DAOU SYSTEMS INC, 424B1, 1997-02-13

DAOU SYSTEMS INC
424B1, 1997-02-13
RETAIL STORES, NEC

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<PAGE>
2,000,000 SHARES

[LOGO]

COMMON STOCK
---------

All of the shares of Common Stock (the "Common Stock") offered hereby are
being sold by DAOU Systems, Inc. ("DAOU" or the "Company"). Prior to this
offering, there has been no public market for the Common Stock. See
"Underwriting" for a discussion of the factors considered in determining the
initial public offering price. The Common Stock has been approved for quotation
on the Nasdaq National Market under the symbol DAOU.
--------------

THE COMMON STOCK OFFERED HEREBY INVOLVES A HIGH DEGREE OF RISK.
SEE "RISK FACTORS" COMMENCING ON PAGE 5.
-------------

THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION
PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.

<TABLE>
<CAPTION>
PRICE UNDERWRITING
TO DISCOUNTS AND PROCEEDS TO
PUBLIC COMMISSIONS(1) COMPANY(2)
<S> <C> <C> <C>
Per Share.......................................... $9.00 $0.63 $8.37
Total(3)........................................... $18,000,000 $1,260,000 $16,740,000
</TABLE>

(1) See "Underwriting" for indemnification arrangements with the several
Underwriters.

(2) Before deducting expenses of the offering estimated at $756,000.

(3) The Company has granted the Underwriters a 30-day option to purchase up to
300,000 additional shares of Common Stock solely to cover over-allotments,
if any. To the extent that the option is exercised, the Underwriters will
offer the additional shares at the Price to Public shown above. If the
option is exercised in full, the total Price to Public, Underwriting
Discounts and Commissions, and Proceeds to the Company will be $20,700,000,
$1,449,000 and $19,251,000, respectively. See "Underwriting."
--------------

The shares of Common Stock are offered by the several Underwriters, subject
to prior sale, when, as and if delivered to and accepted by them, and subject to
the right of the Underwriters to reject any order in whole or in part. It is
expected that delivery of the shares of Common Stock will be made at the offices
of Alex. Brown & Sons Incorporated, Baltimore, Maryland on or about February 19,
1997.

ALEX. BROWN & SONS
INCORPORATED
COWEN & COMPANY
HAMBRECHT & QUIST

THE DATE OF THIS PROSPECTUS IS FEBRUARY 12, 1997.
<PAGE>
[INSIDE FRONT COVER PAGE]

PHOTOGRAPH DESCRIPTIONS AND CAPTIONS

1. Top border: DAOU masthead and logo in color. Caption: Healthcare Information
Technology Solutions -- DAOU Systems designs, implements, supports and manages
computer network systems for large, complex healthcare provider organizations,
such as integrated delivery systems. Advanced computer networks enable provider
organizations to access information such as patient records, X-rays and billing
information at each location where care is provided.

2. Center left side: Color photo of DAOU engineer configuring a network of
computer servers at DAOU's on-site computer lab. Caption: Network Services --
The Company combines its knowledge of the specialized information needs of the
healthcare industry with its expertise in computer technology to design and
install advanced, reliable and cost-effective computer network solutions. The
Company uses the products and applications of various hardware and software
vendors to create advanced computer network systems.

- Network Design

- Network Implementation

3. Bottom right side corner: Color photo of individual viewing Palomar-Palmerado
Health System's website which was created by the Company. Caption: Network
Management Services -- As computer networks become increasingly complex,
provider organizations are experiencing difficulties in hiring, training and
retaining qualified personnel who can maintain the performance of their computer
network systems. DAOU's network management services are designed to continuously
monitor and enhance the efficiency and functionality of a provider
organization's computer network system. The Company offers the following
management services to its customers:

- Enterprise Network Management Services

- DAOU Employees On-Site

- Continuous Network Planning

- "Burst Mode" Implementation

- Network Support

- I/S Outsourcing

IN CONNECTION WITH THIS OFFERING, THE UNDERWRITERS MAY OVER-ALLOT OR EFFECT
TRANSACTIONS WHICH STABILIZE OR MAINTAIN THE MARKET PRICE OF THE COMMON STOCK OF
THE COMPANY AT A LEVEL ABOVE THAT WHICH MIGHT OTHERWISE PREVAIL IN THE OPEN
MARKET. SUCH TRANSACTIONS MAY BE EFFECTED ON THE NASDAQ NATIONAL MARKET, IN THE
OVER-THE-COUNTER MARKET OR OTHERWISE. SUCH STABILIZING, IF COMMENCED, MAY BE
DISCONTINUED AT ANY TIME.

DAOU-SM- AND THE DAOU LOGO ARE SERVICE MARKS OF THE COMPANY. TRADEMARKS AND
SERVICE MARKS OF OTHER COMPANIES ARE ALSO REFERRED TO IN THIS PROSPECTUS.

2
<PAGE>
PROSPECTUS SUMMARY

THE FOLLOWING SUMMARY IS QUALIFIED IN ITS ENTIRETY BY THE MORE DETAILED
INFORMATION AND FINANCIAL STATEMENTS AND NOTES THERETO APPEARING ELSEWHERE IN
THIS PROSPECTUS. THIS PROSPECTUS CONTAINS CERTAIN STATEMENTS OF A
FORWARD-LOOKING NATURE RELATING TO FUTURE EVENTS OR THE FUTURE FINANCIAL
PERFORMANCE OF THE COMPANY. PROSPECTIVE INVESTORS ARE CAUTIONED THAT SUCH
STATEMENTS ARE ONLY PREDICTIONS AND THAT ACTUAL EVENTS OR RESULTS MAY DIFFER
MATERIALLY. IN EVALUATING SUCH STATEMENTS, PROSPECTIVE INVESTORS SHOULD
SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED IN THIS PROSPECTUS,
INCLUDING THE MATTERS SET FORTH UNDER THE CAPTION "RISK FACTORS," WHICH COULD
CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH
FORWARD-LOOKING STATEMENTS.

Pressure to control escalating healthcare costs is causing healthcare
providers to consolidate and form multi-entity provider organizations such as
IDSs. This consolidation has resulted in the need for prompt access to
consistent and comprehensive patient information at multiple locations where
care is provided. The existing information systems in these provider
organizations are frequently inadequate because they were developed to meet the
needs of a single facility, such as a hospital or an outpatient surgery center.
In addition, the increasing variety of hardware and software applications
utilized throughout provider organizations has resulted in connectivity and
compatibility problems for many computer networks. Consequently, provider
organizations have found it increasingly difficult to internally implement and
manage their computer network systems and are looking to third parties for the
technological expertise and personnel to meet their information systems
requirements. DAOU believes that the ongoing consolidation among healthcare
provider organizations and the increasing complexity and rapid evolution of
computer network system technologies have created a significant opportunity for
companies specializing in providing computer network system solutions to
provider organizations.

DAOU offers a broad array of services to assist hospitals, IDSs and other
provider organizations in designing, implementing, supporting and managing
complex computer network systems consistent with their unique and changing
information needs. The Company's design services include an assessment of the
customer's existing computer network system and the preparation of voice, video
and data network specifications, technical design documentation and diagrams.
DAOU's implementation services include the purchase, delivery and installation
of enterprise-wide computer network systems. The Company's support and
management services include remote and on-site network management services, as
well as information systems outsourcing ("I/S outsourcing"), and are typically
provided under multi-year contracts. The Company provides network support
services to its customers through its regional sales and support structure and a
24-hour technical support hotline available seven days a week. DAOU typically
provides its services on a fixed-price, fixed-time frame basis.

DAOU's strategy is to be a leading provider of advanced computer network
systems and network management services to healthcare provider organizations by
continuing to focus its sales and marketing efforts on major medical centers and
hospitals around which IDSs are forming, expanding and developing services that
complement its existing services, and continuing to develop its expertise in
emerging technologies.

3
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THE OFFERING

<TABLE>
<S> <C>
Common Stock offered by the Company............. 2,000,000 shares
Common Stock to be outstanding after the 10,267,678 shares (1)
offering......................................
Use of proceeds................................. Working capital and other general
corporate purposes.
Nasdaq National Market symbol................... DAOU
</TABLE>

SUMMARY FINANCIAL INFORMATION
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------------------------------
1992 1993 1994 1995 1996
--------- --------- --------- ---------- ----------
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues...................................................... $ 2,728 $ 3,483 $ 8,521 $ 14,330 $ 19,311
Gross profit.................................................. 947 1,161 2,336 5,855 5,755
Income (loss) from operations................................. 1 (54) 33 2,024 5
Net income (loss)............................................. 5 (52) 26 1,240 83
Pro forma net income per share(2)............................. $ 0.01
Shares used in computing pro forma net income per share(2).... 8,888
</TABLE>

<TABLE>
<CAPTION>
DECEMBER 31, 1996
-----------------------
AS
ACTUAL ADJUSTED(3)
--------- ------------
<S> <C> <C>
BALANCE SHEET DATA:
Cash, cash equivalents and short-term investments..................................... $ 2,284 $ 18,268
Total assets.......................................................................... 11,910 27,894
Long-term debt, less current portion.................................................. -- --
Redeemable preferred stock............................................................ 8,190 --
Total stockholders' equity............................................................ 857 25,031
</TABLE>

- --------------

(1) Excludes (i) 941,413 shares of Common Stock issuable upon exercise of stock
options outstanding under the Company's 1996 Stock Option Plan with a
weighted average exercise price of $5.16 per share at December 31, and (ii)
133,285 shares of Common Stock issuable upon exercise of outstanding
warrants at an exercise price of $4.99 per share. See "Management -- 1996
Stock Option Plan," "Certain Transactions," "Description of Capital Stock"
and Note 6 of Notes to Financial Statements.

(2) See Note 1 of Notes to Financial Statements for information concerning the
calculation of pro forma net income per share.

(3) Adjusted to give effect to the conversion of all outstanding shares of the
Company's Preferred Stock into 1,603,430 shares of Common Stock upon the
completion of this offering and to the estimated net proceeds of this
offering based upon the initial public offering price of $9.00 per share.
See "Use of Proceeds."
--------------

EXCEPT AS OTHERWISE SPECIFIED, ALL INFORMATION IN THIS PROSPECTUS ASSUMES NO
EXERCISE OF THE UNDERWRITERS' OVER-ALLOTMENT OPTION. SEE "UNDERWRITING." EXCEPT
AS SET FORTH IN THE FINANCIAL STATEMENTS AND AS OTHERWISE NOTED, ALL INFORMATION
IN THIS PROSPECTUS HAS BEEN ADJUSTED TO GIVE EFFECT TO THE REINCORPORATION OF
THE COMPANY IN DELAWARE PRIOR TO THE COMPLETION OF THIS OFFERING AND THE
CONVERSION OF ALL OUTSTANDING SHARES OF PREFERRED STOCK INTO COMMON STOCK UPON
THE COMPLETION OF THIS OFFERING. SEE "CAPITALIZATION" AND "DESCRIPTION OF
CAPITAL STOCK."

4
<PAGE>
RISK FACTORS

IN ADDITION TO THE OTHER INFORMATION IN THIS PROSPECTUS, THE FOLLOWING
FACTORS SHOULD BE CONSIDERED CAREFULLY IN EVALUATING AN INVESTMENT IN THE SHARES
OF COMMON STOCK OFFERED BY THIS PROSPECTUS. THIS PROSPECTUS CONTAINS CERTAIN
STATEMENTS OF A FORWARD-LOOKING NATURE RELATING TO FUTURE EVENTS OR THE FUTURE
FINANCIAL PERFORMANCE OF THE COMPANY. PROSPECTIVE INVESTORS ARE CAUTIONED THAT
SUCH STATEMENTS ARE ONLY PREDICTIONS AND THAT ACTUAL EVENTS OR RESULTS MAY
DIFFER MATERIALLY. IN EVALUATING SUCH STATEMENTS, PROSPECTIVE INVESTORS SHOULD
SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED IN THIS PROSPECTUS,
INCLUDING THE MATTERS SET FORTH BELOW, WHICH COULD CAUSE ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS.

MANAGEMENT OF GROWTH. The Company is currently experiencing a period of
rapid growth which has placed significant and increasing demands on the
Company's management and operational, technical, financial and other resources.
The Company's revenues increased 35% in 1996, from $14.3 million in 1995 to
$19.3 million in 1996, and increased 68% in 1995, from $8.5 million in 1994 to
$14.3 million in 1995. In addition, since January 1, 1995, the Company's
workforce increased from 78 to 126 full-time employees as of December 31, 1996.
Further increases in staffing levels are expected during 1997 although the
Company does not believe that these rates of growth are sustainable. This growth
has resulted in new and increased responsibilities for management personnel and
has placed significant demands on the Company's management and operating and
financial systems. The Company will be required to continue to develop and
improve its operational, financial and other internal systems to accommodate the
increased number of transactions and customers and the increased size of the
Company's operations, workforce and facilities. There can be no assurance,
however, that the Company's management or systems will be adequate to support
the Company's existing or future operations. Any failure to develop and improve
the Company's systems or to hire and retain appropriate personnel to manage its
operations could have a material adverse effect on the Company's business,
financial condition and results of operations. In addition, any future
unexpected shortfall in revenues without a corresponding and timely reduction in
staffing and other expenses (or redeployment of employees to other customer
projects), or any staffing increase that is unaccompanied by a corresponding
increase in revenues, could have a material adverse effect on the Company's
business, financial condition and results of operations. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

NEED TO ATTRACT AND RETAIN KEY EMPLOYEES AND QUALIFIED NETWORK ENGINEERS.
The Company's success and execution of its business strategy will depend in
large part on the continued services of its key management and technical
personnel. The loss of the services of one or more of the Company's key
employees or the inability to hire additional key personnel as needed could have
a material adverse effect on the Company's business, financial condition and
results of operations. The Company's business involves the delivery of computer
network services and is labor-intensive. As a result, its future success will
depend in large part on its ability to hire, train and retain qualified network
engineers who together have expertise in a wide array of network and computer
systems and a broad understanding of the provider organizations that the Company
serves. Competition for qualified network engineers is intense and is expected
to increase. In particular, competition is intense for the limited number of
qualified management personnel and senior network engineers. There can be no
assurance that the Company will be successful in attracting and retaining such
personnel. While the Company is currently experiencing low rates of turnover,
there can be no assurance that these rates of turnover will not increase in the
future. Any inability of the Company to hire, train and retain a sufficient
number of qualified network engineers could impair the Company's ability to
adequately manage and complete its existing projects or to obtain new projects,
which, in turn, could have a material adverse effect on the Company's business,
financial condition and results of operations. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and "Business --
Recruiting and Training of Technical Employees."

5
<PAGE>
VARIABILITY OF QUARTERLY OPERATING RESULTS. A substantial majority of the
Company's operating expenses, particularly personnel and related costs,
depreciation and rent, are relatively fixed in advance of any particular
quarter. However, variations in the Company's revenues and operating results may
occur from time to time, as a result of various factors, including: (i) the
reduction in size, delay in commencement, interruption or termination of one or
more significant projects or contracts; (ii) the commencement or completion
during a quarter of one or more significant projects; (iii) the failure to
estimate accurately the resources required to complete new or ongoing projects;
(iv) the relatively longer sales cycle in obtaining new customers and larger
contracts; (v) the timing and extent of employee training or the loss of key
employees; (vi) competition; (vii) the development and introduction of new
services; and (viii) general economic conditions which may affect the buying
decisions of the Company's current and prospective customers. In addition, the
Company plans to continue to expand its operations by hiring additional network
engineers and other employees, and adding new offices, systems and other
infrastructure. The resulting increase in operating expenses will generally be
incurred prior to any increase in revenues. Consequently, the Company's
business, financial condition and results of operations would be materially and
adversely affected if revenues do not increase to support such expenses. A
variation in the timing of the commencement or completion of customer
assignments, particularly at or near the end of any quarter, may cause
significant variations in operating results from quarter to quarter and could
result in losses for a particular quarter. In addition, an unanticipated delay
or termination of a major project could require the Company to maintain or
terminate under-utilized employees which could, in either case, result in higher
than expected expenses during a quarter. The Company believes that quarterly
revenues and operating results are likely to vary significantly in the future
and that period-to-period comparisons of its revenues and operating results are
not necessarily meaningful and should not be relied on as indications of future
performance. Furthermore, these variations in revenues and operating results
could cause significant variations in the price of the Company's Common Stock.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations."

CUSTOMER CONCENTRATION. The Company has derived, and believes that it will
continue to derive, a significant portion of its revenues from a relatively
limited number of large customer contracts. In 1996, the Company's five largest
customers accounted for approximately 72% of total revenues, with CMC, Mercy and
Candler accounting for approximately 21%, 18% and 15% of such revenues,
respectively. In 1995, the Company's five largest customers accounted for
approximately 77% of total revenues, with Mercy and Candler accounting for
approximately 48% and 11% of such revenues, respectively. The volume of work
performed for specific customers is likely to vary from year to year, and a
major customer in one year may not provide the same level of revenues in any
subsequent year. In particular, the annual revenues under the Company's
five-year contract with Candler are subject to annual budgetary approval and may
decrease from year to year. The loss of any large customer could have a material
adverse effect on the Company's business, financial condition and results of
operations. See "Risk Factors -- Consolidation and Uncertainty in the Healthcare
Industry" and "Management's Discussion and Analysis of Financial Condition and
Results of Operations."

PROJECT RISKS. The Company's computer network systems are designed to
provide access to and accurate delivery of a wide range of information within a
provider organization, including information used by clinicians in the diagnosis
and treatment of patients. Many of the Company's projects are critical to the
operation of its customers' businesses and, therefore, the Company may expose
itself to potentially adverse risks in the event that the Company's services do
not meet the desired expectations of its customers. For example, the failure to
perform services that meet a customer's expectations may result in the Company
not being paid for services rendered and may damage the Company's reputation and
adversely affect its ability to attract new business. In addition, any failure
by the Company's computer network systems to provide accurate, reliable and
timely information could result in claims against the Company. For example,
where the unavailability of such information to a provider of healthcare
services is alleged to have resulted in any physical or emotional injury to a
patient, such provider may become subject to a medical malpractice, product
liability or other claim. The Company could then become subject to a claim
relating to its installation or management of a computer network system. The
Company is also subject to claims by its customers for actions of the Company's
employees which may have caused

6
<PAGE>
damages to customers' businesses or otherwise. Although the Company maintains
errors or omissions insurance, there can be no assurance that such insurance
coverage would adequately cover any claims asserted against the Company and any
such claim could have a material adverse effect on the Company's business,
financial condition and results of operations. In addition, there can be no
assurance that the Company will not be subject to claims that will result in
liability in excess of its insurance coverage or that appropriate insurance will
continue to be available to the Company in the future at commercially reasonable
rates. See "Business -- Information Technology Services."

