Equity awards will be granted under the 1999 Plan and subject to the terms and conditions under the 1999 Plan. The Incentive Plan is expected to commence in 2005 and can be terminated at the discretion of the Compensation Committee.

401(k) Plan

We have a qualified 401(k) plan available to eligible employees. Participants may contribute up to a maximum percentage of their annual compensation to the plan as determined by us, limited to a maximum annual amount set by the Internal Revenue Service. We match employee contributions dollar for dollar up to a maximum of $1,000 per year per person. Matching contributions vest according to the number of years of

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employee service. We contributed and expensed $955,000, $793,000, and $603,000 to the 401(k) plan during 2004, 2003, and 2002, respectively.

NOTE 12—INCOME TAXES

The provision for income taxes consisted of (in thousands):

	Year Ended December 31,
	2004			2003			2002
Federal:
Current	$	22,972		$	137		$	12,095
Deferred		(11,202	)		10,301			(5,915	)
		11,770			10,438			6,180
State:
Current		1,665			(1,841	)		2,087
Deferred		17			1,922			(680	)
		1,682			81			1,407
Foreign:
Current		9,395			(14,590	)		9,598
Deferred		(302	)		20,253			—
		9,093			5,663			9,598
	$	22,545		$	16,182		$	17,185

Income before provision for income taxes consisted of (in thousands):

	Year Ended December 31,
	2004			2003			2002
Domestic	$	113,611		$	(64,821	)	$	(59,213	)
Foreign		(6,466	)		122,516			141,602
	$	107,145		$	57,695		$	82,389

The provision for income taxes differs from the amount obtained by applying the statutory federal income tax rate to income before taxes as follows (in thousands):

	December 31,
	2004			2003			2002
Provision at federal statutory rate	$	37,501		$	20,193		$	28,837
State tax, net of federal tax benefit		1,681			81			1,407
Foreign rate differentials		(17,179	)		(14,057	)		(13,109	)
Tax-exempt interest		(244	)		(787	)		(575	)
Non-deductible goodwill		—			3,003			—
Non-deductible in-process research and development		315			4,907			—
Non-deductible stock-based compensation		287			2,457			—
Research and development credit		(250	)		—			—
Other		434			385			625
	$	22,545		$	16,182		$	17,185

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U.S. income taxes and foreign withholding taxes were not provided for on a cumulative total of $659.0 million of undistributed earnings for certain non-U.S. subsidiaries. We intend to invest these earnings indefinitely in operations outside the U.S.

The components of the deferred tax assets (liabilities) follow (in thousands):

	December 31,
	2004			2003
Deferred tax assets:
Other reserves and accruals	$	1,871		$	13,195
Depreciation and amortization		2,887			5,133
Sales reserve		2,120			2,167
Accrued vacation		2,546			2,345
Tax credit carryovers		3,520			948
Net operating loss and capital loss carryforwards		5,556			23,349
		18,500			47,137
Deferred tax liabilities:
Deferred intercompany payments		—			(58,571	)
Acquired intangible assets		(11,554	)		(16,757	)
		(11,554	)		(75,328	)
	$	6,946		$	(28,191	)

At December 31, 2004 and 2003, our U.S. net operating loss carryforwards for income tax purposes were approximately $192.6 million and $223.7 million, respectively. If not utilized, the Federal net operating loss carryforwards will expire in various years through 2023, and the States net operating loss carryforwards will expire in various years through 2013. The net operating losses are primarily attributable to stock option compensation deductions. We have recorded a valuation allowance for the entire portion of the net operating losses related to the income tax benefits arising from the exercise of employees’ stock options. We have established this valuation allowance because, in our best assessment, it is more likely than not that we will not recognize the tax benefit relating to these net operating loss carryovers. If these losses are ultimately recognized, the tax benefit will be directly allocated to contributed capital.

In 2004 and 2003, we recognized a tax benefit of $18.0 million and $6.4 million, respectively relating to stock option deductions. These tax benefits were directly allocated to contributed capital.

As a result of ownership changes in Performant, approximately $10.0 million of net operating loss carryovers that relate to the Performant acquisition are subject to certain limitations under the U.S. Internal Revenue Code and State tax laws.

Income tax, net recorded in our consolidated balance sheets consisted of the followings (in thousands):

	December 31,
	2004		2003
Deferred tax liabilities, net	$	2	$	28,367
Income taxes payable		65,576		35,404
	$	65,578	$	63,771

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The earnings from foreign operations in Israel are subject to a lower tax rate pursuant to “Approved Enterprise” incentives effective through 2013. The incentives provide for certain tax relief if certain conditions are met. We believe that we continued to be in compliance with these conditions at December 31, 2004.

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 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. At December 31, 2004, we have a prepaid tax asset of $3.2 million included in prepaid expenses and $12.7 million included in other assets.

NOTE 13—DERIVATIVE FINANCIAL INSTRUMENTS

We enter into forward contracts to hedge 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 do not enter 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 hedging instruments to intercompany balances. 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. Gains or losses on forward contracts are recognized as other income or expense in the same period as gains or losses on the underlying evaluation of intercompany balances. We had outstanding forward contracts with notional amounts totaling $31.2 million and $31.5 million at December 31, 2004 and 2003, respectively. The forward contracts in effect at December 31, 2004 matured on January 31, 2005 and were hedges of certain foreign currency exposures in the Australian Dollar, British Pound, Danish Kroner, Euro, Indian Rupee, Japanese Yen, Korean Won, Norwegian Kroner, South African Rand, Swedish Kroner, and Swiss Franc.

We also utilize forward exchange contracts of one fiscal-month duration to offset translation gains and losses of various non-functional currency exposures that occur with foreign currency market fluctuations. 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 contracts. We had outstanding forward contracts with notional amounts totaling $23.7 million and $42.6 million at December 31, 2004 and 2003, respectively.

These forward 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 January 2002 and February 2002, we entered into two interest rate swaps with respect to $300.0 million of our 2000 Notes. In November 2002, we merged the two 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 46.0 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.

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The interest rate swap creates a market exposure to changes in the LIBOR. Under the terms of the swap, we provided 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 classified the initial collateral and will classify 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 statements of operations as “Other income (expense), net.” At December 31, 2004 and 2003, the fair value of the swap was $4.8 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 was $4.5 million and $11.2 million, respectively. The unrealized gains on the interest rate swap were less than $0.1 million for the years ended December 31, 2004 and 2003, respectively. At December 31, 2004 and 2003, our total restricted cash associated with the swap was $6.0 million.

We are exposed to 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 year ended December 31, 2004, we recorded interest expense of $6.1 million and interest income of $14.3 million, respectively, as a result of our interest rate swap. For the year ended December 31, 2003, we recorded interest expense of $5.3 million and interest income of $14.3 million, respectively, as a result of our interest rate swap. For the year ended December 31, 2002, we recorded interest expense of $7.9 million and interest income of $14.5 million, respectively, as a result of our interest rate swap and our prior interest rate swaps for the 2002 period. Our net interest expense, including the interest paid on our 2000 Notes, was $6.0 million, $5.3 million, and $8.9 million for the years ended December 31, 2004, 2003, and 2002, respectively.

NOTE 14—RESTRUCTURING, INTEGRATION AND OTHER RELATED CHARGES

We did not record any restructuring charges during the years ended December 31, 2004 and 2003. See Note 5 for integration and other related charges we recorded during the years ended December 31, 2004 and 2003.

During the first quarter of 2002, we reversed $0.5 million of the cash restructuring charges associated with the cancellation of the marketing event in 2001 because we were able to use the deposit for another event. The charge was originally recorded as part of the restructuring charge in 2001.

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NOTE 15—SUPPLEMENTAL CASH FLOW DISCLOSURES

Supplemental cash flow disclosures for the years ended December 31, 2004, 2003, and 2002 are as follows (in thousands):

	Year ended December 31,
	2004		2003		2002
Supplemental disclosure:
Cash paid during the year for income taxes, net of refunds of $1,257, $882, and $301, respectively	$	4,234	$	6,546	$	4,200
Cash paid during the year for interest expense	$	19,553	$	22,005	$	20,862
Supplemental non-cash investing activities:
Issuance of common stock and stock options in conjunction with acquisitions	$	10,401	$	128,473	$	—
Purchase of domain name in exchange for customer support service, and sales and technical training	$	—	$	491	$	—
Common stock received in exchange for equity investment in privately-held company	$	1,360	$	—	$	—

The fair value of assets acquired and the fair value of liabilities assumed from acquisitions completed in 2004 and 2003 are disclosed in Note 5.

	Year ended December 31,
	2004		2003		2002
Supplemental non-cash financing activities:
Tax benefit from exercise of stock options	$	17,964	$	6,367	$	—
Issuance of common stock for notes receivable	$	—	$	—	$	769
Elimination of debt offering costs in conjunction with debt retirement	$	—	$	—	$	1,229

NOTE 16—RELATED PARTIES

Notes receivable from issuance of common stock

At December 31, 2004 and 2003, we held full-recourse notes receivable collateralized by common stock from our employees totaling $4.2 million and $6.6 million, respectively, for purchases of our common stock. The notes bear interest at the market rate on the date of issuance specific to the employee. Accrued interest is due between one and five years from the date of issuance. The principal amount is due ten years from the anniversary of the notes or as common stock is sold.

Employee receivables

At December 31, 2003, we held full-recourse notes receivable collateralized by our common stock and/or real property with an employee totaling $0.2 million. The notes bore interest at the market rate on the date of issuance specific to the employee. Accrued interest was due either quarterly or annually. The principal amount was due between five and seven years from the anniversary of the notes. As of December 31, 2004, we had no

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outstanding full-recourse notes receivable collateralized by our common stock and/or real property with any employee or officer.

Business with Wells Fargo & Company

Sale of products and services

We sell products and services to Wells Fargo & Company (Wells Fargo), a financial company, as part of the normal course of business. One of the members of our Board is an executive officer of Wells Fargo. We recorded total revenues from the sale of products and services to Wells Fargo of $5.5 million, $2.1 million, and $1.1 million for the years ended December 31, 2004, 2003, and 2002, respectively. Accounts receivable due from Wells Fargo was $2.6 million and $1.3 million as of December 31, 2004 and 2003, respectively.

Banking services

In addition, we obtain banking services from Wells Fargo. During 2003, we entered into four irrevocable letters of credit agreements totaling $1.4 million with Wells Fargo. Three of the agreements, totaling $1.2 million remained outstanding at December 31, 2004. Two of the agreements were related to facility lease agreements assumed by us in conjunction with the acquisition of Kintana in 2003. One of these agreements remains intact and has an automatic annual renewal provision under which the expiration date cannot be extended beyond March 1, 2006, and the other agreement expired in September 2004. A 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. This agreement is automatically extended after January 1, 2005 unless we provide a termination notice to Wells Fargo. At December 31, 2004 and 2003, no amounts had been drawn on the letters of credit. During 2004, 2003, and 2002, we maintained cash deposit accounts and an investment account related to investments in our Israeli research and development facility with Wells Fargo. As of December 31, 2004 and 2003, total cash deposit balance kept in Wells Fargo was $2.5 million and $6.3 million, respectively. As of December 31, 2004 and 2003, the investment account balance kept in Wells Fargo was $102.7 million and $163.8 million, respectively.

Business with Cisco Systems, Inc.

We sell products and services to Cisco Systems, Inc. (Cisco), a networking and communication equipment manufacturer and service provider for the Internet, as part of the normal course of business. In May 2004, the Chief Information Officer of Cisco became a member of our Board. We recorded total revenues from the sale of products and services to Cisco of $4.3 million for the year ended December 31, 2004. As of December 31, 2004, we had no accounts receivable due from Cisco. Prior to May 2004, we purchased phone equipment from Cisco. For the year ended December 31, 2004, total payments made to Cisco aggregated to $2.4 million. At December 31, 2004, we had no outstanding payables due to Cisco.

Marketing agreement with Biz360

In January 2003, our Audit Committee approved a 15-month subscription agreement with Biz360, as one of our members of the Board of Directors serves on the Biz360 board of directors, to purchase marketing services for $110,000. In April 2003, we signed an extension to the subscription agreement with Biz360. In accordance with the extension to the agreement, Biz360 will provide additional marketing service to our European operations for $60,000 over a 15-month period. As of December 31, 2003, we have made $170,000 in payments toward this agreement. We did not enter into any transactions with Biz 360 in 2004.

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Subcontractor arrangement with InteQ Corporation

In April 2001 and July 2002, we invested $3.0 million and $369,000 in InteQ Corporation (InteQ) for 6,782,727 shares and 834,512 shares of its Series B Preferred stock, respectively. These investments are accounted for using the cost method. We do not have a seat on the InteQ board of directors. In June 2002, we entered into a subcontractor agreement with InteQ to outsource the delivery of the monitoring and problem remediation solutions of our Global SiteReliance (GSR) service. The contract was scheduled to end in April 2003 and was extended to June 2003. Prior to the subcontractor agreement, we delivered the GSR service to three customers, which as of June 2002 have been transitioned to InteQ. For a subcontractor fee, InteQ would perform the remaining services for these customers and any additional or new service contracts entered into by us. GSR service revenue of $151,000 and $261,000 related to these customers was netted against the subcontractor fee of $151,000 and $261,000 for the years ended December 31, 2003 and 2002, respectively. There were no GSR service revenue nor subcontractor fee related to InteQ recorded for the year ended December 31, 2004. To perform the GSR service to our existing customers, InteQ has purchased a SiteScope thirteen-month term license from us for approximately $216,000. This term license was sold to InteQ with extended payment terms; consequently we are recognizing the revenue associated with this term license as payments are made by InteQ. To service additional customers, InteQ will have to acquire additional SiteScope licenses based upon certain criteria. In 2004, InteQ did not purchase any SiteScope license. In 2003, InteQ purchased additional SiteScope licenses aggregating $75,000, primarily for an existing customer. For the years ended December 31, 2004, 2003, and 2002, revenue of less than $10,000, $199,000 and $73,000 was recorded for the InteQ SiteScope license, respectively.

In August 2002, we entered into a referral fee agreement whereby InteQ will pay us a 15% referral fee for customers referred by us to InteQ. The referral fee agreement ended on June 30, 2003. For the year ended December 31, 2003, we recorded $151,000 referral fee revenue from InteQ. No referral fee revenue was recognized during the years ended December 31, 2004 and 2002.

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NOTE 17—SEGMENT AND GEOGRAPHIC REPORTING

We organize, manage, and analyze our business geographically. The reportable operating segments are: the Americas, EMEA, APAC, and Japan. We operate in one industry segment: the development, marketing, and selling of integrated application delivery, application management, and IT governance solutions. Our chief decision makers rely on internal management reports, which provide contribution margin analysis by geographic locations, to make financial decisions and allocate resources. Contribution margin consists of revenues from third parties less costs and expenses over which management of the geographic regions can directly control. These costs and expenses are primarily personnel-related costs for supporting our customer service, professional service, managed service, and sales organizations. Other operating segment costs and expenses are excluded from the internal management reporting as our chief decision makers do not use the information to evaluate the operating segment performance. Other operating segment costs and expenses include research and development costs, general and administrative expenses, marketing costs, information technology infrastructure expenses, and other costs not allocated to the geographic locations. Revenues from third parties are attributed to a country primarily based on the location where the invoice is issued. The following table summarizes the financial performance of our operating segments (in thousands):

	Year ended December 31,
	2004			2003			2002
Revenues from third parties by segment:
Americas (including U.S. of $412,173, $310,967, and $251,222 respectively)	$	423,427		$	321,942		$	262,537
EMEA (including U.K. of $79,607, $58,387, and $40,776, respectively)		208,096			149,176			111,980
APAC		38,973			23,851			14,794
Japan		15,051			11,504			10,811
		685,547			506,473			400,122
Direct costs and expenses by segment:
Americas		201,606			150,593			124,979
EMEA		119,722			81,087			62,677
APAC		21,762			13,781			10,926
Japan		6,937			6,130			5,783
		350,027			251,591			204,365
Contribution margin by segment:
Americas		221,821			171,349			137,558
EMEA		88,374			68,089			49,303
APAC		17,211			10,070			3,868
Japan		8,114			5,374			5,028
		335,520			254,882			195,757
Corporate and other unallocated costs and expenses (income):
Research and development (1)		60,407			45,986			37,382
General and administrative (1)		50,458			35,099			29,032
Other (2)		130,995			125,223			61,450
Interest income		(38,614	)		(36,077	)		(35,119	)
Interest expense		20,292			19,551			23,370
Other expense (income), net		4,837			7,405			(2,747	)
		228,375			197,187			113,368
Income before income taxes	$	107,145		$	57,695		$	82,389

(1) Facility expenses are included in the contribution margin calculation. Unallocated information technology infrastructure expenses are included in other expenses.

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(2) Other unallocated costs and expenses include stock-based compensation, restructuring, integration, and other related charges, amortization of intangible assets, marketing expense, unallocated information technology infrastructure expenses, and other costs not allocated to the geographic locations for all periods presented. For the years ended December 31, 2004 and 2003, they also include acquisition-related charges and excess facilities charge.

The following table highlights the percentages of third party revenues from countries that exceeded 10% of the total revenues and international revenues as a percentage to the total revenues from third parties (in thousand):

	For the year ended December 31,
	2004		2003		2002
United States	60	%	61	%	63	%
United Kingdom	12	%	12	%	10	%
International	38	%	36	%	34	%

Long-lived assets, which mainly consist of property and equipment, are attributed to a country primarily based on the physical location of the assets. Property and equipment, net of accumulated depreciation, summarized by operating segment is as follows (in thousands):

Property and equipment, net:	December 31,
	2004		2003
Americas (including U.S. of $41,864 and $40,750, respectively)	$	41,899	$	40,801
EMEA (including Israel of $31,061 and $28,288, respectively)		34,677		31,001
APAC		1,575		1,011
Japan		264		390
	$	78,415	$	73,203

Operations located in the U.S. accounted for 67% and 74% of the consolidated identifiable assets at December 31, 2004 and 2003, respectively. Operations located in Israel accounted for 25% and 19% of the consolidated identifiable assets at December 31, 2004 and 2003, respectively.

Although we operate in one industry segment, our chief decision makers evaluate revenues based on the components of application delivery, application management, and IT governance. With the acquisition of Kintana in August 2003, we began recognizing revenue from sales of IT governance products. Accordingly, the following tables present revenues for application delivery, application management, and IT governance (in thousands):

	For the year ended December 31, 2004
	Application Delivery		Application Management		IT Governance		Total
Revenues:
License fees	$	210,168	$	24,048	$	27,090	$	261,306
Subscription fees		73,998		76,222		1,844		152,064
Total product revenues		284,166		100,270		28,934		413,370
Maintenance fees		174,373		10,040		11,728		196,141
Professional service fees		42,796		13,878		19,362		76,036
	$	501,335	$	124,188	$	60,024	$	685,547

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

	For the year ended December 31, 2003
	Application Delivery		Application Management		IT Governance		Total
Revenues:
License fees	$	181,415	$	11,988	$	7,644	$	201,047
Subscription fees		43,495		55,334		29		98,858
Total product revenues		224,910		67,322		7,673		299,905
Maintenance fees		149,769		7,601		1,660		159,030
Professional service fees		36,814		4,160		6,564		47,538
	$	411,493	$	79,083	$	15,897	$	506,473
	For the year ended December 31, 2002
	Application Delivery		Application Management		IT Governance		Total
Revenues:
License fees	$	182,927	$	9,285	$	—	$	192,212
Subscription fees		20,623		32,401		—		53,024
Total product revenues		203,550		41,686		—		245,236
Maintenance fees		116,939		5,404		—		122,343
Professional service fees		31,317		1,226		—		32,543
	$	351,806	$	48,316	$	—	$	400,122

NOTE 18—SUBSEQUENT EVENTS

On January 7, 2005, we completed the sale of the vacant building we owned at carrying value for $4.9 million in cash, net of $0.3 million in transaction fees.

In February 2005, we entered into a sublease agreement to lease additional buildings at our headquarters in Mountain View, California. The lease begins in May 2005 and July 2005. The agreement expires in March 2013.

In February 2005, we entered into a letter of credit line with Wells Fargo Bank for $5.0 million, of which $2.2 million has been utilized. $1.2 million is related to previously issued letters of credit, as detailed in Note 16 and a $1.0 million newly issued letter of credit is related to the new sublease agreement we executed for the additional building leases at our Mountain View headquarters.

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UNAUDITED QUARTERLY FINANCIAL DATA

The following table sets forth selected unaudited consolidated quarterly financial information for the eight quarters ended December 31, 2004:

	Quarter ended
	Dec. 31, 2004		Sept. 30, 2004			June 30, 2004		March 31, 2004		Dec. 31, 2003		Sept. 30, 2003			June 30, 2003		March 31, 2003
	(in thousands, except per share amounts)
Total revenues	$	204,283	$	165,411		$	159,047	$	156,806	$	151,976	$	126,056		$	118,056	$	110,385
Net income (loss)	$	35,038	$	19,043	a	$	11,611	$	18,908	$	13,098	$	(6,664	)a	$	16,935	$	18,144
Adjusted net income (loss) for diluted net income (loss) per share calculation (b)	$	35,397	$	19,401	a	$	11,970	$	19,266	$	13,460	$	(6,664	)a	$	17,172	$	18,144
Basic net income (loss) per share	$	0.41	$	0.22		$	0.13	$	0.21	$	0.15	$	(0.08	)	$	0.20	$	0.21
Diluted net income (loss) per share	$	0.36	$	0.19		$	0.11	$	0.18	$	0.13	$	(0.08	)	$	0.17	$	0.20
Weighted average common shares (basic)		84,496		87,908			92,448		91,450		90,077		87,705			85,610		85,032
Weighted average common shares (diluted) (b)		98,179		101,214			107,910		107,454		106,703		87,705			100,179		89,349

a. Include a non-recurring charge of $0.9 million and $10.7 million related to in-process research and development acquired from Appilog and Kintana acquisitions in July 2004 and August 2003, respectively.

b. Adjusted net income includes debt expense, net of tax, associated with the Zero Coupon Senior Debt due 2008. Weighted average diluted common shares are adjusted to include 9,673,050 shares of common stock issuable from the conversion from the Zero Coupon Senior Debt due 2008, if shares are dilutive, as required by the adoption of Emerging Issue Task Force (EITF) No. 04-8 in 2004. The 2003 diluted net income per share has been retroactively adjusted as a result of the adoption of EITF 04-8 by a reduction of $0.04 per share.

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EX-10.37

Exhibit 10.37

EMPLOYMENT AGREEMENT

EMPLOYMENT AGREEMENT made as of the 11th day of February 2005 by and between Mercury Interactive Corporation, a Delaware corporation (the “Corporation”), and Amnon Landan (the “Executive”).

WHEREAS, the Corporation desires to continue the Executive’s employment as Chief Executive Officer and Chairman of the Board, and the Executive desires to continue such employment with the Corporation, upon the terms and conditions set forth in this Agreement.

WHEREAS, this Agreement will formalize the terms and conditions governing the Executive’s employment with the Corporation and the termination of that employment.

NOW, THEREFORE, the parties hereto agree as follows:

PART ONE – DEFINITIONS

For purposes of this Agreement, the following definitions shall be in effect:

Applicable Federal Rates mean the short-term, mid-term and long-term interest rates determined pursuant to Code Section 1274 which are in effect at the time each relevant present value calculation is to be made under this Agreement.

Average Annual Compensation means the average of the Executive’s W-2 wages from the Corporation for the five (5) calendar years completed immediately prior to the calendar year in which the Change in Control is effected.

Board means the Corporation’s Board of Directors.

Change in Control means a change in the ownership or control of the Corporation which occurs by reason of any of the following events:

(i) Any “person” (as such term is used in Sections 13(d) and 14(d) of the Exchange Act) is or becomes the “beneficial owner” (as defined in Section 13d-3 of the Exchange Act), directly or indirectly, of securities of the Corporation representing fifty percent (50%) or more of the total combined voting power of the Corporation’s then outstanding voting securities, excluding conversion of any convertible securities issued and outstanding as of the date of this Agreement;

(ii) The composition of the Board changes during any period of thirty-six (36) months such that the individuals who at the beginning of the period were members of the Board (the “Continuing Directors”) cease for any reason to constitute at least a majority of the Board, unless at least two-thirds of the Continuing Directors have (i) approved the election of the new Board members,

(ii) if the election of the new Board members is voted on by shareholders, recommended that the shareholders vote for approval, or (iii) otherwise determined that such change in composition does not constitute a Change of Control, even if the continuing Board members do not constitute a quorum of the whole Board (it being understood that this requirement shall not be capable of satisfaction unless there is at least one Continuing Director); or

(iii) The closing of a merger or consolidation of the Corporation with any other corporation, other than a merger or consolidation which would result in the voting securities of the Corporation outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least fifty percent (50%) of the total combined voting power of the voting securities of the Corporation or such surviving entity outstanding immediately after such merger or consolidation, or the shareholders of the Corporation approve a plan of complete liquidation of the Corporation or an agreement for the sale, exclusive license or disposition of the Corporation of all or substantially all of the Corporation’s assets.

However, the term Change of Control shall not include either of the following events undertaken at the election of the Corporation:

a. any transaction, the sole purpose of which is to change the state in which the Corporation is incorporated; or

b. a transaction, the result of which is to sell all or substantially all of the assets of the Corporation to another corporation (the “surviving corporation”) provided that the surviving corporation is owned directly or indirectly by the shareholders of the Corporation immediately following such transaction in substantially the same proportions as their ownership of the Corporation’s common stock immediately preceding such transaction.

Change in Control Severance Payments means the various payments and benefits to which the Executive may become entitled under Paragraph 18 of Part Five of this Agreement upon his Involuntary Termination in connection with a Change in Control.

Code means the Internal Revenue Code of 1986, as amended.

Common Stock means the Corporation’s common stock.