LONG SALES AND PROJECT DELIVERY CYCLES. The Company's sales process is
often subject to delays associated with the lengthy approval process that
typically accompanies significant capital expenditures by a customer. During
this process, the Company expends substantial time, effort and resources
marketing its services, preparing contract proposals and negotiating contracts.
Any failure by the Company to procure a signed contract after expending
significant time, effort and resources could have a material adverse effect on
the Company's business, financial condition and results of operations. The
delivery of computer network services generally requires a significant
commitment of resources by the Company and by the customer. The length of time
required to complete a project may depend on many factors outside the control of
the Company, including the state of the customer's existing information systems,
budgetary constraints and the customer's ability to commit the personnel and
other resources necessary to complete elements of the project for which the
customer is responsible. In certain instances, projects have been prolonged
substantially as a result of delays attributable to customers. The Company's
contracts with certain of its customers provide for a reduction in the
implementation fee if, among other things, the Company fails to meet certain
milestones on a timely basis. Consequently, the failure of the Company to
deliver its services on a timely and cost-efficient basis could have a material
adverse effect on the Company's business, financial condition and results of
operations. See "Business -- Sales and Marketing" and "Management's Discussion
and Analysis of Financial Condition and Results of Operations."

COMPETITION. The healthcare network services industry is comprised of a
large number of participants and is subject to rapid change and intense
competition. The Company's competitors include system integrators, value added
resellers ("VARs"), consulting companies, local and regional network services
firms, telecommunications providers and network equipment, computer systems and
healthcare software vendors, many of which have significantly greater financial,
technical and marketing resources and greater name recognition than does the
Company. In particular, the Company competes with (i) large information
technology companies such as Hewlett-Packard Company ("Hewlett-Packard"),
Electronic Data Systems Corporation ("EDS"), and Integrated Systems Solutions
Corporation, a subsidiary of International Business Machines Corporation
("IBM"); (ii) healthcare information technology companies such as HBO & Company;
and (iii) smaller regional network systems firms. In addition, the Company has
faced, and expects to continue to face, additional competition from new entrants
into its markets. Other healthcare information technology companies not
presently offering or emphasizing network systems services and large network
services companies not currently focusing on healthcare may enter the Company's
markets. Increased competition could result in price reductions, fewer customer
projects, under-utilization of employees, reduced operating margins and loss of
market share, any of which could materially and adversely affect the Company's
business, financial condition and results of operations. There can be no
assurance that the Company will be able to compete successfully against current
and future competitors. The failure of the Company to compete successfully would
have a material adverse effect on the Company's business, financial condition
and results of operations. In addition, most of the Company's customers have
internal network support and service capabilities and could choose to satisfy
their needs through internal resources rather than through outside service
providers. As a result, the decision by the Company's customers or potential
customers to perform network services internally could have a material adverse
effect on the Company's business, financial condition and results of operations.
See "Business -- Competition."

FIXED-PRICE, FIXED-TIME FRAME CONTRACTS. The Company offers the majority of
its computer network systems services on a fixed-price, fixed-time frame basis,
rather than on a time-and-expense

7
<PAGE>
basis. Consequently, the Company bears the risk of cost over-runs in connection
with these projects. The Company's failure to estimate accurately the resources
and time required for a project or its failure to complete its contractual
obligations within the fixed-time frame committed could have a material adverse
effect on the Company's business, financial condition and results of operations.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations."

CONTRACT CANCELLATION RIGHTS; ABSENCE OF LONG-TERM CONTRACTS. Although the
Company enters into agreements with certain of its customers which contemplate
multi-year contract terms, the Company's customers are generally able to reduce
or cancel their use of the Company's services before the end of the contract
term. As a result, the Company believes that the number and size of its existing
projects are not reliable indicators or measures of future revenues. In
addition, the Company has in the past provided, and is likely in the future to
provide, services to customers without long-term contracts. When a customer
defers, modifies or cancels a project, the Company must be able to rapidly
redeploy network engineers and other personnel to other projects in order to
minimize the under-utilization of employees and the resulting adverse impact on
operating results. In addition, the Company's operating expenses are relatively
fixed and cannot be reduced on short notice to compensate for unanticipated
variations in the number or size of projects in progress. As a result, any
termination, significant reduction or modification of its business relationships
with any of its significant customers or with a number of smaller customers
could have a material adverse effect on the Company's business, financial
condition and results of operations. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations" and "Business -- Sales and
Marketing."

CONSOLIDATION AND UNCERTAINTY IN THE HEALTHCARE INDUSTRY. Substantially all
of the Company's revenues are derived from customers involved in the healthcare
industry. As a result, the Company's business, financial condition and results
of operations are influenced by conditions affecting this industry. Many
provider organizations are consolidating to create larger organizations with
greater regional market power and are forming affiliations for purchasing
products and services. This consolidation could reduce the Company's target
market and result in the termination of certain engagements of the Company. In
particular, this consolidation has resulted, and is likely to continue to
result, in the acquisition of certain of the Company's customers, and such
customers may scale back or terminate their relationship with the Company
following their acquisition. For example, Candler, the Company's first I/S
outsourcing customer, recently signed a letter of intent with St. Joseph's
Hospital to form a joint operating company. The Company anticipates that the
chief executive officer of St. Joseph's Hospital will manage the surviving
entity. The Company believes that it will likely continue its I/S outsourcing
contract with Candler, due in large part to its successful engagement with
Candler and a contractual penalty of $600,000 payable to the Company in the
event of the early termination of this contract due to Candler's merger with St.
Joseph's Hospital. There can be no assurance, however, that the surviving entity
will continue its business relationship with the Company. Moreover, these
consolidating and affiliating enterprises could also have greater bargaining
power which could lead to reductions in the amounts paid to the Company for its
services. The reduction in the size of the Company's target market or the
failure of the Company to maintain adequate price levels could have a material
adverse effect on the Company's business, financial condition and results of
operations. The healthcare industry is also subject to changing political,
economic and regulatory influences that may affect the procurement practices and
operations of participants in the healthcare industry. The Company cannot
predict with any certainty what impact, if any, these developments could have on
its business, financial condition and results of operations. See "Business --
Industry Overview."

RAPID TECHNOLOGICAL CHANGE. The Company has derived, and expects to
continue to derive, substantially all of its revenues from projects based on
complex computer networks. The markets for computer network products and
services are continuing to develop and are subject to rapid change. The
Company's success will depend in part on its ability to offer services that keep
pace with continuing changes in technology, evolving industry standards and
changing customer preferences and to hire, train and retain network engineers
who can fulfill the increasingly complex needs of its customers. There can be no
assurance that the Company will be successful in addressing these developments
in a timely

8
<PAGE>
manner. Any delay or failure by the Company to address these developments could
have a material adverse effect on the Company's business, financial condition
and results of operations. In addition, there can be no assurance that products,
systems or technologies developed by third parties will not render certain of
the Company's services noncompetitive or obsolete. See "Business -- Information
Technology Services."

DEPENDENCE ON THIRD-PARTY HARDWARE AND SOFTWARE VENDORS. The network
systems solutions delivered by the Company utilize the products of third-party
hardware and software vendors. A significant portion of the Company's
implementation service revenues are derived from the purchase and resale of
these products. Although the Company has distribution agreements with certain
product vendors, there can be no assurance that these agreements will be
renewed. Any significant adverse change in any of these relationships could have
a material adverse effect on the Company's business, financial condition and
results of operations. See "Business -- Information Technology Services."

RISKS ASSOCIATED WITH POSSIBLE ACQUISITIONS. The Company may in the future
pursue acquisitions of complementary businesses as it seeks to compete in the
rapidly changing industry of healthcare information technology. Acquisitions
involve numerous risks, including difficulties in the assimilation of the
operations and personnel of the acquired business, the diversion of management's
attention from other business concerns, risks of entering markets in which the
Company has no direct prior experience, and the potential loss of key employees
of the acquired business. In addition, future acquisitions by the Company may
result in potentially dilutive issuances of equity securities, the incurrence of
additional debt and amortization expenses related to goodwill and other
intangible assets, which could adversely affect the Company's business,
financial condition and results of operations. The Company currently does not
have any plans, proposals, arrangements or understandings with respect to any
future acquisitions.

FUTURE ADDITIONAL CAPITAL REQUIREMENTS. Since its inception, the Company
has financed its operations through cash provided by operations, the sale of
equity and through debt. In the event that the Company is unable to generate
sufficient revenues to fund its operations in the future, the Company may be
required to raise additional funds to meet its capital and operating
requirements through public or private financing, including equity financing.
Any additional equity financing may be dilutive to stockholders, and debt
financing, if available, will require payment of interest and may involve
restrictive covenants that could impose limitations on the operating flexibility
of the Company. Adequate funds for the Company's operations may not be available
when needed and, if available, may not be on terms attractive to the Company.
The failure to obtain funding on a timely basis could have a material adverse
effect on the Company's business, financial condition and results of operations.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations."

CONTROL BY EXISTING STOCKHOLDERS AND MANAGEMENT. Upon the completion of
this offering, the present executive officers, directors and their respective
affiliates will beneficially own approximately 54.5% of the outstanding Common
Stock (53.0% if the Underwriters' over-allotment option is exercised in full).
As a result, these stockholders will be able to exercise significant influence
over all matters requiring stockholder approval, including the election of
directors and approval of significant corporate transactions. Such concentration
of ownership may also have the effect of delaying or preventing a change in
control of the Company. See "Principal Stockholders" and "Description of Capital
Stock."

NO PRIOR PUBLIC MARKET; POSSIBLE VOLATILITY OF STOCK PRICE. Prior to this
offering, there has been no public market for the Common Stock and there can be
no assurance that an active trading market will develop or be sustained. The
initial public offering price will be determined by negotiations among the
Company and the representatives of the Underwriters based on several factors,
and may not reflect the price at which the Common Stock will trade after this
offering. In addition, the stock market historically has experienced volatility
which has affected the market price of securities of many companies and which
sometimes has been unrelated to the operating performance of such companies. The
trading price of the Common Stock could also be subject to significant
fluctuations in response to variations in quarterly results of operations,
announcements of new services by the Company or its competitors, changes in

9
<PAGE>
earnings estimates by analysts, government regulatory action, general trends in
the industry, overall market conditions and other factors. See "Underwriting."

SHARES ELIGIBLE FOR FUTURE SALE. Sales of substantial amounts of Common
Stock in the public market after this offering, or the possibility of such sales
occurring, could adversely affect prevailing market prices for the Common Stock.
Of the 10,267,678 shares to be outstanding after this offering, the 2,000,000
shares of Common Stock offered hereby will be freely tradeable without
restriction in the public market, unless such shares are held by "affiliates" of
the Company, as such term is defined in Rule 144 ("Rule 144") under the
Securities Act of 1933, as amended (the "Securities Act"). The remaining
8,267,678 shares will be "restricted securities" as such term is defined in Rule
144. Pursuant to certain lock-up agreements, all of the Company's stockholders
and option holders, including the Company's executive officers and directors who
beneficially hold an aggregate of approximately 5,632,115 shares, have agreed
not to offer, sell or otherwise dispose of any of their shares of Common Stock
for a period of 180 days after the date of this Prospectus without the prior
written consent of Alex. Brown & Sons Incorporated. The Company has also entered
into an agreement with the representatives of the Underwriters that it will not
offer, sell or otherwise dispose of shares of Common Stock for a period of 180
days from the date of this Prospectus other than pursuant to the Company's 1996
Stock Option Plan and currently outstanding warrants. The representatives of the
Underwriters may, in their sole discretion and at any time without notice,
release all or any portion of the shares subject to such lock-up agreements.
Upon the completion of this offering, the beneficial owners of approximately
2,421,846 shares of Common Stock and 133,285 shares of Common Stock issuable
upon the exercise of outstanding warrants will be entitled to certain rights
with respect to the registration of such shares under the Securities Act. In
addition, the Company intends to file a Registration Statement on Form S-8 after
the date of this Prospectus in order to register an aggregate of 1,367,925
shares of Common Stock reserved for issuance under its 1996 Stock Option Plan,
of which options to purchase a total of 941,413 shares were outstanding as of
December 31, 1996. See "Principal Stockholders," "Shares Eligible for Future
Sale" and "Underwriting."

POTENTIAL ANTI-TAKEOVER EFFECTS OF DELAWARE LAW AND CERTAIN CHARTER
PROVISIONS. Certain provisions of Delaware law applicable to the Company could
delay or make more difficult a merger, tender offer or proxy contest involving
the Company, including Section 203 of the Delaware General Corporation Law,
which prohibits a Delaware corporation from engaging in any business combination
with any interested stockholder for a period of three years from the date the
person became an interested stockholder unless certain conditions are met. In
addition, the Board of Directors of the Company may issue shares of Preferred
Stock without stockholder approval on such terms as the Board may determine. 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. In addition, the Company's Certificate of Incorporation and
Bylaws provide for a classified board of directors, eliminate the right of
stockholders to act by written consent without a meeting, require advanced
stockholder notice to nominate directors and raise matters at the annual
stockholders meeting, eliminate cumulative voting in the election of directors
and allow for the removal of directors only for cause and with a two-thirds vote
of the Company's outstanding shares. All of the foregoing could have the effect
of delaying, deferring or preventing a change in control of the Company and
could limit the price that certain investors might be willing to pay in the
future for shares of the Company's Common Stock. See "Management" and
"Description of Capital Stock -- Certain Change of Control Provisions."

ABSENCE OF DIVIDENDS. The Company has never declared nor paid cash
dividends on its capital stock. The Company currently intends to retain any
earnings for funding growth and, therefore, does not intend to pay any cash
dividends in the foreseeable future. See "Dividend Policy."

DILUTION. The initial public offering price is substantially higher than
the pro forma net tangible book value per share of Common Stock. Investors
purchasing shares of Common Stock in this offering will therefore incur
immediate and substantial net tangible book value dilution. See "Dilution."

10
<PAGE>
THE COMPANY

DAOU Systems, Inc. was incorporated in California in 1987 and intends to
reincorporate in Delaware prior to the completion of this offering. Unless the
context otherwise requires, references in this Prospectus to "DAOU" and the
"Company" refer to DAOU Systems, Inc., a Delaware corporation, and where
applicable to its California predecessor. The Company's executive offices are
located at 5120 Shoreham Place, San Diego, California 92122. Its telephone
number is (619) 452-2221.

USE OF PROCEEDS

The net proceeds to the Company from the sale of the 2,000,000 shares of
Common Stock offered hereby at the initial public offering price of $9.00 per
share are estimated to be $16.0 million ($18.5 million if the over-allotment
option is exercised in full), after deducting the underwriting discounts and
commissions and the estimated expenses of this offering.

The Company expects to use the net proceeds from this offering principally
for working capital and general corporate purposes. The Company may also use a
portion of the proceeds to fund acquisitions of complementary businesses,
although there are no current plans, proposals, arrangements or understandings,
and the Company is not currently engaged in negotiations, with respect to any
such transactions. Pending such uses, the Company intends to invest the net
proceeds of this offering in short-term, interest bearing, investment grade
securities.

DIVIDEND POLICY

The Company has never declared nor paid cash dividends on its capital stock.
The Company currently intends to retain any earnings for funding growth and,
therefore, does not intend to pay any cash dividends in the foreseeable future.

11
<PAGE>
CAPITALIZATION

The following table sets forth the capitalization of the Company as of
December 31, 1996 (i) on an actual basis; (ii) on a pro forma basis after giving
effect to the conversion of all outstanding shares of Preferred Stock into
1,603,430 shares of Common Stock upon the completion of this offering and (iii)
as adjusted to give effect to the receipt by the Company of the net proceeds
from the sale of 2,000,000 shares of Common Stock offered hereby at the initial
public offering price of $9.00 per share and after deducting underwriting
discounts and commissions and estimated offering expenses:

<TABLE>
<CAPTION>
DECEMBER 31, 1996
----------------------------------
ACTUAL PRO FORMA AS ADJUSTED
--------- --------- ------------
(IN THOUSANDS)
<S> <C> <C> <C>
Redeemable preferred stock................................................... $ 8,190 $ -- $ --

Stockholders' equity (1):
Preferred stock: $.001 par value, 5,000,000 shares authorized, actual, pro
forma and as adjusted; no shares issued and outstanding, actual pro forma
and as adjusted.......................................................... -- -- --

Common stock: $.001 par value, 50,000,000 shares authorized, actual, pro
forma and as adjusted; 6,664,248 shares issued and outstanding, actual;
8,267,678 shares issued and outstanding, pro forma; and 10,267,678 shares
issued and outstanding, as adjusted (2).................................. 7 8 10

Additional paid-in capital................................................. 1,246 8,863 24,845
Deferred compensation...................................................... (1,166) (1,166) (1,166)
Accretion of redeemable preferred stock.................................... (572) -- --
Retained earnings.......................................................... 1,342 1,342 1,342
--------- --------- ------------
Total stockholders' equity 857 9,047 25,031
--------- --------- ------------
Total capitalization................................................... $ 9,047 $ 9,047 $ 25,031
--------- --------- ------------
--------- --------- ------------
</TABLE>

- --------------

(1) The Company does not have any short-term or long-term debt.

(2) Excludes (i) 941,413 shares of Common Stock issuable upon exercise of stock
options outstanding under the Company's 1996 Stock Option Plan with a
weighted average exercise price of $5.16 per share at December 31, 1996 and
(ii) 133,285 shares of Common Stock issuable upon exercise of outstanding
warrants at an exercise price of $4.99 per share. See "Management -- 1996
Stock Option Plan," "Certain Transactions," "Description of Capital Stock"
and Note 6 of Notes to Financial Statements.

12
<PAGE>
DILUTION

The pro forma net tangible book value of the Company's Common Stock as of
December 31, 1996 was approximately $9.0 million or $1.09 per share. Pro forma
net tangible book value per share represents the amount of the Company's
stockholders' equity, less intangible assets, divided by 8,267,678 shares of
Common Stock outstanding after giving effect to the conversion of all
outstanding shares of Preferred Stock into 1,603,430 shares of Common Stock upon
the completion of this offering.