Disability means a physical or mental disability which renders it impracticable for the Executive to continue to perform his duties under this Agreement. The Executive shall be deemed to have incurred such Disability if (i) a physician selected by the Corporation and reasonably satisfactory to the Executive advises the Corporation that the Executive’s physical or

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mental condition will render him unable to perform his duties under this Agreement for a period exceeding three (3) consecutive months or (ii) due to a physical or mental condition the Executive has not substantially performed the material duties required of him hereunder for a period of three (3) consecutive months.

Employment Period means the duration of the Executive’s employment with the Corporation pursuant to the terms of this Agreement.

Exchange Act means the Securities Exchange Act of 1934, as amended from time to time.

Fair Market Value means, with respect to the shares of Common Stock subject to any of the Executive’s Options or other Stock Awards, the closing selling price per share on the date in question, as such price is reported by the National Association of Securities Dealers on the Nasdaq National Market and published in The Wall Street Journal. If there is no closing selling price reported for the Common Stock on the date in question, then the Fair Market Value will be the closing selling price on the last preceding date for which such published report exists.

Independent Auditors means the accounting firm serving as the Corporation’s independent certified public accountants immediately prior to the Change in Control; provided, however, that in the event such accounting firm also serves as the independent certified public accountants for the corporation or other entity effecting the Change in Control transaction with the Corporation or such accounting firm concludes that the services required of it hereunder would adversely affect its independent status under applicable accounting standards or the performance of such services would otherwise be in contravention of applicable law, then the Independent Auditors shall mean a nationally-recognized public accounting firm mutually acceptable to both the Corporation and the Executive.

Involuntary Termination means (i) the Corporation’s termination of the Executive’s employment for any reason other than a Termination for Cause, (ii) the termination of the Executive’s employment by reason of his Disability or (iii) the Executive’s resignation within one hundred eighty (180) days following (A) a material reduction in the scope of his duties and responsibilities, (B) a change in his level of reporting so that he no longer directly reports to the Board, (C) a reduction in the aggregate dollar amount of his base salary and Target Bonus by more than ten percent (10%), (D) a relocation of his principal place of employment by more than fifty (50) miles, (E) the election by the Corporation not to renew the term of the Employment Period for any additional one-year period for which the Employment Period would have been extended under the terms of Paragraph 2 had the Corporation not so elected, (F) the failure by the Corporation to obtain the assumption of its obligations under this Agreement by any successor entity or (G) a material breach by the Corporation of any of its obligations under this Agreement and the failure of the Corporation to cure such breach within sixty (60) days after receipt of written notice from the Executive in which the actions or omissions constituting such material breach are specified.

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An Involuntary Termination shall automatically be deemed to occur in the event the Executive resigns within one hundred eighty (180) days following the effective date of a Change in Control transaction which results in the cessation of his service as the chief executive officer of a publicly-traded entity subject to the periodic reporting requirements of the Exchange Act.

A greater than ten percent (10%) aggregate reduction in the Executive’s base salary and Target Bonus shall not constitute grounds for an Involuntary Termination under clause (C) above if substantially all of the other executive officers of the Corporation are subject to the same aggregate reduction to their base salary and target bonuses.

The failure of the Corporation to recommend to the Corporation’s Nominating Committee that the Executive be nominated for re-election as Chair of the Board at any stockholders meeting held during his period of employment with the Corporation at which the Chair of the Board is to be elected shall not constitute grounds for an Involuntary Termination under clause (A) or (G) above, but the failure of the Corporation to recommend to the Corporation’s Nominating Committee that the Executive be nominated for re-election to the Board at any stockholders meeting held during such employment period at which Board members are to be elected shall constitute grounds for such an Involuntary Termination.

LTIP Bonus means any bonus payable to the Executive under the Corporation’s Long-Term Incentive Plan (or any successor plan) upon the attainment of designated corporate and/or individual performance milestones and the continuation of the Executive’s employment with the Corporation for a period of one or more years following the year for which the designated milestones were attained.

Option means any option granted to the Executive under the Plan or otherwise to purchase shares of Common Stock which is outstanding at the time of (i) a Change in Control or (ii) his Involuntary Termination, whether or not in connection with a Change in Control. In the event of a Change in Control, the Options will be divided into two (2) categories as follows:

Acquisition-Accelerated Options: any outstanding Option (or installment thereof) which immediately accelerates upon a Change in Control pursuant to the provisions of Paragraph 16 of this Agreement or otherwise.

Severance-Accelerated Options: any outstanding Option (or installment thereof) which, pursuant to the terms of this Agreement, vests on an accelerated basis upon the Executive’s Involuntary Termination.

Option Parachute Payment means, with respect to any Acquisition-Accelerated Option or any Severance-Accelerated Option, the portion of that Option deemed to be a parachute payment under Code Section 280G and the Treasury Regulations issued thereunder. The portion of such Option which is categorized as an Option Parachute Payment will be calculated in accordance with the valuation provisions established under Code Section 280G and the applicable Treasury Regulations.

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Other Parachute Payment means any payment or benefit in the nature of compensation (other than the Change in Control Severance Payments and his Acquisition-Accelerated Options) which is made to Executive in connection with the Change in Control and deemed to constitute a parachute payment under Code Section 280G(b)(2) and the Treasury Regulations issued thereunder.

Parachute Payment means (i) any Change in Control Severance Payment which is deemed to constitute a parachute payment within the meaning of Code Section 280G(b)(2) and the Treasury Regulations issued thereunder and (ii) any Option Parachute Payment attributable to his Acquisition-Accelerated Options.

Plan means (i) the Corporation’s Amended and Restated 1999 Stock Option Plan, as subsequently amended or restated from time to time, and (ii) any other stock incentive plan established or implemented by the Corporation.

Present Value means the value, determined as of the date of the Change in Control, of any payment in the nature of compensation to which the Executive becomes entitled in connection with the Change in Control or his subsequent Involuntary Termination, including (without limitation) the Option Parachute Payment attributable to the Executive’s Acquisition-Accelerated and Severance-Accelerated Options and the Parachute Payment attributable to the additional benefits to which the Executive becomes entitled under Part Four of this Agreement. The Present Value of each such payment shall be determined in accordance with the provisions of Code Section 280G(d)(4), utilizing a discount rate equal to one hundred twenty percent (120%) of the Applicable Federal Rate in effect at the time of such determination, compounded semi-annually to the effective date of the Change in Control.

Qualifying Termination means the termination of the Executive’s employment for any reason, including (without limitation) death or Disability, but excluding a Termination for Cause, after completion of an additional 5 years of employment with the Corporation measured from January 1, 2005.

Special Long-Term Service Bonus means the special lump sum bonus payment calculated in accordance with the provisions of Paragraph 13(a) to which the Executive may become entitled pursuant to the provisions of this Agreement.

Target Bonus means the annual incentive bonus to which the Executive may become entitled for one or more fiscal years upon the Corporation’s attainment of the performance milestones designated for the applicable year and the Executive’s attainment of any personal objectives specified for him for that year.

Termination for Cause means the termination of the Executive’s employment for any of the following reasons: (i) the Executive’s conviction of a felony or his commission of any act of personal dishonesty involving the property or assets of the Corporation intended to result in substantial financial enrichment to the Executive, (ii) a material breach by Executive of one or more of his obligations under Paragraph 9 of this Agreement or his Proprietary Information and Inventions Agreement with the Corporation, (iii) any intentional misconduct by Executive which has a material adverse effect upon the Corporation’s business or reputation,

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(iv) Executive’s material dereliction of the major duties, functions and responsibilities of his executive position, (v) a material breach by Executive of any of Executive’s fiduciary obligations as an officer of the Corporation or (vi) the Executive’s willful and knowing participation in the preparation or release of false or materially misleading financial statements relating to the Corporation’s operations and financial condition or his willful and knowing submission of any false or erroneous certification required of him under the Sarbanes-Oxley Act of 2002 or any securities exchange on which shares of the Common Stock are at the time listed for trading. However, prior to any termination of Executive’s employment for any of the reasons specified in clauses (ii) through (v), the Corporation shall give written notice to Executive of the actions or omissions deemed to constitute the grounds for a Termination for Cause, and Executive shall have a period of not less than sixty (60) days in which to cure the specified default in his performance.

Stock Award means any restricted stock, restricted stock unit, performance share or other Common Stock-based awards (other than Options) made from time by the Corporation to the Executive during the Employment Period, whether under the Plan or otherwise.

PART TWO — TERMS AND CONDITIONS OF EMPLOYMENT

1. Duties and Responsibilities.

A. Executive shall continue to serve as the Chief Executive Officer of the Corporation and shall in such capacity report directly to the Board. As Chief Executive Officer, Executive shall have primary responsibility for the formulation, implementation and execution of strategic policies relating to the Corporation’s business operations, financial objectives and market growth and shall accordingly have overall responsibility for the formulation of the business plan for each fiscal year to be submitted for Board approval. The Corporation shall, throughout the period of Executive’s employment with the Corporation as Chief Executive Officer recommend to the Corporation’s Nominating Committee that he be nominated for re-election as Chairman of the Board at each stockholders meeting held during such period at which Board members are to be elected.

B. Executive hereby agrees to remain in his capacity as Chief Executive Officer during the employment period specified in Paragraph 2 and to perform in good faith and to the best of his ability all services which may be required of Executive hereunder and to be available to render services at all reasonable times and places in accordance with such reasonable directions and requests made by the Corporation acting by majority vote of the Board.

C. Executive shall be based at the Corporation’s principal offices in the Silicon Valley Area, California, but Executive may be required from time to time to travel to other geographic locations in connection with the performance of his duties hereunder.

2. Employment Period. Executive’s employment with the Corporation shall be governed by the provisions of this Agreement for the period commencing January 1, 2005 and continuing through December 31, 2007. However, the term of the Executive’s employment pursuant to the terms of this Agreement shall automatically be extended for successive one-year periods thereafter, unless either the Corporation acting by majority vote of

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the Board or the Executive elects, by written notice delivered to the other not later than sixty (60) days prior to the start of any such one-year period, not to renew the term of this Agreement. In no event, however, may the Corporation exercise its election not to renew the term of this Agreement if the Corporation is at the time a party to an agreement, understanding or letter of intent pertaining to a transaction which would, if consummated, constitute a Change in Control. To the extent expressly provided herein, one or more provisions of this Agreement shall survive any such termination of this Agreement, and those provisions shall remain in full force and effect during the period the Executive continues in employment with the Corporation following such termination of this Agreement. This Agreement may also be terminated at any time in accordance with the termination of employment provisions set forth in Paragraph 8 or Paragraph 11. The period during which Executive’s employment is governed by the terms and provisions of this Agreement shall constitute the Employment Period hereunder.

3. Cash Compensation.

A. Executive shall be paid a base salary at an annual rate of not less than Seven Hundred Fifty Thousand Dollars ($750,000.00). Such rate shall be subject to annual review by the Board and may be adjusted at the Board’s discretion, subject to the provisions of the Involuntary Termination definition set forth in Part One under which certain reductions to the Executive’s base salary and Target Bonus may constitute grounds for an Involuntary Termination. Base salary shall be paid at periodic intervals in accordance with the Corporation’s payroll practices for salaried employees.

B. For each fiscal year of the Corporation during the Employment Period, beginning with the fiscal year commencing January 1, 2005, Executive shall be eligible to receive a Target Bonus in an amount not less than one hundred percent (100%) of the annual rate of base salary in effect for him at the start of that year, if the financial objectives and performance milestones for that year are attained. Such financial objectives and performance milestones shall be set by the Board (or a committee of independent Board members) within the first ninety (90) days of each fiscal year, and the bonus earned for each fiscal year shall become payable within two and one half months after the close of that year. The Executive may become entitled to an actual incentive bonus greater than the Target Bonus for one or more fiscal years, if there is greater than one hundred percent (100%) attainment of the applicable financial objectives and performance milestones for such year or years.

C. The Corporation shall deduct and withhold from the compensation payable to Executive hereunder any and all applicable federal, state and local income and employment withholding taxes and any other amounts required to be deducted or withheld by the Corporation under applicable statutes, regulations, ordinances or orders governing or requiring the withholding or deduction of amounts otherwise payable as compensation or wages to employees.

4. Equity Compensation.

A. Executive has received a series of Options over his period of employment to date with the Corporation. Each of those Options shall vest and become exercisable for the

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shares of Common Stock subject to that Option in accordance with the applicable vesting schedule currently in effect for each such Option.

B. The Executive shall be eligible to receive one or more additional Option grants or other Stock Awards during the Employment Period, as the Board or the Compensation Committee of the Board may deem appropriate in order to provide him with sufficient equity incentives for his position.

C. The shares of Common Stock subject to the Options summarized in Paragraph 4.A above, together with each additional Option or Stock Award which Executive may subsequently receive over the remainder of the Employment Period, shall be subject to (i) the vesting acceleration and, if applicable, extended exercise period provisions of Paragraphs 15(f) and 15(g) of Part Four should there occur an Involuntary Termination of Executive’s employment in the absence of a Change in Control and (ii) the applicable vesting acceleration and, if applicable, extended exercise period provisions of Paragraphs 16, 18(f) and 18(g) of Part Five in the event there should occur a Change in Control.

5. Expense Reimbursement. In addition to the compensation specified in Paragraph 3, Executive shall be entitled, in accordance with the reimbursement policies in effect from time to time, to receive reimbursement from the Corporation for all reasonable business expenses incurred by Executive in the performance of his duties hereunder, provided Executive furnishes the Corporation with vouchers, receipts and other details of such expenses in the form required by the Corporation sufficient to substantiate a deduction for such business expenses under all applicable rules and regulations of federal and state taxing authorities.

6. Fringe Benefits.

A. Executive shall, throughout the Employment Period, be eligible to participate in all pension, profit-sharing and fringe benefit plans, such as group term life insurance plans, group health plans, accidental death and dismemberment plans, short-term and long-term disability programs, and any other benefit programs which are made available to the Corporation’s key executives and for which Executive qualifies.

B. Executive shall accrue paid vacation benefits during the Employment Period in accordance with the vacation policies of the Corporation applicable to senior executives and may take his accrued vacation at such times as are mutually convenient to Executive and the Corporation.

7. Indemnification. The Executive shall be entitled to indemnification from the Corporation pursuant to the provisions of the Corporation’s bylaws relating to the indemnification of the Corporation’s officers and Board members, and the Corporation shall also maintain in full force and effect its existing indemnification agreement with the Executive. In addition, the Executive shall be entitled to full coverage under any Directors and Officers Liability Insurance Policy maintained by the Corporation for one or more other officers of the Corporation or Board members. The provisions of this Paragraph 7 shall remain in full force and effect throughout the period of the Executive’s employment with the Corporation, whether or not this Agreement is otherwise in effect at the time.

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8. Death or Disability. Upon Executive’s death or Disability during the Employment Period, the employment relationship created pursuant to this Agreement shall immediately terminate, and the Corporation shall pay Executive or his estate (i) any unpaid base salary earned under Paragraph 3 for services rendered through the date of death or Disability, (ii) the dollar value of all accrued and unused vacation benefits and sick pay based upon Executive’s most recent level of base salary and (iii) any Target Bonus or other bonus amount actually earned pursuant to Paragraph 3.B for one or more fiscal years but not previously paid to the Executive at the time of his death or Disability, subject to any pre-existing deferral elections which may be in effect for such amounts. In addition, the Executive shall be entitled to the payments and benefits provided under Part Three, Part Four or Part Five of this Agreement, as applicable.

9. Restrictive Covenants. During the Employment Period:

(i) Executive shall not directly or indirectly provide services to any person, firm or other entity except the Corporation, unless otherwise authorized by the Board in writing. However, Executive may continue to serve during the Employment Period as a non-employee member of the board of directors of any companies for which he so serves on the effective date of this Agreement and may join the board of directors of other companies in the future with the Board’s consent.

(ii) Executive shall not conduct (or otherwise participate in) any business or financial enterprise for his own account or for any other person, firm or entity without first obtaining the Corporation’s written consent.

However, Executive shall have the right to perform such incidental services as are necessary in connection with (a) Executive’s private passive investments, but only if Executive is not obligated or required to (and shall not in fact) devote any managerial efforts which interfere with the services required to be performed by him hereunder, or (b) Executive’s charitable or community activities or participation in trade or professional organizations, but only if such incidental services do not interfere with the performance of Executive’s services hereunder.

10. Proprietary Information. Executive shall, throughout the term of the Employment Period, remain subject to the terms and conditions of the Proprietary Information and Inventions Agreement which he previously executed with the Corporation, and nothing in this Agreement shall supersede, modify or affect the Executive’s obligations, duties and responsibilities under such Proprietary Information and Inventions Agreement, and that agreement shall accordingly continue in full force and effect. However, to the extent the provisions of such Proprietary Information and Inventions Agreement conflict with the provisions of this Agreement, the provisions of this Agreement shall be controlling.

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11. Termination of Employment.

A. The Corporation, acting by majority vote of the Board, may terminate the Executive’s employment under this Agreement at any time for any reason, with or without cause, by giving at least sixty (60) days prior written notice of such termination to the Executive. If such termination notice is given to the Executive, the Corporation may, if it so desires, immediately relieve the Executive of some or all of his duties. However, during any such notice period, the Executive shall continue to be entitled to his regular compensation and benefits hereunder. In no event shall such sixty (60)-day notice requirement be applicable to a Termination for Cause under Paragraph C. below.

B. The Executive may terminate his employment under this Agreement at any time by giving the Corporation at least sixty (60) days prior written notice of such termination. However, in the event of a Change in Control, such sixty (60)-day notice requirement shall be reduced to ten (10) days with respect to any resignation by the Executive for one or more reasons constituting grounds for an Involuntary Termination.

C. The Corporation, acting by majority vote of the Board, may at any time, upon written notice, discharge the Executive from employment with the Corporation hereunder pursuant to a Termination for Cause. Such termination shall be effective immediately upon such notice; provided, however, that the Corporation shall first have complied with all applicable notice and cure period requirements relating to the event or events constituting the grounds for such Termination for Cause.

D. Upon the termination of the Executive’s employment for any reason (other than Termination for Cause) during the Employment Period, Executive shall be paid (i) any unpaid base salary earned under Paragraph 3 for services rendered through the date of such termination, (ii) the dollar value of all accrued and unused vacation benefits and sick pay based upon Executive’s most recent level of base salary and (iii) any Target Bonus or other bonus amount actually earned pursuant to Paragraph 3.B for one or more fiscal years but not previously paid to the Executive at the time of such termination of employment, subject to any pre-existing deferral elections which may be in effect for such amounts. In addition, the Executive shall be entitled to the payments and benefits provided under Part Three, Part Four or Part Five of this Agreement, to the extent applicable.

E. If the Executive’s employment is terminated by reason of a Termination for Cause or should the Executive voluntarily resign (other than by reason of a Qualifying Termination or any event or occurrence which qualifies as grounds for an Involuntary Termination), then the Corporation shall only be required to pay the Executive (i) any unpaid base salary earned under Paragraph 3 for services rendered through the date of such termination, (ii) any Target Bonus or other bonus amount actually earned pursuant to Paragraph 3.B for one or more fiscal years but not previously paid to the Executive and (iii) the dollar value of all accrued and unused vacation benefits and sick pay based upon Executive’s most recent level of base salary, and no benefits shall be payable to the Executive under Part Three, Part Four or Part Five of this Agreement. In addition, all vesting in Executive’s outstanding Options and Stock

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Awards shall cease at the time of such termination or resignation, and the Executive shall not have more than the period of time specified in the applicable stock option agreement for each Option in which to exercise that Option following such termination of employment for the shares of Common Stock which are vested and exercisable at the time of his termination or resignation.

PART THREE – LONG-TERM SERVICE BENEFITS

12. Entitlement. In the event of a Qualifying Termination of the Executive’s employment with the Corporation, he or his estate shall become entitled to receive the benefits provided under this Part Three.

The benefit provisions of this Part Three shall survive any election by the Corporation not to renew the Employment Period for one or more successive one-year periods following the December 31, 2007 expiration date of the initial three (3)-year term of this Agreement. Accordingly, the Executive shall be entitled to the benefits of this Part Three whether his Qualifying Termination occurs during the Employment Period or at any time thereafter. Upon an Involuntary Termination of the Executive’s employment at any time after the expiration of the Employment Period under circumstances which do not otherwise satisfy the requirements for a Qualifying Termination, the Executive shall immediately vest in his Special Long-Term Service Bonus calculated on the basis of his years of employment (not to exceed twenty-five (25) years) and salary and bonus payments through the date of such Involuntary Termination, and the present value of the ten (10)-year annual income stream upon which such bonus amount is based shall be determined through the use of discount factor or factors equal to the Applicable Federal Rates in effect on the date of the Involuntary Termination and shall be paid to the Executive in a lump sum as soon as administratively practicable following his Involuntary Termination. In the event of such Involuntary Termination, the Executive and his eligible dependents shall also be entitled to continued health care coverage in accordance with Paragraph 13(c) below.

Notwithstanding the foregoing, no benefits shall be paid to the Executive under this Part Three unless he shall comply with the following requirement:

• The Executive shall, at the time of his termination of employment, execute and deliver to the Corporation a general release (substantially in the form of attached Exhibit A) which becomes effective in accordance with applicable law and pursuant to which the Executive releases the Corporation and its officers, directors, employees and agents from any and all claims the Executive may otherwise have with respect to the terms and conditions of his employment with the Corporation and the termination of that employment. In no event, however, shall such release cover any claims, causes of action, suits, demands or other obligations or liabilities relating to:

(i) any payments, benefits or indemnification to which the Executive is or becomes entitled pursuant to the provisions of this Agreement (including, without limitation, the payments and benefits provided under this Part Three and the continued indemnification coverage under Paragraph 25); and

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(ii) any claims for workers’ compensation benefits under any of the Corporation’s workers’ compensation insurance policy or fund.

No such release shall be required as a condition to the payment of the benefits provided under this Part Three to the Executive’s estate, should the Qualifying Termination event be attributable to the Executive’s death.

13. Termination Benefits. The benefits payable to Executive or his estate under this Part Three shall consist of the following:

(a) Special Long-Term Service Bonus A Special Long-Term Service Bonus shall be paid to the Executive or his estate in a lump sum within ten (10) business days following the date the general release required of the Executive pursuant to Paragraph 12 becomes effective or (in the event of the Executive’s death) within thirty (30) days after his death. The Special Long-Term Service Bonus shall be in a dollar amount which is the present value dollar equivalent of an annual income stream payable in ten (10) consecutive annual installments, beginning as of the date of the Executive’s termination of employment, in a dollar amount per annual installment determined in accordance with the following formula:

X = 1% x A x B, where

X is the dollar amount of the installment payable each year over the ten (10)-year term.

A is the number of years of employment the Executive has completed with the Corporation at the time of his termination of employment, measured from his original hire date by the Corporation, but in no event more than twenty-five (25) years.

B is the greater of (i) the highest average annual salary and bonus paid to the Executive for any consecutive five (5)-year period within the last ten (10) years of the Executive’s employment with the Corporation or (ii) the dollar amount of One Million Five Hundred Thousand Dollars ($1,500,000).

The present value of the annual income stream calculated pursuant to the foregoing formula shall be determined through the use of discount factors equal to the Applicable Federal Rates in effect on the date of the Executive’s termination of employment or death and that present value amount shall constitute the Special Long-Term Bonus payable in a lump sum to the Executive or his estate under this Paragraph 13(a).

Payment of the Special Long-Term Service Bonus shall be subject to the Corporation’s collection of all applicable withholding taxes.

(b) Funding Requirement. The Corporation (or the successor entity) shall, within thirty (30) days after the closing of a Change in Control transaction, establish a grantor trust which complies with the requirements of the Model Trust set forth in Internal Revenue Service Procedure 92-64 (or any successor procedure or ruling) and contribute to such

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trust the amount necessary to fund the Special Long-Term Service Bonus accrued to that date. Within sixty (60) days after the start of each subsequent calendar year, the Corporation (or the successor entity) shall contribute such additional dollars to the trust as is necessary to maintain full funding for the Special Long-Term Service Bonus accrued as of the last day of the immediately preceding calendar year. The full funding of the Special Long-Term Service Bonus shall be determined through the use of interest factors equal to the Applicable Federal Rates in effect at the start of each calendar year. Notwithstanding such funding requirements, the Corporation (or the successor entity in the Change in Control transaction) shall at all times remain liable for the payment of the entire Special Long-Term Service Bonus, and to the extent the assets of the trust should prove insufficient to pay that bonus, the Corporation (or such successor entity) shall pay the difference out of its general assets.

(c) Health Care Coverage. The Corporation shall, at its sole cost and expense, provide the Executive and his spouse and other eligible dependents with continued health care coverage, at substantially the same level of coverage and benefits in effect for them at the time of the Executive’s Qualifying Termination. Such health care coverage at the Corporation’s expense shall continue until the earlier of (i) the expiration of the thirty-six (36)-month period measured from the date of the Executive’s Qualifying Termination or (ii) the first date the Executive is covered under another employer’s heath benefit program which provides substantially the same level of benefits without exclusion for pre-existing medical conditions. In the event that the Corporation’s provision of such continued health care coverage would result in the recognition of taxable income (whether for federal, state or local income tax purposes) by the Executive or his spouse or other eligible dependent, the Corporation shall provide an additional cash payment to the affected party or parties in an amount sufficient to cover the income and employment tax liability resulting from such coverage and from the additional payment itself so that the Executive and his spouse and eligible dependents do not incur any out-of-pocket tax liability with respect to such continued health care coverage. To the maximum extent permissible, the Corporation shall be entitled to provide the coverage required under this Paragraph 13(c) through the health care coverage provisions of Code Section 4980B (“COBRA”), and the Executive and his spouse and eligible dependents shall accordingly file the appropriate elections to receive such COBRA coverage, but at the Corporation’s sole cost and expense and subject to their right to the tax gross-up payments set forth above.

(d) Continued Board Service. Should the Executive remain on the Board following his Qualifying Termination, then he shall be entitled to receive for such service the same cash and/or equity compensation payable at the time to other non-employee Board members. The Executive’s Options and Stock Awards outstanding at the time of such Qualifying Termination will be governed by the terms and provisions in effect for them at that time.