Net tangible book value dilution per share represents the difference between
the amount per share paid by purchasers of shares of Common Stock in the
offering made hereby and the pro forma net tangible book value per share of
Common Stock immediately after the completion of this offering. After giving
effect to the sale of the 2,000,000 shares of Common Stock offered hereby at the
initial public offering price of $9.00 per share, and after deducting
underwriting discounts and commissions and estimated offering expenses payable
by the Company, the Company's pro forma net tangible book value at December 31,
1996 would have been approximately $25.0 million, or $2.44 per share. This
represents an immediate increase in pro forma net tangible book value of $1.35
per share to existing stockholders and an immediate dilution in net tangible
book value of $6.56 per share to new investors purchasing Common Stock in this
offering. The following table illustrates this dilution on a per share basis:

<TABLE>
<S> <C> <C>
Assumed initial public offering price per share............................. $ 9.00
Pro forma net tangible book value per share at December 31, 1996.......... $ 1.09
Increase per share attributable to new investors.......................... 1.35
---------
Pro forma net tangible book value per share after the offering.............. 2.44
---------
Net tangible book value dilution per share to new investors................. $ 6.56
---------
</TABLE>

The following table sets forth, on a pro forma basis as of December 31,
1996, after giving effect to the conversion of all outstanding shares of
Preferred Stock into Common Stock upon the completion of this offering, the
difference between the existing stockholders and the purchasers of shares in the
offering (at the initial public offering price of $9.00 per share) with respect
to the number of shares purchased from the Company, the total consideration paid
and the average price per share paid:

<TABLE>
<CAPTION>
SHARES PURCHASED TOTAL CONSIDERATION AVERAGE
-------------------------- --------------------------- PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
------------- ----------- -------------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Existing stockholders............................. 8,267,678 80.5% $ 8,010,000 30.8% $ 0.97
New investors..................................... 2,000,000 19.5 18,000,000 69.2 $ 9.00
------------- ----- -------------- -----
Total......................................... 10,267,678 100.0% $ 26,010,000 100.0%
------------- ----- -------------- -----
------------- ----- -------------- -----
</TABLE>

The foregoing computations assume no exercise of stock options or warrants
outstanding at December 31, 1996. At December 31, 1996, there were outstanding
stock options to purchase an aggregate of 941,413 shares of Common Stock at a
weighted average exercise price of $5.16 per share. In addition, at December 31,
1996, 133,285 shares of Common Stock were issuable upon exercise of outstanding
warrants at an exercise price of $4.99 per share. To the extent these stock
options and warrants are exercised, there will be further dilution to purchasers
in this offering. See "Management -- 1996 Stock Option Plan," "Certain
Transactions," "Description of Capital Stock" and Note 6 of Notes to Financial
Statements.

13
<PAGE>
SELECTED FINANCIAL DATA

The selected financial data set forth below should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Financial Statements of the Company and Notes thereto
included elsewhere in this Prospectus. The statements of operations data for the
years ended December 31, 1994, 1995 and 1996 and the balance sheet data at
December 31, 1995 and 1996 are derived from the Company's financial statements
that have been audited by Ernst & Young LLP, independent auditors, included
elsewhere in this Prospectus. The selected balance sheet data as of December 31,
1994 is derived from the Company's audited balance sheet not included in this
Prospectus. The selected financial data as of December 31, 1992 and 1993 and for
the years then ended is derived from unaudited financial data not included in
this Prospectus. The unaudited financial data include, in the opinion of
management, all adjustments (consisting only of normal recurring adjustments)
necessary for a fair presentation of the Company's financial position at those
dates and results of operations for those periods.

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------------------------------------
1992 1993 1994 1995 1996
--------- --------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues........................................................... $ 2,728 $ 3,483 $ 8,521 $ 14,330 $ 19,311
Cost of revenues................................................... 1,781 2,322 6,185 8,475 13,556
--------- --------- --------- --------- ---------
Gross profit....................................................... 947 1,161 2,336 5,855 5,755
Operating expenses:
Sales and marketing.............................................. 390 640 796 938 1,853
General and administrative....................................... 556 575 1,507 2,893 3,897
--------- --------- --------- --------- ---------
Total operating expenses........................................... 946 1,215 2,303 3,831 5,750
--------- --------- --------- --------- ---------
Income (loss) from operations...................................... 1 (54) 33 2,024 5
Interest income (expense) net...................................... 4 2 12 67 197
--------- --------- --------- --------- ---------
Income (loss) before income taxes.................................. 5 (52) 45 2,091 202
Provision for income taxes......................................... -- -- 19 851 119
--------- --------- --------- --------- ---------
Net income (loss).................................................. 5 (52) 26 1,240 83
Accretion of redeemable preferred stock............................ -- -- -- 87 485
--------- --------- --------- --------- ---------
Net income (loss) attributable to common stock..................... $ 5 $ (52) $ 26 $ 1,153 $ (402)
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Pro forma net income per share(1).................................. $ 0.01
---------
---------
Shares used in computing pro forma net income per share(1)......... 8,888
---------
---------
</TABLE>

<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------------------------------------
1992 1993 1994 1995 1996
--------- --------- --------- --------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash, cash equivalents and short-term investments......... $ 81 $ 278 $ 264 $ 6,285 $ 2,284
Total assets.............................................. 557 1,474 1,727 12,545 11,910
Long-term debt, less current portion...................... 8 4 -- -- --
Redeemable preferred stock................................ -- -- -- 7,705 8,190
Total stockholders' equity................................ 52 -- 29 1,182 857
</TABLE>

- ----------------

(1) See Note 1 of Notes to Financial Statements for information concerning the
calculation of pro forma net income per share.

14
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

THIS PROSPECTUS CONTAINS CERTAIN STATEMENTS OF A FORWARD-LOOKING NATURE
RELATING TO FUTURE EVENTS OR THE FUTURE FINANCIAL PERFORMANCE OF THE COMPANY.
PROSPECTIVE INVESTORS ARE CAUTIONED THAT SUCH STATEMENTS ARE ONLY PREDICTIONS
AND THAT ACTUAL EVENTS OR RESULTS MAY DIFFER MATERIALLY. IN EVALUATING SUCH
STATEMENTS, PROSPECTIVE INVESTORS SHOULD SPECIFICALLY CONSIDER THE VARIOUS
FACTORS IDENTIFIED IN THIS PROSPECTUS, INCLUDING THE MATTERS SET FORTH UNDER THE
CAPTION "RISK FACTORS," WHICH COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY
FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS.

OVERVIEW

The Company designs, implements, supports and manages advanced computer
network systems for hospitals, IDSs and other provider organizations. The
Company believes that its success is attributable to its healthcare industry
focus, depth and breadth of technological expertise, ability to objectively
evaluate its customers' computer network systems due to its vendor independence
and its history of successful customer engagements. The Company's design
services include an assessment of the customer's existing computer network
system, the preparation of voice, video and data network specifications,
technical design documentation and diagrams. DAOU's implementation services
include the purchase, delivery and installation of enterprise-wide computer
network systems. In 1996, revenues from design services averaged approximately
$49,000 per project. In addition, revenues in 1996 from enterprise-wide
implementation service engagements ranged from approximately $470,000 to $3.7
million per project, while revenues from other implementation projects averaged
approximately $70,000. Implementation service revenues consist of third-party
hardware and software products, as well as the Company's professional services.
The Company's gross margin with respect to implementation services varies
significantly depending on the percentage of such services consisting of
products (with respect to which the Company obtains a lower margin) versus
professional services. The Company's support and management services include
remote and on-site network management, as well as I/S outsourcing. The Company
typically provides these services under multi-year contracts.

Historically, the majority of the Company's revenues have been derived from
network design and implementation services which are generally provided on a
fixed-fee basis. These revenues are recognized using the
percentage-of-completion method with progress to completion measured by labor
costs incurred to date compared to total estimated labor costs. The Company may
also provide design and implementation services on a "time and expense" basis
for which revenues are also recognized as services are performed. A design
project typically lasts from three to five months. The time to complete
implementation projects generally ranges from three to six months, although
certain projects have required up to 13 months for completion.

Support and management service revenues are recognized ratably over the
period that these services are provided. The Company anticipates that revenues
from support and management services will increase as a percent of total
revenues in the future. Payments received in advance of services performed are
recorded as deferred revenues. Certain contract payment terms may result in
customer billing occurring at a pace slower than revenue recognition. The
resulting revenues recognized in excess of amounts billed and project costs are
classified as contract work in progress on the Company's balance sheet.

RESULTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 1996 AND 1995

The Company's revenues were $19.3 million and $14.3 million for the years
ended December 31, 1996 and 1995, respectively, representing an increase of 35%.
Revenues increased primarily due to the introduction of the Company's I/S
outsourcing services for Candler in April 1996. Services to CMC, Mercy and
Candler accounted for approximately $4.1 million, $3.4 million and $2.9 million
of total revenues in 1996, representing approximately 21%, 18% and 15% of total
revenues, respectively.

15
<PAGE>
Cost of revenues was $13.6 million and $8.5 million for the years ended
December 31, 1996 and 1995, respectively, representing an increase of 60%. Gross
margin was 30% and 41% for the years ended December 31, 1996 and 1995,
respectively. This decrease in gross margin was primarily due to the increased
content of professional services in certain implementation projects during 1995,
as well as the lower gross margin related to the Company's I/S outsourcing
services initiated in 1996. The Company believes that the 1996 gross margin is
more indicative of future results than its 1995 gross margin due to the
anticipated growth of its I/S outsourcing services relative to other services.

Sales and marketing expenses were $1.9 million and $938,000 for the years
ended December 31, 1996 and 1995, respectively, representing an increase of 98%.
This increase was primarily due to the establishment of a regional sales
structure, an increase in sales and marketing personnel and the expansion of the
Company's marketing programs. Sales and marketing expenses were 10% and 7% of
revenues for the years ended December 31, 1996 and 1995, respectively. The
Company intends to continue investing in its sales infrastructure and expects
that sales and marketing expenses will continue to increase in dollar terms to
support the anticipated growth in the Company's business.

General and administrative expenses were $3.9 million and $2.9 million for
the years ended December 31, 1996 and 1995, respectively, representing an
increase of 35%. The primary factors contributing to this increase were costs
associated with the Company's larger corporate facility, implementation of a
management information system and the addition of senior management during 1996.
General and administrative expenses were 20% of revenues for the years ended
December 31, 1996 and 1995. The Company expects that general and administrative
expenses will continue to increase in dollar terms to support the anticipated
growth in the Company's business.

Net interest income was $197,000 and $67,000 for the years ended December
31, 1996 and 1995, respectively. Interest income consists of interest on
short-term investments, cash and cash equivalents and notes receivable from
officers and stockholders. Interest expense consists of interest associated with
the Company's business line of credit and term financing of insurance premiums,
but was not significant during either period.

YEARS ENDED DECEMBER 31, 1995 AND 1994

The Company's revenues were $14.3 million and $8.5 million for the years
ended December 31, 1995 and 1994, respectively, representing an increase of 68%.
Revenues increased primarily due to growth in design and implementation service
revenues. Increases in both the number and size of management service projects
from both new and existing customers resulted in a 42% increase in management
service revenues in 1995. Services to Mercy accounted for $6.8 million, or
approximately 48%, of total revenues in 1995.

Cost of revenues was $8.5 million and $6.2 million for the years ended
December 31, 1995 and 1994, respectively, representing an increase of 37%. Cost
of revenues increased primarily due to greater product costs associated with
implementation projects and increased labor costs associated with new management
service contracts. Gross margin was 41% and 27% of revenues for the years ended
December 31, 1995 and 1994, respectively. This increase was attributable
primarily to the higher content of professional services in implementation
projects, an increase in the number of management service contracts, a reduction
in the use of third-party professional services and increased utilization of
internal engineering resources.

Sales and marketing expenses were $938,000 and $796,000 for the years ended
December 31, 1995 and 1994, respectively, representing an increase of 18%. This
increase was due primarily to the growth in revenues and the number of people
involved in sales activities, as well as the introduction of a new corporate
marketing strategy. Sales and marketing expenses were 7% and 9% of revenues for
the years ended December 31, 1995 and 1994, respectively. This decrease as a
percentage of revenues was due primarily to increased revenues and decreased
commissions.

16
<PAGE>
General and administrative expenses were $2.9 million and $1.5 million for
the years ended December 31, 1995 and 1994, respectively, representing an
increase of 92%. This increase was due to one-time relocation costs and expenses
of approximately $205,000 associated with the Company's move to new corporate
facilities and continued growth in administrative staffing levels in finance,
purchasing and human resources. General and administrative expenses were 20% and
18% of revenues for the years ended December 31, 1995 and 1994, respectively.
Excluding one-time relocation expenses, there was no significant change on a
percentage of revenue basis.

INCOME TAXES

In 1996, 1995 and 1994, the effective tax rates were 59%, 41% and 42%,
respectively, and exceeded the expected combined federal and state statutory
rate of 40% primarily due to the nondeductibility of certain operating expenses,
including the amortization expense related to compensatory stock options granted
during 1996.

LIQUIDITY AND CAPITAL RESOURCES

Since its inception, the Company has financed its operations primarily
through a combination of cash generated from operations and the private sale of
equity securities. As of December 31, 1996, the Company had raised $7.6 million,
net of issuance costs, from the private sale of equity securities. At December
31, 1996, the Company had $2.3 million in cash and cash equivalents and $1.5
million available under a revolving line of credit. Advances under the revolving
line of credit bear interest at the bank's reference rate (8.25% at December 31,
1996) plus 0.5% per annum. Through December 31, 1996, there have been no
borrowings under the revolving line of credit, which expires October 1, 1997.
This line of credit is secured by substantially all of the assets of the Company
and contains customary covenants and restrictions. As of December 31, 1996, the
Company was in compliance with all such covenants and restrictions.

During the year ended December 31, 1996, cash used in operating activities
was $3.2 million, which resulted primarily from an increase in unbilled
receivables and cash expended for contract costs reported as contract work in
progress on the Company's balance sheet (see Note 1 of Notes to Financial
Statements). The net cash used in operating activities was offset by the
liquidation of short-term investments upon maturity.

The Company believes that the net proceeds from this offering, together with
available funds, will be sufficient to meet its capital requirements for the
foreseeable future. The Company may also utilize cash to acquire or invest in
complementary businesses, although the Company does not have any plans,
proposals, arrangements or understandings with respect to any future
acquisitions. The Company may sell additional equity or debt securities or
obtain additional credit facilities. The sale of additional equity securities
could result in additional dilution to the Company's stockholders and the
incurrence of additional debt could result in additional interest expense.

17
<PAGE>
QUARTERLY RESULTS AND SEASONALITY

The following table presents quarterly operating results for each of the
last eight quarters. This information has been derived from unaudited financial
statements and has been prepared on the same basis as the Company's audited
financial statements which appear elsewhere in this Prospectus. In the opinion
of the Company's management, this information reflects all adjustments,
consisting only of normal recurring adjustments, necessary for a fair
presentation of such information in accordance with generally accepted
accounting principles. The operating results for any quarter are not necessarily
indicative of the results for any future period.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-----------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30,
1995 1995 1995 1995 1996 1996 1996
----------- ----------- ----------- ----------- ----------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
Revenues............................. $ 2,597 $ 1,390 $ 3,096 $ 7,247 $ 2,329 $ 5,201 $ 4,827
Cost of revenues..................... 847 1,013 2,005 4,610 1,675 3,668 3,307
----------- ----------- ----------- ----------- ----------- ----------- -----------
Gross profit......................... 1,750 377 1,091 2,637 654 1,533 1,520
Operating expenses:
Sales and marketing................ 273 216 202 247 330 376 461
General and administrative......... 372 478 827 1,216 791 944 926
----------- ----------- ----------- ----------- ----------- ----------- -----------
Total operating expenses............. 645 694 1,029 1,463 1,121 1,320 1,387
----------- ----------- ----------- ----------- ----------- ----------- -----------
Income (loss) from operations........ 1,105 (317) 62 1,174 (467) 213 133
Interest income (expense), net....... -- (4) (2) 73 70 50 43
----------- ----------- ----------- ----------- ----------- ----------- -----------
Income (loss) before income taxes.... 1,105 (321) 60 1,247 (397) 263 176
Provision (benefit) for income
taxes............................... 399 (149) 61 540 (234) 155 104
----------- ----------- ----------- ----------- ----------- ----------- -----------
Net income (loss).................... $ 706 $ (172) $ (1) $ 707 $ (163) $ 108 $ 72
----------- ----------- ----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- ----------- ----------- -----------

DEC. 31,
1996
-----------

<S> <C>
Revenues............................. $ 6,954
Cost of revenues..................... 4,906
-----------
Gross profit......................... 2,048
Operating expenses:
Sales and marketing................ 686
General and administrative......... 1,236
-----------
Total operating expenses............. 1,922
-----------
Income (loss) from operations........ 126
Interest income (expense), net....... 34
-----------
Income (loss) before income taxes.... 160
Provision (benefit) for income
taxes............................... 94
-----------
Net income (loss).................... $ 66
-----------
-----------
</TABLE>

The following table sets forth, as a percentage of revenues, certain
unaudited quarterly statements of operations data:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-----------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30,
1995 1995 1995 1995 1996 1996 1996
----------- ----------- ----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C> <C>
AS A PERCENT OF REVENUES:
Revenues............................. 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Gross margin......................... 67.4 27.1 35.2 36.4 28.1 29.5 31.5
Sales and marketing.................. 10.5 15.5 6.5 3.4 14.2 7.2 9.6
General and administrative........... 14.3 34.4 26.7 16.8 34.0 18.2 19.2
Income (loss) from operations........ 42.6 (22.8) 2.0 16.2 (20.1) 4.1 2.8
Net income (loss).................... 27.2 (12.4) 0.0 9.8 (9.8) 2.2 1.5

DEC. 31,
1996
-----------
<S> <C>
AS A PERCENT OF REVENUES:
Revenues............................. 100.0%
Gross margin......................... 29.5
Sales and marketing.................. 9.9
General and administrative........... 17.8
Income (loss) from operations........ 1.8
Net income (loss).................... 1.0
</TABLE>

A substantial majority of the Company's operating expenses, particularly
personnel and related costs, depreciation and rent, are relatively fixed in
advance of any particular quarter. However, variations in the Company's revenues
and operating results occur from time to time, as a result of various factors,
including: (i) the reduction in size, delay in commencement, interruption or
termination of one or more significant projects or contracts; (ii) the
completion during a quarter of one or more significant projects; (iii) the
failure to estimate accurately the resources required to complete new or ongoing
projects; (iv) the relatively longer sales cycle in obtaining new customers and
larger contracts; (v) the timing and extent of employee training or the loss of
key employees; (vi) competition; (vii) the development and introduction of new
services; and (viii) general economic conditions which may affect the buying
decisions of the Company's current and prospective customers. In addition, the
Company plans to continue to expand its operations by hiring additional network
engineers and other employees, and

18
<PAGE>
adding new offices, systems and other infrastructure. The resulting increase in
operating expenses will generally be incurred prior to any increase in revenues.
Consequently, the Company's business, financial condition and results of
operations would be materially and adversely affected if revenues do not
increase to support such expenses. A variation in the timing of the commencement
or completion of customer assignments, particularly at or near the end of any
quarter, may cause significant variations in operating results from quarter to
quarter and could result in losses for a particular quarter. In addition, an
unanticipated delay or termination of a major project could require the Company
to maintain or terminate under-utilized employees which could, in either case,
result in higher than expected expenses during a quarter. The Company believes
that quarterly revenues and operating results are likely to vary significantly
in the future and that period-to-period comparisons of its revenues and
operating results are not necessarily meaningful and should not be relied on as
indications of future performance. Furthermore, these variations in revenues and
operating results could cause significant variations in the price of the
Company's Common Stock.