PART FOUR — SEVERANCE BENEFITS

14. Entitlement. Should the Executive’s employment with the Corporation terminate during the Employment Period by reason of an Involuntary Termination in the absence of a Change in Control or by reason of an Involuntary Termination more than eighteen (18) months after a Change in Control, then the Executive shall become entitled to receive the severance benefits provided under this Part Four. Those benefits shall be subject to the

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Executive’s compliance with the restrictive covenants of Part Seven of this Agreement and shall in all cases be in lieu of any other severance benefits to which Executive might otherwise be entitled by reason of his termination of employment under such circumstances.

Notwithstanding the foregoing, the Executive’s entitlement to any severance benefits under this Part Four shall be subject to his compliance with the following requirement:

• The Executive shall, at the time of such Involuntary Termination, execute and deliver to the Corporation a general release (substantially in the form of attached Exhibit A) which becomes effective in accordance with applicable law and pursuant to which the Executive releases the Corporation and its officers, directors, employees and agents from any and all claims the Executive may otherwise have with respect to the terms and conditions of his employment with the Corporation and the termination of that employment. In no event, however, shall such release cover any claims, causes of action, suits, demands or other obligations or liabilities relating to:

(i) any payments, benefits or indemnification to which Executive is or becomes entitled pursuant to the provisions of this Agreement (including, without limitation, the payments and benefits provided under this Part Four and the continued indemnification coverage under Paragraph 25); and

(ii) any claims for workers’ compensation benefits under any of the Corporation’s workers’ compensation insurance policy or fund.

15. Severance Benefits. The severance benefits payable to Executive under this Part Four shall consist of the following:

(a) Long-Term Service Payment. Within ten (10) business days following the date the general release required of the Executive pursuant to Paragraph 14 becomes effective, the Executive shall receive in a lump sum payment equal to the present value of the ten (10)-year income stream in the annual dollar amount calculated pursuant to the benefit formula set forth in Paragraph 13(a) and based on his years of employment (not to exceed twenty-five (25) years) and salary and bonus payments through the date of such Involuntary Termination. The present value of such annual income stream shall be calculated with discount factor or factors equal to the Applicable Federal Rates in effect on the date of the Involuntary Termination. Such payment shall be in lieu of any Special Long-Term Service Bonus to which the Executive might otherwise at the time be entitled under Paragraph 13(a) and shall be subject to the Corporation’s collection of all applicable withholding taxes.

(b) Salary/Target Bonus Payment Executive shall be entitled to receive from the Corporation a severance benefit in an amount equal to seventy-five percent (75%) of the sum of (i) the highest annual rate of base salary in effect for him at any time during the twelve (12)-month period ending with the date of his Involuntary Termination and (ii) the highest level of Target Bonus in effect for him at any time during that same twelve (12)-month

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period. Such benefit shall be paid in one lump sum within ten (10) business days following the date the general release required of the Executive pursuant to Paragraph 14 becomes effective, and such payment shall be subject to the Corporation’s collection of all applicable withholding taxes.

(c) Pro-Rated Target Bonus. For each full month of employment (with any partial month of fifteen (15) days or more treated as a full month) which the Executive completes with the Corporation in the fiscal year in which his Involuntary Termination occurs, Executive shall also be entitled to receive a lump sum cash payment equal to one-twelfth (1/12th) of the annual Target Bonus in effect for him for that year, irrespective of whether or not the performance objectives for that year are attained. Such lump sum payment shall be made within ten (10) business days following the date the general release required of the Executive pursuant to Paragraph 14 becomes effective and shall be subject to all applicable withholding taxes.

(d) Health Care Coverage. The Corporation shall, at its sole cost and expense, provide the Executive and his spouse and other eligible dependents with continued health care coverage, at substantially the same level of coverage and benefits in effect for them at the time of the Executive’s Involuntary Termination. Such health care coverage at the Corporation’s expense shall continue until the earlier of (i) the expiration of the thirty-six (36)-month period measured from the date of the Executive’s Involuntary Termination or (ii) the first date the Executive is covered under another employer’s heath benefit program which provides substantially the same level of benefits without exclusion for pre-existing medical conditions. In the event that the Corporation’s provision of such continued health care coverage would result in the recognition of taxable income (whether for federal, state or local income tax purposes) by the Executive or his spouse or other eligible dependent, the Corporation shall provide an additional cash payment to the affected party or parties in an amount sufficient to cover the income and employment tax liability resulting from such coverage and from the additional payment itself so that the Executive and his spouse and eligible dependents do not incur any out-of-pocket tax liability with respect to such continued health care coverage. To the maximum extent permissible, the Corporation shall be entitled to provide the coverage required under this Paragraph 15(d) through the health care coverage provisions of Code Section 4980B (“COBRA”), and the Executive and his spouse and eligible dependents shall accordingly file the appropriate elections to receive such COBRA coverage, but at the Corporation’s sole cost and expense and subject to their right to the tax gross-up payments set forth above.

(e) LTIP Bonus Payments. To the extent one or more LTIP Bonuses have been accrued for the Executive upon the attainment of the designated performance milestones for those bonuses but such bonuses are otherwise at the time of his Involuntary Termination subject to an additional service vesting requirement, the Executive shall immediately vest in those LTIP Bonuses upon his Involuntary Termination and shall be paid those bonuses in a single lump sum. Should the Executive’s Involuntary Termination occur prior to the close of a fiscal year for which the designated performance milestones have not yet attained, then the Executive shall be entitled to a pro-rated LTIP Bonus for that year in an amount determined by multiplying one-twelfth (1/12th) of his target LTIP Bonus for such year by the number of months he remained in the Corporation’s employ during that year (with any

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partial month of fifteen (15) days or more treated as a full month). All amounts due the Executive under this Paragraph 15(e) shall be paid to him in a lump sum within ten (10) business days following the date the general release required of him pursuant to Paragraph 14 becomes effective and shall be subject to the Corporation’s collection of all applicable withholding taxes.

(f) Partial Vesting Acceleration. The Executive shall be immediately credited with an additional twenty-four (24)-months of vesting credit under each outstanding Option held (directly or indirectly) by the Executive at the time of his Involuntary Termination so that each Option shall immediately vest and become exercisable for the additional number of shares for which that Option would have otherwise been vested and exercisable under the applicable vesting schedule for such Option had the Executive actually completed an additional twenty-four (24) months of employment with the Corporation prior to the date of his Involuntary Termination. The Executive shall also receive an immediate twenty-four (24) months of additional vesting credit under any other Stock Award held (directly or indirectly) by him at the time of such Involuntary Termination.

(g) Extension of Exercise Period. For each outstanding Option which is granted the Executive on or after the date of this Agreement or which is outstanding on such date but has an exercise price per share above the Fair Market Value per share of the Common Stock on that date, the Executive shall have until the earlier of (i) the expiration of the twelve (12)-month period measured from the date of his Involuntary Termination or (ii) the expiration date of the option term in which to exercise that Option. For any other Option, the Executive shall have until the earlier of (i) the expiration of the option term or (ii) the end of the period specified in the applicable stock option agreement for the exercise of the Option following the date of the Executive’s Involuntary Termination.

PART FIVE – CHANGE IN CONTROL PAYMENTS

This Part Five sets forth certain payments and benefits to which Executive may become entitled in connection with a Change in Control or upon his subsequent Involuntary Termination or death. The payment and benefit provisions of this Part Five (other than Paragraphs 18(b), 18(c) and 18(d)) shall survive any election by the Corporation not to renew the Employment Period for one or more successive one-year periods following the December 31, 2007 expiration date of the initial three (3)-year term of this Agreement. Accordingly, the Executive shall be entitled to the payment and benefits provided under this Part Five (other than Paragraphs 18(b), 18(c) and 18(d)), whether the Change in Control and/or his Involuntary Termination or death occur during the Employment Period or at any time thereafter.

16. Vesting Acceleration. Each Option, to the extent outstanding at the time of a Change in Control but not otherwise vested and exercisable for all the shares of Common Stock subject to that Option will, immediately prior to the effective date of that Change in Control, vest and become exercisable for all of the shares of Common Stock at the time subject to the Option and may be exercised for any or all of those shares as fully-vested shares of Common Stock, provided and only if the following conditions are satisfied with respect to that Change in Control:

(i) the Option is not to be assumed by the successor corporation (or its parent company) or otherwise continued in effect pursuant to the terms of the Change in Control transaction, and

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(ii) the Option is not to be replaced with a substitute option or cash incentive plan that preserves the spread existing at the time of the Change in Control on any shares for which that Option is not otherwise at that time vested and exercisable (the excess of the Fair Market Value of those shares over the applicable option exercise price) and which vests at the same or faster rate as the vesting schedule applicable to that Option.

In addition, any Stock Award which is not to be assumed or otherwise continued in effect following such Change in Control shall, immediately prior to that Change in Control, vest in full on an accelerated basis.

17. Entitlement to Change in Control Severance Payments. Should the Executive’s employment terminate by reason of his Involuntary Termination or death within eighteen (18) months after such Change in Control, then the Executive or his estate shall become entitled to receive the Change in Control Severance Payments set forth in Paragraph 18, subject to his compliance with the following requirements:

(i) The Executive shall, at the time of such Involuntary Termination (other than a termination resulting from his death), execute and deliver to the Corporation a general release (substantially in the form of attached Exhibit A) which shall become effective under applicable law and pursuant to which the Executive releases the Corporation and its officers, directors, employees and agents from any and all claims the Executive may otherwise have with respect to the terms and conditions of his employment with the Corporation and the termination of that employment. In no event, however, shall such release cover any claims, causes of action, suits, demands or other obligations or liabilities relating to:

(a) any payments, benefits or indemnification to which the Executive is or becomes entitled pursuant to the provisions of this Agreement (including, without limitation, the Change in Control Severance Payments provided under this Part Five and the continued indemnification coverage under Paragraph 25); and

(b) any claims for workers’ compensation benefits under any of the Corporation’s workers’ compensation insurance policy or fund.

(ii) Except in the event of Executive’s death, the Change in Control Severance Payments under this Part Five shall be subject to the Executive’s compliance with the restrictive covenants set forth in Part Seven of this Agreement.

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The Change in Control Severance Payments provided under this Part Five shall be in lieu of any other severance benefits to which Executive might otherwise, by reason of the termination of his employment or death within eighteen (18) months following a Change in Control, be entitled under any other severance plan, program or arrangement of the Corporation.

18. Nature of Change in Control Severance Payments. The Change in Control Severance Payments to which the Executive shall receive under this Part Five shall consist of the following payments and benefits:

(a) Long-Term Service Payment. Within ten (10) business days following the date the general release required of the Executive pursuant to Paragraph 17 becomes effective or (in the event of the Executive’s death) within thirty (30) days after his death, the Executive or his estate shall receive a lump sum payment equal to the present value of the ten (10)-year income stream in the annual dollar amount calculated pursuant to the benefit formula set forth in Paragraph 13(a) and based on his years of employment (not to exceed twenty-five (25) years) and salary and bonus payments through the date of such Involuntary Termination or death. The present value of such annual income stream shall be calculated with discount factor or factors equal to the Applicable Federal Rates in effect on the date of the Executive’s Involuntary Termination or death. Such payment shall be in lieu of any Special Long-Term Service Bonus to which the Executive might otherwise at the time be entitled under Paragraph 13(a) and shall be subject to the Corporation’s collection of all applicable withholding taxes.

(b) Salary/Target Bonus Payment. Executive shall be entitled to receive from the Corporation a severance benefit in an amount equal to one hundred seventy-five (175%) of the sum of (i) the highest annual rate of base salary in effect for him at any time during the twelve (12)-month period ending with the date of his Involuntary Termination or death and (ii) the highest level of Target Bonus in effect for him at any time during that same twelve (12)-month period. Such benefit shall be paid to the Executive in one lump sum within ten (10) business days following the date the general release required of the Executive pursuant to Paragraph 17 becomes effective or (in the event of the Executive’s death) paid in one lump sum to his estate within thirty (30) days after his death. The payment shall be subject to the Corporation’s collection of all applicable withholding taxes.

(c) Pro-Rated Target Bonus. For each full month of employment (with any partial month of fifteen (15) days or more treated as a full month) which the Executive completes with the Corporation in the fiscal year in which his Involuntary Termination or death occurs, Executive shall also be entitled to receive a lump sum cash payment equal to one-twelfth (1/12th) of the annual Target Bonus in effect for him for that year, irrespective of whether the performance objectives for that year are actually attained. Such lump sum payment shall be made within ten (10) business days following the date the general release required of the Executive pursuant to Paragraph 17 becomes effective or (in the case of the Executive’s death) within thirty (30) days after the date of this death. The payment shall be subject to the Corporation’s collection of all applicable withholding taxes.

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(d) Health Care Coverage. The Corporation shall, at its sole cost and expense, provide the Executive and his spouse and other eligible dependents with continued health care coverage, at substantially the same level of coverage and benefits in effect for them at the time of the Executive’s Involuntary Termination or death. Such health care coverage at the Corporation’s expense shall continue until the earlier of (i) the expiration of the thirty-six (36)-month period measured from the date of the Executive’s Involuntary Termination or death or (ii) the first date the Executive is covered under another employer’s heath benefit program which provides substantially the same level of benefits without exclusion for pre-existing medical conditions. In the event that the Corporation’s provision of such continued health care coverage would result in the recognition of taxable income (whether for federal, state or local income tax purposes) by the Executive or his spouse or other eligible dependent, the Corporation shall provide an additional cash payment to the affected party or parties in an amount sufficient to cover the income and employment tax liability resulting from such coverage and from the additional payment itself so that the Executive and his spouse and eligible dependents do not incur any out-of-pocket tax liability with respect to such continued health care coverage. To the maximum extent permissible, the Corporation shall be entitled to provide the coverage required under this Paragraph 18(d) through the health care coverage provisions of Code Section 4980B (“COBRA”), and the Executive and his spouse and eligible dependents shall accordingly file the appropriate elections to receive such COBRA coverage, but at the Corporation’s sole cost and expense and subject to their right to the tax gross-up payments set forth above.

(e) LTIP Bonus Payments. To the extent one or more LTIP Bonuses have been accrued for the Executive upon the attainment of the designated performance milestones for those bonuses but such bonuses are otherwise at the time of his Involuntary Termination or death subject to an additional service vesting requirement, the Executive shall immediately vest in those LTIP Bonuses upon his Involuntary Termination or death, and those bonuses shall be paid in a single lump sum. The Executive shall also immediately vest in his target LTIP Bonus for the fiscal year in which such Involuntary Termination occurs. All amounts due the Executive under this Paragraph 18(e) shall be paid to him in a lump sum within ten (10) business days following the date the general release required of him pursuant to Paragraph 17 becomes effective or (in the case of the Executive’s death) within thirty (30) days after the date of this death. The Payment shall be subject to the Corporation’s collection of all applicable withholding taxes.

(f) Vesting Acceleration. Each outstanding Option held (directly or indirectly) by the Executive at the time of such Involuntary Termination or death, to the extent not otherwise vested and exercisable for all the shares subject to that Option, will immediately vest and become exercisable for all those option shares and may be exercised for any or all of those shares as fully vested shares. In addition, all Stock Awards held (directly or indirectly) by him at the time of such Involuntary Termination or death shall also immediately vest in full.

(g) Extension of Exercise Period. For each outstanding Option which is granted the Executive on or after the date of this Agreement or which is outstanding on that date but has an exercise price per share above the Fair Market Value per share of the Common Stock on that date, the Executive shall have until the earlier of (i) the expiration of the twelve (12)-month period measured from the date of his Involuntary Termination or death or (ii) the expiration date of the option term in which to exercise that Option. For any other Option, the

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Executive shall have until the earlier of (i) the expiration of the option term or (ii) the end of the period specified in the applicable stock option agreement for the exercise of the Option following the date of the Executive’s Involuntary Termination or death.

PART SIX – SPECIAL BENEFIT LIMITATION

19. Limitation of Benefits. The amount of the Change in Control Severance Payments otherwise due the Executive under Part Five of the Agreement shall be reduced to the extent necessary to assure that the aggregate Present Value of the Parachute Payment attributable to his Change in Control Severance Payments, the Option Parachute Payment attributable to his Acquisition-Accelerated Options and any Other Parachute Payments to which the Executive may be entitled does not exceed the greater of the following dollar amounts (the “Benefit Limit”)

a. 2.99 times the Executive’s Average Annual Compensation, or

b. the greatest after-tax amount payable to the Executive under Part Five after taking into account any excise tax imposed under Code Section 4999 on the payments and benefits which are provided him under Part Five or which constitute Other Parachute Payments to which he might be entitled.

In determining whether such Benefit Limit is exceeded, the Independent Auditors shall make a reasonable determination of the value to be assigned to the restrictive covenants which will be in effect for the Executive pursuant to Part Seven of the Agreement, and the amount of his potential Parachute Payments shall reduced by the value of those restrictive covenants to the extent consistent with Code Section 280G and the Treasury Regulations thereunder.

20. Reduction of Benefits. Once the requisite determinations under Paragraph 19 have been made, then to the extent the aggregate Present Value, measured as of the Change in Control, of (i) the Option Parachute Payment attributable to the Acquisition-Accelerated and Severance-Accelerated Options (or installments thereof) plus (ii) the Parachute Payment attributable to the Executive’s other benefit entitlements under Part Five of the Agreement would, when added to the Present Value of all of his Other Parachute Payments, exceed the Benefit Limit, then the following reductions shall be made to the Change in Control Severance Payments to which the Executive is otherwise entitled under Part Five of the Agreement and his Acquisition-Accelerated Options, to the extent necessary to assure that such Benefit Limit is not exceeded:

first, the salary/target bonus continuation payment to which the Executive would otherwise be entitled shall be reduced,

then, the special lump sum payment under Part Five shall be reduced,

then, the LTIP Bonus payments shall be reduced,

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then the number of shares which would otherwise be purchasable under his Acquisition-Accelerated and Severance-Accelerated Options shall be reduced (based on the amount of the Option Parachute Payment attributable to each such Option) to the extent necessary to eliminate such excess, with the actual Options to be so reduced to be determined by the Executive, and

finally the number of shares which would otherwise vest on an accelerated basis under one or more outstanding Stock Awards shall be reduced (based on the amount of the Parachute Payment attributable to each such accelerated Stock Award) to the extent necessary to eliminate such excess, with the actual Stock Awards to be so reduced to be determined by the Executive.

21. Resolution Procedures. In the event there is any disagreement between the Executive and the Corporation as to whether one or more payments to which the Executive becomes entitled in connection with the Change in Control or his subsequent Involuntary Termination constitute Parachute Payments, Option Parachute Payments or Other Parachute Payments or as to the determination of the Present Value thereof, such dispute will be resolved as follows:

(i) In the event the Treasury Regulations under Code Section 280G (or applicable judicial decisions) specifically address the status of any such payment or the method of valuation therefor, the characterization afforded to such payment by the Regulations (or such decisions) will, together with the applicable valuation methodology, be controlling.

(ii) In the event Treasury Regulations (or applicable judicial decisions) do not address the status of any payment in dispute, the matter will be submitted for resolution to the Independent Auditors. The resolution reached by the Independent Auditors will be final and controlling; provided, however, that if in the judgment of the Independent Auditors, the status of the payment in dispute can be resolved through the obtainment of a private letter ruling from the Internal Revenue Service, a formal and proper request for such ruling will be prepared and submitted by the Independent Auditors, and the determination made by the Internal Revenue Service in the issued ruling will be controlling. All expenses incurred in connection with the retention of the Independent Auditors and (if applicable) the preparation and submission of the ruling request shall be shared equally by the Executive and the Corporation.

(iii) In the event Treasury Regulations (or applicable judicial decisions) do not address the appropriate valuation methodology for any payment in dispute, the Present Value thereof will, at the Independent Auditor’s election, be determined through an independent third-party appraisal, and the expenses incurred in obtaining such appraisal shall be shared equally by the Executive and the Corporation.

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PART SEVEN — RESTRICTIVE COVENANTS

22. Restrictive Covenants. For a period of twelve (12) months following the date of an Involuntary Termination of Executive’s employment under circumstances which entitle him to severance benefits under Part Four or Part Five of this Agreement, the Executive shall comply with each of the following restrictive covenants:

(A) The Executive shall not directly or indirectly, on his own behalf or on behalf of others, (i) solicit, induce, recruit or encourage any of the Corporation’s employees to leave the Corporation’s employ, (ii) solicit, induce, recruit or encourage any of the Corporation’s consultants to leave their consulting assignment or (iii) attempt to do any of the foregoing.

(B) The Executive shall not render any services or otherwise provide any advice or assistance to any Competing Business, whether as an employee, consultant, partner, principal, agent, representative, equity holder or in any other capacity, without the express prior written consent of the Corporation; provided, however, that such restriction shall not apply to any passive investment representing an interest of less than one percent (1%) of an outstanding class of publicly-traded securities of any corporation or other enterprise which may otherwise be designated hereunder as a Competing Business at the time of such investment.

A Competing Business shall mean the six (6) companies designated by the Corporation on Appendix I to this Agreement. The Corporation may revise Appendix I at any time, and from time to time, by adding names to, or subtracting names from, such list; provided, however, that the Corporation must comply with the following requirements in making any changes to Appendix I:

(i) absent the Executive’s express written consent, any such change to Appendix I must be made at least sixty (60) days before termination of Executive’s employment for any reason;

(ii) any change must be made in writing and either personally delivered to the Executive or sent to the Executive’s last known address by certified mail, return receipt requested; and

(iii) the Corporation can never include more than six (6) companies or entities on Appendix I. (Thus, if Appendix I lists six (6) companies or entities and the Corporation adds one or more companies or entities to Appendix I, then the Corporation must delete a like number.)

Notwithstanding the foregoing, a change in the list of Competing Businesses shall automatically be deemed to occur from time to time to the extent the Corporation designates one or more entities (other than those listed at that time on Appendix I) as its principal competitors in any public filings made by the Corporation, pursuant to the periodic reporting requirements of the Exchange Act, more than sixty (60) days prior to the termination of the Executive’s employment; provided, however, that not more than six (6) designated entities in total shall comprise the class of Competing Businesses at any time hereunder.

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Any severance benefits or payments to which Executive may become entitled under Part Four or Part Five of this Agreement shall immediately cease should the Executive fail to comply with any of the restrictive covenants set forth in this Part Seven. In addition, the Corporation shall be entitled to monetary damages in the event of the Executive’s breach of such restrictive covenants, but in no event in an amount in excess of the aggregate cash payments actually made to the Executive under Part Four or Part Five of this Agreement. Executive hereby acknowledges that monetary damages may not be sufficient to compensate the Corporation for any economic loss which may be incurred by reason of the Executive’s breach of the restrictive covenants set forth in this Part Seven. Accordingly, in the event of any breach of those covenants, the Corporation shall be entitled to obtain equitable relief in the form of an injunction precluding the Executive from continuing such breach.

PART EIGHT — MISCELLANEOUS PROVISIONS

23. Delayed Commencement of Benefits. Notwithstanding any provision to the contrary in this Agreement, no Special Long-Term Service Bonus (or the lump sum equivalent under Part Four or Part Five) or salary/Target Bonus payments or any other payments to which the Executive becomes entitled under Part Three, Part Four or Part Five of this Agreement shall be made or paid to the Executive prior to the earlier of (i) the expiration of the six (6)-month period measured from the date of his “separation from service” with the Corporation (as such term is defined in Treasury Regulations issued under Code Section 409A) or (ii) the date of his death, if the Executive is deemed at the time of such separation from service a “key employee” within the meaning of that term under Code Section 416(i) and such delayed commencement is otherwise required in order to avoid a prohibited distribution under Code Section 409A(a)(2). Upon the expiration of the applicable Code Section 409A(a)(2) deferral period, all payments deferred pursuant to this Paragraph 23 (whether they would have otherwise been payable in a single sum or in installments in the absence of such deferral) shall be paid in a lump sum to the Executive, and any remaining payments due under this Agreement shall be paid in accordance with the normal payment dates specified for them herein. The Executive shall be entitled to interest on the deferred benefits and payments for the period the commencement of those benefits and payments is delayed under Part Three, Part Four or Part Five of this Agreement by reason of Code Section 409A(a)(2), with such interest to accrue at the prime rate in effect from time to time during that period and to be paid in a lump sum upon the expiration of the deferral period.

24. Compliance with Section 409A. It is the intent of the Corporation and the Executive that the provisions of this Agreement comply with all applicable requirements of Code Section 409A. Accordingly, to the extent any provisions of this Agreement would otherwise contravene one or more requirements or limitations of Code Section 409A, then the Corporation and the Executive shall, within the remedial amendment period provided under the Treasury Regulations issued under Code Section 409A, effect through mutual agreement the appropriate amendments to those provisions which are necessary in order to bring the provisions of this Agreement into compliance with Section 409A.

25. Continued Indemnification. The indemnification provisions for Officers and Directors under the Corporation’s bylaws and the Directors and Officers Liability Insurance Policy (if any) shall (to the maximum extent permitted by law) be extended to the Executive

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during the period following his resignation or termination of employment for any reason (other than a Termination for Cause), whether or not in connection with a Change in Control, with respect to all matters, events or transactions occurring or effected during the Executive’s period of employment with the Company. The indemnification coverage provided by this Paragraph 25 shall survive any termination of this Agreement.

26. No Mitigation Duty. The Corporation shall not be entitled to set off any of the following amounts against the payments or benefits to which the Executive may become entitled under Part Three, Part Four or Part Five of this Agreement: (i) any amounts which the Executive may subsequently earn through other employment or service following his termination of employment with the Corporation or (ii) any amounts which the Executive might have potentially earned in other employment or service had he sought such other employment or service.

27. Death. Should Executive die before he receives the full amount of payments and benefits to which he may become entitled under this Agreement, then the balance of such payments shall be made, on the due dates hereunder had Executive survived, to the executors or administrators of his estate.

28. Successors and Assigns. The provisions of this Agreement shall inure to the benefit of, and shall be binding upon, (i) the Corporation and its successors and assigns, including any successor entity by merger, consolidation or transfer of all or substantially all of the Corporation’s assets (whether or not such transaction constitutes a Change in Control), and (ii) the Executive, the personal representative of his estate and his heirs and legatees. In the event of a Change in Control, this Agreement shall, notwithstanding any provision to the contrary herein, automatically continue in full force and effect for a period of not less than eighteen (18) months following the effective date of the Change in Control and, accordingly, may not at any time be terminated by the Corporation or the successor entity prior to the expiration of that eighteen (18)-month period.

29. General Creditor Status. The benefits to which Executive may become entitled under Part Three, Part Four or Part Five of this Agreement shall be paid, when due, from the Corporation’s general assets and, to the extent required thereunder, from the trust established under Paragraph 13(b). Except for the trust established pursuant to Paragraph 13(b), no trust fund, escrow arrangement or other segregated account shall be established as a funding vehicle for such payments. The Executive’s right (or the right of the executors or administrators of Executive’s estate) to receive such benefits shall at all times be that of a general creditor of the Corporation and shall have no priority over the claims of other general creditors.

30. Notices.

A. Any and all notices, demands or other communications required or desired to be given hereunder by any party shall be in writing and shall be validly given or made to another party if delivered either personally or if deposited in the United States mail, certified or registered, postage prepaid, return receipt requested. If such notice, demand or other communication shall be delivered personally, then such notice shall be conclusively deemed give at the time of such personal delivery. If such notice, demand or other communication is given by

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mail, such notice shall be conclusively deemed given forty-eight (48) hours after deposit in the United States mail addressed to the party to whom such notice, demand or other communication is to be given as hereinafter set forth:

To the Corporation:	Mercury Interactive Corporation
	379 North Whisman Road
	Mountain View, CA 94043
	Attention:	General Counsel

Any notice to the Executive shall be addressed to his home address as set forth at the time in the records of the Corporation.

B. Any party hereto may change its address for the purpose of receiving notices, demands and other communications as herein provided by a written notice given in the manner aforesaid to the other party hereto.

31. Governing Documents. This Agreement, together with (i) the agreements evidencing the Executive’s currently outstanding Options and LTIP Bonus awards and any future Option grants, Stock Awards or LTIP Bonus awards, (ii) his existing Officer’s Indemnification Agreement with the Corporation and (iii) his existing Proprietary Information and Inventions Agreement with the Corporation, shall constitute the entire agreement and understanding of the Corporation and the Executive with respect to the terms and conditions of the Executive’s employment with the Corporation and the payment of severance benefits and shall supersede all prior and contemporaneous written or verbal agreements and understandings between the Executive and the Corporation relating to such subject matter. including (without limitation) the February 26, 1998 letter agreement between the Corporation and the Executive providing certain change in control severance benefits. This Agreement may only be amended by written instrument signed by the Executive and an authorized officer of the Corporation. Any and all prior agreements, understandings or representations relating to the Executive’s employment with the Corporation, other than (i) the agreements evidencing the Executive’s currently outstanding Options and LTIP Bonus awards, (ii) his existing Officer’s Indemnification Agreement and (iii) his existing Proprietary Information and Inventions Agreement, are hereby terminated and cancelled in their entirety and are of no further force or effect.

32. Governing Law. The provisions of Agreement shall be construed and interpreted under the laws of the State of California applicable to agreements executed and wholly performed within the State of California. If any provision of this Agreement as applied to any party or to any circumstance should be adjudged by a court of competent jurisdiction to be void or unenforceable for any reason, the invalidity of that provision shall in no way affect (to the maximum extent permissible by law) the application of such provision under circumstances different from those adjudicated by the court, the application of any other provision of this Agreement, or the enforceability or invalidity of this Agreement as a whole. Should any provision of this Agreement become or be deemed invalid, illegal or unenforceable in any jurisdiction by reason of the scope, extent or duration of its coverage, then such provision shall be deemed amended to the extent necessary to conform to applicable law so as to be valid and

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enforceable or, if such provision cannot be so amended without materially altering the intention of the parties, then such provision will be stricken, and the remainder of this Agreement shall continue in full force and effect.

33. Arbitration.

A. Arbitration. Any and all controversies, claims or disputes with the Corporation or with anyone, including without limitation any employee, manager, officer, agent, shareholder, fiduciary or administrator of the Corporation, arising from or relating to or resulting from the Executive’s employment with the Corporation pursuant to the terms of this Agreement or the termination of such employment shall be subject to and resolved by binding arbitration. Binding arbitration pursuant to this Agreement shall be pursuant to California law, including California Code of Civil Procedure Section 1280 through 1294.2, including Section 1283.05. This Paragraph 33 also applies to any disputes that the Corporation may have with the Executive, other than as set forth in Paragraph 22. In agreeing to arbitrate any and all claims, the Executive HEREBY WAIVES ANY RIGHT TO TRIAL BY JURY, INCLUDING ANY STATUTORY CLAIMS UNDER STATE AND FEDERAL LAW, INCLUDING BUT NOT LIMITED TO CLAIMS UNDER TITLE VII OF THE CIVIL RIGHTS ACT OF 1964, THE AMERICANS WITH DISABILITIES ACT OF 1990, THE AGE DISCRIMINATION IN EMPLOYMENT ACT OF 1967, THE OLDER WORKERS BENEFIT PROTECTION ACT, THE CALIFORNIA FAIR EMPLOYMENT AND HOUSING ACT, THE CALIFORNIA LABOR CODE, CLAIMS OF SEXUAL OR OTHER UNLAWFUL HARASSMENT OR DISCRIMINATION OR WRONGFUL TERMINATION, ANY OTHER STATUTORY CLAIMS, AND ANY CLAIMS FOR BREACH OF CONTRACT, TORT, OR ANY OTHER BASES IN STATE, FEDERAL, LOCAL OR COMMON LAW.

B. Procedure. Any arbitration will be administered by the American Arbitration Association (“AAA”) and a neutral arbitrator will be selected in a manner consistent with its National Rules for the Resolution of Employment Disputes (the “Rules”). The arbitration shall take place in Santa Clara County, California, and the arbitrator shall conduct and administer any arbitration in a manner consistent with the Rules, and with California law, including the power to conduct adequate discovery, decide any motions brought by any parties, and to award any remedies, including attorneys’ fees and costs, available under applicable law. The arbitrator shall issue a binding written award that sets forth the essential findings and conclusions on which the award is based. The Corporation shall pay for all fees charged by the arbitrator and by the AAA, regardless of the party initiating the arbitration. The Corporation shall reimburse the Executive in any arbitration up to a maximum of $2,000 for his travel expenses incurred for travel to the Santa Clara County area in connection with the arbitration hearing if the Executive resides more than 300 miles from the location selected in Santa Clara County for the arbitration.

C. Remedies and Injunctive Relief. Arbitration shall be the sole, exclusive and final remedy for any dispute between the Corporation and the Executive, except as otherwise set forth in Paragraph 22. Accordingly, neither the Corporation nor the Executive will be permitted to pursue court action regarding claims that are subject to arbitration. However, nothing in this Agreement will prohibit either party from seeking provisional relief, including an

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injunction or other such relief. No bond or other security shall be required in obtaining such relief. In the event either party seeks injunctive relief from a court, the prevailing party shall be entitled to recover reasonable costs and attorneys’ fees, to the extent allowable under applicable law.

D. Administrative Relief. This Agreement does not prohibit the Executive from pursuing an administrative claim with a local, state or federal administrative body or agency, such as the California Department of Fair Employment and Housing, the U.S. Equal Employment Opportunity Commission, or the California Workers’ Compensation Board. This Paragraph 33 does, however, prohibit the Executive from seeking or pursuing court action regarding any such claim.

E. Recovery of Fees and Costs. The Corporation shall bear the entire cost of (i) the arbitrator’s fee, (ii) any other type of expense or cost that the Executive would not be required to bear if the Executive were free to bring the dispute or claim in court and (iii) any other expense or cost that is unique to arbitration. The parties intend that this Paragraph 33 shall be valid, binding, enforceable and irrevocable and shall survive the termination of this Agreement. Any final decision of the arbitrator so chosen may be enforced by a court of competent jurisdiction. If the Executive is determined by the arbitrator to be the prevailing party in the arbitration, then the Executive shall be entitled to reimbursement from the Corporation of all the reasonable fees (including attorney fees) and expenses the Executive incurs in connection with such arbitration.

34. Attorney Fees. The Corporation shall reimburse, as promptly as practicable after its receipt of documentation therefor, all of Executive’s reasonable and documented attorneys’ fees and expenses in connection with the preparation, negotiation, and execution of this Agreement.

35. Counterparts. This Agreement may be executed in more than one counterpart, each of which shall be deemed an original, but all of which together shall constitute but one and the same instrument.

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IN WITNESS WHEREOF, the parties have executed this Employment Agreement as of the day and year written above.

MERCURY INTERACTIVE CORPORATION
By:	/s/ Giora Yaron
Title:	Chairman of the Compensation Committee
/s/ Amnon Landan
AMNON LANDAN

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APPENDIX I

LIST OF COMPETING BUSINESSES

(AS OF FEBRUARY 11, 2005)

Compuware

BMC Software

IBM

Hewlett-Packard Company

Computer Associates

Quest Software

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EXHIBIT A

FORM OF GENERAL RELEASE

RELEASE AND WAIVER OF CLAIMS

In consideration of the severance payments and other benefits to which I have become entitled, pursuant to that certain Employment Agreement between Mercury Interactive Corporation, a Delaware corporation (the “Company”), and myself dated                     , 2005 (the “Employment Agreement), in connection with the termination of my employment on this date, I, Amnon Landan, hereby furnish the Company with the following release and waiver (“Release and Waiver”).

I hereby release and forever discharge the Company, its officers, directors, agents, employees, stockholders, successors, assigns and affiliates from any and all claims, liabilities, demands, causes of action, costs, expenses, attorney fees, damages, indemnities and obligations of every kind and nature, in law, equity or otherwise, known and unknown, suspected and unsuspected, disclosed and undisclosed, arising from or relating to my employment with the Company and the termination of that employment, including (without limitation) claims of wrongful discharge, emotional distress, defamation, fraud, breach of contract, breach of the covenant of good faith and fair dealing, discrimination claims based on sex, age, race, national origin, disability or any other basis under Title VII of the Civil Rights Act of 1964, as amended, the California Fair Employment and Housing Act, the Federal Age Discrimination in Employment Act of 1967, as amended (“ADEA”), the Americans with Disability Act, contract claims, tort claims, and wage or benefit claims, including but not limited to, claims for salary, bonuses, commissions, stock grants, stock options, vacation pay, fringe benefits, severance pay or any other form of compensation (other than the payments, rights, benefits and indemnification to which I am entitled under the express provisions of the Employment Agreement, my vested rights under the Company’s Section 401(k) Plan and any worker’s compensation benefits under any Company workers’ compensation insurance policy or fund).

In releasing claims unknown to me at present, I am waiving all rights and benefits under Section 1542 of the California Civil Code, and any law or legal principle of similar effect in any jurisdiction: “A general release does not extend to claims which the creditor does not know or suspect to exist in his favor at the time of executing the release, which if known by him must have materially affected his settlement with the debtor.”

This Release and Waiver does not pertain to any claims which may subsequently arise in connection with the Company’s default in any of its payment or indemnification obligations under the Employment Agreement or any obligations which expressly survive the termination of that Agreement.

I acknowledge that, among other rights subject to his Release and Waiver, I am hereby waiving and releasing any rights I may have under ADEA, that this release and waiver is knowing and voluntary, and that the consideration given for this release and waiver is in addition to anything of value to which I was already entitled as an executive of the Company. I further acknowledge that I have been advised, as required by the Older Workers Benefit Protection Act, that: (a) the release and waiver granted herein does not relate to claims which may arise after this release and waiver is executed; (b) I have the right to consult with an attorney prior to executing this release and waiver (although I may choose voluntarily not to do so); and if I am

over 40 years old upon execution of this (c) I have twenty-one (21) days from the date of termination of my employment with the Company in which to consider this release and waiver (although I may choose voluntarily to execute this release and waiver earlier); (d) I have seven (7) days following the execution of this release and waiver to revoke my consent to this release and waiver; and (e) this release and waiver shall not be effective until the seven (7)-day revocation period has expired.

Date:                                , 20
	AMNON LANDAN

2

EX-10.42

Exhibit 10.42

Mercury Interactive Corporation

Long-Term Incentive Plan

(Amended as of February 11, 2005)

Section 1. Purpose. The purpose of this Long-Term Incentive Plan (the “Plan”) is to aid Mercury Interactive Corporation, a Delaware corporation (together with its successors and assigns, the “Company”), in attracting, retaining, motivating and rewarding key senior employees and executives of the Company or its subsidiaries or affiliates using stock-based and cash-based incentives.

Section 2. Definitions. In addition to the terms defined in Section 1 above and elsewhere in the Plan, the following capitalized terms used in the Plan have the respective meanings set forth in this Section:

(a) “Award” means any right granted to a Participant under this Plan to receive cash awards.

(b) “Board” means the Board of Directors of the Company.

(c) “Cause” means, unless otherwise provided by the Committee or in an employment agreement of any Participant, (i) any act of personal dishonesty taken by a Participant in connection with such Participant’s responsibilities as an employee and intended to result in substantial personal enrichment; (ii) a Participant being convicted of a felony; or (iii) a willful act by a Participant which constitutes gross misconduct and which is materially injurious to the Company.

(d) “Change of Control Agreement” means a change of control agreement between a Participant and the Company.

(e) “Code” means the Internal Revenue Code of 1986, as amended. References to any provision of the Code or regulation (including a proposed regulation) thereunder shall include any successor provisions and regulations.

(f) “Committee” means the compensation committee or other committee consisting of one or more directors designated by the Board to administer the Plan. If no Committee has been designated to administer the Plan, the Board shall be the “Committee” for purposes of the Plan.

(g) “Participant” means a person who has been granted an Award under the Plan.

(h) “Performance Goals” means the performance objectives of the Company during a Performance Period for the purposes of determining whether, and to what extent, Awards will be earned for the Performance Period.

(i) “Performance Period” means the period of time over and within which performance is measured for the purposes of determining whether an Award has been earned.

Section 3. Administration; Eligibility; Termination and Amendment.

(a) Administration. The Committee shall have full power and authority to construe, interpret and administer the Plan. All decisions, actions or interpretations of the Committee shall be final, conclusive, and binding upon all parties.

(b) Eligibility. Participants in the Plan shall be selected by the Committee in its discretion from among the executive officers and senior managers of the Company. In making this selection and in determining the form and amount of awards, the Committee may consider any factors it deems relevant, including, without limitation, the individuals’ functions, responsibilities, value of services to the Company and past and potential contributions to the Company’s profitability and growth.

(c) Term. The Plan shall commence on the date determined by the Committee, which is expected to be the start of fiscal 2005, and may continue in full force and effect until terminated by the Committee.

(d) Amendment and Termination. The Committee reserves the right at any time to amend, suspend, or terminate the Plan in whole or in part and for any reason and without the consent of any Participant; provided that any outstanding Award shall not be materially adversely affected without the consent of the Participant.

Section 4. Cash Awards.

(a) Generally. Cash-based Awards that are granted by the Committee shall be earned if and to the extent the Company achieves Performance Goals as specified by the Committee hereunder. The Committee may also determine to consider a Participant’s individual performance making Awards hereunder and may condition receipt of payment of an Award on vesting beyond the Performance Period.

(b) Business Criteria. The Committee shall determine the business criteria for the Company that shall be used in establishing Performance Goals for such Awards. These criteria may include earnings per share, revenues, bookings, expenses, gross profit, operating income, net income, cash flow, capital expenditures, working capital, economic value added, stock price per share, market value, enterprise value, book value, return on equity, return on book value, return on invested capital, return on asset, capital structure, return on investment, and/or utilization. The Committee expects the initial Performance Goals to be earnings per share and bookings growth. The Committee shall determine the

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target level of performance that must be achieved with respect to each criterion that is identified in a Performance Goal in order for a Performance Goal to be treated as attained as well as the incremental effect of achieving performance greater than the target.

(c) Performance Period; Timing for Establishing Performance Goals. Achievement of Performance Goals in respect of such Awards shall be measured over a Performance Period established by the Committee. In addition, the Committee may specify a vesting period for payment of the Award that may be longer than the Performance Period. Initially, the Performance Period is expected to be one fiscal year with vesting after three years. If necessary and desired to meet the requirements of Section 162(m) of the Code for any Participant, the Performance Goals shall be established in writing not later than 90 days after the beginning of any Performance Period applicable to such Award.

(d) Payment.

(i) General. Except as otherwise set forth herein or determined by the Committee, a Participant must be an active employee in good standing and on the Company’s or an approved subsidiary’s payroll on the day the Award is paid to receive any portion of the Award. A Participant who is not actively employed or on an approved payroll for whatever reason on the date an Award is paid is not entitled to a partial or pro rata Award. The Committee may make exceptions in its sole discretion.

(ii) Involuntary Termination. Unless otherwise determined by the Committee when granting an Award, if a Participant’s employment with the Company is terminated without Cause before an outstanding Award has been paid, then: (A) if such termination occurs after completion of the applicable Performance Period in which the Performance Goals were met but before vesting of the Award, the Participant shall receive payment of the Award; or (B) if such termination occurs during a Performance Period, then the Participant shall receive a pro-rated portion of the Award based on performance to date under the Performance Period as determined by the Committee, with a maximum payment based on such Participant’s target level.

(iii) Death of Participant. In the event of the death of a Participant after an Award has been granted but before payment of the Award, the amount of the Award shall be paid to the Participant’s estate or by a person who acquired the right to the Award by bequest or inheritance.

(iv) Change of Control. With respect to any Participant who is subject to a Change of Control Agreement, upon an Involuntary Termination (as defined in a Change of Control Agreement) of such Participant during the Change of Control Period (as defined in a Change of

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Control Agreement) before an outstanding Award has been paid, then (A) if such termination occurs after completion of the applicable Performance Period in which the Performance Goals were met but before vesting of the Award, the Participant shall receive payment of the Award in the amount determined by the actual achievement of the Performance Goals; or (B) if such termination occurs during a Performance Period, then the Participant shall receive the target level of such Award.

Section 5. Equity Awards. The Committee may grant equity awards to Participants as part of its long-term incentive program. Any equity awards will be granted under the Company’s Amended and Restated 1999 Stock Option Plan or such other equity incentive plan as designated by the Committee (in any case, the “Equity Plan”). The terms and conditions of any such equity awards shall be as set forth in the applicable Equity Plan and as determined by the Committee.

Section 6. General Provisions.

(a) Limits on Transferability; Beneficiaries. No Award under the Plan shall be assignable or transferable by the Participant thereof, except by will or by the laws of descent and distribution, unless the Committee shall elect to permit such an assignment or transfer in its sole discretion.

(b) Withholding. Whenever payments under the Plan are to be made, the Company will withhold therefrom, or from any other amounts payable to or in respect of the Participant, an amount sufficient to satisfy any applicable governmental withholding tax requirements related thereto.

(c) Unfunded Status of Awards; Creation of Trusts. The Plan is intended to constitute an “unfunded” plan. With respect to any payments not yet made to a Participant or other obligations under an Award, nothing contained in the Plan or any Award shall give any such Participant any rights that are greater than those of a general creditor of the Company.

(d) Nonexclusivity of the Plan. The adoption of the Plan by the Board shall not be construed as creating any limitations on the power of the Board or a committee thereof to adopt such other incentive arrangements, apart from the Plan, as it may deem desirable.

(e) Compliance with Section 162(m). The Committee may determine to submit the Plan for approval by the Company’s stockholders for purposes of qualifying Awards to executives covered under Section 162(m) of the Code and regulations thereunder (“Section 162(m)”) as “performance based compensation” with the meaning of Section 162(m), to the extent consistent with the business goals of the Company. If the Committee has made that determination, in connection with language that is designated as intended to comply with Section 162(m) of the Code, the terms of the Plan shall be interpreted in a manner consistent with Section 162(m). If any provision of the Plan or any Award

4

document relating to an Award that is designated as intended to comply with Section 162(m) does not comply or is inconsistent with the requirements of Section 162(m), such provision shall be construed or deemed amended to the extent necessary to conform to such requirements, and no provision shall be deemed to confer upon the Committee or any other person discretion to increase the amount of compensation otherwise payable in connection with any such Award upon attainment of the applicable performance objectives.

(f) Governing Law. The validity, construction, and effect of the Plan, any rules and regulations relating to the Plan and any Award document shall be determined in accordance with the laws of the State of California, without giving effect to principles of conflicts of laws, and applicable provisions of federal law.

(g) Limitation on Rights Conferred under Plan. Neither the Plan nor any action taken hereunder shall be construed as (i) giving any Participant the right to continue in the employ or service of the Company, (ii) interfering in any way with the right of the Company to terminate any Participant’s employment or service at any time (subject to the terms and provisions of any separate written agreements), or (iii) giving a Participant any claim to be granted any Award under the Plan or to be treated uniformly with other Participants and employees.

(h) Severability; Entire Agreement. If any of the provisions of this Plan or any Award document is finally held to be invalid, illegal or unenforceable (whether in whole or in part), such provision shall be deemed modified to the extent, but only to the extent, of such invalidity, illegality or unenforceability, and the remaining provisions shall not be affected thereby; provided, that, if any of such provisions is finally held to be invalid, illegal, or unenforceable because it exceeds the maximum scope determined to be acceptable to permit such provision to be enforceable, such provision shall be deemed to be modified to the minimum extent necessary to modify such scope in order to make such provision enforceable hereunder. The Plan and any Award documents contain the entire agreement of the parties with respect to the subject matter thereof and supersede all prior agreements, promises, covenants, arrangements, communications, representations and warranties between them, whether written or oral with respect to the subject matter thereof.

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EX-10.43

Exhibit 10.43

Mercury Executive Annual Incentive Bonus Plan

Overview and Purpose

Mercury’s annual incentive plan was created as a means to recognize and reward the link between the achievement of Mercury’s corporate objectives and the executive’s contribution to this success. The plan is designed to actively engage executives in achieving performance goals by placing compensation “at risk” based on performance. The specific purpose of the plan is to:

• Align the risks/rewards for the senior management team to achieve Mercury’s top business priorities, and

• Motivate and retain executives by providing above market compensation opportunities linked to performance.

• Establish a direct link between operational performance that creates shareholder value and individual performance and rewards.

• Align interests and objectives of shareholders and executives to drive Company growth that creates shareholder value.

Performance Period

The plan is based on annual performance for 2005.

Eligibility and Participation

Executives who participate as a member of the Operations Team and who are employed at the end of the fiscal year are considered eligible to participate and receive an award under the plan. An executive must be rated “Solid” or better through the performance review process for the fiscal year to be eligible for an award under the plan.

Performance Measures

• The Plan rewards performance as measured against Mercury’s financial performance and individual performance as measured against a pre-defined set of Key Performance Indicators (KPIs).

Award Pool Funding

This pool is the amount of total dollars that are available for incentive awards for the executive team. The pool is based on Mercury’s financial performance for the year against the key metrics outlined above.

Mercury Executive Annual Incentive Bonus Plan

The company must meet a minimum level of performance, referred to as the threshold, to initiate funding in the pool. Threshold performance is met when the company has achieved 75% of plan against the financial metrics. Company performance between 75% and 125% funds the pool at 100% of target incentive opportunity.

Each executive position has a defined target incentive opportunity, expressed as a percent of salary, based on the competitive assessment. This target is used to determine the amount of funding contributed to the overall award pool. The sum of all executive target award opportunities as a percent of earned salary time company performance determines the overall funding of the pool.

Determining Individual Awards

Once the award pool is funded, the President/COO and CEO complete the annual executive performance review process to determine the executive’s individual performance versus their KPIs. Individual award payouts may range from 0% and 125% of target opportunity based on the executive’s performance as assessed in the review process.

Mercury’s Board of Directors maintains the discretion to determine any funding of the plan if the company’s performance does not meet threshold levels or if the company significantly exceeds plan.

Administration

Incentive awards will be prorated for executives who join Mercury during the year and are based on earned salary during the fiscal year.

Awards will typically be paid within the quarter following the close of the fiscal year. Incentive awards are subject to all applicable payroll taxes.

Mercury reserves the right to modify the plan, and individual awards, at any time. You will be notified of any plan changes.

Acknowledgement

My signature below indicates that I have received a copy of the plan and that my target incentive opportunity has been communicated to me.

Signature Date

EX-10.44

Exhibit 10.44

AGREEMENT OF SUBLEASE

THIS AGREEMENT OF SUBLEASE (this “Sublease”) is made and entered into this 28th day of February, 2005, by and between NETSCAPE COMMUNICATIONS CORPORATION, a Delaware corporation (hereinafter referred to as the “Sublandlord”), and MERCURY INTERACTIVE CORPORATION, a Delaware corporation (hereinafter referred to as the “Subtenant”).