19
<PAGE>
BUSINESS

THE COMPANY

DAOU Systems, Inc. ("DAOU" or the "Company") designs, implements, supports
and manages advanced computer network systems for hospitals, integrated
healthcare delivery systems ("IDSs"), and other healthcare provider
organizations ("provider organizations"). DAOU combines its knowledge of the
specialized information needs of the healthcare industry with its technological
expertise in computer network systems to provide advanced, reliable and
cost-effective computer network solutions to provider organizations. The Company
believes that its success is attributable to its healthcare industry focus,
depth and breadth of technological expertise, ability to objectively evaluate
its customers' computer network systems due to its vendor independence and its
history of successful customer engagements. The Company's design services
include an assessment of the customer's existing computer network system and the
preparation of voice, video and data network specifications, technical design
documentation and diagrams. DAOU's implementation services include the purchase,
delivery and installation of enterprise-wide computer network systems. The
Company's support and management services are typically provided under
multi-year contracts and include remote and on-site network management services,
as well as information systems outsourcing ("I/S outsourcing"). The Company
provides network support services to its customers through its regional sales
and support structure and a 24-hour technical support hotline available seven
days a week. DAOU typically provides its services on a fixed-price, fixed-time
frame basis. Since 1987, the Company has provided computer network services to
over 350 customers ranging in size from single-site organizations to multi-state
organizations with over 80 sites. The Company's customers include Catholic
Medical Center of Brooklyn and Queens, Inc., New York ("CMC"); Mercy Health
Services, Farmington Hills, Michigan ("Mercy"); Atlantic Health System,
Morristown, New Jersey; Lutheran Health Systems, Fargo, North Dakota; Candler
Health System, Savannah, Georgia ("Candler"); and St. Mary's Health Network,
Reno, Nevada.

INDUSTRY OVERVIEW

Pressure by employers, health insurers and government payors to control
escalating healthcare costs is driving a movement in the healthcare industry
towards managed care and new forms of reimbursement for healthcare providers.
Payors are also demanding that providers differentiate their services by
demonstrating quality of care. These economic and competitive pressures are
causing healthcare providers to consolidate and form multi-entity provider
organizations such as IDSs. IDSs may consist of hospitals, primary care and
multi-specialty physician groups, out-patient care facilities and home
healthcare providers, and are designed to serve economically the healthcare
needs of a regional population. The consolidation of provider organizations and
the formation of IDSs have resulted in changing healthcare information needs as
these organizations increasingly require prompt access to consistent and
comprehensive patient information at each location where care is provided.

The existing information systems in many provider organizations were
developed to meet the needs of a single facility, such as a hospital or an
out-patient surgery center. The consolidation of these facilities and the
formation of IDSs create complex organizations with many disparate and
specialized information system infrastructures. The Company believes that these
infrastructures frequently are inadequate to support the flow and integration of
information necessary to efficiently manage a complex provider organization. A
typical multi-site IDS, for example, requires a computer network that is capable
of supporting multiple applications and processing high volumes of data across
geographically remote locations. In addition, the increasing variety of hardware
and software applications utilized throughout provider organizations has
resulted in connectivity and compatibility problems for many computer networks.
These networks must not only meet the heightened information needs of provider
organizations, but also have the capability to migrate to emerging technologies.

As a result of the competitive healthcare environment and the growing
complexity of computer network systems, provider organizations have found it
increasingly difficult to implement and manage these systems. In addition, the
Company believes that the high demand for qualified network engineers and other
technical personnel has made it increasingly difficult for provider
organizations to recruit and

20
<PAGE>
train qualified information technology professionals. Consequently, many
provider organizations are looking to third parties for the technological
expertise and personnel to meet their information systems requirements. DAOU
believes that the ongoing consolidation among healthcare provider organizations
and the increasing complexity and rapid evolution of computer network system
technologies have created a significant opportunity for companies specializing
in providing computer network system solutions to provider organizations.

THE DAOU SOLUTION

DAOU provides a broad array of services to assist hospitals, IDSs and other
provider organizations in designing, implementing, supporting and managing
complex computer network systems consistent with their unique and changing
information needs. The Company believes that the delivery of a combination of
design, implementation and management services better enables the Company's
personnel to fully understand the customer's computing and operating
environments, install computer networks that meet the customer's specialized
requirements, train the customer's users and internal network management staff
prior to the full migration to a new computer network system and provide
effective, ongoing support and management of the computer network. DAOU has
extensive experience resolving the integration, implementation and management
issues faced by provider organizations. In addition, the Company has substantial
knowledge of numerous software applications developed by healthcare information
system and software vendors, as well as extensive expertise in advanced
information technologies and computer network systems, including WANs,
network/host security, high-performance LANs, Internet/Intranet and asynchronous
transfer mode ("ATM") technologies. DAOU uses the products and applications of
various hardware and software vendors to integrate the existing computing and
communication devices and equipment of legacy systems to create advanced
computer network systems. In addition, the Company does not manufacture hardware
or develop software, nor does it have exclusive arrangements with any vendors of
these products. DAOU believes that this vendor independence enables it to
objectively assess its customers' information technology requirements and select
the optimal mix of applications and products. The Company believes that its
cumulative experience, healthcare focus and technology expertise enable it to
deliver advanced computer network systems and services on a timely basis and at
fixed prices.

STRATEGY

The Company's objective is to be a leading provider of advanced computer
network systems and network management services to healthcare provider
organizations. The principal elements of the Company's strategy are:

- EXPAND AND STRENGTHEN CUSTOMER RELATIONSHIPS. The Company will continue to
focus its sales and marketing efforts on major medical centers and
hospitals around which IDSs are forming. In addition, the Company plans to
focus additional resources on serving the information technology needs of
emerging provider organizations, such as physician practice management
companies, long-term care providers and rehabilitation service providers.
DAOU intends to further develop its regional sales and support structure
in order to monitor more closely the needs of existing and prospective
customers. For example, the Company recently has placed throughout its
regional structure customer-dedicated account managers who are responsible
for maintaining customer satisfaction and developing new business
opportunities.

- DEVELOP COMPLEMENTARY SERVICES. The Company intends to develop services
which complement its existing services and increase its recurring revenue
stream. Currently, DAOU is expanding its services in the areas of voice,
video and data integration, telemedicine, I/S outsourcing, Internet/
Intranet and cabling services. The Company intends to develop additional
service capabilities such as network outsourcing, remote network
monitoring and network traffic pattern analysis. To obtain feedback
regarding its present and future services from a customer perspective, the
Company has established an advisory board comprised of chief information
officers in the healthcare industry.

21
<PAGE>
- MAINTAIN TECHNOLOGY EXPERTISE. The Company believes that demand for
complex, emerging technologies will grow as provider organizations seek to
employ new applications that combine voice, video and data. The Company
intends to remain at the forefront of information technology solutions for
provider organizations and to continue developing its expertise in
emerging technologies. Specific development efforts include in-house
vendor presentations to educate employees on technological advances and
new products, in-house testing of new systems, products and applications,
attendance at various information technology trade shows and participation
in the ATM Forum, an industry council that provides input regarding
emerging ATM standards.

- RECRUIT, TRAIN AND RETAIN QUALIFIED PERSONNEL. The Company believes that
its competitive position is enhanced by its ability to hire, train and
retain qualified technical and management personnel. DAOU believes that a
key factor in recruiting and retaining its technical personnel is its
ability to provide them with exposure to and training in a variety of
leading edge technologies. The Company intends to continue dedicating
significant resources to train its technical employees by conducting
in-house workshops presented by senior network engineers, inviting vendors
to provide on-site presentations and sponsoring employees to attend vendor
certification programs.

- HEIGHTEN DAOU'S HEALTHCARE INDUSTRY PRESENCE. The Company intends to
leverage its history of successful customer engagements to become a
recognized leader in providing information technology solutions to
provider organizations. The Company is expanding its marketing program to
enhance the market presence and visibility of the Company and its services
among potential healthcare customers.

INFORMATION TECHNOLOGY SERVICES

DAOU designs, implements, supports and manages computer network systems that
are capable of providing access to information such as patient records, X-rays
and billing information at each site of a provider organization. The Company
provides to its customers a broad range of computer network services, which
often follow a progression from initial network design through implementation
and computer network management. DAOU believes that the delivery of a
combination of design, implementation and management services better enables the
Company's personnel to fully understand the customer's computing and operating
environments, install computer networks that meet the customer's specialized
requirements, train the customer's users and internal network management staff
prior to the full migration to a new computer network system and provide
effective, ongoing support and management of the computer network. The Company
uses the products and applications of various hardware and software vendors to
integrate the existing computing and communication devices and equipment of
legacy systems to create advanced computer network systems. The Company focuses
on the specialized requirements of each customer project and utilizes formal
planning, monitoring and communication systems and methodologies to ensure
proper project completion and customer satisfaction.

NETWORK SERVICES

DAOU provides network services ranging from network design to large-scale
network implementation. The Company generally provides network design services
prior to the delivery of its other network or management services in order to
determine the proper scope and delivery of these other services. DAOU generally
contracts with its customers on a fixed-price basis for defined services
delivered in accordance with scheduled milestones. The typical sales cycle for
these services begins with an engagement for network design followed by the
installation of enterprise-wide computer network systems.

NETWORK DESIGN. DAOU's network design services include a review and audit
of a customer's existing information technology infrastructure and an assessment
of the functional requirements of its computer network system. The Company
conducts detailed site visits and interviews key customer personnel in order to
identify the specific technologies to be used. The Company then determines how
new technologies will integrate into the customer's existing hardware and
software and how the entire computer network system will be managed on an
ongoing basis. Following its review, the Company

22
<PAGE>
prepares technical design documentation and diagrams of the physical, logical,
operational and communication infrastructures. The Company also prepares voice,
video and data network specifications, as appropriate, and details the
implementation steps necessary to meet the customer's specific computer network
requirements. As part of this process, the Company designs integration
strategies for designated applications, fault-tolerant strategies to help ensure
reliable network operation and migration strategies for customer utilization of
emerging technologies. The Company also develops detailed recommendations for
computer network systems, including the selection of appropriate network
products and the design of multi-vendor integration plans. The typical
engagement period for network design services is three to five months.

NETWORK IMPLEMENTATION. The Company's network implementation services
involve the purchase, delivery, testing and installation of enterprise-wide
computer network systems. Networks installed by the Company provide a variety of
features and services, including switch/bridge/router configuration, PC-to-host
emulation, legacy network integration, gateway installation, universal
workstation design and installation, remote-site connectivity solutions, dial-up
remote access solutions, document management, imaging installations, video
conferencing and telemedicine installations. For each implementation project,
the Company assigns a project management team typically consisting of a project
manager, an account manager, a senior engineer and other technical personnel, as
well as subcontractors and third-party vendors if required. Each project
management team is carefully selected for its technical expertise in specific
areas to meet the requirements of a particular project. The project team is
responsible for creating an installation schedule, ensuring compliance with
established milestones, providing on-site coordination of the activities of
DAOU's personnel, subcontractors and third-party vendors, testing network
performance, including stress and data traffic diagnostics, and providing
regular progress reports to the project manager.

The Company installs a computer network by first conducting a detailed
review of the network design to determine the connectivity and product
requirements. DAOU typically purchases the various network components which have
been specified. After delivery to its facilities, the Company connects these
components prior to installation at the customer's site and then conducts
various tests of the computer network system, simulating the customer's actual
computing environment in accordance with the customer's software applications
and specifications. The Company also tests the network's configuration,
connectivity and compatibility and analyzes the load and data throughput
capacity of the network. This testing process reduces downtime risk and helps
ensure that the network installation will occur with minimal disruption to the
customer's ongoing business operations.

The Company manages the installation of the computer network equipment, as
well as software and cabling, using its own personnel or selected
subcontractors. Throughout the installation process, the Company's personnel
monitor the project's progress to ensure compliance with all network
specifications. Upon completion of the equipment installation, the Company
conducts additional connectivity testing and diagnostics. The engagement period
for these services generally ranges from three to six months, but varies
depending on the size and complexity of the implementation project.

MANAGEMENT SERVICES

As computer network systems become more complex, provider organizations are
experiencing difficulties in hiring, training and retaining information
technology professionals who can maintain the performance and functionality of
their computer network systems. Accordingly, provider organizations have begun
to outsource certain maintenance and management functions of their information
systems departments. DAOU provides support and management services that are
designed to maintain the effective performance of a customer's computer network
system, as well as I/S outsourcing services that are designed to manage a
customer's information services functions. The Company generally provides these
services in multi-year engagements on a fixed-price basis.

23
<PAGE>
NETWORK SUPPORT. The Company provides a 24-hour technical support hotline
available seven days a week, as well as other network support resources such as
on-site seminars and on-line support. DAOU also informs its customers of new
technological advances and network solutions that may help increase the utility
and functionality of their computer network systems. The Company intends to
develop additional support services such as continuous network monitoring in
order to monitor remotely the performance of computer network systems on an
ongoing basis and detect and report network problems. The initial engagement
period for the Company's existing support services typically is for one year,
subject to annual renewal.

ENTERPRISE NETWORK MANAGEMENT. The Company provides a range of enterprise
network management services to manage and support a customer's computer network
system. The Company uses its technical expertise and staffing experience to
package, price and deliver combinations of these services at collective rates
which are frequently lower than if provided in-house by the customer. The
customer benefits from the Company's experience in providing enterprise network
management services in a broad range of operating environments, including
client/server networks supporting both Internet and workgroup protocols
intermingled with legacy networks. The engagement period for these services
typically ranges from one to five years. The Company's enterprise network
management services include combinations of the following services, which are
selected by the customer to meet its specific needs:

- DAOU EMPLOYEES ON-SITE. DAOU works with a customer to assess the
appropriate staffing needs to maintain and support its computer network
system. The Company places its employees on-site on a full-time basis to
provide network support services and ongoing training of the customer's
internal staff. This service allows the customer to benefit continuously
from DAOU's technical expertise and to reduce its hiring and training of
internal network management personnel.

- CONTINUOUS NETWORK PLANNING. DAOU's design personnel evaluate a customer's
computer network system and provide recommendations for new network
capabilities and capacity on an ongoing basis consistent with the evolving
needs and strategy of the customer. In addition, DAOU evaluates hardware
and software options, interprets research and development results, updates
existing network designs and researches specific products and technologies
of interest to customers. The Company provides these services subject to
predetermined schedules.

- "BURST MODE" IMPLEMENTATION. DAOU provides additional technical personnel
during periods of peak network requirements to accommodate and assist in
network upgrade implementation or to accommodate the anticipated or
unanticipated need for additional technical staff. This service enables
the customer to preplan changes in its computer network without the
problems associated with recruiting and training temporary staff or hiring
excess permanent technical personnel.

- NETWORK SUPPORT. Depending on the specific needs of each customer, the
Company also provides network support services as part of its combination
of enterprise network management services.

I/S OUTSOURCING. The Company has recently introduced comprehensive I/S
outsourcing services for provider organizations that elect to outsource all or a
portion of their information systems functions. I/S outsourcing services involve
long-term engagements with customers whereby the Company may staff up to the
entire information systems department and is responsible for the management and
support of the customer's computer network system. DAOU provides its I/S
outsourcing services in accordance with pre-determined, detailed schedules and
plans established with the customer. DAOU entered into its first I/S outsourcing
contract in April 1996 with Candler (the "Candler Contract"). Under the Candler
Contract, the Company is responsible for the management and staffing of
Candler's information systems functions with the Company's own employees and
acts on behalf of Candler with respect to ongoing enhancements and maintenance
of hardware and software products from third-party vendors. Additional I/S
outsourcing services under the Candler Contract include: (i) the implementation
of operating procedures for and management and staffing of various information
systems departments; (ii) the establishment and management of the information
systems budget, including personnel and capital expenditures; (iii) the
negotiation and management of hardware and software vendor contracts; (iv)
attendance at internal and external management meetings, user groups, convention
activity and corporate meetings;

24
<PAGE>
(v) the development and implementation of an information technology strategic
plan; and (vi) ongoing recruiting and training of Candler's employees with
respect to the computer network and its applications. The term of the Candler
Contract is for five years and the Company anticipates that the typical contract
period for additional I/S outsourcing contracts will be for three to five years.
There can be no assurance, however, that a customer will not terminate its
contract with the Company prior to the completion of the contract term. See
"Risk Factors -- Contract Cancellation Rights; Absence of Long-Term Agreements"
and "-- Consolidation and Uncertainty in the Healthcare Industry."

OTHER SERVICES

The Company is expanding its current services and developing new services
that will assist provider organizations with the management and support of their
computer network systems. DAOU is expanding its current services in the areas of
voice, video and data integration, telemedicine, I/S outsourcing,
Internet/Intranet and cabling. The Company intends to develop new service
capabilities, such as network outsourcing (whereby the Company outsources
hardware as well as personnel), remote network monitoring and network traffic
pattern analysis. The Company intends to expand or develop these services either
internally or through acquisitions.

DAOU ADVISORY BOARD

In 1994, the Company established its Advisory Board (the "Advisory Board"),
a non-governing body currently comprised of twelve chief information officers
("CIOs") of various provider organizations. The Advisory Board meets as a group
annually and the members confer separately with the Company periodically to
provide advice on issues and trends in the healthcare industry and emerging
technologies, as well as to provide strategic direction and feedback regarding
the Company's present and future services. Members of the Advisory Board are
reimbursed for travel, lodging and meal expenses incurred in connection with
attendance at the Advisory Board's sessions and may also receive options to
purchase shares of the Company's Common Stock. Larry Grandia, the CIO of
Intermountain Health Care Inc., serves as the Chairman of the Advisory Board.

RECRUITING AND TRAINING OF TECHNICAL EMPLOYEES

The Company dedicates significant time and resources to recruit, train and
retain qualified technical personnel. The technical staff of the Company
consists of senior network engineers, network engineers and network systems
technicians. The Company hires many of its technical staff as entry-level
network systems technicians and provides these individuals with the necessary
training and experience to become network engineers who are responsible for
network configuration, testing, burn-in analysis, installation and
documentation. Further training and experience is provided to enable these
engineers to become senior network engineers who are responsible for project and
resource management. The Company's technical staff undergoes extensive training
and maintains certifications from leading network technology vendors such as
Cisco Systems, Inc., Bay Networks, Inc., Microsoft Corporation and 3Com
Corporation. In addition, the Company is a member of leading technological
forums and organizations, including the ATM Forum, the CHIM Telecommunications
Committee, the HL7 Committee and the BICSI Organization.

The Company believes that its future success will depend in large part on
its ability to hire, train and retain qualified network engineers who together
have expertise in a wide array of network and computer systems and a broad
understanding of the provider organizations that the Company serves. Competition
for qualified network engineers is intense and is expected to increase. In
particular, competition is intense for the limited number of qualified senior
network engineers. Consequently, there can be no assurance that the Company will
be successful in attracting and retaining such personnel. While the Company is
currently experiencing low rates of turnover, there can be no assurance that
these rates of turnover will not increase in the future. Any inability of the
Company to hire, train and retain a sufficient number of qualified network
engineers could impair the Company's ability to adequately manage and

25
<PAGE>
complete its existing projects or to obtain new projects, which, in turn, could
have a material adverse effect on the Company's business, financial condition
and results of operations.