W I T N E S S E T H:

WHEREAS, pursuant to that certain Lease Agreement by and between 464 Ellis Street Associates, L.P. (the “Prime Landlord”) and Sublandlord, dated as of January 31,1997 (the “Prime Lease”), Sublandlord presently leases three (3) separate, adjacent buildings having addresses at 464 Ellis Street (“Building 20”), 466 Ellis Street (“Building 21”) & 468 Ellis Street (“Building 22”), Mountain View, California (collectively, “Phase I”);

WHEREAS, Subtenant desires to sublease from Sublandlord the entirety of Phase I including each of the following buildings (each a “Building”): (i) the entirety of Building 20, which contains approximately sixty four thousand one hundred eight (64,108) rentable square feet of office space (the “Building 20 Premises”), (ii) the entirety of Building 21 which contains approximately seventy five thousand two hundred thirty three (75,233) rentable square feet of office space (the “Building 21 Premises”), and (iii) the entirety of Building 22, which contains approximately 55,662 rentable square feet, including (a) approximately 15,400 rentable square feet of office space located on the 2nd floor of the Building (“Building 22 Office Space”), (b) approximately 25,775 rentable square feet of cafeteria and kitchen area (“Cafeteria Space”); and (c) approximately 14,487 rentable square feet of fitness center space (“Fitness Center Space”) (collectively, the “Building 22 Premises”). The Building 20 Premises, Building 21 Premises, and Building 22 Premises shall be referred to hereinafter collectively as the “Demised Premises”. Capitalized terms used in this Sublease but not otherwise defined shall have the meaning ascribed to such terms in the Prime Lease;

WHEREAS, Sublandlord and Subtenant acknowledge that they are parties to that certain Side Agreement, dated as of December 15, 2003 (“Side Agreement”), pursuant to which, among other things, Subtenant currently has certain rights to use the Cafeteria and Fitness Center located in Building 22. The Side Agreement superseded that certain Agreement of Sublease, dated as of October 21, 2003 (“Phase II Sublease”), pursuant to which Subtenant subleased from Sublandlord the buildings located at 389 Whisman Road, 399 Whisman Road, 369 Whisman Road and 379 Whisman Road (“Phase II Buildings”). As of the date that the Side Agreement became effective, Sublandlord’s master lease for the Phase II Buildings and the Phase II Sublease terminated, and Subtenant’s direct lease with Sublandlord’s landlord for the Phase II Buildings became effective; and

WHEREAS, the Side Agreement shall remain in effect until terminated on April 30, 2005 in accordance with the terms of this Sublease.

NOW, THEREFORE, for and in consideration of the mutual covenants and agreements hereinafter set forth, the parties hereto agree as follows:

1. Demised Premises.

a. Demised Premises Defined. Subject to receipt of Prime Landlord’s written consent to this Sublease in accordance with Section 28 below, Sublandlord does hereby sublease to Subtenant, and Subtenant does hereby sublease from Sublandlord, for the term and upon the conditions hereinafter provided, the Demised Premises, as more particularly described on the plan attached hereto and made part hereof as Exhibit A. Sublandlord and Subtenant hereby stipulate that the aggregate rentable area of the Demised Premises is one hundred ninety-five thousand three (195,003) rentable square feet and agree that this square footage shall be conclusive for all purposes under this Sublease.

b. Condition of Premises. Subject to the provisions of this Section 1(b), the Demised Premises are sublet to Subtenant in their “as is” condition existing on the date delivered to Subtenant. Sublandlord shall have no obligation to complete any alterations, improvements, repairs or decorations to the Demised Premises either prior to the time possession is given to Subtenant or during the Term. The foregoing sentence notwithstanding, Sublandlord represents to the best of Sublandlord’s knowledge, all building systems serving the Demised Premises, including without limitation, all mechanical, electrical, HVAC and life safety systems, and the plumbing systems and fixtures (collectively, “Building Systems”), are in good working condition as of the date hereof, and the Building Systems shall be in good working condition on the date that Sublandlord delivers possession of the Demised Premises to Subtenant pursuant to Section 3 below. In addition, Sublandlord hereby transfers to Subtenant, during the Early Access Period (as defined below) and during the Term, all warranties (to the extent the same are freely transferable) of improvements made by or at the direction of Sublandlord or Prime Landlord, for the benefit of Sublandlord, under the Prime Lease.

c. Initial Improvements. Subtenant may, at its option and subject to the provisions of the Prime Lease, including, without limitation, Article 8 thereof, complete certain initial improvements to prepare the Demised Premises for Subtenant’s occupancy thereof as described in the Work Letter Agreement attached hereto and made a part hereof as Exhibit B (the “Initial Improvements”), at Subtenant’s sole cost and expense without any contribution or improvement allowance from Sublandlord described in the Work Letter Agreement attached hereto and made a part hereof as Exhibit B); provided, however, Subtenant shall not make or permit anyone to make any Initial Improvements without the prior written consent of Sublandlord, which shall not be unreasonably withheld or delayed, and of Prime Landlord in accordance with the Prime Lease. In connection with the foregoing, Subtenant shall submit to Sublandlord, for prior written approval by Sublandlord, which

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shall not be unreasonably withheld or delayed, and Prime Landlord, complete plans and specifications for any and all Initial Improvements; including, without limitation, schematic designs and work drawings. Any and all costs and expenses associated with the acquisition of cabling, equipment, furniture, security systems, or other personal property for Subtenant or the Demised Premises or the installation or placement of any of the foregoing within the Demised Premises or with the project management for the performance of the Initial Improvements (collectively, “Subtenant’s Personal Property and Services”), shall be paid for by and be the sole responsibility of Subtenant. Sublandlord acknowledges and agrees that Subtenant shall not be required to remove any Initial Improvements upon the expiration or earlier termination of this Sublease unless the removal is required by Prime Landlord or Sublandlord is otherwise obligated to pay Prime Landlord the costs of any removal of any Initial Improvements pursuant to Section 8(e) of the Prime Lease.

2. Term. Provided Sublandlord has received Prime Landlord’s consent to this Sublease in accordance with the Prime Lease and this Sublease, the term of this Sublease (the “Term”) shall be for a period commencing: (a) for Building 22 - May 1, 2005 (the “Building 22 Commencement Date”), and (b) for Buildings 20 and 21 - - July 1, 2005 (the “Building 20 and 21 Commencement Date”) (each a “Commencement Date”) and, unless this Sublease is earlier terminated pursuant to its terms or pursuant to the terms of the Prime Lease that are incorporated herein, expiring at midnight (PST) on March 26, 2013 (the “Expiration Date”).

3. Delivery of Demised Premises.

a. Early Access. Sublandlord shall deliver the Building 22 Office Space to Subtenant in the condition required by this Sublease promptly following receipt of Prime Landlord’s consent to this Sublease in accordance with Section 28 and, from and after the date on which Sublandlord delivers the Building 22 Office Space to Subtenant (the “Delivery Date”) until the Building 22 Commencement Date, Subtenant shall have the right, subject to Prime Landlord’s prior written consent, to enter the Building 22 Office Space for purposes of moving Subtenant’s personal property into, performing the Initial Improvements to, and otherwise preparing the Building 22 Office Space for Subtenant’s occupancy. In connection with the foregoing, Subtenant acknowledges and agrees that the foregoing early access rights shall be non-exclusive and that Sublandlord will have the right, to perform de-commissioning work in Building 22, and continue operating the Cafeteria and Fitness Center facilities pursuant to Section 19 below, between the date hereof and the Building 22 Commencement Date. All terms and conditions of this Sublease shall apply to Subtenant’s early access prior to the Building 22 Commencement Date except that Base Rent shall not begin to accrue with respect to any particular Building until the Commencement Date for such Building (as defined below), provided Subtenant shall pay, within twenty (20) days after receipt of demand by Sublandlord therefore, all utility costs and other Additional Rent allocable to the Building 22 Office Space during the period commencing on the Delivery Date and expiring on the Building 22 Commencement Date (the “Early Access Period”).

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b. Delivery of the Remainder of the Demised Premises. Subject to receipt of Prime Landlord’s consent to this Sublease in accordance with Section 28, Sublandlord presently anticipates delivering the remainder of the Demised Premises to Subtenant, in the condition required under this Sublease, as follows: (i) the Cafeteria Space and the Fitness Center Space on the Building 22 Commencement Date; and (ii) Buildings 20 and 21 on the Building 20 and 21 Commencement Date. If Sublandlord is unable to deliver possession of the applicable space by such dates, Sublandlord shall not have any liability whatsoever to Subtenant, this Sublease shall not be rendered void or voidable, and, subject to the provisions of Section 3(c) below, Subtenant’s sole remedy in such event will be an extension of the Commencement Date for the applicable space or Building on a day-for-day basis based upon the number of days delay in delivery of such space or Building.

c. Outside Termination Date. Notwithstanding the foregoing, in the event Sublandlord fails, as result of occurrences other than a Subtenant default hereunder or Force Majeure Events, to deliver all Buildings comprising the Demised Premises to Subtenant on or before December 31, 2005 (the “Outside Termination Date”), then Subtenant may terminate this Sublease by providing written notice thereof to Sublandlord within ten (10) days after the Outside Termination Date; provided, however, notwithstanding any other provision to the contrary in this Sublease or the Prime Lease, upon any such termination of this Sublease pursuant to this Section 3, all Initial Improvements and other Alterations made by or for Subtenant in the Demised Premises prior to the effective date of such termination (collectively, the “Build-Out Improvements”) shall, unless Sublandlord provides Subtenant written notice otherwise, become the property of Sublandlord and Subtenant shall neither have an obligation nor a right to remove any of the Build-Out Improvements upon such termination of this Sublease. In addition, Subtenant shall assign any and all contracts for the design or construction of the Build-Out Improvements and for engineering or construction management services relating thereto (collectively, the “Build-Out Contracts”), to the extent assignable, to Sublandlord, along with any and all plans, specifications, designs, drawings, reports, and other work product produced in connection with any such contracts (collectively, the “Build-Out Work Product”). In connection with the foregoing, Subtenant shall use good-faith, diligent efforts to obtain a right to freely assign each of the Build-Out Contracts and all Build-Out Work Product pursuant to the terms of such contracts. Immediately prior to any termination of this Sublease pursuant to this Section 3, and as a condition precedent to the effectiveness of such termination, Subtenant agrees to deliver to Sublandlord originals of all fully-executed Build-Out Contracts and of all Build-Out Work Product and to assign, to the extent assignable, all such Build-Out Contracts and Build-Out Work Product to Sublandlord as of the effective date of such termination.

4. Use. Subtenant shall use and occupy the Demised Premises solely for office, distribution, research, development, and/or light manufacturing, and for no other purpose, pursuant to and in accordance with the Prime Lease. In addition, subject to obtaining Prime Landlord’s prior written consent, Sublandlord also agrees that Subtenant may use the Demised Premises for customer training and sales presentations purposes.

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5. Base Rent. From and after the Commencement Date for each Building and throughout the Term, Subtenant shall pay, as base rent for the Demised Premises, in advance and in lawful currency of the United States on or before the first day of each calendar month, without deduction or offset, in the amounts set forth below (“Base Rent”):

Term	Rental Rate/SF/Month-NNN
May 1, 2005 – June 30, 2005	$1.05, or $58,445.10
July 1, 2005 - April 30, 2006	$1.05, or $204,753.15
May 1, 2006 – April 30, 2007	$1.10, or $214,503.30
May 1, 2007- April 30, 2008	$1.15, or $224,253.45
May, 1 2008 – April 30, 2009	$1.20, or $234,003.60
May 1, 2009 – April 30, 2010	$1.25, or $243,753.75
May 1, 2010 – April 30, 2011	$1.30, or $253,503.90
May 1, 2011 – April 30 2012	$1.35, or $263,254.05
May 1, 2012 – March 26, 2013	$1.40, or $273,004.20

* Subtenant will pay said Base Rent to Sublandlord or to such other party as Sublandlord may designate at its address set forth in Section 22 below, or at such other address as Sublandlord may hereafter designate in writing.

6. Additional Rent. Commencing on the earlier of: (i) the Delivery Date for each Building or (ii) the Commencement Date for the applicable Building, Subtenant shall pay to Sublandlord, as additional rent (“Additional Rent”), all Additional Charges (as defined in the Prime Lease), including but not limited to Real Estate Taxes, Expenses, and all other such amounts payable by Sublandlord under the Prime Lease allocable to such Building, and, following the Building 20 and 21 Commencement Date for the entire Demised Premises (excluding Specific Default Charges). As used herein, “Specific Default Charges” shall mean, to the extent not caused in whole or in part by Subtenant’s default hereunder, any amounts resulting solely from a default by Sublandlord under the Prime Lease and identified in a notice of default delivered by Prime Landlord to Sublandlord, which amounts may include, without limitation, any late fees or interest payable by Sublandlord pursuant to Section 4(e) of the Prime Lease. Without limiting the generality of the foregoing, Subtenant shall pay to Sublandlord, as Additional Rent, all charges for (i) alterations (excluding charges for alterations made by Sublandlord prior to the date hereof), (ii) all amounts payable to by Subtenant pursuant to Section 2(c) of the Work Letter Agreement attached as Exhibit B hereto, (iii) any

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additional services provided to the Demised Premises or otherwise in connection with the Prime Lease, including, without limitation, charges and fees for after-hours heating and air conditioning services, if any, and (iv) all costs for electricity consumed at the Demised Premises. Sublandlord shall provide Subtenant with copies of all relevant statements and bills received by Sublandlord pursuant to the applicable provisions of the Prime Lease. Subtenant shall pay one-twelth of the annual Expenses and Real Property Taxes, as defined and estimated pursuant to Article 4 of the Prime Lease, to Sublandlord together with each monthly payment of Base Rent subject to annual reconciliation in accordance with Section 4(c)(3) of the Prime Lease. Notwithstanding the foregoing, if the Prime Lease requires Sublandlord to pay Expenses or Real Estate Taxes other than on a monthly basis based on estimates of such costs, Subtenant shall make payments of each element of Expenses or Real Estate Taxes on the later of (i) two (2) business days prior to the date on which Sublandlord is obligated to pay the applicable sum under the Prime Lease (only if the applicable element of Expenses and/or Real Estate Taxes is payable by Sublandlord under the Prime Lease), or (ii) twenty (20) business days after receipt of a statement from Sublandlord setting forth the amount of Real Estate Taxes and/or Expenses due. Subtenant shall pay all other Additional Rent within twenty (20) business days after receipt of an invoice therefore from Sublandlord. Subtenant’s obligation to pay Additional Rent shall survive the expiration or earlier termination of this Sublease.

7. Furniture. During the Term, Subtenant may use the furniture, including, without limitation, the work stations, and office and conference room tables and chairs, owned by Sublandlord and existing in the Demised Premises as of the Commencement Date, all as more particularly described in Exhibit D hereto (the “Furniture”), at no additional cost or expense to Subtenant. Without limiting the generality of the foregoing, “Furniture” shall also include the cables connecting each desktop area within the Demised Premises to the central computer room, including all related patch panels and the racks upon which such patch panels are situated, but excluding Sublandlord’s telephone switches and other telephone and computer equipment. Subtenant shall be responsible for the maintenance and repair of the Furniture during the Term, but Sublandlord shall pay the personal property taxes with respect thereto. Provided no default, beyond applicable notice and cure periods, under the terms of this Sublease is then-existing, Subtenant shall have an option, exercisable by delivering written notice thereof to Sublandlord no later than the date that is sixty (60) days before the Expiration Date, to purchase, for $10.00, the Furniture on an “as-is”, “where-is” basis, without warranty, except as to ownership free and clear of all liens created by or through Sublandlord based on the best of Sublandlord’s then-current knowledge, upon expiration of the Prime Lease, pursuant to the terms of a bill of sale reasonably acceptable to both parties. Otherwise, Subtenant shall remove and return the Furniture to Sublandlord upon the expiration or earlier termination of this Sublease, or, at Sublandlord’s option in the event this Sublease terminates prior to the Expiration Date, surrender the Furniture to Sublandlord at the Demised Premises in its then existing and configured condition.

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8. Security.

a. Phase I Security System. On the Phase 22 Building Commencement Date, Sublandlord shall transfer to Subtenant all of Sublandlord’s right, title and interest in and to the electronic card reader system and security cameras currently serving the Demised Premises (the “Phase I Security System”) for the sum of $1.00. Such transfer will be on an “as-is” “where-is” basis, without warranty except as to ownership free and clear of all liens based on the best of Sublandlord’s then-current knowledge, and, in confirmation of the foregoing, Sublandlord will deliver to Subtenant a fully executed bill of sale in substantially the form of Exhibit G attached hereto. Subject to the terms of the Prime Lease, Subtenant may, in its sole discretion, determine the vendor or vendors it will use in connection with the operation, maintenance, and repair of the Phase I Security System or any other security system used by Subtenant as permitted hereunder (any such new security system, a “New Security System”). On the Building 22 Commencement Date, Subtenant shall at Subtenant’s cost, provide access cards to Sublandlord and its employees, and any other subtenant of Sublandlord occupying space in the buildings listed on Exhibit E attached hereto and such subtenants’ permitted assignees or sub-subtenants (such third parties collectively “Access Parties”), for use in connection with the Cafeteria (as defined in Section 19 below) and/or the Fitness Center (as defined in Section 19 below), in each case pursuant to and in accordance with Section 19 below. Within fifteen (15) days after the Building 22 Commencement Date, Sublandlord shall provide Subtenant with a list of all individuals or Access Parties to whom Sublandlord has provided or intends to provide active access cards and the corresponding code numbers of the cards held by each individual or Access Party. Sublandlord agrees to promptly provide Subtenant with reasonable notice of any changes to the information on such list. Additionally, Sublandlord shall obtain from the Access Parties and deliver to Subtenant, a similar list of all individuals to whom such Access Parties have provided or intend to provide access cards and will promptly forward any updated information received from such Access Parties to Subtenant. Subtenant shall be solely responsible and liable for the operation of the Phase I Security System and for any failure in the performance of such system or any other New Security System. Notwithstanding the foregoing, Subtenant will permit Sublandlord, its agents, and representatives, to enter the Demised Premises, without charge therefor to Sublandlord and without diminution of the rent payable by Subtenant, (i) to examine, inspect and protect the Demised Premises, and (ii) to otherwise comply with and carry out Sublandlord’s obligations under the Prime Lease. In connection with any such entry, Sublandlord shall (A) use commercially reasonable efforts to minimize the disruption to Subtenant’s use of the Demised Premises, and (B) give Tenant reasonable advance written or email notice of such entry which shall not be less than twenty-four (24) hours advanced notice (except in the event of an emergency). Subtenant may, at its option, require that Sublandlord be accompanied by a representative of Subtenant during any such entry (except in the case of emergency).

b. Security System for Phase II Buildings. Effective as of the Building 22 Commencement Date, Sublandlord shall transfer to Subtenant all of

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Sublandlord’s right, title and interest in and to the Phase II security system as described in Section 4 of the Side Agreement (the “Phase II Security System”) for the sum of $1.00. Such transfer will be on an “as-is” “where-is” basis, without warranty except as to ownership free and clear of all liens based on the best of Sublandlord’s then-current knowledge, and, in confirmation of the foregoing, Sublandlord will deliver to Subtenant a fully executed bill of sale in substantially the form of Exhibit G attached hereto.

9. Obligations Under the Prime Lease.

a. Incorporation of Prime Lease. This Sublease and Subtenant’s rights under this Sublease shall at all times be subject to and is made upon all of the terms, covenants, and conditions of the Prime Lease, with the same force and effect as if fully set forth herein at length, and except as otherwise expressly provided for in this Sublease, Subtenant shall keep, observe and perform or cause to be kept, observed and performed, faithfully all those terms, covenants and conditions of Sublandlord under the Prime Lease with respect to the Demised Premises. The parties specifically agree that any provisions relating to any construction obligations of “Prime Landlord” under the Prime Lease, are hereby deleted; provided, however, the foregoing provision shall in no way be construed as limiting Sublandlord’s obligation to use commercially reasonable, good faith efforts to enforce, pursuant to Section 9(b) below, the obligations of Prime Landlord under the Prime Lease, including, without limitation, the obligations of Prime Landlord set forth in Section 8(a) of the Prime Lease. For the purposes of this Sublease and for purposes of the Prime Lease as applied to the Subtenant, all references to the Premises in the Prime Lease shall be deemed to refer only to the Demised Premises, all references to the “Term” or “initial Term” therein shall refer to the Term under this Sublease, all references to “Landlord” therein shall, except as provided otherwise herein and subject to the first sentence of Section 9(b) of this Sublease, refer to Sublandlord, excluding any such references to “Landlord” under Article 40 of the Prime Lease and further excluding any liabilities assumed by Landlord under the Prime Lease that are not expressly assumed by Sublandlord hereunder; and all references to “Tenant” therein shall refer to Subtenant except as expressly set forth herein. In addition, all representations, warranties, and obligations of Tenant with respect to “Tenant Improvements” under the Prime Lease shall be deemed to be representations, warranties, and obligations of Subtenant with respect to the “Initial Improvements” under this Sublease. Notwithstanding the foregoing, the following provisions of the Prime Lease are hereby expressly excluded and shall not be incorporated in this Sublease: Basic Lease Information pertaining to Tenant, Tenant’s Address, the permitted uses of the Demised Premises, Scheduled Occupancy Date, Scheduled Rent Commencement Date, Expiration Date, Monthly Base Rent, Base Rent Adjustments, Security Deposit, Broker and Broker’s Fees; Sections 1(b); 3 (except that the definition of “Occupancy Date” in Section 3(a) is incorporated herein, all but the first three (3) sentences of Section 3(b) are incorporated herein but are subject to the limitations set forth in Section 9(b) of this Sublease; Section 4(b); subsection (iii) in Section 13, subsection (iii) in Section 21(a); 21(b); 21(e)(2); 34; 38, 39; 40(d), 43, 44, and Exhibit “D”. In addition, (1) references to “Tenant” in the first sentence of Section 4(a)(1) shall mean only Sublandlord; and (2) references to “Landlord” in Section 1(d),

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Section 5 (with respect only to “Landlord’s” assumption of the management of the Premises and Common Area), Section 8(a), Section 9 (with respect only to Landlord’s maintenance, repair and replacement obligations but not with respect to the limitations on Landlord’s liability set forth in Section 9(f) of the Prime Lease), Section 12(e), Section 17 and Section 23 shall mean only Prime Landlord. Finally, in addition, for purposes of this Sublease, the reference to “Occupancy Date”, as first described in Section 3(a) of the Prime Lease, and used throughout the Prime Lease, shall mean the Delivery Date with respect to the Building 22 Office Space and, with respect to the remainder of the Demised Premises, the date on which Sublandlord delivers the remainder of the Demised Premises to Subtenant in accordance with the terms of this Sublease. Further, notwithstanding the foregoing, all grace periods specified in the Prime Lease shall, for purposes of determining compliance by Subtenant with the provisions hereof, be each reduced by (i) three (3) days for all grace periods ten (10) days or longer, (ii) two (2) days for all grace periods less than ten (10) days and longer than five (5) days, and (iii) one (1) day for all grace periods of five (5) days or shorter. Sublandlord shall have all of the rights of Prime Landlord under the Prime Lease as against Subtenant. Anything in the Prime Lease to the contrary notwithstanding, and excluding Sublandlord’s indemnity obligations under Section 11 hereof, the liability of Sublandlord for its obligations under this Sublease shall in no event exceed (i) the aggregate of all Base Rent payable by Subtenant hereunder during the twenty-four (24) month period immediately preceding the applicable event giving rise to such Sublandlord liability, or (ii) if twenty-four (24) months have not passed at the time of such event, the calculation of the twenty-four (24) month aggregate of all Base Rent payable by Subtenant shall be based on the Base Rent payable by Subtenant during the month in which such event occurs. No personal liability shall at any time be asserted or enforceable against Sublandlord’s stockholders, directors, officers or partners on account of any of Sublandlord’s obligations or actions under this Sublease.

b. Sublandlord’s Obligations. Sublandlord does not assume any obligation to perform the terms, covenants, conditions, provisions and agreements contained in the Prime Lease on the part of Prime Landlord to be performed. In the event Prime Landlord shall fail to perform any of the terms, covenants, conditions, provisions and agreements contained in the Prime Lease on its part to be performed, Sublandlord shall have no liability to Subtenant. Notwithstanding anything to the contrary contained in this Sublease, Sublandlord shall use commercially reasonable, good-faith efforts to enforce the obligations of Prime Landlord under the Prime Lease, and such efforts shall include, without limitation: (i) upon Subtenant’s written request, notifying Prime Landlord of any nonperformance under the Prime Lease and requesting that Prime Landlord perform its obligations thereunder; and (ii) after the time for Prime Landlord to cure a breach has expired, cooperating with Subtenant, at Subtenant’s sole cost and expense, to enforce Prime Landlord’s obligations, which cooperation shall include, in cases of any uncured breach by Prime Landlord that, in Subtenant’s reasonable opinion, materially impairs the conduct of Subtenant’s business operations within the Demised Premises, instituting legal proceedings so long as Subtenant is not in default, beyond any applicable notice and cure periods, of its payment obligations under this Section 9(b), in the name of Subtenant with legal counsel selected by Sublandlord and reasonably approved by Subtenant, to enforce the aforesaid

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unperformed, material Prime Landlord obligation under the Prime Lease (including executing such documents as may be reasonably required by such legal counsel). Sublandlord and Subtenant shall be entitled to jointly control the conduct of the litigation; provided, however that in the conduct of any such litigation, both Sublandlord and Subtenant shall have an obligation to act in a commercially reasonable manner and with the goal of employing a strategy which is designed to secure performance of the aforesaid unperformed, material Prime Landlord obligation under the Prime Lease, provided no action, including settlement, may be taken or required by either party in connection with such litigation to the extent such action may materially and adversely affect the other party’s rights or obligations under the Prime Lease or Sublease without such other party’s consent, which shall not be unreasonably withheld, conditioned, or delayed. All costs incurred in connection with any enforcement action (including reasonable attorneys’ fees and consultant and expert witness fees) undertaken by Sublandlord at the request of Subtenant shall be paid to Sublandlord by Subtenant, as Additional Rent, upon Sublandlord’s delivery to Subtenant of reasonably detailed invoices therefor. In the event of any dispute regarding responsibility for payment of such costs, or any dispute regarding whether either party is acting in a commercially reasonable manner and with the goal of employing a strategy which is designed to secure, subject to the conditions above, performance of the aforesaid unperformed, material Prime Landlord obligation under the Prime Lease, such dispute shall be resolved by arbitration as set forth in Article 41 of the Prime Lease. Subtenant shall indemnify Sublandlord against, and hold Sublandlord harmless from, all costs, expenses, claims, counter-claims, cross-claims, losses, and liabilities incurred by Sublandlord in connection with any initiation of litigation by Sublandlord pursuant to the foregoing provisions, except to the extent such litigation is caused by Sublandlord’s default under this Sublease or, to the extent not caused by Subtenant, by Sublandlord’s default under the Prime Lease. The execution of this Sublease and Prime Landlord’s consent thereto, shall not relieve Sublandlord of any of its obligations to Prime Landlord under the Prime Lease. A copy of the Prime Lease is attached hereto and made a part hereof as Exhibit C.