Each technical employee is required to enter into a confidentiality
agreement with the Company designed to protect the Company's trade secrets and
other confidential information during and subsequent to employment with the
Company. Any significant loss of employees to a competitor could have a material
adverse effect on the Company's business, financial condition and results of
operations.

SALES AND MARKETING

The Company's sales and support operations are divided into four regional
organizations located in the west, midwest, east and southeast regions of the
United States. A vice president heads each regional organization and oversees
the management of existing customers by the account managers and the development
of new customers by the account executives. In particular, account managers are
responsible for maintaining customer satisfaction and developing new business
opportunities as customer needs for computer network services evolve or
increase. The Company intends to create a fifth regional organization in the
southwest region during 1997.

The Company seeks to establish long-term relationships with its customers by
providing high levels of service and by becoming an integral part of their
computer network systems operations. The Company focuses its sales and marketing
efforts on the CIOs and other technology decision makers of IDSs, hospitals and
other provider organizations. The Company relies upon its reputation in the
marketplace, the personal contacts and networking of its professionals and the
various programs of its marketing department to develop new business
opportunities. The Company also receives sales leads directly from consultants,
VARs and product and service vendors.

The principal objectives of the Company's marketing department are to
increase the Company's market presence, provide strategic direction and to
generate sales leads. As a supplement to the direct selling efforts of the
Company, the marketing department has developed various programs that include
advertising campaigns, trade show participation, direct mail campaigns, public
relations programs, marketing research and communications and the development of
sales presentation materials. The Company's marketing efforts are enhanced by
speaking engagements and the publication of technical articles and reports
directed to the healthcare information technology industry. The Company's
marketing department is also responsible for the continued development of the
Company's presence on the Internet as a new marketing channel.

COMPETITION

The healthcare network services industry is comprised of a large number of
participants and is subject to rapid change and intense competition. The
Company's competitors include system integrators, VARs, consulting companies,
local and regional network services firms, telecommunications providers and
network equipment, computer systems and healthcare software vendors, many of
which have significantly greater financial, technical and marketing resources
and greater name recognition than does the Company. In particular, the Company
competes with (i) large information technology companies such as
Hewlett-Packard, EDS and Integrated Systems Solutions Corporation, a subsidiary
of IBM; (ii) healthcare information technology companies such as HBO & Company;
and (iii) smaller regional network systems firms. In addition, the Company has
faced, and expects to continue to face, additional competition from new entrants
into its markets. Other healthcare information technology companies not
presently offering or emphasizing network systems services and large network
services companies not currently focusing on healthcare may enter the Company's
markets. Increased competition could result in price reductions, fewer customer
projects, under-utilization of employees, reduced operating margins and loss of
market share, any of which could materially and adversely affect the Company's
business, financial condition and results of operations. There can be no
assurance that the Company will be able to compete successfully against current
and future competitors. The failure of the Company to compete successfully would
have a material adverse effect on the Company's business, financial condition
and results of operations. In addition, most of the Company's customers have
internal network support and

26
<PAGE>
service capabilities and could choose to satisfy their needs through internal
resources rather than through outside service providers. As a result, the
decision by the Company's customers or potential customers to perform network
services internally could have a material adverse effect on the Company's
business, financial condition and results of operations.

The Company believes that the principal competitive factors in the markets
in which it competes include: reputation, healthcare industry expertise, network
performance and reliability, timely delivery of services, quality of service,
responsiveness to customers, product knowledge and technological expertise,
marketing, customer relationships and price. The Company believes that it is
competitive with respect to the above mentioned factors.

CUSTOMERS

Since 1987, DAOU has provided computer network services to over 350
customers ranging in size from single-site organizations to multi-state
organizations with over 80 sites. The Company's customers include CMC, New York;
Mercy, Farmington Hills, Michigan; Atlantic, Morristown, New Jersey; Lutheran
Health Systems, Fargo, North Dakota; Candler, Savannah, Georgia; and St. Mary's
Health Network, Reno, Nevada. The Company has derived, and believes that it will
continue to derive, a significant portion of its revenues from a relatively
limited number of large customer contracts. In 1996, CMC, Mercy and Candler
accounted for approximately 21%, 18% and 15% of total revenues, respectively. In
1995, Mercy and Candler accounted for approximately 48% and 11% of total
revenues, respectively. No other customer accounted for more than 10% of the
Company's revenues during such periods.

BACKLOG

The Company includes in sales backlog all unrecognized revenues attributable
to signed contracts for network and management services. At December 31, 1996
and December 31, 1995, the Company's sales backlog was approximately $15.8
million and $6.0 million, respectively. The Company estimates that approximately
46% of its backlog at December 31, 1996 will not be recognized as revenues
during the following twelve months due to the long-term nature of the Company's
contracts. Although the Candler Contract has an initial term of five years,
sales backlog at December 31, 1996 includes estimated payments to be received
under the Candler Contract only through December 31, 1997, because the Company
cannot determine with certainty the exact amounts of the payments to be received
under the Candler Contract subsequent to that date. Furthermore, the Company's
customers are generally able to reduce or cancel their use of the Company's
services before the end of the contract term. Consequently, there can be no
assurance that services included in sales backlog will generate revenues in the
amount estimated or that such revenues will be recognized during the specified
twelve-month period or at all. See "Risk Factors -- Contract Cancellation
Rights; Absence of Long-Term Contracts" and "--Consolidation and Uncertainty in
the Healthcare Industry."

EMPLOYEES

As of December 31, 1996, the Company employed 126 persons. Of these
employees, 82 were involved in providing computer network services, 13 in sales
and marketing and 31 in general administration, finance and clerical. The
Company's employees are not represented by a labor union and the Company's
management believes that its relationship with its employees is good.

FACILITIES

The Company leases approximately 32,000 square feet of office space in San
Diego, California for its principal administrative, support and training
facilities. This lease expires in September 1998. In addition, the Company has
executive offices in Chicago and Atlanta to provide regional sales and support
activities to its customers and plans to establish executive offices in Boston
and Philadelphia during the first quarter of 1997. The Company continually
evaluates the adequacy of its existing facilities and believes that its current
and planned facilities will be adequate for the next twelve months.

27
<PAGE>
MANAGEMENT

EXECUTIVE OFFICERS AND DIRECTORS

The executive officers and directors of the Company and their ages as of the
date of this Prospectus are as follows:

<TABLE>
<CAPTION>
NAME AGE POSITION
- --------------------------------------- --- -------------------------------------------------------------
<S> <C> <C>
Georges J. Daou........................ 35 Chairman of the Board and Chief Executive Officer

Daniel J. Daou......................... 32 President and Director

Robert J. McNeill...................... 58 Executive Vice President and Chief Operating Officer

Fred C. McGee.......................... 50 Senior Vice President, Chief Financial Officer and Secretary

Dan L. Porter.......................... 57 Senior Vice President, Human Resources

Ron V. Mirabile........................ 35 Vice President, Field Services

Eric S. Ringwall....................... 32 Vice President, Technology Services

David W. Jahns (1)(2).................. 31 Director

Bernard F. McDonagh (1)(2)............. 53 Director

John H. Moragne (1)(2)................. 39 Director
</TABLE>

- --------------

(1) Member of the Audit Committee

(2) Member of the Compensation Committee

MR. GEORGES DAOU, a founder of the Company, has served as Chairman of the
Board and Chief Executive Officer since the Company's inception in 1987. Mr.
Daou sits on the boards of various healthcare and community organizations,
including the College of Healthcare Management Executives and the Healthcare
Information Managers Association. He holds a B.S. in Electrical Engineering and
an M.S. in Information and Communication Theory from the University of
California, San Diego.

MR. DANIEL DAOU, a founder of the Company, has served as President since
December 1994 and as a director since the Company's inception in 1987. From
November 1992 to December 1994, he was the President of Complex Network
Solutions, Inc., an engineering services company. From July 1987 to November
1992, he served as Vice President of the Company. Mr. Daou sits on the board of
a private software company. He holds a B.S. in Computer Engineering from the
University of California, San Diego.

MR. MCNEILL joined the Company as Executive Vice President and Chief
Operating Officer in November 1996. From September 1981 through November 1996,
he served in various executive capacities with Shared Medical Systems
Corporation ("SMS"), a healthcare information services company. In his most
recent position with SMS as Senior Vice President of Marketing, Mr. McNeill was
responsible for marketing and professional services and managed several business
units, including networking and imaging systems integration. He holds a B.S. in
Accounting from St. Joseph's University.

MR. MCGEE joined the Company as Senior Vice President and Chief Financial
Officer in August 1996. From October 1988 through July 1996, Mr. McGee was Vice
President of Finance and Chief Financial Officer of Infrasonics, Inc., a
publicly-traded manufacturer of medical devices used in respiratory care. Prior
thereto, Mr. McGee held various financial and management positions with Sears
Roebuck & Co. and other retail, wholesale and manufacturing companies. He holds
a B.S. in Finance from San Diego State University.

MR. PORTER has served as Senior Vice President, Human Resources, of the
Company since June 1994. From October 1993 to June 1994, he was the Director,
Human Resources of the San Diego Convention Center. From October 1979 to October
1993, Mr. Porter was the Corporate Vice President, Human Resources, of Scripps
Memorial Hospitals, where he was responsible for all human resources activities
at five acute-care facilities, two extended-care facilities and all affiliated
businesses. He holds a B.A. in Psychology from the University of Tulsa.

28
<PAGE>
MR. MIRABILE has served as Vice President, Field Services, since January
1996 and is responsible for network implementation and the Company's engineering
department. After joining the Company as a network engineer in March 1989, he
served as Director of Technical Services from July 1994 to December 1995. Mr.
Mirabile holds a B.S. in Business Information and Decision Systems from San
Diego State University.

MR. RINGWALL has served as Vice President, Technology Services, since
January 1996. From May 1993 to January 1996, he worked as an engineering
consultant to the Company designing computer networks for provider organizations
nationwide. From September 1992 to May 1993, Mr. Ringwall was a network engineer
for Citizens National Mortgage Corporation, a mortgage loan institution. Prior
thereto, he obtained a masters degree in Information Systems Management from the
Naval Postgraduate School. Mr. Ringwall holds a B.A. in Biology from Cornell
University.

MR. JAHNS has been a director of the Company since October 1995. Mr. Jahns
joined Galen Associates, a venture capital investment firm, in January 1993, and
has served as Vice President since January 1994. Prior thereto, he earned an
M.B.A. from the J.L. Kellogg Graduate School of Business. Mr. Jahns currently
serves on the board of directors of various private healthcare services and
technology companies. He holds a B.A. in Political Science and Economics from
Colgate University.

MR. MCDONAGH has been a director of the Company since March 1996. Since
February 1995, he has been Vice President, Investor Relations and Business
Research for United Healthcare Corporation, a managed care services provider,
where he is responsible for the venture investments of that company. From August
1989 to February 1995, Mr. McDonagh was a Senior Healthcare Services Analyst and
managing director for Piper Jaffray, Inc., an investment banking firm. He holds
a B.A. from Manhattan College, a Ph.D. in Statistics from The Catholic
University of America and an M.B.A. from the University of Minnesota.

MR. MORAGNE has been a director of the Company since October 1995. Mr.
Moragne has been a managing director of Trident Capital, Inc., a private
investment firm, since May 1993 and a member of Trident Capital Management, LLC,
an affiliated entity, since October 1995. From August 1989 to May 1993, Mr.
Moragne was a principal of Bain Capital, a private investment firm, as well as a
principal of Information Partners, a private equity firm associated with Dun &
Bradstreet Enterprises and Bain Capital. He currently serves on the board of
directors of various private information technology companies. He holds a B.A.
from Dartmouth College, an M.S. from the Stanford Graduate School of Applied
Engineering and an M.B.A. from the Stanford Graduate School of Business.

All directors currently hold office until the next annual meeting of
stockholders and until their successors have been duly elected and qualified.
After this offering, the Company intends to elect two additional directors to
the Board of Directors who are not affiliated with the Company. Upon
reincorporation in Delaware, the Board of Directors will be classified into
three classes. Each class will consist of approximately the same number of
directors, who will serve for a one, two or three-year period or until their
successors are duly elected and qualified. At each annual meeting of
stockholders, the successors to the class of directors whose term then expires
will be elected to hold office for a term expiring at the annual meeting of
stockholders held subsequently in three years. The Board of Directors has a
Compensation Committee and an Audit Committee, each composed of Messrs. Jahns,
McDonagh and Moragne. The Compensation Committee makes recommendations to the
Board of Directors concerning salaries and incentive compensation for the
Company's officers and employees and administers the Company's 1996 Stock Option
Plan. The Audit Committee aids management in the establishment and supervision
of the Company's financial controls, evaluates the scope of the annual audit,
reviews audit results, consults with management and the Company's independent
auditors prior to the presentation of financial statements to the stockholders
and, if appropriate, initiates inquiries into aspects of the Company's financial
affairs. Officers are elected by and serve at the discretion of the Board of
Directors. Georges Daou and Daniel Daou are brothers and Joseph Daou, a former
officer and director of the Company, is their father.

29
<PAGE>
EXECUTIVE COMPENSATION

The following table sets forth certain information for the year ended
December 31, 1996, regarding the compensation of the Company's Chief Executive
Officer and each of the four most highly compensated executive officers of the
Company whose salary and bonus for such year were in excess of $100,000 on an
annualized basis (the "Named Executive Officers"):

SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
ANNUAL
COMPENSATION
------------------------ ALL OTHER
NAME AND PRINCIPAL POSITION SALARY BONUS COMPENSATION
- ----------------------------------------------------------------------- ----------- ----------- --------------
<S> <C> <C> <C>
Georges Daou
Chairman of the Board and
Chief Executive Officer.............................................. $ 201,923 $ 35,409 $ 4,774(1)
Daniel Daou
President............................................................ 201,923 41,129 8,244(2)
Joseph Daou
Former Treasurer..................................................... 105,769 -- 6,264(3)
Robert J. McNeill
Executive Vice President and
Chief Operating Officer.............................................. 16,827(4) -- 105,000(5)
Fred C. McGee
Senior Vice President,
Chief Financial Officer and Secretary................................ 44,269(6) -- --
</TABLE>

- --------------

(1) Includes $3,056 of automobile expenses and $1,718 of health insurance
benefits.

(2) Includes $2,480 of automobile expenses, $3,536 of health insurance benefits
and $2,228 of contributions made by the Company under its 401(k) plan.

(3) Includes $2,728 of automobile expenses and $3,536 of health insurance
benefits.

(4) The Company hired Mr. McNeill in November 1996 at an annual salary of
$175,000.

(5) Reflects a one-time signing bonus. See "--Employment Agreement."

(6) The Company hired Mr. McGee in August 1996 at an annual salary of $130,000.

30
<PAGE>
OPTION GRANTS. The following table sets forth certain information for the
year ended December 31, 1996, with respect to grants of stock options to Named
Executive Officers. The Company has not granted any stock appreciation rights to
Named Executive Officers.

OPTION GRANTS IN THE LAST FISCAL YEAR

<TABLE>
<CAPTION>
INDIVIDUAL GRANTS POTENTIAL REALIZABLE
------------------------------------------------------------------------- VALUE AT ASSUMED
NUMBER OF PERCENT OF ANNUAL RATES OF
SECURITIES TOTAL OPTIONS STOCK PRICE
UNDERLYING GRANTED TO FAIR MARKET APPRECIATION FOR
OPTIONS EMPLOYEES IN EXERCISE VALUE ON OPTION TERM(3)
GRANTED FISCAL YEAR PRICE DATE OF GRANT EXPIRATION ---------------------------------
NAME (#)(1) 1996 ($/SH)(2) ($/SH) DATE 0%($) 5%($) 10%($)
- --------------------- ----------- ----------------- ----------- --------------- ----------- --------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Robert J. McNeill
(4)................. 140,300 14.9% $4.28 $ 10.69 11/10/06 $ 899,323 $1,842,139 $3,290,035
Fred C. McGee (5).... 63,135 6.7% 4.28 4.28 01/01/06 -- 169,833 430,581
</TABLE>

- --------------

(1) These options were granted under the Company's 1996 Stock Option Plan.

(2) The exercise price is to be paid in cash, by surrendering shares of Common
Stock held by optionee for more than 12 months, or in any combination of
such consideration or such other consideration and method of payment
permitted under applicable law.

(3) The 0%, 5% and 10% assumed annual rates of compounded stock price
appreciation are mandated by rules of the Securities and Exchange
Commission. There can be no assurance that the actual stock price
appreciation over the ten-year option term will be at the assumed 0%, 5% or
10% levels or at any other defined level.

(4) In November 1996, the Company granted to Mr. McNeill an option to purchase
140,300 shares of Common Stock at an exercise price of $4.28 per share. This
option vests over five years on each anniversary of November 1, 1996. The
Company has agreed to pay to Mr. McNeill a cash bonus in the amount of the
difference, if any, between (i) the net value of the options at the end of
the third anniversary of their date of issuance and (ii) $1,550,000. See
"--Employment Agreement."

(5) In August 1996, the Company granted to Mr. McGee an option to purchase
63,135 shares of Common Stock at an exercise price of $4.28 per share. This
option vests over five years on each anniversary of January 2, 1996.

The following table sets forth information for the Named Executive Officers
regarding the value of unexercised options held as of December 31, 1996. No
options were exercised by the Named Executive Officers during the year ended
December 31, 1996.

FISCAL YEAR-END OPTION VALUES

<TABLE>
<CAPTION>
VALUE OF UNEXERCISED
NUMBER OF SECURITIES IN-THE-MONEY
UNDERLYING UNEXERCISED OPTIONS AT OPTIONS AT
DECEMBER 31, 1996(#) DECEMBER 31, 1996($)(1)
NAME (EXERCISABLE/UNEXERCISABLE) (EXERCISABLE/UNEXERCISABLE)
- ------------------------------------------------ ---------------------------------- ---------------------------
<S> <C> <C>
Robert J. McNeill (2)........................... --/140,300 $ --/$899,323
Fred C. McGee................................... --/ 63,135(3) --/ 404,695
</TABLE>

- --------------

(1) Calculated by determining the difference between the fair market value of
the securities underlying the option at December 23, 1996 ($10.69 per share
as determined by the Board of Directors) and the exercise price of the
option.

(2) The Company has agreed to pay to Mr. McNeill a cash bonus in the amount of
the difference, if any, between (i) the net value of the options at the end
of the third anniversary of their date of issuance and (ii) $1,550,000. See
"--Employment Agreement."

(3) Includes options to purchase 12,627 shares which vested on January 2, 1997.