10. Insurance. Subtenant shall obtain and at all times during the term hereof maintain, at its sole cost and expense, policies of insurance required by Article 12 of the Prime Lease. Subtenant shall deliver to Sublandlord certificates of such insurance at the beginning of the term of this Sublease. All such insurance policies shall name Sublandlord and Prime Landlord and any other entity named in Article 12 of the Prime Lease as additional insureds, as their interests may appear.

11. Liability for Hazardous Materials.

a. Obligations. Pursuant to Article 40 of the Prime Lease, Subtenant is aware that the Demised Premises are subject to remediation orders issued by the U.S. Environmental Protection Agency (“EPA”) as set forth on Exhibit L to the Prime Lease. Subtenant acknowledges receipt of copies of the reports listed on Schedule 1 to such Exhibit L and has been provided sufficient opportunity to review the additional reports listed on Schedule 2 to such Exhibit L. Subtenant agrees to comply with all obligations of “Tenant” under such Article 40, including, without limitation, the

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restrictions and disclosure requirements set forth in Section 40(f) and, for the avoidance of doubt, Subtenant acknowledges and agrees that all limitations on the rights of “Tenant” under Article 40 of the Prime Lease shall apply to and similarly limit the rights of Subtenant hereunder. Subtenant releases Sublandlord and Prime Landlord from any liability for, and waives all claims against Sublandlord and Prime Landlord, and shall indemnify, defend and hold harmless Sublandlord, its agents, servants, contractors and employees, and all Landlord Parties (as defined in the Prime Lease) against any and all claims, suits, loss, costs and other liabilities described in and subject to Section 40(b) of the Prime Lease.

b. Prime Landlord Indemnity. Sublandlord shall defend, (with counsel reasonably acceptable to Subtenant) indemnify and hold Subtenant harmless, to the extent Subtenant incurs any loss, cost, or liability or is subject to any third party claim or regulatory order, that Prime Landlord indemnifies Sublandlord for under Section 40(c) of the Prime Lease. Sublandlord hereby agrees to use diligent, good-faith efforts, so long as Subtenant is not in default, beyond any applicable notice and cure periods, of its payment obligations under this Section 11(b), to enforce such indemnity obligations, which efforts shall include, without limitation, where reasonably necessary, the commencement and/or prosecution of litigation. Sublandlord and Subtenant shall be entitled to jointly control the conduct of the litigation; provided, however that in the conduct of any such litigation, both Sublandlord and Subtenant shall have an obligation to act in a commercially reasonable manner and with the goal of employing a strategy which is designed to secure performance of the aforesaid indemnity obligation of Prime Landlord under Section 40(c) of the Prime Lease, provided no action, including settlement, may be taken or required by either party in connection with such litigation to the extent such action may materially and adversely affect the other party’s rights or obligations under the Prime Lease or this Sublease without such other party’s consent, which shall not be unreasonably withheld, conditioned, or delayed. All costs incurred in connection with any enforcement action (including reasonable attorneys’ fees and consultant and expert witness fees) undertaken by Sublandlord hereunder shall be paid to Sublandlord by Subtenant, as Additional Rent, upon Sublandlord’s delivery to Subtenant of reasonably detailed invoices therefor. In the event of any dispute regarding responsibility for payment of such costs, or any dispute regarding whether either party is acting in a commercially reasonable manner and with the goal of employing a strategy which is designed to secure, subject to the conditions above, performance of the aforesaid indemnity obligation of Prime Landlord under Section 40(c) of the Prime Lease, such dispute shall be resolved by arbitration as set forth in Article 41 of the Prime Lease. Subtenant shall indemnify Sublandlord against, and hold Sublandlord harmless from, all costs, expenses, claims, counter-claims, cross-claims, losses, and liabilities incurred by Sublandlord in connection with any initiation of litigation by Sublandlord pursuant to the foregoing provisions, except to the extent such litigation is caused by Sublandlord’s default under this Sublease or, to the extent not caused by Subtenant, by Sublandlord’s default under the Prime Lease. Notwithstanding the foregoing, in the event Prime Landlord extends the indemnity rights granted under Section 40(c) of the Prime Lease to Subtenant pursuant to a written agreement, Sublandlord’s indemnity obligations under this Section 11(b) shall automatically terminate and be of no further force or effect.

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c. Seller Indemnity. Sublandlord shall defend, (with counsel reasonably acceptable to Subtenant) indemnify and hold Subtenant harmless, to the extent Subtenant incurs any loss, cost, or liability or is subject to any third party claim or regulatory order that Seller indemnifies Sublandlord for under the Seller Indemnity described in Section 40(d) of the Prime Lease. Sublandlord hereby agrees to use diligent, good-faith efforts, so long as Subtenant is not in default, beyond any applicable notice and cure periods, of its payment obligations under this Section 11(c), to enforce such indemnity obligations, which efforts shall include, without limitation, where reasonably necessary, the commencement and/or prosecution of litigation. Sublandlord and Subtenant shall be entitled to jointly control the conduct of the litigation; provided, however that in the conduct of any such litigation, both Sublandlord and Subtenant shall have an obligation to act in a commercially reasonable manner and with the goal of employing a strategy which is designed to secure performance of the aforesaid indemnity obligation of Seller under the Seller Indemnity, provided no action, including settlement, may be taken or required by either party in connection with such litigation to the extent such action may materially and adversely affect the other party’s rights or obligations under the Prime Lease or Sublease without such other party’s consent, which shall not be unreasonably withheld, conditioned, or delayed. All costs incurred in connection with any enforcement action (including reasonable attorneys’ fees and consultant and expert witness fees) undertaken by Sublandlord hereunder shall be paid to Sublandlord by Subtenant, as Additional Rent, upon Sublandlord’s delivery to Subtenant of reasonably detailed invoices therefore. In the event of any dispute regarding responsibility for payment of such costs, or any dispute regarding whether either party is acting in a commercially reasonable manner and with the goal of employing a strategy which is designed to secure, subject to the conditions above, performance of the aforesaid indemnity obligation of Seller under the Seller Indemnity, such dispute shall be resolved by arbitration as set forth in Article 41 of the Prime Lease. Subtenant shall indemnify Sublandlord against, and hold Sublandlord harmless from, all costs, expenses, claims, counter-claims, cross-claims, losses, and liabilities incurred by Sublandlord in connection with any initiation of litigation by Sublandlord pursuant to the foregoing provisions, except to the extent such litigation is caused by Sublandlord’s default under this Sublease or, to the extent not caused by Subtenant, by Sublandlord’s default under the Prime Lease. Notwithstanding the foregoing, in the event Seller extends the indemnity rights granted in the Seller Indemnity to Subtenant pursuant to a written agreement, Sublandlord’s indemnity obligations under this Section 10(c) shall automatically terminate and be of no further force or effect.

d. Sublandlord’s Indemnity. Sublandlord shall indemnify, defend (with counsel reasonably acceptable to Subtenant), and hold Subtenant harmless from and against any loss, cost, liability, or any third party claim or regulatory order to the extent arising from or in connection with the use, generation, treatment, storage, disposal or discharge of Hazardous Materials by Sublandlord, its agents, employees, or contractors in violation of any Environmental Law.

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12. Security Deposit.

a. Form of Security Deposit. Within five (5) days of the execution and delivery of this Sublease, Subtenant shall deliver to Sublandlord as collateral security (and not prepaid rent) for the payment by Subtenant of all Base Rent and Additional Rent due hereunder and the performance by Subtenant of all other obligations, covenants and agreements set forth in this Sublease a security deposit in the amount of One Million Twenty-Three Thousand Seven Hundred Sixty Five and 75/100 Dollars ($1,023,765.75) (the “Security Deposit”) in the form of an unconditional, irrevocable letter of credit (“LOC”). At any time during the Term, Subtenant shall have the right to replace the LOC with a cash security deposit in the required amount, and within three (3) business days after the receipt of such cash security deposit by Sublandlord, Sublandlord shall return the LOC, undrawn, to Subtenant.

b. Letter of Credit Security Deposit. Any such LOC shall be issued by an LOC Bank (as hereinafter defined) selected by Subtenant and reasonably acceptable to Sublandlord. An LOC Bank is a bank that accepts deposits, maintains accounts, has an office in the City of Mountain View, California that will negotiate a letter of credit, and the deposits of which are insured by the Federal Deposit Insurance Corporation. Subtenant represents and warrants that, at the time of issuance of any LOC hereunder by Wells Fargo Bank, such bank shall be an LOC Bank. Accordingly, Sublandlord hereby acknowledges and agrees that Wells Fargo Bank is an acceptable LOC Bank. Subtenant shall pay all expenses, points or fees incurred to obtain the LOC. The LOC shall provide that drafts will be honored on sight if accompanied by a statement signed by Sublandlord asserting either (i) that Subtenant is in default, beyond applicable notice and cure periods, under this Sublease or that Subtenant is in default under this Sublease and is not entitled to a notice and/or cure period for the applicable default, and that Sublandlord is entitled to draw upon the LOC pursuant to the terms of this Sublease, or (ii) Subtenant failed to renew or replace the LOC at least thirty (30) days prior to its expiration date. The LOC shall provide that it is freely transferable by Sublandlord, without charge and without recourse, to the assignee or transferee of Sublandlord’s interest in the Demised Premises, and that the LOC Bank will confirm the same to Sublandlord and such assignee or transferee upon request. The LOC shall be automatically renewable on an annual basis, subject to the reduction provisions of the last sentence of Section 12(a) above, during the Term and for thirty (30) days following the expiration or earlier termination of this Sublease. If Subtenant fails to renew or replace any LOC at least thirty (30) days prior to its expiration, Sublandlord may, without prejudice to any other remedy it has and upon ten (10) days’ written notice to Subtenant, draw on all of the LOC and such drawn amount shall be held as a cash Security Deposit.

c. Rights and Obligations of Parties. If any sum payable by Subtenant to Sublandlord shall be due and owing beyond applicable notice and cure periods, or if Sublandlord makes any payments on behalf of Subtenant due to Subtenant’s default hereunder beyond applicable notice and cure periods, or if Subtenant fails, beyond applicable notice and cure periods, to perform any of its other obligations under this Sublease, then Sublandlord, at its option, and without prejudice to

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any other remedy which Sublandlord may have, may draw from the Security Deposit, such amount of cash as may be necessary to compensate Sublandlord for such past due rent or other amount or any other loss or damage incurred or sustained by Sublandlord as a result of such default. Sublandlord shall not be required to hold any cash Security Deposit in a separate account. No interest will be payable on the Security Deposit. If any sum payable by Subtenant to Sublandlord shall be due and owing beyond applicable notice and cure periods, or if Sublandlord makes any payments on behalf of Subtenant due to Subtenant’s default hereunder beyond applicable notice and cure periods, or if Subtenant fails, beyond applicable notice and cure periods, to perform any of its other obligations under this Sublease, then Sublandlord, at its option, and without prejudice to any other remedy which Sublandlord may have, may apply such part of the Security Deposit necessary to compensate Sublandlord for such past due rent or other amount or any other loss or damage incurred or sustained by Sublandlord as a result of such default. Subtenant shall restore the Security Deposit to the required amount within two (2) business days after receipt of demand in the event Sublandlord applies all or any portion thereof. Notwithstanding anything contained in this Section 12 to the contrary, if Sublandlord draws on the LOC, then Subtenant shall have the right, upon ten (10) days’ prior written notice to Sublandlord, to obtain a refund from Sublandlord of any unapplied proceeds of the LOC which Sublandlord has drawn upon, any such refund being conditioned upon Subtenant simultaneously delivering to Sublandlord a new replacement LOC in the amount then required, and otherwise meeting the requirements contained in this Section.

d. Return of Security Deposit; Transfer of Security Deposit. Provided Subtenant shall have made all payments and performed all of its covenants and agreements hereunder, Sublandlord shall return any cash Security Deposit and/or the LOC to Subtenant (except to the extent of any portion thereof which has been applied by Sublandlord hereunder and not restored by Subtenant) within thirty (30) days following the expiration or termination of the Term. In the event (i) the Prime Lease is terminated and this Sublease is continued as a direct lease between Prime Landlord and Subtenant, or (ii) Sublandlord’s interest in the Prime Lease is assigned to an assignee, Sublandlord shall transfer the Security Deposit to Prime Landlord or such assignee, as the case may be, and, upon any such transfer of the Security Deposit, Subtenant shall look solely to Prime Landlord or the assignee, as applicable, for return of the Security Deposit, and Sublandlord shall be released from all liability to Subtenant for the return of the Security Deposit.

13. Default. If Subtenant shall default with respect to this Sublease and the Demised Premises, Sublandlord shall have all of the rights and remedies accorded to Prime Landlord under the Prime Lease. In addition, if Subtenant shall default beyond applicable notice and cure periods with respect to this Sublease and the Demised Premises, Sublandlord shall have all of the rights and remedies accorded to Prime Landlord under the Prime Lease for defaults thereunder beyond applicable notice and cure periods.

14. Subordination. This Sublease is subject and subordinate to the Prime Lease, to the Declaration (as defined in Article 40 of the Prime Lease), to all

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ground and underlying leases, and to all mortgages and deeds of trust which may now or hereafter affect such leases, the leasehold estate or estates thereby created or the real property of which the Demised Premises form a part, and to any and all renewals, modifications, consolidations, replacements and extensions thereof.

15. Quiet Enjoyment. Sublandlord covenants and agrees with Subtenant that, upon Subtenant paying the Base Rent and Additional Rent reserved in this Sublease and observing and performing all the terms, covenants and conditions of this Sublease on Subtenant’s part to be observed and performed, Subtenant may peaceably and quietly enjoy the Demised Premises during the Term of this Sublease, in accordance with the terms, covenants and conditions of this Sublease, but subject to the exceptions, reservations and conditions hereof.

16. Alterations. Except as expressly provided in Exhibit B attached hereto, Subtenant shall not make any alterations, additions, or other physical changes in or about the Demised Premises without the consent of Sublandlord, which shall not be unreasonably withheld or delayed, and Prime Landlord in accordance with Article 8 of the Prime Lease. Upon the written request of Subtenant in accordance with Section 8(e) of the Prime Lease and prior to the installation of the applicable Initial Improvements or other Alterations hereunder, Sublandlord shall request that Prime Landlord notify Sublandlord of Prime Landlord’s election to require that such Alterations be removed upon expiration or earlier termination of the Prime Lease. If Prime Landlord delivers Sublandlord a notice of its intent to exercise, or not exercise, such election pursuant Section 8(e) of the Prime Lease, Sublandlord will promptly deliver such notice to Subtenant and such election shall be deemed to be an election by Sublandlord to require Subtenant to remove or not to remove (as stated in Prime Landlord’s election notice) such Alterations upon expiration or earlier termination of this Sublease. Any failure by Prime Landlord to notify Sublandlord of Prime Landlord’s election to require removal of such Alterations shall be deemed Prime Landlord’s election to require such removal of the Alterations pursuant to Section 8(e) of the Prime Lease, and, therefore, shall further be deemed to be an election by Sublandlord to require Subtenant to remove such Alterations upon expiration or earlier termination of this Sublease.

17. Assignments and Further Subleases.

a. Restriction on Transfers. Subtenant agrees that it will not assign or encumber, or permit to be encumbered, its rights or interests under this Sublease, nor sublet the whole or any part of the Demised Premises, directly or indirectly, by operation of law, a change of control transaction, or otherwise, without the prior written consent of Prime Landlord in accordance with the Prime Lease, and the consent of Sublandlord, which shall not be unreasonably withheld or delayed. Without limiting Sublandlord’s rights hereunder, Sublandlord shall in no event consent to a proposed sublease for less than a contiguous, full-floor within the Demised Premises. In the event that Subtenant shall be permitted to either assign or sublet the Demised Premises, and excluding any Permitted Transfers hereunder, all Net Profits (as defined in the next sentence) realized from such assignment or sublease shall be split equally between the Sublandlord and the Subtenant, after the Prime Landlord’s share, if any, is

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deducted out of such amounts pursuant to Section 11(e) of the Prime Lease. As used herein, “Net Profits” shall mean any sums received by Subtenant in excess of the amounts payable by Subtenant to Sublandlord, on a per-square-foot basis, for the applicable term pursuant to this Sublease after deducting from such excess only the actual and reasonable, third-party, out of pocket expenses incurred by Subtenant in connection with such assignment or subletting, together with the actual, fair market rental or sales proceeds received by Subtenant that are equitably allocable to the sale or rental of Subtenant’s personal property (but not to the furniture described on Exhibit D or the Initial Improvements) to the assignee or sublessee (all such deducted expenses and proceeds shall be referred to herein as the “Deducted and Unrelated Costs”). All Deducted and Unrelated Costs shall be amortized, on a straight-line basis, over the period commencing on the date such costs are incurred and expiring on the Expiration Date. Subtenant shall use commercially reasonable efforts to provide Sublandlord reasonable advance notice of Subtenant’s calculations of any Net Profits and Deducted and Unrelated Costs but, in all cases, shall have an obligation to provide Sublandlord such calculations on or before the date of delivery to Sublandlord of the assignment or sublease agreement for which Sublandlord’s consent is requested hereunder. As used herein, “change of control transaction” shall mean any transaction or series of transactions resulting in (i) the transfer of control of Subtenant, other than by reason of death, or, (ii) if Subtenant is a corporation, the direct or indirect change in the control of Subtenant or in the ownership by the stockholders or an affiliated group of stockholders of fifty percent (50%) or more of the outstanding stock as of the date of the execution and delivery of this Sublease. As used in this Section 17, “control” means the power to direct or cause the direction of the day-to-day management and policies of a company, whether through the ownership of voting securities, or partnership or membership interests, by contract, by interlocking boards of directors, or otherwise. Notwithstanding anything to the contrary contained in this Sublease, any transfer or issuance of stock over the New York Stock Exchange, the American Stock Exchange, or NASDAQ shall not be deemed an assignment, subletting or other transfer of this Sublease or the Demised Premises requiring Sublandlord’s consent for purposes of this Section 17.

b. Permitted Transfers. Provided Subtenant is not then in default of its obligations under this Sublease and provides Sublandlord no less than thirty (30) days’ prior written notice of the applicable Permitted Transfer, Subtenant shall have the right to assign this Sublease without Sublandlord’s consent (but subject to Prime Landlord’s consent to the extent required under the Prime Lease) pursuant to a Permitted Transfer permitted under Section 11(g) of the Prime Lease. Notwithstanding any such assignment, the original Subtenant shall remain liable for performance and compliance with all of the terms, conditions and provisions of this Sublease. Except as expressly provided otherwise in this Section 17 above, Article 11 of the Prime Lease shall apply to and govern all assignments, and sublettings, encumbrances, and transfers of the Demised Premises or Subtenant’s interest therein, and all attempts to effect the foregoing, it being the intent of the parties that this Section 17 supplements, but does not supersede, Article 11 of the Prime Lease.

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c. Sublandlord’s Right to Transfer. In addition, Subtenant acknowledges and agrees that, as between Sublandlord and Subtenant, Sublandlord shall be entitled to freely assign this Sublease and its interest in the Demised Premises so long as such transfer is not a default under the Prime Lease, and the proposed assignee assumes in writing the obligations of Sublandlord under this Sublease that are based on or arise out of events or conditions occurring on or after the date of any such assignment. In such event, the Sublandlord named herein shall not be liable to Subtenant for any obligations or liabilities based on or arising out of events or conditions occurring on or after the date of any such transfer. Furthermore, Subtenant agrees to attorn to any such transferee upon all the terms and conditions of this Sublease.

d. Additional Conditions. Notwithstanding anything to the contrary contained in this Sublease, Sublandlord shall have no right to terminate this sublease pursuant to Section 11(c) of the Prime Lease, or to recapture the Demised Premises pursuant to Section 11(d) of the Prime Lease. However, nothing in the preceding sentence shall be deemed to modify or terminate Prime Landlord’s rights with respect to Sections 11(c), (d) and (e) of the Prime Lease. For the avoidance of doubt, Sublandlord and Subtenant acknowledge and agree that Subtenant shall have no right to sublease the Demised Premises pursuant to Section 17(h) of the Prime Lease and that such provision is expressly excluded from this Sublease.

18. Parking.

Subject to and in accordance with Article 36 of the Prime Lease, Subtenant shall be entitled to use, on a non-exclusive basis during the Term, the parking spaces available to Sublandlord within the parking facilities serving Phase I (the “Parking Facilities”). Subtenant and its agents, employees, contractors and invitees shall comply with Article 36 of the Prime Lease and all reasonable rules and regulations promulgated by Sublandlord and Prime Landlord for the safe and orderly functioning of the Parking Facilities.

19. Cafeteria and Fitness Center Facilities.

a. Transfer of Operation and Control. Sublandlord will continue operating the existing retail cafeteria facility within the Building 22 Cafeteria Space (the “Cafeteria”), and the fitness center facility located within the Building 22 Fitness Center Space, together with the outdoor volleyball, basketball and hockey courts within Phase I (collectively, the “Fitness Center”) until April 30, 2005 (the “Amenity Transfer Date”) in accordance with the terms of Section 5 of the Side Agreement. The terms of the Side Agreement, including without limitation, Subtenant’s obligation to pay the Monthly Fitness Center Fee as defined in Section 5(b) thereof, shall continue to govern Subtenant’s use of the Cafeteria and Fitness Center through and including the Amenity Transfer Date. Notwithstanding anything to the contrary in the Side Agreement, the Side Agreement shall automatically terminate, and the Side Agreement Term (as defined in the Side Agreement) shall automatically expire at midnight (PST) on the Amenity Transfer Date, without requiring further action on the part of Sublandlord or Subtenant. Prior to the Amenity Transfer Date, Subtenant agrees to cooperate with Sublandlord to

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ensure that Sublandlord’s third party contracts for the operation of the Cafeteria and Fitness Center are terminated and replaced by Subtenant’s contracts by the Building 22 Commencement Date and facilitate uninterrupted operation of the Cafeteria and Fitness Center. On the Building 22 Commencement Date, Subtenant shall assume control and operation of the Cafeteria and Fitness Center subject to the terms of this Section 19, and Sublandlord shall no longer be required to provide such amenities for the remainder of the Term.

b. Cafeteria and Fitness Center Equipment. Provided no default, beyond applicable notice and cure periods, then exists under the terms of this Sublease, Sublandlord will convey title to the equipment located within the Cafeteria Space and the Fitness Center Space owned by Sublandlord and used in connection with Cafeteria and Fitness Center operations, all as more particularly described on Exhibit F attached hereto (hereinafter, the “Cafeteria Equipment” and the “Fitness Center Equipment,” as applicable) on the Building 22 Commencement Date at no additional cost to Subtenant. Sublandlord will convey the Cafeteria Equipment and Fitness Center Equipment on an “as-is”, “where-is” basis, without warranty, except as to ownership free and clear of all liens created by or through Sublandlord based on the best of Sublandlord’s then-current knowledge, pursuant to the terms of a bill of sale in substantially the form of Exhibit G attached hereto.

c. Operations During the Amenities Period. During the four (4) year period from and after the Building 22 Commencement Date (the “Amenities Period”), Subtenant shall: (i) continuously operate the Cafeteria and Fitness Center as they currently are being operated by Sublandlord without materially changing the operating hours or making other material modifications to the Cafeteria and Fitness Center operations, and (ii) permit Sublandlord, America Online, Inc. and their respective employees (collectively, the “Sublandlord Parties”), and the Access Parties to access and use the Cafeteria and Fitness Center without charge to the Sublandlord Parties or such Access Parties subject to and in accordance with this Section 19. Notwithstanding the foregoing, Subtenant shall have the right up to two (2) times in any calendar year during the Term, upon forty-eight (48) hours’ prior notice to Sublandlord and the Access Parties, to close the Cafeteria for up to twenty-four (24) hours for Subtenant-only events. Also notwithstanding the foregoing, Subtenant shall have the option, exercisable upon delivery of at least sixty (60) days’ prior written notice to Sublandlord, to close and cease operations of the Fitness Center at any time after the end of the thirty-sixth (36^th) month of the Amenities Period. Subtenant’s exercise of the foregoing option is conditioned upon Subtenant paying a termination fee to Sublandlord in the amount of $25,000.00 simultaneously with delivery of written notice of the termination. Subtenant may elect to discontinue operations of the Cafeteria and/or Fitness Center altogether or to limit usage to Subtenant’s employees, officers, directors, consultants, customers and visitors (the “Subtenant Parties”) at any time after the expiration of the Amenities Period without paying a termination fee to Sublandlord. In the event that Subtenant elects to continue operations of the Cafeteria and/or Fitness Center after the Amenities Period expires, the Sublandlord Parties may continue using such facilities subject to Sublandlord and Subtenant agreeing upon mutually acceptable terms and conditions applicable to such use prior to the expiration of the Amenities Period.