31
<PAGE>
EMPLOYMENT AGREEMENT

The Company entered into an employment agreement effective as of November
11, 1996 with Robert McNeill, its Executive Vice President and Chief Operating
Officer. The agreement provides for (i) a base salary of $175,000 per year, (ii)
a one-time signing bonus not to exceed $105,000 and (iii) up to $120,000 in
annual bonus compensation, subject to achievement by the Company of specified
performance goals. In addition, the Company granted to Mr. McNeill non-qualified
stock options to purchase 140,300 shares of Common Stock at an exercise price of
$4.28 per share, and has agreed to pay to Mr. McNeill a cash bonus in the amount
of the difference, if any, between (i) the net value of the options at the end
of the third anniversary of their date of issuance and (ii) $1,550,000. The
agreement also contains provisions designed to ensure that the after-tax effect
of the options issued to Mr. McNeill will be equivalent to the result that would
pertain had they been issued as incentive stock options ("ISOs") rather than
non-qualified stock options. To accomplish this, the agreement provides that (i)
the Company loan to Mr. McNeill on an interest fee basis an amount of money
equal to the tax liability he incurs upon exercise of the options in excess of
the amount that would have been incurred had the options been originally issued
as ISOs, and (ii) the aforementioned loan will become due and payable at the
earlier of (a) the time of sale or disposition of the shares subject to the
options, (b) the termination date of Mr. McNeill's employment with the Company
or (c) January 17, 2002. The loan amount subject to repayment will be reduced by
the amount, if any, by which the cumulative tax liability on exercise of the
options and on disposition of the underlying shares by Mr. McNeill exceeds the
tax that would have been incurred had the options originally been issued as
ISOs. In the event that Mr. McNeill is terminated without cause, he will be
entitled to severance payments in an aggregate amount not to exceed 18 months of
his base salary. See "Certain Transactions."

DIRECTOR COMPENSATION

Directors of the Company do not receive cash for services that they provide
as directors or as committee members. The Company has granted to each
non-employee director an option to purchase 21,045 shares of Common Stock at an
exercise price of $4.28 per share. These options vest over three years. The
Company anticipates that it will compensate its independent directors in the
future. See "Management -- 1996 Stock Option Plan" and "Certain Transactions."

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

In 1996, the Compensation Committee of the Board of Directors consisted of
Messrs. Daniel Daou and Moragne and currently consists of Messrs. Jahns,
McDonagh and Moragne. Entities affiliated with Messrs. Jahns, McDonagh and
Moragne have purchased 1,052,975, 210,596 and 737,083 shares of Common Stock,
respectively. No executive officer of the Company served on the compensation
committee of another entity or on any other committee of the board of directors
of another entity performing similar functions during the last fiscal year.

1996 STOCK OPTION PLAN

The Company's 1996 Stock Option Plan (the "1996 Stock Option Plan") provides
for the grant of incentive stock options to employees and nonstatutory stock
options to employees, directors and consultants. A total of 1,367,925 shares of
Common Stock have been reserved for issuance under the 1996 Stock Option Plan,
under which options to purchase 941,413 shares of Common Stock have been granted
as of December 31, 1996. Options granted under the 1996 Stock Option Plan
typically vest over five years. The Compensation Committee of the Board of
Directors administers the 1996 Stock Option Plan and determines the exercise
price of options granted thereunder. The exercise price of incentive stock
options must be at least equal to the fair market value of the Common Stock on
the date of grant. In addition, the exercise price of any stock option granted
to an optionee who owns stock representing more than 10% of the voting power of
all classes of stock of the Company must equal at least 110% of the fair market
value of the Common Stock on the date of grant. The exercise price may be paid
in such consideration as determined by the Board of Directors. With respect to
any participant who owns stock representing more than 10% of the voting power of
all classes of stock of the Company, the term of the option is limited to five
years or less. The term for all other options may not exceed ten years.

The Board of Directors may amend or modify the 1996 Stock Option Plan at any
time without the consent of the optionees, so long as such action does not
adversely affect their outstanding options. The

32
<PAGE>
1996 Stock Option Plan will terminate in 2006, unless terminated earlier by the
Board of Directors. Each outstanding option provides that, in the event of a
"change in control," including the dissolution or liquidation of the Company or
a merger of the Company with or into another corporation, each optionee will be
entitled to exercise up to 70% of the shares of Common Stock underlying his
unvested options immediately prior to the consummation of such "change in
control" event.

SECTION 401(K) PLAN

In August, 1994, the Company adopted a 401(k) Salary Savings Plan (the
"401(k) Plan") covering the Company's full-time employees located in the United
States. The 401(k) Plan is intended to qualify under Section 401(k) of the
Internal Revenue Code, so that contributions to the 401(k) Plan by employees or
by the Company, and the investment earnings thereon, are not taxable to
employees until withdrawn from the 401(k) Plan, and so that contributions by the
Company, if any, will be deductible by the Company when made. Pursuant to the
401(k) Plan, employees may elect to reduce their current compensation by up to
the statutorily prescribed annual limit ($9,500 in 1996) and to have the amount
of such reduction contributed to the 401(k) Plan. The 401(k) Plan permits, but
does not require, additional matching contributions to the 401(k) Plan by the
Company on behalf of all participants in the 401(k) Plan.

LIMITATIONS ON DIRECTORS' LIABILITY AND INDEMNIFICATION

The Company has adopted provisions in its Certificate of Incorporation that
limit the liability of directors to the maximum extent permitted by Delaware
law. Delaware law provides that directors of a corporation will not be
personally liable for monetary damages for breach of their fiduciary duties as
directors, except liability for (i) any breach of their duty of loyalty to the
corporation or its stockholders, (ii) acts or omissions not in good faith or
which involve intentional misconduct or a knowing violation of law, (iii)
unlawful payments of dividends or unlawful stock repurchases or redemptions, or
(iv) any transaction from which the director derived an improper personal
benefit. Such limitation of liability does not apply to liabilities arising
under the federal securities laws and does not affect the availability of
equitable remedies such as injunctive relief or rescission.

The Company's Bylaws provide that the Company shall indemnify its directors
and executive officers and may indemnify its other officers and employees and
other agents to the fullest extent permitted by law. The Company believes that
indemnification under its Bylaws covers at least negligence and gross negligence
on the part of indemnified parties. The Company's Bylaws also permit it to
secure insurance on behalf of any officer, director, employee or other agent for
any liability arising out of his or her actions in such capacity, regardless of
whether the Bylaws permit such indemnification.

The Company has entered into agreements to indemnify its directors and
executive officers, in addition to indemnification provided for in the Company's
Bylaws. These agreements, among other things, indemnify the Company's directors
and executive officers against expenses (including attorneys' fees), judgments,
fines and settlement amounts incurred by any such person in any action or
proceeding, including expenses incurred in connection with any action by or in
the right of the Company, arising out of such person's services as a director or
executive officer of the Company, any subsidiary of the Company or any other
company or enterprise to which the person provides services at the request of
the Company. The Company believes that these provisions and agreements are
necessary to attract and retain qualified persons as directors and executive
officers.

The Company's indemnification provisions set forth in its Certificate of
Incorporation, Bylaws and agreements with directors and executive officers
provide for broad indemnification under Delaware law with no express exclusion
for liabilities arising under or in connection with the Securities Act of 1933
(the "Securities Act"). Insofar as indemnification for liabilities arising under
the Securities Act may be permitted to directors, officers and controlling
persons of the Company pursuant to the foregoing provisions, or otherwise, the
Company has been advised that, in the opinion of the Securities and Exchange
Commission, such indemnification is against public policy as expressed in the
Securities Act and is, therefore, unenforceable. At present, there is no pending
litigation or proceeding involving a director or officer of the Company in which
indemnification is required or permitted, and the Company is not aware of any
threatened litigation or proceeding that may result in a claim for such
indemnification.

33
<PAGE>
CERTAIN TRANSACTIONS

In October 1995, the Company issued and sold an aggregate of 1,603,430
shares of Preferred Stock at a purchase price of $4.99 per share. Upon the
completion of this offering, each share of Preferred Stock will convert into one
share of Common Stock. In connection with the Company's sale of Preferred Stock,
Georges Daou, Daniel Daou and Joseph Daou sold an aggregate of 818,416 shares of
Common Stock to the same investors at $4.28 per share. The purchasers of such
shares of Common Stock and Preferred Stock included, among others, the following
entities affiliated with directors of the Company:

<TABLE>
<CAPTION>
SHARES OF SHARES OF
NAME COMMON STOCK PREFERRED STOCK
- ------------------------------------------------------------------------------- --------------- ----------------
<S> <C> <C>
ENTITIES AFFILIATED WITH DIRECTORS
Galen Partners II, L.P. (1).................................................. 256,251 502,041

Galen Partners International II, L.P. (1).................................... 98,043 192,086

Galen Employee Fund, L.P. (1)................................................ 1,539 3,015

Information Associates, L.P. (2)............................................. 242,321 474,751

Information Associates, C.V. (2)............................................. 6,762 13,249

HLM Partners VII, L.P. (3)................................................... 71,167 139,429
</TABLE>

- --------------

(1) David Jahns, a director of the Company, is a Vice President of Galen
Associates, which is affiliated with Galen Partners II, L.P., Galen Partners
International II, L.P. and Galen Employee Fund, L.P. Mr. Jahns disclaims
beneficial ownership of the shares held by these entities, except to the
extent of his interest in the shares of Galen Employee Fund, L.P. arising
from his limited partnership interest in such fund. In addition, the Company
has granted to Mr. Jahns options to purchase 21,045 shares of Common Stock
at a price of $4.28 per share.

(2) John Moragne, a director of the Company, is a member of Trident Capital
Management, LLC, the general partner of Information Associates, L.P. and
Information Associates, C.V. Mr. Moragne disclaims beneficial ownership of
the shares held by these entities, except to the extent of his interest in
such shares arising from his interest in Trident Capital Management, LLC. In
addition, the Company has granted to Mr. Moragne options to purchase 21,045
shares of Common Stock at a price of $4.28 per share.

(3) Bernard McDonagh, a director of the Company, is the Vice President, Investor
Relations and Business Research at United Healthcare Corporation, which is
affiliated with HLM Partners VII, L.P. Mr. McDonagh disclaims beneficial
ownership of the shares held by this entity. In addition, the Company has
granted to Mr. McDonagh options to purchase 21,045 shares of Common Stock at
a price of $4.28 per share.

The Company has an employment agreement with Robert McNeill, its Executive
Vice President and Chief Operating Officer. See "Management -- Employment
Agreement."

Complex Network Solutions, Inc. ("CNS"), a company founded in October 1992
by Georges Daou, Daniel Daou and Joseph Daou and of which Daniel Daou served as
President, provided certain engineering services to the Company from October
1992 to December 1994. The Company paid an aggregate of approximately $1.6
million for these services in 1994, but does not intend to enter into any future
business arrangements with CNS.

The Company has from time to time granted options and other compensation to
its directors and executive officers. See "Management -- Executive
Compensation," "-- Director Compensation," "-- 1996 Stock Option Plan" and
"Principal Stockholders."

The Company loaned to Georges Daou, Daniel Daou and Joseph Daou certain
amounts for personal use. As of December 31, 1996, the balances of these loans
to Messrs. George Daou, Daniel Daou and Joseph Daou were $79,709, $77,374 and
$70,797, respectively. These loans are unsecured, accrue interest at the rate of
6% per annum and are due and payable prior to the completion of this offering.

34
<PAGE>
All future transaction, including any loans from the Company to its
officers, directors, principal stockholders or affiliates, will be approved by a
majority of the Board of Directors, including a majority of the disinterested
members of the Board of Directors or, if required by law, a majority of
disinterested stockholders, and will be on terms no less favorable to the
Company than could be obtained from unaffiliated third parties.

35
<PAGE>
PRINCIPAL STOCKHOLDERS

The following table sets forth information known to the Company with respect
to the beneficial ownership of its Common Stock as of December 31, 1996, and as
adjusted to reflect the sale of Common Stock offered by the Company hereby and
conversion of all outstanding shares of Preferred Stock into shares of Common
Stock, for (i) each person who is known by the Company to own beneficially more
than five percent of the Common Stock, (ii) each of the Company's directors,
(iii) each of the Named Executive Officers and (iv) all directors and executive
officers as a group. Unless otherwise indicated in the footnotes to the table
set forth below, each person or entity named below has an address in care of the
Company's principal executive offices.

<TABLE>
<CAPTION>
SHARES BENEFICIALLY OWNED SHARES BENEFICIALLY
BEFORE OWNED AFTER
OFFERING OFFERING
------------------------- -------------------------
NAMES AND ADDRESSES(1) NUMBER PERCENT NUMBER PERCENT
- ------------------------------------------------------------------ ----------- ------------ ----------- ------------
<S> <C> <C> <C> <C>
Georges J. Daou (2)............................................... 1,957,361 23.7% 1,957,361 19.1%
Chairman of the Board and
Chief Executive Officer

Daniel J. Daou (3)................................................ 1,952,361 23.6 1,952,361 19.0
President and Director

Joseph H. Daou (4)................................................ 1,660,661 20.1 1,660,661 16.2
Former Treasurer and Former Director

Entities Affiliated with Galen Associates (5)..................... 1,059,990 12.8 1,059,990 10.3
666 Third Avenue, Suite 1400
New York, New York 10017-4011

Entities Affiliated with Trident Capital (6)...................... 744,098 9.0 744,098 7.2
2480 Sand Hill Road, Suite 100
Menlo Park, California 94025

HLM Partners VII, L.P. (7)........................................ 217,611 2.6 217,611 2.1
222 Berkeley Street
Boston, Massachusetts 02116

All directors and executive officers as a group
(10 persons) (8)................................................ 5,632,115 67.6% 5,632,115 54.5%
</TABLE>

- --------------

(1) Except as otherwise indicated in the footnotes to this table and pursuant to
applicable community property laws, the persons named in the table have sole
voting and investment power with respect to all shares of Common Stock.
Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission and generally includes voting or
investment power with respect to securities. Shares of Common Stock subject
to options or warrants exercisable within 60 days of December 31, 1996 are
deemed outstanding for computing the percentage of the person or entity
holding such options but are not deemed outstanding for computing the
percentage of any
other person.

(2) These shares are owned by the Georges J. Daou Trust dated May 2, 1996, of
which George J. Daou is trustee. This shareholder intends to transfer
approximately 8,888 shares of Common Stock to certain Daou family members
upon the effectiveness of this Registration Statement.

(3) These shares are owned by the Daniel and Robin Daou Family Trust dated May
29, 1996, of which Daniel J. Daou and Robin Lyn Daou are trustees. This
shareholder intends to transfer approximately 19,998 shares of Common Stock
to certain Daou family members upon the effectiveness of this Registration
Statement.

(4) These shares are owned by the Joseph and Marie Daou Family Trust dated March
11, 1996, of which Joseph H. Daou and Marie J. Daou are trustees. This
shareholder intends to transfer approximately

36
<PAGE>
13,332 shares of Common Stock to certain Daou family members upon the
effectiveness of this Registration Statement.

(5) Of the total shares indicated as beneficially owned, Galen Partners II, L.P.
owns 758,292 shares which represent 9.2% and 7.4% of total shares before and
after this offering, respectively. Galen Partners International II, L.P.
owns 290,129 shares which represent 3.5% and 2.8% of total shares before and
after this offering, respectively. Galen Employee Fund, L.P. owns 4,554
shares which represent less than one percent of total shares before and
after this offering. The general partner of Galen Partners II, L.P., a
Delaware limited partnership, and Galen Partners International II, L.P., a
Delaware limited partnership, is GWW Partners, L.P., a Delaware limited
partnership, the general partners of which are William R. Grant, L. John
Wilkerson, Bruce F. Wesson and Rebound Two (Delaware), L.L.C., a Delaware
limited liability company. Mr. Wesson is also the general partner of Galen
Employee Fund, L.P., a Delaware limited partnership. The total share amounts
for the "Entities Affiliated with Galen Associates" set forth in the above
table include 7,015 shares issuable under stock options held by David Jahns,
a director of the Company, which are exercisable within 60 days of December
31, 1996. Mr. Jahns is a Vice President of Galen Associates, the investment
manager of these entities, and a limited partner of Galen Employee Fund,
L.P. Mr. Jahns disclaims beneficial ownership of the shares held by these
entities, except to the extent of his interest in the shares of Galen
Employee Fund, L.P. arising from his interest in such entity.

(6) Of the total shares indicated as beneficially owned, Information Associates,
L.P. owns 717,072 shares which represent 8.7% and 7.0% of total shares
before and after this offering, respectively. Information Associates, C.V.
owns 20,011 shares which represent less than one percent of total shares
before and after this offering. Information Associates, L.P. is a Delaware
limited partnership and Information Associates, C.V. is a Netherlands
Antilles limited partnership. The general partner of each of these entities
is Trident Capital Management, L.L.C., a Delaware limited liability company
("Trident Capital"), the members of which include Donald R. Dixon, Stephen
M. Hall, Robert C. McCormack, Rockwell A. Schnabel and John Moragne, a
director of the Company. The total share amounts for the "Entities
Affiliated with Trident Capital" set forth in the above table include 7,015
shares issuable under stock options held by Mr. Moragne which are
exercisable within 60 days of December 31, 1996. Mr. Moragne disclaims
beneficial ownership of the shares held by these entities, except to the
extent of his interest in such shares arising from his interest in Trident
Capital.

(7) Includes 7,015 shares issuable under stock options granted to Bernard
McDonagh, a director of the Company, which are exercisable within 60 days of
December 31, 1996. HLM Partners VII, L.P. is a Delaware limited partnership
and its general partner is HLM Associates VII, L.P., a Delaware limited
partnership. The general partners of HLM Associates VII, L.P. are Peter
Grua, James Mahoney, Frances Hawk, Judith Lawrie and A.R. Haberkorn, III.

(8) Includes 61,732 shares issuable under stock options held by directors and
executive officers exercisable within 60 days of December 31, 1996.

37
<PAGE>
DESCRIPTION OF CAPITAL STOCK

The authorized capital stock of the Company will consist of 50,000,000
shares of Common Stock, par value $0.001 per share, and 5,000,000 shares of
Preferred Stock, par value $0.001 per share, after giving effect to the
Company's reincorporation in Delaware and the completion of this offering. The
following summaries of certain provisions of the Common Stock and Preferred
Stock do not purport to be complete and are subject to, and qualified in their
entirety by, the provisions of the Company's Restated Certificate of
Incorporation, which is included as an exhibit to the Registration Statement of
which this Prospectus forms a part, and by applicable law.

COMMON STOCK

As of December 31, 1996, after giving effect to the conversion of all shares
of Preferred Stock into shares of Common Stock, there were 8,267,678 shares of
Common Stock outstanding, which were held of record by 19 stockholders. The
holders of Common Stock are entitled to one vote per share on all matters
submitted to a vote of the stockholders. Subject to preferences that may be
applicable to outstanding shares of Preferred Stock, if any, holders of Common
Stock are entitled to receive ratably such dividends, if any, as may be declared
from time to time by the Board of Directors out of funds legally available
therefor. See "Dividend Policy." In the event of a liquidation, dissolution or
winding up of the Company, holders of Common Stock are entitled to share ratably
in all assets remaining after payment of the Company's liabilities and the
liquidation preference, if any, of any outstanding shares of Preferred Stock.
Holders of Common Stock have no preemptive rights and no rights to convert their
shares of Common Stock into any other securities, and there are no redemption or
sinking fund provisions with respect to such shares. All of the outstanding
shares of Common Stock are fully paid and non-assessable, and the shares of
Common Stock to be outstanding upon the completion of this offering will be
fully paid and non-assessable. The rights, preferences and privileges of holders
of Common Stock are subject to, and may be adversely affected by, the rights of
the holders of shares of any series of Preferred Stock which the Company may
designate and issue in the future.

PREFERRED STOCK

The Board of Directors has the authority, without action by the
stockholders, to designate and issue Preferred Stock in one or more series and
to designate the rights, preferences and privileges of each series, any or all
of which may be greater than the rights of the Common Stock. It is not possible
to state the actual effect of the issuance of any shares of Preferred Stock upon
the rights of holders of the Common Stock until the Board of Directors
determines the specific rights of the holders of such Preferred Stock. However,
the effects might include, among other things, restricting dividends on the
Common Stock, diluting the voting power of the Common Stock, impairing the
liquidation rights of the Common Stock and delaying or preventing a change in
control of the Company without further action by the stockholders. The Company
has no present plans to issue any shares of Preferred Stock.

WARRANTS

Upon the completion of this offering and the conversion of all of the issued
and outstanding shares of the Company's Preferred Stock into Common Stock, the
Company will have two warrants outstanding, exercisable into a total of 133,285
shares of Common Stock at an exercise price of $4.99 per share. The warrants
expire on October 26, 2000.

REGISTRATION RIGHTS

The holders of approximately 2,421,846 shares of Common Stock and warrants
to purchase 133,285 shares of Common Stock (collectively the "Registrable
Securities"), or their transferees, are entitled to certain rights with respect
to the registration of such shares under the Securities Act. These rights are
provided under the terms of the Investors' Rights Agreement between the Company
and such holders. Subject to certain limitations in such agreement, the holders
of a majority of the Registrable Securities

38
<PAGE>
have the right to require on one occasion that the Company register their shares
for public resale. In addition, if the Company registers any of its Common Stock
either for its own account or for the account of any other stockholders, the
holders of Registrable Securities are entitled to include their shares of Common
Stock in up to two registrations. A holder's right to include shares in an
underwritten registration is subject to the good faith determination by the
Company that the inclusion of such shares is compatible with the success of the
offering. All expenses incurred in connection with any registration effected
pursuant to the Investors' Rights Agreement (other than the underwriting
discounts and commissions) will be borne by the Company. The foregoing
registration rights terminate seven years following the consummation of this
offering.

CERTAIN CHANGE OF CONTROL PROVISIONS

As a Delaware corporation, the Company is subject to Section 203 of the
Delaware General Corporation Law, an anti-takeover law. In general, Section 203
prohibits a publicly-held Delaware corporation from engaging in a "business
combination" with an "interested stockholder" for a period of three years
following the date that the person became an interested stockholder, unless
(with certain exceptions) the "business combination" or the transaction in which
the person became an interested stockholder is approved in a prescribed manner.
Generally, a "business combination" incudes a merger, asset or stock sale, or
other transaction resulting in a financial benefit to the interested
stockholder. Generally, an "interested stockholder" is a person who, together
with affiliates and associates, owns (or within three years prior to the
determination of interested stockholder status, did own) 15% or more of a
corporation's voting stock. The existence of this provision would be expected to
have anti-takeover effects with respect to transactions not approved in advance
by the Board of Directors, such as discouraging takeover attempts that might
result in a premium over the market price of the Common Stock.

The Company's Certificate of Incorporation provides that the Board of
Directors will be divided into three classes of directors, with each class
serving a staggered three-year term. The classification system of electing
directors may tend to discourage a third party from making a tender offer or
otherwise attempting to obtain control of the Company and may maintain the
incumbency of the Board of Directors, as a classified board of directors
generally increases the difficulty of replacing a majority of the directors. The
Certificate of Incorporation and Bylaws do not provide for cumulative voting in
the election of directors and allow for the removal of directors only for cause
and with a two-thirds vote of the Company's outstanding shares. In addition, the
Company's Certificate of Incorporation and Bylaws eliminate the right of
stockholders to act by written consent without a meeting and require advanced
stockholder notice to nominate directors and raise matters at the annual
stockholders meeting. Furthermore, the authorization of undesignated Preferred
Stock makes it possible for the Board of Directors to issue Preferred Stock with
voting or other rights or preferences that could impede the success of any
attempt to change control of the Company. These and other provisions may have
the effect of deferring hostile takeovers or delaying changes in control or
management of the Company. The amendment of any of these provisions would
require approval by holders of at least two-thirds of the outstanding shares of
Common Stock.

TRANSFER AGENT AND REGISTRAR

The transfer agent and registrar for the Company's Common Stock is
Continental Stock Transfer & Trust Company. Its telephone number is (212)
509-4000.

39
<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE

Prior to this offering, there has been no market for the Common Stock of the
Company. Future sales of substantial amounts of Common Stock in the public
market could adversely affect market prices prevailing from time to time and the
ability of the Company to raise equity capital in the future.

Upon the completion of this offering, the Company will have 10,267,678
shares of Common Stock outstanding, assuming no exercise of the Underwriters'
over-allotment, option and no exercise of outstanding warrants or outstanding
options granted under the 1996 Stock Option Plan after December 31, 1996. Of
these shares, the 2,000,000 shares of Common Stock sold in this offering will be
freely tradeable without restriction under the Securities Act, unless held by
"affiliates" of the Company, as that term is defined in Rule 144 under the
Securities Act. The remaining 8,267,678 shares of Common Stock held by existing
stockholders will be "restricted securities" as that term is defined in Rule 144
of the Securities Act (the "Restricted Shares"). The Restricted Shares may be
sold in the public market only if registered under the Securities Act or if they
qualify for an exemption from registration under Rule 144 or Rule 701
promulgated under the Securities Act. Sales of the Restricted Shares in the
public market, or the availability of such shares for sale, could adversely
affect the market price of the Common Stock.

The holders of all of the Restricted Shares have entered into lock-up
agreements, under which they have agreed not to offer, sell, contract to sell,
grant any option to purchase or otherwise dispose of, or agree to dispose of,
directly or indirectly, any shares of Common Stock, options or warrants to
acquire shares of Common Stock or securities exchangeable for or convertible
into Common Stock owned by them for a period of 180 days after the date of this
Prospectus, without the prior written consent of Alex. Brown & Sons
Incorporated. The Company has entered into a similar agreement, except that it
may issue, and grant options to purchase, shares of Common Stock under the 1996
Stock Option Plan and pursuant to currently outstanding warrants.

As of December 31, 1996, an aggregate of 941,413 shares were subject to
outstanding options under the 1996 Stock Option Plan and 133,285 shares were
subject to outstanding warrants. All of these shares are subject to the lock-up
agreements described above. After the date of this Prospectus, the Company
intends to file a registration statement on Form S-8 covering shares issuable
under the 1996 Stock Option Plan (including shares subject to then outstanding
options), thus permitting the resale of such shares in the public market without
restriction under the Securities Act after expiration of the lock-up agreements.
Based on the number of shares reserved for issuance and previously exercised,
approximately 1,367,925 shares will be registered. Accordingly, shares
registered under such registration statement will, subject to Rule 144 volume
limitations applicable to affiliates, be available for sale in the public
market, unless such shares are subject to vesting restrictions with the Company
or the lock-up agreements described above.

Upon expiration of the lock-up agreements, 5,703,574 shares of Common Stock
(including approximately 133,191 shares subject to outstanding vested options)
will become eligible for immediate public resale, subject in some cases to
volume limitations pursuant to Rule 144. The remaining approximately 2,697,295
shares held by existing stockholders will become eligible for public resale at
various times over a period of less than two years following the completion of
this offering, subject in some cases to vesting provisions and volume
limitations. Approximately 2,421,846 of the shares outstanding immediately
following the completion of this offering will be entitled to registration
rights with respect to such shares upon the release of lock-up agreements. The
number of shares sold in the public market could increase if such rights are
exercised.

In general, under Rule 144 as currently in effect, a person (or persons
whose shares are aggregated) who has beneficially owned shares for at least two
years (including the holding period of any prior owner, except an affiliate) is
entitled to sell in "broker's transactions" or to market makers, within any
three-month period commencing 90 days after the date of this Prospectus, a
number of shares that does not exceed the greater of (i) one percent of the
number of shares of Common Stock then outstanding (approximately 102,677 shares
immediately after this offering) or (ii) the average weekly trading volume of
the Common Stock during the four calendar weeks preceding the required filing of
a Form 144 with respect to such sale. Sales under Rule 144 are generally subject
to certain manner of sale provisions and

40
<PAGE>
notice requirements and to the availability of current public information about
the Company. Under Rule 144(k), a person who is not deemed to have been an
affiliate of the Company at any time during the 90 days preceding a sale, and
who has beneficially owned the shares proposed to be sold for at least three
years, is entitled to sell such shares without having to comply with the manner
of sale, public information, volume limitation or notice provisions of Rule 144.
Under Rule 701 under the Securities Act, persons who purchase shares upon
exercise of options granted prior to the effective date of this offering are
entitled to sell such shares 90 days after the effective date of this offering
in reliance on Rule 144, without having to comply with the holding period
requirements of Rule 144 and, in the case of nonaffiliates, without having to
comply with the public information, volume limitation or notice provisions of
Rule 144.

The Securities and Exchange Commission (the "Commission") has recently
proposed reducing the initial Rule 144 holding period to one year and the Rule
144(k) holding period to two years. There can be no assurance as to when or
whether such rule changes will be enacted. If enacted, such modification will
have a material effect on the time when shares of the Company's Common Stock
become eligible for resale.

41
<PAGE>
UNDERWRITING

Subject to the terms and conditions of the Underwriting Agreement, the
Underwriters named below (the "Underwriters"), through their Representatives,
Alex. Brown & Sons Incorporated, Cowen & Company and Hambrecht & Quist LLC, have
severally agreed to purchase from the Company the following respective numbers
of shares of Common Stock at the initial public offering price less the
underwriting discounts and commissions set forth on the cover page of this
Prospectus:

<TABLE>
<CAPTION>
NUMBER OF
UNDERWRITER SHARES
- ----------------------------------------------------------------------------------------------------- -----------
<S> <C>
Alex. Brown & Sons Incorporated...................................................................... 485,000
Cowen & Company...................................................................................... 485,000
Hambrecht & Quist LLC................................................................................ 485,000
Merrill Lynch, Pierce, Fenner & Smith Incorporated................................................... 50,000
Montgomery Securities................................................................................ 50,000
Morgan Stanley & Co. Incorporated.................................................................... 50,000
Oppenheimer & Co., Inc............................................................................... 50,000
Robertson, Stephens & Company LLC.................................................................... 50,000
Smith Barney Inc..................................................................................... 50,000
Brean Murray & Co., Inc.............................................................................. 35,000
Furman Selz LLC...................................................................................... 35,000
Jefferies & Company.................................................................................. 35,000
McDonald & Company Securities, Inc................................................................... 35,000
Needham & Company, Inc............................................................................... 35,000
Punk, Ziegel & Knoell................................................................................ 35,000
Wessels, Arnold & Henderson, L.L.C................................................................... 35,000
-----------

Total................................................................................................ 2,000,000
-----------
-----------
</TABLE>

The Underwriting Agreement provides that the obligations of the Underwriters
are subject to certain conditions precedent and that the Underwriters will
purchase all shares of the Common Stock offered hereby if any of such shares are
purchased.

The Company has been advised by the Representatives of the Underwriters that
the Underwriters propose to offer the shares of Common Stock to the public at
the initial public offering price set forth on the cover page of this Prospectus
and to certain dealers at such price less a concession not in excess of $0.35.
The Underwriters may allow, and such dealers may reallow, a concession not in
excess of $0.10 per share to certain other dealers. After the initial public
offering, the offering price and other selling terms may be changed by the
Representatives of the Underwriters.

The Company has granted to the Underwriters an option, exercisable not later
than 30 days after the date of this Prospectus, to purchase up to 300,000
additional shares of Common Stock at the initial public offering price less the
underwriting discounts and commissions set forth on the cover page of this
Prospectus. To the extent that the Underwriters exercise such option, each of
the Underwriters will have a firm commitment to purchase approximately the same
percentage thereof that the number of shares of Common Stock to be purchased by
it shown in the above table bears to 2,000,000, and the Company will be
obligated, pursuant to the option, to sell such shares to the Underwriters. The
Underwriters may exercise such option only to cover over-allotments made in
connection with the sale of Common Stock offered hereby. If purchased, the
Underwriters will offer such additional shares on the same terms as those on
which the 2,000,000 shares are being offered.

The Company has agreed to indemnify the Underwriters against certain
liabilities, including liabilities under the Securities Act of 1933, as amended.
Stockholders of the Company, holding in the aggregate 8,267,678 shares of Common
Stock, have agreed not to offer, sell or otherwise dispose of any of such shares
of Common Stock for a period of 180 days after the date of this Prospectus
without the prior written consent of Alex. Brown & Sons Incorporated. The
Company has entered into a similar

42
<PAGE>
agreement, except that it may issue, and grant options to purchase, shares of
Common Stock under the 1996 Stock Option Plan and pursuant to currently
outstanding warrants. See "Shares Eligible for Future Sale."

The Representatives of the Underwriters have advised the Company that the
Underwriters do not intend to confirm sales to any account over which they
exercise discretionary authority.

Prior to this offering, there has been no public market for the Common Stock
of the Company. Consequently, the initial public offering price for the Common
Stock was determined by negotiation among the Company and the Representatives of
the Underwriters. Among the factors considered in such negotiations were
prevailing market conditions, the results of operations of the Company in recent
periods, the market capitalizations and stages of development of other companies
which the Company and the Representatives of the Underwriters believe to be
comparable to the Company, estimates of the business potential of the Company,
the present stage of the Company's development and other factors deemed
relevant.

LEGAL MATTERS

Certain legal matters with respect to the legality of the issuance of the
shares of Common Stock offered hereby will be passed upon for the Company by
Baker & McKenzie, San Diego, California. Certain legal matters related to this
offering will be passed upon for the Underwriters by Cooley Godward LLP, San
Diego, California.

EXPERTS

The Financial Statements of the Company at December 31, 1995 and 1996 and
for each of the three years in the period ended December 31, 1996 appearing in
this Prospectus and Registration Statement have been audited by Ernst & Young
LLP, independent auditors, as set forth in their report thereon appearing
elsewhere herein and in the Registration Statement, and are included in reliance
upon such report given upon the authority of such firm as experts in accounting
and auditing.

ADDITIONAL INFORMATION

The Company is not currently subject to the information requirements of the
Securities Exchange Act of 1934, as amended (the "Exchange Act"). As a result of
this offering, the Company will be required to file reports and other
information with the Commission pursuant to the informational requirements of
the Exchange Act.

The Company has filed with the Commission a Registration Statement on Form
SB-2 under the Securities Act, with respect to the Common Stock offered hereby.
As permitted by the rules and regulations of the Commission, this Prospectus,
which is part of the Registration Statement, omits certain information,
exhibits, schedules and undertakings set forth in the Registration Statement.
For further information pertaining to the Company and the Common Stock,
reference is made to such Registration Statement and the exhibits and schedules
thereto. Statements contained in this Prospectus as to the contents or
provisions of any documents referred to herein are not necessarily complete, and
in each instance, reference is made to the copy of the document filed as an
exhibit to the Registration Statement. The Registration Statement may be
inspected without charge at the office of the Commission at 450 Fifth Street,
N.W., Washington, D.C. 20549. Copies of the Registration Statement may be
obtained from the Commission at prescribed rates from the Public Reference
Section of the Commission at such address, and at the Commission's regional
offices located at 7 World Trade Center, 13th Floor, New York, New York 10048,
and at Northwestern Atrium Center, 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661. In addition, registration statements and certain other filings
made with the Commission through its Electronic Data Gathering, Analysis and
Retrieval ("EDGAR") system are publicly available through the Commission's site
on the Internet's World Wide Web, located at http://www.sec.gov. The
Registration Statement, including all exhibits thereto and amendments thereof,
has been filed with the Commission through EDGAR.

43
<PAGE>
The Company intends to furnish to its stockholders annual reports containing
audited financial statements examined by independent auditors and quarterly
reports containing interim unaudited financial information for the first three
quarters of each fiscal year.

44
<PAGE>
DAOU SYSTEMS, INC.
INDEX TO FINANCIAL STATEMENTS

<TABLE>
<S> <C>
Report of Ernst & Young LLP, Independent Auditors......................... F-2

Balance Sheets at December 31, 1995 and 1996.............................. F-3

Statements of Operations for the years ended December 31, 1994, 1995 and
1996.................................................................... F-4

Statements of Stockholders' Equity for the years ended December 31, 1994,
1995 and 1996........................................................... F-5

Statements of Cash Flows for the years ended December 31, 1994, 1995 and
1996.................................................................... F-6

Notes to Financial Statements............................................. F-7
</TABLE>

F-1
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders

DAOU Systems, Inc.

We have audited the accompanying balance sheets of DAOU Systems, Inc. as of
December 31, 1995 and 1996 and the related statements of operations,
stockholders' equity, and cash flows for each of the three years in the period
ended December 31, 1996. 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 in accordance with generally accepted auditing
standards. 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 includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of DAOU Systems, Inc. at
December 31, 1995 and 1996 and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1996 in conformity
with generally accepted accounting principles.

ERNST & YOUNG LLP

San Diego, California
January 14, 1997

F-2
<PAGE>
DAOU SYSTEMS, INC.

BALANCE SHEETS

(IN THOUSANDS)

ASSETS

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1996
--------- --------- PRO FORMA
STOCKHOLDERS'
EQUITY AT
DECEMBER 31,
1996
--------------
(UNAUDITED)
<S> <C> <C> <C>
Current assets:
Cash and cash equivalents..................................................... $ 2,599 $ 2,284 $ --
Short-term investments........................................................ 3,686 --
Accounts receivable........................................................... 5,038 4,085
Contract work in progress..................................................... 394 3,600
Deferred income taxes......................................................... 209 176
Other current assets.......................................................... 102 572
--------- ---------
Total current assets........................................................ 12,028 10,717
Due from officers/stockholders.................................................. 211 228
Equipment, furniture and fixtures, net.......................................... 280 827
Deferred income taxes........................................................... 10 23
Other assets.................................................................... 16 115
--------- ---------
$ 12,545 $ 11,910
--------- ---------
--------- ---------

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable........................................................ $ 607 $ 530
Accrued salaries and wages.................................................... 327 583
Deferred revenue.............................................................. 441 844
Other accrued liabilities..................................................... 1,306 745
Income taxes payable.......................................................... 975 99
--------- ---------
Total current liabilities................................................... 3,656 2,801
Deferred rent................................................................... 2 62
Commitments and contingencies...................................................
Redeemable preferred stock...................................................... 7,705 8,190

Stockholders' equity:

Preferred stock, $.001 par value:
Authorized shares -- 5,000
Issued and outstanding shares -- none....................................... -- -- --
Common stock, $.001 par value:
Authorized shares -- 50,000
Issued and outstanding shares -- 6,664 at December 31, 1995 and 1996 (8,268
shares pro forma)......................................................... 7 7 8
Additional paid-in capital.................................................... 3 1,246 8,863
Deferred compensation......................................................... -- (1,166) (1,166)
Accretion of redeemable preferred stock....................................... (87) (572) --
Retained earnings............................................................. 1,259 1,342 1,342
--------- --------- -------
Total stockholders' equity.................................................. 1,182 857 $ 9,047
--------- --------- -------
-------
$ 12,545 $ 11,910
--------- ---------
--------- ---------
</TABLE>

See accompanying notes.