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d. Cafeteria. During the Amenities Period, the Sublandlord Parties, and the Access Parties shall have the right to use the Cafeteria on a non-exclusive basis during the Cafeteria’s regular hours of operation. Sublandlord’s employees and the Access Parties shall be required to comply with all reasonable rules and regulations with respect to the Cafeteria, as reasonably promulgated by Subtenant from time to time and shall be responsible for paying for all Cafeteria purchases when ordered. Additionally, the Sublandlord Parties, but not the Access Parties, shall receive a twenty-percent (20%) discount (“Discount”) on all Cafeteria purchases calculated based upon the published and/or public food and beverage prices charged by Subtenant. Subtenant shall have the right to request from the Sublandlord Parties reasonable identification in connection with the granting of the Discount. In addition, the Discount shall not be applicable to catering or to bulk purchases of food requested by the Sublandlord Parties. Except to the extent caused by the negligence or willful misconduct of Subtenant, its agents, employees or contractors, Sublandlord hereby releases Subtenant and agrees to indemnify, defend and hold Subtenant harmless from and against any liability arising from the use of the Cafeteria during the Amenities Period by the Sublandlord Parties (but not the Access Parties), including, without limitation, any claims asserted or caused by the Sublandlord Parties or their invitees.

e. Fitness Center and Outdoor Courts. During the Amenities Period, subject to subsection (c) above, up to 100 employees of the Access Parties and up to 450 of the Sublandlord Parties shall have the right to use the Fitness Center on a non-exclusive basis during its regular hours of operation at no additional cost to the Sublandlord Parties. Subtenant shall be permitted to condition the Access Parties’ use of the Fitness Center upon the Access Parties paying a fitness center fee directly to Subtenant in an amount not to exceed the amounts specified for each Access Party on Exhibit E hereto. Sublandlord shall not be liable for payment or collection of such fitness center fees or any costs incurred by Subtenant in connection therewith, but in the event of non-payment of the fitness center fee, Subtenant shall have the right to deny the Access Parties access to the Fitness Center. The Sublandlord Parties and the Access Parties shall be required to comply with all reasonable rules and regulations as promulgated by Subtenant from time to time with respect to the Fitness Center. Except to the extent caused by the negligence or willful misconduct of Subtenant, its agents, employees or contractors, Sublandlord hereby releases Subtenant and agrees to indemnify, defend and hold Subtenant harmless from and against any liability arising from the use of the Fitness Center during the Amenities Period by the Sublandlord Parties (but not the Access Parties), including, without limitation, any claims asserted or caused by the Sublandlord Partiesor their invitees.

20. Signage. Subject to the signage rights granted to Sublandlord, as tenant, under Article 42 of the Prime Lease and to the provisions of Article 8 of the Prime Lease, Subtenant shall have the right, at Subtenant’s sole cost and expense, to install and display its company name on the exterior of each Building, the entry doors of each Building, and within the lobby of each Building, in each case, subject to the terms of the Prime Lease and provided Subtenant has obtained the prior written consent of Sublandlord, which shall not be unreasonably withheld or delayed, and Prime Landlord pursuant to the provisions of the Prime Lease, including, without limitation, Article 42 thereof..

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21. Compliance. Subtenant covenants and agrees that Subtenant will not do anything which would constitute a default under the Prime Lease or omit to do anything which Subtenant is obligated to do under the terms of this Sublease and which would constitute a default under the Prime Lease.

22. Notices. Any notice, demand or other communication which must or may be given or made by either party hereto shall be in writing and shall be in accordance with the provisions of the Prime Lease, addressed:

In the case of Subtenant, prior to the Commencement Date, to:

Mercury Interactive Corporation

379 N. Whisman Road

Mountain View, California

Attn: Vice President and General Counsel

Fax: 650/584-3572

In the case of Sublandlord, to:

c/o America Online, Inc.

22110 Pacific Boulevard

Dulles, Virginia 20166

Attn: Director of Real Estate

Fax: 703/265-1509

With a copy (default notices only) to:

c/o America Online, Inc.

22000 AOL Way

Dulles, Virginia 20166-9323

Attn: Legal Department

Fax: 703/265-1008

Either party may, by notice to the other given as aforesaid, designate a new or additional address to which any such notice, demand or other communication thereafter shall be given, made or mailed. Any notice, demand or communication given hereunder shall be deemed delivered when actually received.

23. Indemnity.

a. Sublandlord’s Indemnity. Sublandlord agrees to perform its obligations to Prime Landlord under the Prime Lease (to the extent those obligations are not made the obligation of Subtenant hereunder and to the extent such performance is not adversely affected by a Subtenant default hereunder), including, without limitation, the obligation to pay all rent required to be paid by “Tenant” to Prime Landlord in

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accordance with the terms of the Prime Lease, in order to keep the Prime Lease in full force and effect during the entire Term of this Sublease; subject, however, to any earlier termination of the Prime Lease not caused by Sublandlord or caused by Subtenant. Sublandlord shall promptly provide Subtenant copies of all default notices relative to the Demised Premises received by Sublandlord from Prime Landlord during the Term. Further, in addition to Sublandlord’s other indemnification obligations hereunder, Sublandlord agrees to indemnify, defend and hold Subtenant free and harmless from and against any and all claims and related liabilities, judgments, causes of action, damages (including reasonable attorneys’ fees), costs and expenses incurred by or claimed against Subtenant to the extent arising out of (i) any default by Sublandlord under this Sublease (through no fault of Subtenant); (ii) any default by Sublandlord of Sublandlord’s remaining obligations under the Prime Lease (through no fault of Subtenant); and/or (iii) the gross negligence or willful misconduct of Sublandlord or any of its agents, employees or contractors. Subtenant shall provide notice to Sublandlord of any claim for which it is seeking indemnification hereunder promptly after it actually becomes aware of such claim, and Sublandlord shall defend such claim with counsel reasonably acceptable to Subtenant. Subtenant shall, at Sublandlord’s sole cost and expense, cooperate with Sublandlord in the prosecution of such defense.

b. Subtenant’s Indemnity. Subtenant agrees (i) to comply with all provisions of this Sublease and, to the extent incorporated into this Sublease, the Prime Lease; and (ii) to perform all the obligations on the part of the “Tenant” to be performed under the terms of the Prime Lease with respect to the Demised Premises to the extent incorporated herein. In addition to Subtenant’s other indemnification obligations hereunder, Subtenant shall indemnify, defend, and hold Sublandlord free and harmless from and against any and all claims and related liabilities, judgments, causes of action, damages (including reasonable attorneys’ fees), costs and expenses incurred by or claimed against Sublandlord to the extent arising out of (i) any default by Subtenant under this Sublease (through no fault of Sublandlord); (ii) any default by Subtenant under the Prime Lease (through no fault of Sublandlord), to the extent incorporated into this Sublease; (iii) the gross negligence of willful misconduct of Subtenant or any of its agents, employees, contractors or invitees, and/or (iv) any accident, injury, or damage to any person or property occurring on or after the Delivery Date within the Demised Premises, except to the extent caused by the negligence or willful misconduct of Sublandlord, its agents, employees, or contractors. Sublandlord shall provide notice to Subtenant of any claim for which it is seeking indemnification hereunder promptly after it actually becomes aware of such claim, and Subtenant shall defend such claim with counsel reasonably acceptable to Sublandlord. Sublandlord shall, at Subtenant’s sole cost and expense, cooperate with Subtenant in the prosecution of such defense.

The indemnification obligations set forth in this Section and elsewhere in this Sublease (and the Prime Lease to the extent incorporated herein) shall survive the expiration or earlier termination of this Sublease, and no indemnification set forth in this Sublease or, as between Sublandlord and Subtenant, the Prime Lease, shall include the obligation to indemnify either for punitive damages or, (excluding the indemnification set forth in Section 25 below), for consequential damages (e.g., lost profits or lost business

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opportunity). In addition, except as expressly provided otherwise in this Sublease, neither party shall have any liability to the other party hereunder for any indirect, consequential, or punitive damages. Subtenant covenants and agrees that Subtenant will not do anything which would constitute a default under the Prime Lease or omit to do anything which Subtenant is obligated to do under the terms of this Sublease and which would constitute a default under the Prime Lease.

24. Surrender. Not later than the Expiration Date, Subtenant shall quit and surrender to Sublandlord the Demised Premises, broom clean and in as good order and condition as they were on the Commencement Date and, to the extent excepted under the Prime Lease, excepting ordinary wear and tear, acts of God, casualty, condemnation, and alterations with respect to which neither Sublandlord nor Prime Landlord has a right to require removal, or the payment of the costs of removal, as set forth in this Sublease or the Prime Lease. In connection with the foregoing, Subtenant shall remove from the Demised Premises all of its property including, without limitation, the Furniture (subject to Section 7 above), the Fitness Equipment and the Cafeteria Equipment. In addition, and notwithstanding anything to the contrary in Section 9 of this Sublease, Subtenant hereby expressly assumes all restoration and removal obligations of “Tenant” under the Prime Lease, including, without limitation, the obligation to pay for the removal of any Alterations and other improvements from the Demised Premises to the extent Sublandlord is required to make such payments to Prime Landlord pursuant to the terms of the Prime Lease. Subtenant’s obligations to perform and observe the foregoing covenants shall survive the expiration or other termination of the Term of this Sublease. If the last day of this Sublease shall fall on a Saturday, Sunday or legal holiday, this Sublease shall expire on the last business day preceding such last day, provided, however, that if Subtenant and Prime Landlord have executed and delivered a direct lease with a commencement date immediately following the Expiration Date and Prime Landlord has signed and delivered to Sublandlord a written waiver of any and all obligations of Tenant under the Prime Lease to comply with the obligations described in the foregoing provisions, Subtenant shall not be required to comply with the provisions of this Section, and may remain in the Demised Premises through the last day of the term of the Prime Lease.

25. Holdover. Subtenant shall surrender the Demised Premises on or before the Expiration Date without any delay. In the event Subtenant does not immediately surrender the Demised Premises on the Expiration Date, Subtenant’s continued possession shall be on the basis of a tenancy at the sufferance of the Sublandlord. In such event, Subtenant shall continue to comply with and perform all of the terms and obligations of this Sublease except that the Rent payable during each month or portion thereof shall be equal to One Hundred Fifty Percent (150%) of the Rent payable during the last full month prior to the expiration or termination of the Sublease, as applicable. Subtenant shall be liable to Sublandlord for, and shall indemnify and hold Sublandlord harmless against, all damage which Sublandlord suffers because of any holding over by Subtenant, including without limitation, all claims made against Sublandlord resulting from Sublandlord’s delay in delivering possession of the Demised Premises to Prime Landlord. Notwithstanding anything to the contrary contained in this Sublease, if Subtenant and Prime Landlord have executed and

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delivered a direct lease with a commencement date immediately following the Expiration Date and Prime Landlord has signed and delivered to Sublandlord a written waiver of Prime Landlord’s rights under Article 16 of the Prime Lease, Subtenant may remain in the Demised Premises through the last day of the term of the Prime Lease without being subject to the provisions of this Section 25.

26. Brokers. Sublandlord and Subtenant each represent and warrant that neither has dealt with any brokers or consultants in connection with this transaction, except for (i) Roger Gage, Matt Hargrove, Mike Shellow and Janet Polanchyck, collectively of Cushman & Wakefield, Inc. of California, Sublandlord’s exclusive “Leasing Broker” for this Sublease, and (ii) Bruce McLellan of McLellan Commercial Real Estate, Inc., Subtenant’s exclusive “Tenant Broker” for this Sublease. Sublandlord shall pay all commissions due such brokers pursuant to a separate agreement with the Leasing Broker and Tenant Broker. Each party shall hold and save the other harmless of and from any and all loss, costs, damage, injury or expense arising out of or in any way related to claims for any other real estate brokers, sales persons or finder’s commissions or fees based upon allegations made by the claimant that it is entitled to such a fee from the indemnified party arising out of contact with the indemnified party or alleged introductions of the indemnifying party to the indemnified party.

27. Confidentiality. Each party agrees to hold the material terms and conditions of this Sublease and the transactions contemplated or permitted hereby, including, without limitation, any assignment of this Sublease, strictly confidential. Accordingly, except to the extent required by law, including, without limitation, any law requiring Subtenant or Sublandlord to disclose all or certain terms of this Sublease in a filing required by the Securities and Exchange Commission or any successor thereto, or by court order (in the case of a court order, following advanced written notice to the non-disclosing party), neither party shall, without the other party’s prior written consent, release, publish or otherwise distribute (and shall not authorize or permit any other person or entity to release, publish or otherwise distribute) any information concerning the material terms or conditions of the Sublease, or the transactions contemplated or permitted hereby, to any person or entity, including, without limitation, any other subtenant or potential subtenant of Sublandlord or other occupant of Sublandlord’s space in Mountain View, California.. Notwithstanding the foregoing, each party may disclose such information to the its prospective lenders, legal and financial advisors, accountants, engineers or other persons if and to the extent such persons have a legitimate business purpose for needing such information in furtherance of, or consistent with, the transactions contemplated hereby and provided that such persons agree to hold such information strictly confidential to the same degree as if such persons were bound by the provisions of this Section 27. The terms of this Section 27 shall survive the expiration or earlier termination of this Sublease for a period of five (5) years.

28. Prime Landlord Consent. This Sublease and the obligations of Sublandlord and Subtenant under this Sublease and the Work Letter Agreement are expressly conditioned upon receipt of the prior written consent of Prime Landlord to this

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Sublease, the form and content of which shall: (a) be acceptable to Sublandlord and Subtenant in their reasonably exercised discretion, (b) constitute a consent to this Sublease by Prime Landlord as required by Article 11 of the Prime Lease, and (c) contain an acknowledgement that the Demised Premises may be used by Subtenant for customer training and sales presentation purposes. Notwithstanding the foregoing, Subtenant and Sublandlord shall be deemed to have accepted, for purposes of subsection (a) above, a consent to this Sublease by Prime Landlord if such consent satisfies the conditions set forth in subsections (b)-(c), unless such consent contains additional terms that are not customary in the current Mountain View leasing market for comparable buildings and, if agreed to by Subtenant and/or Sublandlord, would materially and adversely change Subtenant’s rights or obligations hereunder. In addition, Sublandlord shall use commercially reasonable efforts, at no cost or expense to Sublandlord, to obtain a subordination, nondisturbance and attornment agreement from Prime Landlord for the benefit of Subtenant or the inclusion of subordination, nondisturbance, and attornment language within the written consent to this Sublease signed and delivered by Prime Landlord.

29. General Provisions.

(a) Benefit and Burden. The covenants, conditions, agreements, terms and provisions herein contained shall be binding upon, and shall inure to the benefit of, the parties hereto and each of their respective personal representatives, successors, heirs, executors, administrators and assigns.

(b) Governing Law. It is the intention of the parties hereto that this Sublease (and the terms and provisions hereof) shall be construed and enforced in accordance with the laws of the State of California.

(c) Entire Agreement. This Sublease, which includes all exhibits attached hereto, contains all of the covenants, agreements, terms, provisions, conditions, warranties and understandings relating to the leasing of the Demised Premises and Sublandlord’s obligations in connection therewith, and neither Sublandlord nor any agent or representative of Sublandlord has made or is making, and Subtenant in executing and delivering this Sublease is not relying upon, any warranties, representations, promises or statements whatsoever, except to the extent expressly set forth in this Sublease. All understandings and agreements, if any, heretofore had between the parties are merged to this Sublease, which alone fully and completely expresses the agreement of the parties. The failure of Sublandlord or Subtenant to insist in any instance upon the strict keeping, observance or performance of any covenant, agreement, term, provision or condition of this Sublease or to exercise any election herein contained shall not be construed as a waiver or relinquishment for the future of such covenant, agreement, term, provision, condition or election, but the same shall continue and remain in full force and effect. No waiver or modification of any covenant, agreement, term, provision or condition of this Sublease shall be deemed to have been made unless expressed in writing and signed by Subtenant and Sublandlord. No surrender of possession of the Demised Premises or of any part thereof or of any

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remainder of the Term shall release Subtenant from any of its obligations hereunder unless accepted by Sublandlord in writing. The receipt and retention by Sublandlord of monthly Base Rent or Additional Rent from anyone other than Subtenant shall not be deemed a waiver of the breach by Subtenant of any covenant, agreement, term or provision of this Sublease, or as the acceptance of such other person as a tenant, or as a release of Subtenant of the covenants, agreements, terms, provisions and conditions herein contained. The receipt and retention by Sublandlord of monthly Base Rent or Additional Rent with knowledge of the breach of any covenant, agreement, term, provision or condition herein contained shall not be deemed a waiver of such breach.

(d) Conflicts Between this Sublease and the Prime Sublease. With respect to the relationship between the Sublandlord and the Subtenant, the terms and conditions of this Sublease shall take precedence with respect to any conflict between the terms and conditions contained herein and the terms and conditions of the Prime Lease. As between Sublandlord and Prime Landlord, nothing herein shall be construed in any way to affect the rights and obligations of the Sublandlord and the Prime Landlord under the Prime Lease.

(e) Captions. The captions throughout this Sublease are for convenience of reference only and the words contained therein shall in no way be held or deemed to define, limit, describe, explain, modify, amplify or add to the interpretation, construction or meaning of any provision of or the scope or intent of this Sublease, nor in any way affect this Sublease.

(f) Singular and Plural. Wherever appropriate herein, the singular includes the plural and the plural includes the singular.

(g) Counterparts; Facsimile. This Sublease may be executed in several counterparts, but all counterparts shall constitute but one and the same instrument. The parties agree and intend that a signature delivered by facsimile machine shall bind the party so signing with the same effect as though the signature were an original signature.

(h) No Recordation. Neither this Sublease nor any short-form memorandum or version hereof shall be recorded by either party.

30. Release and Waiver of Subrogation. Notwithstanding anything to the contrary contained in this Sublease or the Prime Lease, Sublandlord shall use diligent efforts during the first twelve (12) months of the Term to obtain a written agreement from Prime Landlord providing that the release of subrogation provisions set forth in the last two sentences of Article 13 of the Prime Lease shall be deemed an agreement between Prime Landlord and Subtenant as if Subtenant were “Tenant” under the Prime Lease. In addition, subject to Section 9(a) above, the release and waiver of subrogation provisions of Article 13 of the Prime Lease shall be deemed to apply to Sublandlord and Subtenant as if they were respectively “Landlord” and “Tenant” thereunder; provided, however, for purposes of construing such release and waiver provisions as incorporated herein, the parties acknowledge and agree that Sublandlord

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shall have no obligation to maintain the insurance requirements of “Landlord” under the Prime Lease but rather shall be required to continue to maintain the insurance requirements of “Tenant” thereunder.

31. Right to Cure. Notwithstanding anything to the contrary contained in this Sublease or the Prime Lease, in the event that Sublandlord defaults in the performance or observance of any of Sublandlord’s obligations under the Prime Lease (to the extent not the obligation of Subtenant hereunder or caused by Subtenant’s default hereunder) or this Sublease, or fails to perform Sublandlord’s stated obligations under Section 9(b) of this Sublease and such default or failure, in Subtenant’s reasonable opinion, materially impairs the conduct by Subtenant of its business operations in the Demised Premises, then Subtenant shall give Sublandlord notice specifying in what manner Sublandlord has defaulted, and if such default shall not be cured by Sublandlord within a reasonable time, but in no event longer than thirty (30) days thereafter (except that if such default cannot be cured within said period, this period shall be extended for an additional reasonable time, provided that Sublandlord commences to cure such default within such period and proceeds diligently thereafter to effect the cure as quickly as reasonably practicable), then Subtenant shall be entitled, at Subtenant’s option, to cure such default and promptly collect from Sublandlord the reasonable, out-of-pocket expenses actually incurred by Subtenant in curing such default. Subtenant shall not be required, however, to wait the entire cure period described herein if earlier action is required to comply with the Prime Lease or with any applicable governmental law, regulation or order. For the avoidance of doubt, the parties acknowledge and agree that the foregoing self-help remedies shall not be construed as exclusive remedies of Subtenant and that any exercise of such remedies pursuant to the terms set forth herein shall not be deemed to constitute a waiver of any other remedies available to Subtenant under this Sublease or applicable law.

32. Amendment or Modification. Notwithstanding anything to the contrary contained in this Sublease or the Prime Lease, Sublandlord shall not amend or modify the Prime Lease in any way so as to materially and adversely affect Subtenant or its interest hereunder, materially increase Subtenant’s obligations hereunder or materially restrict Subtenant’s rights hereunder, without the prior written consent of Subtenant, which may be withheld in Subtenant’s sole but reasonably exercised discretion.

33. Representations. Sublandlord represents that, to Sublandlord’s current knowledge, (i) the copy of the Prime Lease attached hereto is a true, correct and complete copy thereof; (ii) there exist no amendments, or modifications to the Prime Lease (whether oral or written) except as attached thereto; (iii) neither Sublandlord nor Prime Landlord is in default under the provisions of the Prime Lease, nor is there any event, condition or circumstance existing which with notice, or the passage of time or both, would constitute a “default” thereunder; (iv) the Prime Lease is in full force and effect and is a valid and binding obligation of Sublandlord and of Prime Landlord, and (v) there are no pending actions, suits or proceedings before any governmental entity, court or administrative agency against Sublandlord that are reasonably likely to materially and adversely affect the ability of Sublandlord to perform its obligations under

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this Sublease or the Prime Lease. Subtenant represents, to Subtenant’s current knowledge, that there are no pending actions, suits or proceedings before any governmental entity, court or administrative agency against Subtenant that are reasonably likely to materially and adversely affect the ability of Subtenant to perform its obligations under this Sublease.

34. Voluntary Termination. For so long as Subtenant is not in default of its obligations under this Sublease beyond any applicable notice and cure periods, Sublandlord shall not voluntarily terminate the Prime Lease or surrender the Demised Premises during the Term unless and until Prime Landlord has agreed to (i) thereafter assume all rights and obligations of “Sublandlord” under this Sublease (a “Prime Landlord Assumption”), or (ii) simultaneously enter into a direct lease with Subtenant (the “Direct Lease”) upon substantially the same terms and conditions of this Sublease, including without, limitation, the Base Rent payable by Subtenant hereunder, such that the terms and conditions of the Direct Lease do not materially and adversely change Subtenant’s rights or obligations under this Sublease. If Prime Landlord consents to a Prime Landlord Assumption, Subtenant shall attorn to Prime Landlord in connection with any such voluntary termination or surrender, and shall execute an attornment agreement in such form as may reasonably be requested by Prime Landlord and reasonably acceptable to Subtenant. The terms of this Section 34 shall not apply with respect to Sublandlord’s exercise of its termination rights in the event of casualty pursuant to Sections 22 (c) or (d) of the Prime Lease, but Sublandlord shall notify Subtenant in writing at the time Sublandlord notifies Prime Landlord of the exercise of any such termination right.

35. Acknowledgment of Sublandlord. Sublandlord acknowledges that Subtenant intends to negotiate with Prime Landlord a Direct Lease with a commencement date immediately following the Expiration Date of this Sublease. Provided that this Sublease remains in effect as of the date on which Sublandlord’s Exercise Notice is due pursuant to Section 43 of the Prime Lease and that Subtenant is not in default of its obligations under this Sublease beyond any applicable notice and cure period as of such date, Sublandlord hereby agrees not to exercise its Option to Renew pursuant to Article 43 of the Prime Lease without the prior written consent of Subtenant, which may be withheld in Subtenant’s sole but reasonably exercised discretion.

[SIGNATURES APPEAR ON NEXT PAGE]

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IN WITNESS WHEREOF, Sublandlord and Subtenant have each executed this Sublease on the day and year first hereinabove written.

SUBLANDLORD:
NETSCAPE COMMUNICATIONS CORPORATION, A DELAWARE CORPORATION
By:	/s/ Michael Bartscherer
Name:	Michael Bartscherer
Title:	Vice President, Corporate Services
SUBTENANT:
MERCURY INTERACTIVE CORPORATION, A DELAWARE CORPORATION
By:	/s/ Anthony Zingale
Name:	Anthony Zingale
Title:	President & COO

EXHIBIT A

OUTLINE OF DEMISED PREMISES

Attached hereto.

EXHIBIT B

WORK LETTER AGREEMENT

In consideration of the mutual covenants contained in the Sublease, of which this Exhibit B is a part, Subtenant and Sublandlord agree that the Demised Premises shall be improved as hereinafter set forth. Except as defined in this Work Agreement to the contrary, all terms utilized in this Work Agreement shall have the same meaning as the defined terms in the Sublease. The provisions of the Sublease, except where clearly inconsistent or inapplicable to this Work Agreement, are hereby incorporated into this Exhibit B.

1. General. The purpose of this Work Agreement is to set forth how the Initial Improvements in the Demised Premises as set forth on the Construction Documents, as defined below in Section 2(c), are to be designed and constructed. Notwithstanding the terms of this Work Agreement, Subtenant acknowledges and agrees that any construction of the Initial Improvements permitted in this Exhibit B shall also be subject to the terms and provisions of the Prime Lease, including, without limitation, Article 8 thereof.

2. Initial Improvement Plans.

(a) Base Building Tenant Improvement Standards. Sublandlord has submitted a copy of the Tenant Improvement Standards (“Standards”) to Subtenant and Subtenant stipulates that such Standards, together with additional information Subtenant has received and/or developed, are sufficient to allow Subtenant’s contractors and consultants to prepare all necessary layout, design, engineering, and construction plans for the full and complete construction of the Initial Improvements. The Standards are listed on the attached Schedule I. Subtenant, in designing and constructing its Initial Improvements, must use materials which are equal to or better than the quality of the materials specified on Schedule I.

(b) Development and Approval of Plans. Subtenant shall employ, at its sole cost and expense, architects, engineers and/or other design contractors (each a “Design Professional”), to prepare and deliver to Sublandlord (i) on or before December 31, 2005 for Building 22, (ii) on or before December 31, 2006 for Building 21, and (iii) on or before December 31, 2007 for Building 20, space plans, architectural plans, engineering plans, and other customary project documents (collectively, the “Project Plans”) showing in specific detail the Initial Improvements that Subtenant desires to make in the Demised Premises. Each of Subtenant’s Design Professional(s) shall be duly licensed and subject to Sublandlord’s prior written approval, which approval shall not be unreasonably withheld or delayed, and shall be conditioned on the Design Professional’s reputation for quality of work, timeliness of performance, integrity and Sublandlord’s prior experience (if any) with such Design Professional, and to Prime Landlord’s approval in accordance with the terms of the Prime Lease. The foregoing Project Plans shall be subject to Sublandlord’s approval, which approval shall not be unreasonably withheld, conditioned, or delayed, and to Prime Landlord’s approval pursuant to the terms of the Prime Lease. Once received by Sublandlord, Sublandlord shall (i) submit the Project Plans to the Prime Landlord for approval; and (ii) review the Project Plans and notify Subtenant, within seven (7) business days, if Sublandlord has any material objections. In the event that either Sublandlord or Prime Landlord has

material objections, Subtenant shall revise the Project Plans only as to such objections and shall, within three (3) business days of Subtenant’s receipt of such objections, resubmit them to Sublandlord, for Sublandlord’s and Prime Landlord’s review and approval, in which event, the foregoing procedure shall be repeated until Sublandlord and Prime Landlord ultimately approve the Project Plans.

(c) Construction Documents. As approved, the Project Plans shall be deemed the “Construction Documents.” Subtenant shall reimburse Sublandlord, as Additional Rent under the Sublease, Sublandlord’s actual and reasonable costs, including any charges payable to Prime Landlord pursuant to Section 8(f) of the Prime Lease, as demonstrated by Sublandlord’s invoice(s) therefor or other reasonably-detailed documentation, incurred in connection with the preparation, review and approval of the Project Plans. Deliveries of the Project Plans (or any subpart thereof) shall be delivered by messenger service, by personal hand delivery or by overnight parcel service.

(d) Standards for Sublandlord’s Approval. Sublandlord’s criteria for approvals of the Project Plans shall be based on reasonable criteria established from time to time by Sublandlord. Without limiting the generality of the foregoing, Sublandlord will automatically be deemed to have acted reasonably if a Sublandlord disapproval is predicated upon (i) Prime Landlord’s disapproval of the Project Plans; (ii) non-compliance with the terms of the Sublease or Prime Lease; (iii) any affect on the structural integrity of any Building, (iv) reasonably anticipated damage to any Building’s mechanical, electrical, plumbing or HVAC systems, (v) non-compliance with applicable laws, codes, regulations, or generally accepted industry standards, (vi) failure to use materials equal to or better than those required by Schedule I pertaining to Standards, and (vii) any affect on the exterior appearance of any Building (“Approved Criteria”). While Sublandlord has the right to approve the Project Plans, Sublandlord’s interest in doing so is to protect each Building’s and Sublandlord’s interests. Accordingly, Subtenant shall not rely upon Sublandlord’s approvals and Sublandlord shall not be the guarantor of, nor responsible for, the correctness or accuracy of any such Project Plans, or the compliance thereof with applicable laws, statutes, codes, ordinances, rates, and regulations (collectively “Laws”), and Sublandlord shall incur no liability or cost of any kind by reason of granting such approvals.

(e) Change Orders. In the event that Subtenant requests or approves of any changes to the Construction Documents (each, a “Change Order”), Sublandlord shall not unreasonably withhold or delay its consent to any such Change Order, but subject to the Approval Criteria listed above.

(f) Standards of Performance. Subtenant represents and warrants that all Design Professionals and Contractors (as defined in Section 4 below) performing work relating to the Initial Improvements shall (i) comply with all Laws, (ii) be familiar with each Building (including all systems therein) and the Standards, and (iii) exercise due care and diligence in the performance of services relating to the Initial Improvements and shall perform such services in a good and workmanlike manner. In addition, the Project Plans shall clearly identify any impact of such plans on the structure, equipment, appearance, or systems of each Building.

3. Permits. Subtenant shall be responsible for obtaining all governmental approvals of the Construction Documents to the full extent necessary for the issuance of a building permit for the Initial Improvements based upon such Construction Documents. Thereafter, Subtenant shall also cause to be obtained all

other necessary approvals and permits from all governmental agencies having authority over the construction and installation of the Initial Improvements in accordance with the approved Construction Documents and shall undertake all steps necessary to insure that the construction of the Initial Improvements is accomplished in strict compliance with all Laws applicable to such construction and the requirements and standards of any insurance underwriting board, inspection bureau, or insurance carrier insuring the Demised Premises pursuant to the Sublease.

4. Construction. Subtenant shall employ an outside contractor or contractors of Subtenant’s choice (each a “Contractor”) to construct the Initial Improvements in substantial conformance with the Construction Documents. Each of Subtenant’s Contractor(s) and all lower-tier contractors shall be duly licensed and subject to Sublandlord’s prior written approval, which approval shall not be unreasonably withheld or delayed and shall be conditioned on the contractor’s reputation for quality of work, timeliness of performance, integrity and Sublandlord’s prior experience (if any) with such contractor, and Prime Landlord’s approval in accordance with the terms of the Prime Lease. Subtenant shall pay for the entire cost of design and construction of the Initial Improvements (including the supply of all materials thereto) and all permits, review and approval fees in connection therewith. Subtenant shall cause its Contractor or Contractors to commence construction of the Initial Improvements within thirty (30) days following Sublandlord’s and Prime Landlord’s approval of the Project Plans, or following plan approval by the City of Mountain View, whichever is later, and shall use reasonable commercial efforts to cause the Initial Improvements to be completed no later than twelve (12) months thereafter. Subtenant, each Subtenant Contractor and the performance of all work relating to the Initial Improvements shall be subject to the following conditions:

(a) Sublandlord and Prime Landlord and their respective agents shall each have the right to inspect the construction of the Initial Improvements during the progress thereof, at reasonable times and without unreasonable interference with the construction of the Initial Improvements, it being the intent of the parties hereto that Sublandlord shall be reasonable in its inspection of the construction of the Initial Improvements and that Sublandlord shall recognize, to the extent commercially reasonable and practicable, the necessity of field changes based on field conditions. However, neither the privilege herein granted to Sublandlord to make such inspections, nor the making of such inspections by Sublandlord, shall operate as a waiver of any rights of Sublandlord to require good and workmanlike construction and improvements erected in accordance with the Construction Documents and the Prime Lease.

(b) The Initial Improvements shall be constructed in accordance with the Construction Documents and the Prime Lease, and Subtenant or Subtenant’s Contractor(s) shall submit schedules of all work relating to the Initial Improvements to Sublandlord before any such Contractor may be approved by Sublandlord. Subtenant shall abide by all rules made by Prime Landlord or reasonably made by Sublandlord with respect to the use of parking and loading areas, storage of materials, and any other matter in connection with this Work Agreement, including, without limitation, the construction of the Initial Improvements.

(c) Subtenant’s Contractors and the respective subcontractors and sub-subcontractors performing any part of the Initial Improvements shall guarantee to Subtenant and for the benefit of Sublandlord and Prime Landlord that the portion of the Initial Improvements for which such contractor is responsible shall be free from any

defects in workmanship and materials for a period of not less than one (1) year from the date of completion thereof. All such warranties or guarantees as to materials or workmanship of or with respect to the Initial Improvements shall be contained in the applicable contract or subcontract and shall be written such that such guarantees or warranties shall inure to the benefit of Prime Landlord, Sublandlord, and Subtenant, as their respective interests may appear, and can be directly enforced by any such parties.

5. Default. Any default by either party under the terms of this Work Agreement shall constitute a default under the Sublease. Each party shall have any and all rights to remedy such defaults of the other party pursuant to the provisions of the Sublease.

6. Reasonable Diligence. Both Sublandlord and Subtenant agree to use reasonable diligence in performing all of their respective obligations and duties under this Work Agreement and in proceeding with the construction and completion of the Initial Improvements in the Demised Premises.

7. Insurance Requirements.

(a) General Coverages. Subtenant shall require all Subtenant’s Contractors and all other lower-tier contractors (i.e., subcontractors and sub-subcontractors) to carry worker’s compensation insurance covering all of their respective employees, and to carry public liability insurance, including property damage, all with limits, in form and with companies as are required to be carried by Subtenant as set forth in Section 10 of the Sublease.

(b) Special Coverages. Subtenant shall carry “Builder’s All Risk” insurance in an amount approved by Sublandlord covering the construction of the Initial Improvements, and such other insurance as Sublandlord reasonably may require, it being understood and agreed that the Initial Improvements shall be insured by Subtenant pursuant to Section 10 of the Sublease immediately upon completion thereof. Such insurance shall be in amounts and shall include such extended coverage endorsements as may be reasonably required by Sublandlord including, but not limited to, the requirement that all of Subtenant’s Contractors and lower-tier contractors shall carry excess liability and Products and Completed Operation Coverage insurance, each in amounts not less than $500,000 per incident, $1,000,000 in aggregate, and in form and with companies as are required to be carried by Subtenant as provided in Section 10 of the Sublease.

(c) General Terms. Certificates for all insurance carried pursuant to this Work Agreement must comply with the requirements of Section 10 of the Sublease and shall be delivered to Sublandlord before the commencement of construction of the Initial Improvements and before the Contractor’s equipment is moved into the Demised Premises. In the event that the Initial Improvements are damaged by any cause during the course of the construction thereof, Subtenant shall immediately repair the same at Subtenant’s sole cost and expense. Subtenant’s Contractors and all lower-tier contractors shall maintain all of the foregoing insurance coverage in force until the Initial Improvements are fully completed and accepted by Sublandlord, except for any Products and Completed Operation Coverage insurance required by Sublandlord, which is to be maintained for ten (10) years following completion of the work and acceptance by Sublandlord and Subtenant. All policies carried under this Section 7 shall insure Prime Landlord, Sublandlord, and Subtenant, as their interests may appear, as well as

the Contractor. All insurance, except Workers’ Compensation, maintained by Subtenant’s Contractors and all lower-tier contractors shall preclude subrogation claims by the insurer against anyone insured thereunder. Such insurance shall provide that it is primary insurance as respects the owner and that any other insurance maintained by owner is excess and noncontributing with the insurance required hereunder.

8. Notice of Completion; Copy of Record Set of Plans. Within ten (10) days after completion of construction of the Initial Improvements, Subtenant shall cause a Notice of Completion to be recorded in the office of the Recorder of Santa Clara County in accordance with Section 3093 of the Civil Code of the State of California or any successor statute, and shall furnish a copy thereof to Sublandlord upon such recordation. If Subtenant fails to do so, Sublandlord may execute and file the same on behalf of Subtenant as Subtenant’s agent for such purpose, at Subtenant’s sole cost and expense. At the conclusion of construction, (i) Subtenant shall cause the Design Professionals and Contractors (A) to update the Construction Documents as necessary to reflect all changes made to the Construction Documents during the course of construction, (B) to certify to the best of their knowledge that the “record-set” of as-built drawings are true and correct, which certification shall survive the expiration or termination of this Sublease, and (C) to deliver to Sublandlord two (2) sets of copies of such record set of drawings and one (1) additional electronic copy (in .dwg format in accordance with AIA layering standards) within ninety (90) days following issuance of a certificate of occupancy for the Demised Premises, and (ii) Subtenant shall deliver to Sublandlord a copy of all warranties, guaranties, and operating manuals and information relating to the improvements, equipment, and systems in the Demised Premises.

SCHEDULE I

TO EXHIBIT B

TENANT IMPROVEMENT STANDARDS

(Attached hereto)

EXHIBIT C

PRIME LEASE

Attached hereto.

EXHIBIT D

FURNITURE LIST

Inventory for 464 Ellis Street, Mtn View, Ca.

Building 20

First Floor:

Cubicles: (95) 10 x 10 Consisting of: Teknion TOS panel systems furniture

Panels: (7) 66/60 panels and (1) 66/30 panel

Worksurfaces: (2) 60/30 corners and (1) 60/30 straight

Components: (1) Shelf w/ task light, (1) Overhead Bin w/ task light, (1) 60x30 whiteboard element, (1) pencil drawer, (1) file, file pedestal, (1) box,box,file pedestal and (1) task chair(optional)

Labs: (2) Consisting of: Symbiote Lab furniture

(1) room is empty – (1) consists of: Panels: (9) 80/48 panels, (1) 80/24 panel Worksurfaces: (2) 48/30 corners, (5) 48/30 str. surfaces, (1) 24/30 str. surface, (10) 48/18 str. shelves

Conference Rooms: (8) Consisting of:

(3-5) 60 x 30 KI tables, (1) phone table, and (8-12) chairs

Second Floor:

Cubicles: (113) 10 x 10 Consisting of: Teknion TOS systems furniture

Panels: (7) 66/60 panels and (1-2) 66/30 panels

Worksurfaces: (2) 60/30 corners and (1) 60/30 straight

Components: (1) Shelf w/ task light, (1) Overhead Bin w/ task light, (1) 60x30 whiteboard element, (1) pencil drawer, (1) file, file pedestal, (1) box,box,file pedestal and (1) task chair(optional)

LABS: (3) CONSISTING OF: SYMBIOTE LAB FURNITURE AND/OR TEKNION PANEL FURNITURE

(1) room is empty – (1) consists of: Symbiote Panels: (9) 80/48 panels, (1) 80/24 panel, (16) 62/48 panels

Worksurfaces: (2-3) 48/30 corners, (1-5) 48/30 str. surfaces, (1) 24/30 str. surface, (4) 72/30 str., (3) 96/30 str., and (10) 48/18 str. shelves

Teknion furniture: Panels: (12) 66/60 panels, (1) 66/36 panel, (1) 66/24 panel

Worksurfaces: (2 60/30 corners, (1) 96/30 str., (7) 60/30 str. and (7) 48/24 shelves

Conference Rooms: (10) Consisting of: (3-6) 60 x 30 KI tables, (1) phone table and/or (1) credenza, and (8-12) chairs

Inventory for 466 Ellis Street, Mtn View, Ca.

Building 21

First Floor:

Cubicles: (59) 10 x 10 and (15) 7.5 x 10 Consisting of: Teknion TOS panel systems furniture

Panels: 10 x 10 : (7) 66/60 panels and (1) 66/30 panel 7.5 x 10: (5) 66/60 panels (2) 66/30 panels

Worksurfaces: 10 x 10: (2) 60/30 corners and (1) 60/30 straight or (2) 30/30 straights

7.5 x 10: (1-2) 60/30 corners, and (1-2) 30/30 straights

Components: (1) Shelf w/ task light, (1) Overhead Bin w/ task light, (1) 60x30 whiteboard element, (1) pencil drawer, (1) file, file pedestal, (1) box, box, file pedestal and (1) task chair(optional)

Labs: (4) Consisting of: Symbiote Lab furniture and Teknion system furniture

Symbiote: Panels: (8) 80/48 panels, (3) 80/24 panel and (4-6) 62/48 panels, and (7) racks

Worksurfaces: (1-3) 48/30 corners, (2) 96/30 str., (1-2) 48/30 str., (1-3) 24/30 str., and (4-8) 48/18 shelves

Teknion: Panels: (10) 66/48 panels, and (1) 66/24 panel

Worksurfaces: (2) 96/30 str., (3) 60/30 corners (1) 24/30 str., and (4) 48/30 str., and (4) 48/24 shelves

Conference Rooms: (4) Consisting of:

(3-4) 60 x 30 KI tables, (1) phone table, and (8-10) chairs

Second Floor:

Cubicles: (89) 10 x 10 Consisting of: Teknion TOS systems furniture

Panels: (7) 66/60 panels and (1) 66/30 panel

Worksurfaces: (2) 60/30 corners and (1) 60/30 straight

Components: (1) Shelf w/ task light, (1) Overhead Bin w/ task light, (1) 60x30 whiteboard element, (1) pencil drawer, (1) file, file pedestal, (1) box, box, file pedestal and (1) task chair(optional)

LABS: (3) CONSISTING OF: SYMBIOTE LAB FURNITURE

Panels: (6) 80/48 panels, (1) 80/24 panel, (2) 62/60 panels, (10) 62/48 panels, and (1-2) 62/24 panels.

Worksurfaces: (1-2) 48/30 corners, (6) 96/30 str., (1) 72/30 str., (1-4) 48/30 str., (2) 24/30 str, and (8-10) 48/18 str. shelves

Conference Rooms: (9) Consisting of: (3-7) 60 x 30 KI tables, (1) phone table, and (8-18) chairs

Third Floor:

Cubicles: (85) 10 x 10 Consisting of: Teknion TOS systems furniture

Panels: (7) 66/60 panels and (1) 66/30 panel

Worksurfaces: (2) 60/30 corners and (1) 60/30 straight

Components: (1) Shelf w/ task light, (1) Overhead Bin w/ task light, (1) 60x30 whiteboard element, (1) pencil drawer, (1) file, file pedestal, (1) box, box, file pedestal and (1) task chair(optional)

Labs: (4) Consisting of: Symbiote Lab furniture and Teknion system furniture

Symbiote: Panels: (1) 80/60 panel, (1-12) 80/48 panels, and (1-4) 80/24 panels

Worksurfaces: (3) 48/30 corners, (1) 96/30 str., (1) 60/30 str., (1-6) 48/30 str., (1) 24/30 str., and (6) 48/18 shelves

Teknion: Panels: (5) 66/60 panels, (4) 66/48 panels, and (1) 66/36 panel

Worksurfaces: (2) 60/30 corners, (1) 60/30 str., (4) 48/30 str., and (1) 36/30 str., (1) 60/24 shelf, (4) 48/24 shelves, and (1) 36/24 shelf

Conference Rooms: (10) Consisting of: (3-6) KI tables, (1) phone table, and (8-16) chairs

Inventory for 468 Ellis Street, Mtn View, Ca.

Building 22

First Floor:

Dining Room: 65 42” square dining tables either on the floor or in the storage room, approximately 300 dining chairs. One Pool Table, one ping pong table.

General seating: 10 stools, 20 casual seating chairs, 7 coffee/end tables, three couches.

Former Corporate Store: existing store fixtures and shelving.

Other: Teknion workstation product in Concierge (for 3 occupants) space and in kitchen staff space (for 5 occupants) including workstation seating for 3 operators including panels, worksurfaces, under-cabinet storage and task chairs.

Second Floor:

Cubicles: (55) 7.5 x 10 and (4) 7.5 x 7.5 Consisting of: Teknion TOS panel systems furniture

Panels: 7.5 x 10: (6) 66/60 panels and (1) 66/30 panel 7.5 x 7.5: (4) 66/60 panels, and (3) 66/30 panels

Worksurfaces: 7.5 x 10: (1-2) 60/30 corners and/or (1-2) 60/30 straight, and (1) 30/30 straight 7.5 x 7.5: (1) 60/30 corner, and (1) 30/30 straight

Components: 7.5 x 10: (1) Shelf w/ task light, (1) Overhead Bin w/ task light, (1) 60x30 whiteboard element, (1) pencil drawer, (1) file, file pedestal, (1) box,box,file pedestal and (1) task chair (optional) 7.5 x 7.5: (1) Shelf w/ task light, or (1) Overhead Bin w/ task light, and/or (1) file, file pedestal, and (1) box, box, file pedestal

Conference Rooms: (7) Consisting of:

(2-6) 60 x 30 KI tables, (1) phone table, and/or (1)credenza, and (8-16) chairs

Training Room: KI tables and conference room chairs for approximately 18 partipants.

Operator Room: Workstation seating for 3 operators including panels, worksurfaces, under-cabinet storage and task chairs.

EXHIBIT E

LIST OF ADDITIONAL BUILDINGS/ACCESS PARTIES

Building	Permitted Fitness Center Fee
1. 490 Middlefield Road	Vernier Networks – up to 20 employees at $500/month, additional employees at $50/month

EXHIBIT F

CAFETERIA EQUIPMENT AND FITNESS CENTER EQUIPMENT LISTS

Equipment	Quantity	Brand	Description - Cardio or Strength
Treadmills	8	Star Trac	Cardio equipment for running/walking
Stationary Bikes	4	Star Trac	Cardio upright bikes
Recumbent Bikes	4	Star Trac	Cardio recumbent bikes
Elipticals	5	Precor	Cardio EFX
Total Gym (Cable row, lat pull down, Tricep Push Down, etc)	1	Lifefitness	Strength univeral equipment
Upper Body Ergometer	1	SciFit Pro 1000	Upper body cardio bike
Free Motion Cable Cross	1	Free motion	Strength equipment various stretches
Free Motion Lat	1	Free motion	Strength Equipment various stretches
Squat Rack	1	Max Rack	Strength Equipment - Squat Rack
Spin Bikes	13	Schwinn	Cardio spin bikes for spin class
Leg Press	1	Lifefitness	Strength Equipment
Leg Extension	1	Lifefitness	Strength Equipment
Leg Curl	1	Lifefitness	Strength Equipment
Tricep Extension	1	Lifefitness	Strength Equipment
Bicep Curl	1	Lifefitness	Strength Equipment
Chest Press	1	Lifefitness	Strength Equipment
Shoulder Press	1	Lifefitness	Strength Equipment
Chest/Back Fly	1	Lifefitness	Strength Equipment
Fitness Tree	1	Hoist	Fitness Tree to house attachments
Free weights (Dumbbells)		Hampton	Strength dumbbell set 3lb - 75lb
Color TV’s	8		25 “ tv’s hung in Cardio area
Satelite TV receivers	4	Direct TV	channels and FM radio
Stability ball rack & Balls	6		6 balls and 1 rack
Medicine Balls & Rack	6		Varying weights and rack

EXHIBIT G

BILL OF SALE

For good and valuable consideration, receipt and sufficiency of which is hereby acknowledged, the undersigned, Netscape Communications Corporation, a Delaware corporation (“Netscape”), does hereby give, grant, bargain, sell, transfer, assign, convey and deliver to Mercury Interactive Corporation, a Delaware corporation (“Mercury”), pursuant to that certain Sublease Agreement dated as of                     , 2005, by and between Netscape and Mercury, all of Netscape’s interest in and to the personal property identified and described on Schedule A attached hereto (the “Transferred Property”). The foregoing conveyance is made on an “AS IS – WHERE IS” basis without warranty of any kind, express or implied; provided, however, Netscape represents, to the best of its knowledge, that, as of the date hereof, it owns the Transferred Property free and clear of all liens.

Dated:                      2005

Netscape Communications Corporation,

a Delaware corporation

By:

Name:

Its:

EX-21.1

EXHIBIT 21.01

SUBSIDIARIES OF MERCURY INTERACTIVE CORPORATION

SUBSIDIARY LEGAL NAME	JURISDICTION OF INCORPORATION
Mercury Interactive Austria GesmbH	Austria
Mercury Interactive Brasil Limitada	Brazil
Mercury Interactive Canada, Inc.	Canada
Mercury Interactive A/S	Denmark
Mercury Interactive Oy	Finland
Mercury Interactive (Israel) Limited	Israel
Mercury Interactive (Australia) Pty Ltd. (1)	Australia
Mercury Interactive Japan K.K.	Japan
Mercury Interactive (Korea) Co. Ltd.	Korea
Mercury Interactive B.V.	Netherlands
Mercury Interactive Srl (2)	Italy
Mercury Interactive (Luxembourg) S.A. (5)	Luxembourg
Mercury Interactive (Hong Kong) Limited (5)	Hong Kong
Mercury Interactive (Europe) B.V. (Holding Company – Not operating)	Netherlands
Mercury Interactive France S.A.S.	France
Mercury Interactive Germany GmbH	Germany
Mercury Interactive (UK) Limited	United Kingdom
Mercury Interactive Poland Sp.z.o.o.	Poland
Mercury Interactive (Singapore) Pte Ltd.	Singapore
Mercury Interactive Sales and Service India Private Limited (3)	India
Mercury Interactive SA (Pty) Ltd.	South Africa
Mercury Interactive S.L. Unipersonal	Spain
Mercury Interactive Nordic AB	Sweden
Mercury Interactive (Switzerland) GmbH	Switzerland
Mercury Interactive Freshwater, Inc.	California
Mercury Interactive Mexico, S. de R.L. de C.V. (4)	Mexico
Performant, Inc.	Delaware
Kanga Acquisition LLC	Delaware

(1) 50% interest owned by Mercury Interactive Corporation and 50% interest owned by Mercury Interactive (Israel) Limited

(2) 95% interest owned by Mercury Interactive Corporation and 5% interest owned by Mercury Interactive B.V.

(3) 99% interest owned by Mercury Interactive Corporation and 1% interest owned by Mercury Interactive (Singapore) Pte Ltd.

(4) 99% interest owned by Mercury Interactive Corporation and 1% interest owned by Mercury Interactive Freshwater, Inc.

(5) 99% interest owned by Mercury Interactive Corporation and 1% interest owned by Mercury Interactive B.V.

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 33-71018, 33-74728, 33-95178, 333-09913, 333-27951, 333-62125, 333-81401, 333-94837, 333-47140, 333-56316, 333-61786, 333-83064, 333-98031, 333-103214, 333-106646, 333-108266, 333-111915 and 333-117599) and the Registration Statements on Form S-3 (No. 333-106515) of Mercury Interactive Corporation of our report dated March 14, 2005 relating to the financial statements, management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting, which appears in this Form 10-K.

/s/    PRICEWATERHOUSECOOPERS LLP

San Jose, California

March 14, 2005

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 annual report on Form 10-K 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 company as of, and for, the periods presented in this report;

4. The company’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)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the company 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 company, 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) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the company’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 company’s internal control over financial reporting that occurred during the company’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 company’s internal control over financial reporting; and

5. The company’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the company’s independent registered public accounting firm and the audit committee of the company’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 company’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: March 14, 2005

/s/ Amnon Landan

Amnon Landan

Chief Executive Officer

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 annual report on Form 10-K 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 company as of, and for, the periods presented in this report;

4. The company’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)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the company 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 company, 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) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the company’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 company’s internal control over financial reporting that occurred during the company’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 company’s internal control over financial reporting; and

5. The company’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the company’s independent registered public accounting firm and the audit committee of the company’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 company’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: March 14, 2005

/s/ Douglas P. Smith

Douglas P. Smith

Executive Vice President and Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION 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 annual report on Form 10-K of Mercury Interactive Corporation (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, Chief Executive Officer of Mercury Interactive, 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 result of operations of Mercury Interactive Corporation.

Date: March 14, 2005

/s/ Amnon Landan

Amnon Landan

Chief Executive Officer

EX-32.2

Exhibit 32.2

CERTIFICATION 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 annual report on Form 10-K of Mercury Interactive Corporation (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, Chief Financial Officer of Mercury Interactive, 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 result of operations of Mercury Interactive Corporation.

Date: March 14, 2005

/s/ Douglas P. Smith

Douglas P. Smith

Executive Vice President and Chief Financial Officer