F-3
<PAGE>
DAOU SYSTEMS, INC.

STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1994 1995 1996
--------- --------- ---------
<S> <C> <C> <C>
Revenues....................................................................... $ 8,521 $ 14,330 $ 19,311
Cost of revenues............................................................... 6,185 8,475 13,556
--------- --------- ---------
Gross profit................................................................... 2,336 5,855 5,755
Operating expenses:
Sales and marketing.......................................................... 796 938 1,853
General and administrative................................................... 1,507 2,893 3,897
--------- --------- ---------
2,303 3,831 5,750
--------- --------- ---------
Income from operations......................................................... 33 2,024 5
Interest income (expense), net................................................. 12 67 197
--------- --------- ---------
Income before income taxes..................................................... 45 2,091 202
Provision (benefit) for income taxes........................................... 19 851 119
--------- --------- ---------
Net income..................................................................... 26 1,240 83
Accretion of redeemable preferred stock........................................ -- 87 485
--------- --------- ---------
Net income (loss) attributable to common stock................................. $ 26 $ 1,153 $ (402)
--------- --------- ---------
--------- --------- ---------
Pro forma net income per share................................................. $ 0.01
---------
---------
Shares used in computing pro forma net income per common share................. 8,888
---------
---------
</TABLE>

See accompanying notes.

F-4
<PAGE>
DAOU SYSTEMS, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY

(IN THOUSANDS)

<TABLE>
<CAPTION>
ACCRETION OF
COMMON STOCK ADDITIONAL REDEEMABLE RETAINED
-------------- PAID-IN DEFERRED PREFERRED EARNINGS
SHARES AMOUNT CAPITAL COMPENSATION STOCK (DEFICIT) TOTAL
------ ------ ---------- ------------ ------------ ------- -------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31,
1993........................ 6,664 $ 7 $ 3 $ -- $ -- $ (7 ) $ 3
Net income.................. -- -- -- 26 26
------ ------ ---------- ------------ ------ ------- -------
Balance at December 31,
1994........................ 6,664 7 3 -- -- 19 29
Accretion of redeemable
preferred stock........... -- -- -- -- (87 ) -- (87)
Net income.................. -- -- -- -- -- 1,240 1,240
------ ------ ---------- ------------ ------ ------- -------
Balance at December 31,
1995........................ 6,664 7 3 -- (87 ) 1,259 1,182
Deferred compensation....... -- -- 1,243 (1,243 ) -- -- --
Amortization of deferred
compensation.............. -- -- -- 77 -- -- 77
Accretion of redeemable
preferred stock........... -- -- -- -- (485 ) -- (485)
Net income.................. -- -- -- -- -- 83 83
------ ------ ---------- ------------ ------ ------- -------
Balance at December 31,
1996........................ 6,664 $ 7 $ 1,246 $ (1,166 ) $ (572 ) $1,342 $ 857
------ ------ ---------- ------------ ------ ------- -------
------ ------ ---------- ------------ ------ ------- -------
</TABLE>

See accompanying notes.

F-5
<PAGE>
DAOU SYSTEMS, INC.

STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1994 1995 1996
--------- --------- ---------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income........................................................................ $ 26 $ 1,240 $ 83
Adjustments to reconcile net income to net cash provided by (used in) operating
activities:
Depreciation and amortization................................................... 101 252 280
Provision for uncollectible accounts............................................ -- -- 100
Deferred income taxes........................................................... (24) (192) 20
Changes in operating assets and liabilities:
Accounts receivable........................................................... (285) (4,642) 853
Contract work in progress..................................................... 213 179 (3,206)
Other assets.................................................................. (25) (81) (569)
Trade accounts payable........................................................ 331 96 (77)
Accrued salaries and wages.................................................... -- 167 256
Deferred revenue.............................................................. (399) (415) 403
Other accrued liabilities..................................................... 296 1,208 (561)
Income taxes payable.......................................................... -- 932 (876)
Deferred rent................................................................. 1 (29) 60
--------- --------- ---------
Net cash provided by (used in) operating activities............................... 235 (1,285) (3,234)

INVESTING ACTIVITIES
Purchases of equipment, furniture and fixtures.................................... (309) (215) (750)
Purchase of short-term investments................................................ -- (3,686) --
Maturities of short-term investments.............................................. -- -- 3,686
Advances to officers/stockholders................................................. (149) (306) (17)
Proceeds from repayment of due from officers...................................... 213 209 --
--------- --------- ---------
Net cash (used in) provided by investing activities............................... (245) (3,998) 2,919

FINANCING ACTIVITIES
Repayment of long-term debt....................................................... (4) -- --
Proceeds from issuance of redeemable preferred stock.............................. -- 7,618 --
--------- --------- ---------
Net cash (used in) provided by financial activities............................... (4) 7,618 --
--------- --------- ---------
(Decrease) increase in cash and cash equivalents.................................. (14) 2,335 (315)
Cash and cash equivalents at beginning of period.................................. 278 264 2,599
--------- --------- ---------
Cash and cash equivalents at end of period........................................ $ 264 $ 2,599 $ 2,284
--------- --------- ---------
--------- --------- ---------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Income taxes paid................................................................. $ -- $ 111 $ 975
--------- --------- ---------
--------- --------- ---------
</TABLE>

See accompanying notes.

F-6
<PAGE>
DAOU SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

ORGANIZATION

DAOU Systems, Inc. (the "Company") designs, implements, supports and manages
advanced computer network systems for hospitals, integrated healthcare delivery
systems and other healthcare provider organizations.

The Company's design services include an assessment of the customer's
existing computer network system and the preparation of voice, video and data
network specifications, technical design documentation and diagrams. DAOU's
implementation services include the purchase, delivery and installation of
enterprise-wide computer network systems. The Company's support and management
services are typically provided under multi-year contracts and include remote
and on-site network management services, as well as information systems
outsourcing. DAOU typically provides its services on a fixed-price, fixed-time
frame basis.

On November 12, 1996 the Company's Board of Directors approved the
reincorporation of the Company in Delaware which was accomplished through a
merger of the existing California corporation into a new Delaware corporation.
The ratio of exchange was 1.403 to one. The number of authorized shares of the
new Delaware corporation are 50,000,000 shares of common stock and 5,000,000
shares of preferred stock. All share and per share amounts and stock option data
have been restated to retroactively give effect to the reincorporation.

REVENUE RECOGNITION

Contract revenue for the development and implementation of network solutions
is recognized on the percentage-of-completion method with progress to completion
measured by labor costs incurred to date compared to total estimated labor
costs. Provisions for estimated losses on contracts, if any, are made during the
period when the loss becomes probable and can be reasonably estimated. Revenues
recognized in excess of amounts billed and project costs are classified as
contract work in progress. Revenue from technical support and network management
services is recognized over the period the services are performed. Payments
received in advance of services performed are recorded as deferred revenue.

CONCENTRATION OF CREDIT RISK

Substantially all of the Company's accounts receivable are from hospitals
and other healthcare providers. Generally, the Company obtains a significant
deposit from its customers upon signing a contract and collateral is not
required. The Company provides for losses from uncollectible accounts and such
losses have historically not exceeded management's expectations.

CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

Cash and cash equivalents consist of cash and highly liquid investments with
maturities of three months or less when purchased. Short-term investments are
recorded at amortized cost plus accrued interest which approximates market
value. The Company generally invests its excess cash in U.S. government
securities. The Company has established guidelines relative to diversification
and maturities that are periodically reviewed and modified to take advantage of
trends in yields and interest rates. The Company historically has not
experienced any losses on its cash equivalents or short-term investments.

The Company applies Statement of Financial Accounting Standards No. 115,
"Accounting for Certain Investments in Debt and Equity Securities" to value its
investments. Under the statement, the Company

F-7
<PAGE>
DAOU SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
classifies its short-term investments as "Available-for-Sale" and records such
assets at estimated fair value in the balance sheet. As of December 31, 1995 and
1996, the cost of cash equivalents and short-term investments was equal to
estimated fair value.

EQUIPMENT, FURNITURE AND FIXTURES

Equipment, furniture and fixtures are carried at cost. Depreciation is
computed using the straight-line method over the estimated useful lives of the
assets, generally three years. Leasehold improvements are amortized over the
estimated useful lives of the assets or the remaining lease term, whichever is
less.

USE OF ESTIMATES

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions about the future that affect the amounts reported in the financial
statements and disclosures made in the accompanying notes of the financial
statements. The actual results could differ from those estimates.

IMPAIRMENT OF LONG-LIVED ASSETS

Effective January 1, 1996, DAOU Systems, Inc. adopted Statement of Financial
Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121"). SFAS 121
establishes accounting standards for recording the impairment of long-lived
assets, certain identifiable intangibles and goodwill. The adoption of SFAS 121
did not have a material impact on DAOU's financial position or the results of
its operations.

NET INCOME PER SHARE

Historical net income per share is computed using the weighted average
number of common shares and common stock equivalents outstanding during the
periods presented. Common equivalent shares result from stock options, warrants
to purchase redeemable preferred stock and redeemable preferred stock. For loss
periods, common equivalent shares are excluded from the computation as their
effect would be antidilutive, except that the Securities and Exchange Commission
requires common and common share equivalents issued during the twelve-month
period prior to the initial filing of a proposed public offering, to be included
in the calculation as if they were outstanding for all periods presented (using
the treasury stock method and the assumed initial public offering price).

Historical net income per share information is as follows:

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1994 1995 1996
--------- --------- ---------
<S> <C> <C> <C>
Net income per share............................................................... $ -- $ 0.16 $ 0.01
--------- --------- ---------
--------- --------- ---------
Shares used in computing net income per share (in thousands)....................... 7,231 7,519 8,487
--------- --------- ---------
--------- --------- ---------
</TABLE>

PRO FORMA NET INCOME PER SHARE AND UNAUDITED PRO FORMA STOCKHOLDERS' EQUITY

Pro forma net income per share has been computed as described above and also
gives effect to the conversion of the redeemable preferred stock, which will
automatically convert to common stock upon completion of the Company's initial
public offering, using the as if-converted method from the original date of
issuance which was October 26, 1995.

F-8
<PAGE>
DAOU SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
If the offering contemplated by this Prospectus is consummated, all of the
convertible preferred stock outstanding as of the closing date will be converted
into 1,603,430 shares of common stock. Unaudited pro forma stockholders' equity
at December 31, 1996, as adjusted for the conversion of redeemable preferred
stock, is disclosed in the accompanying balance sheet.

STOCK OPTIONS

In October 1995, the Financial Accounting Standards Board issued SFAS No.
123, ACCOUNTING FOR STOCK-BASED COMPENSATION, which is effective for the year
ending December 31, 1996. SFAS No. 123 allows companies to either account for
stock-based compensation under the new provisions of SFAS No. 123 or under the
provisions of Accounting Principles Opinion No. 25, ACCOUNTING FOR STOCK ISSUED
TO EMPLOYEES("APB 25"), but requires pro forma disclosure in the footnotes to
the financial statements as if the measurement provisions of SFAS No. 123 had
been adopted. The Company has continued accounting for its stock-based
compensation in accordance with the provisions of APB 25.

2. SELECTED BALANCE SHEET DETAILS

Equipment, furniture and fixtures consist of the following (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1996
--------- ---------
<S> <C> <C>
Equipment and furniture........................................................................ $ 691 $ 1,340
Leasehold improvements......................................................................... 6 91
--------- ---------
697 1,431
Less accumulated depreciation and amortization................................................. (417) (604)
--------- ---------
$ 280 $ 827
--------- ---------
--------- ---------
</TABLE>

Other accrued liabilities consist of the following (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1996
--------- ---------
<S> <C> <C>
Accrued job related costs.................................................................... $ 932 $ 626
Other accrued liabilities.................................................................... 374 119
--------- ---------
$ 1,306 $ 745
--------- ---------
--------- ---------
</TABLE>

3. LINE OF CREDIT

In October 1996, the Company entered into a $1.5 million line of credit. The
line bears interest at a rate equal to the Bank's reference rate plus 0.5%
(8.75% at December 31, 1996) and expires October 1, 1997. At December 31, 1996,
no amounts were outstanding under the line of credit.

4. LEASE COMMITMENTS

The Company leases its facilities and certain equipment under operating
lease agreements. The facility leases provide for abatement of rent during
certain periods and escalating rent payments during the lease term. Rent expense
for 1994, 1995 and 1996 totaled $105,000, $106,000 and $347,000, respectively.

F-9
<PAGE>
DAOU SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

4. LEASE COMMITMENTS (CONTINUED)
Future minimum lease payments under noncancellable operating leases with
initial terms of one year or more consist of the following (in thousands):

<TABLE>
<CAPTION>
YEARS ENDING DECEMBER 31,
- -----------------------------------------------------------
<S> <C>
1997....................................................... $ 512
1998....................................................... 283
1999....................................................... 12
2000....................................................... 12
2001....................................................... 7
-------------
$ 826
-------------
-------------
</TABLE>

In October 1995, the Company's Board of Directors approved a relocation to a
larger facility. In connection with the relocation, the Company recorded a
provision for relocation costs and expenses of $205,000 which included an
accrual for future rent commitments on the Company's former facility, losses on
non-recoverable leaseholds and other assets and other costs directly associated
with the relocation. This charge is included in general and administrative
expenses in the 1995 statement of operations. During 1996, the Company's former
facility was subleased to a related party. Aggregate future minimum rentals to
be received under the sublease are $126,000.

5. MAJOR CUSTOMERS

Sales to individual customers exceeding 10% or more of revenues in the years
ended December 31 were as follows: during 1994, one customer accounted for 30%
of revenues; during 1995, two customers accounted for 48% and 11% of revenues,
respectively; and during 1996, three customers accounted for 21%, 18% and 15% of
revenues, respectively.

6. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY

REDEEMABLE PREFERRED STOCK

During 1995, 1,603,430 shares of redeemable preferred stock were issued at
$4.99 per share for proceeds of $7,618,000 net of issuance costs. Holders of the
redeemable preferred stock are entitled to receive cumulative dividends at the
rate of $0.03 per share per annum, when and if declared by the Board of
Directors and prior to any dividends on the common shares. The redeemable
preferred stock has a liquidation preference of $4.99 per share plus any
declared but unpaid dividends and is convertible at the option of the holder
into one share of common stock, subject to certain antidilution adjustments. The
shares of preferred stock are automatically convertible in the event of an
initial public offering of the Company's common stock. The holder of each share
of preferred stock is entitled to one vote for each share into which it would
convert.

On or after August 31, 2000, the redeemable preferred stock is redeemable
subject to a written request from the holders of a majority of the then
outstanding shares. The price of the redemption is equal to the original issue
price plus 6% of the original issue price compounded annually, less any
dividends paid. The increase in the redemption value of the redeemable preferred
stock was $87,000 in 1995 and $485,000 in 1996.

F-10
<PAGE>
DAOU SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

6. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED)
STOCK OPTION PLANS

During 1996, the Company adopted the 1996 Stock Option Plan (the "Plan"),
under which 947,025 shares of the Company's common stock were initially reserved
for issuance upon exercise of options granted by the Company. During November
1996, the Board of Directors increased the number of shares reserved for
issuance under the plan to 1,367,925. The Plan provides for the grant of both
incentive and nonstatutory stock options to officers, directors, employees and
consultants of the Company. Options granted by the Company generally vest over a
three to five-year period and are exercisable for a period of ten years from the
date of the grant.

The Company recorded $1,243,000 of deferred compensation for options granted
during the year ended December 31, 1996, representing the difference between the
option exercise price and the deemed fair market value for financial statement
presentation purposes. The Company is amortizing the deferred compensation
ratably over the vesting period of the options.

A summary of stock option transactions is as follows:

<TABLE>
<CAPTION>
WEIGHTED
AVERAGE
EXERCISE
OPTION PRICE PRICE PER
SHARES PER SHARE SHARE
--------- --------------- -----------
<S> <C> <C> <C>
Outstanding at January 1, 1996.......................................... -- $ -- --
Granted............................................................... 962,458 4.28 - 10.69 $ 5.16
Exercised............................................................. -- -- --
Canceled.............................................................. (21,045) 4.28 4.28
--------- --------------- -----
Outstanding at December 31, 1996........................................ 941,413 4.28 - 10.69 $ 5.16
--------- --------------- -----
--------- --------------- -----
</TABLE>

At December 31, 1996, no options to purchase common shares were exercisable
and 426,512 options to purchase common shares were available for future grant.

Adjusted pro forma information regarding net income is required by SFAS 123,
and has been determined as if the Company had accounted for its employee stock
options under the fair value method of that Statement. The fair value for these
options was estimated at the date of grant using the "minimal value" method for
option pricing with the following weighted-average assumptions: risk-free
interest rate of 6%; dividend yield of 0%; and a weighted-average expected life
of the option of seven years.

For purposes of adjusted pro forma disclosures, the estimated fair value of
the options is amortized to expense over the options' vesting period. The
Company's adjusted pro forma information is as follows (in thousands, except for
per share information):

<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31, 1996
---------------------
<S> <C>
Adjusted pro forma net income (loss)......................................................... $ (40)
Adjusted pro forma net income (loss) per share............................................... $ --
</TABLE>

The weighted-average fair value of options granted during 1996 was $2.81.

F-11
<PAGE>
DAOU SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

6. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED)
WARRANTS

In connection with the issuance of the redeemable preferred stock, the
Company issued two warrants to purchase an aggregate of 133,285 shares of
redeemable preferred stock at an exercise price of $4.99 per share. The warrants
are exercisable immediately and expire on October 26, 2000.

COMMON STOCK RESERVED

At December 31, 1996, a total of 3,104,640 shares of the Company's common
stock have been reserved for the conversion of redeemable preferred stock and
the exercise of stock options and warrants.

7. INCOME TAXES

The provision for income taxes consists of the following (in thousands):

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1994 1995 1996
--------- --------- ---------
<S> <C> <C> <C>
Current:
Federal............................................................................ $ 36 $ 816 $ 62
State.............................................................................. 7 227 37
--------- --------- ---------
43 1,043 99
Deferred:
Federal............................................................................ (21) (166) 32
State.............................................................................. (3) (26) (12)
--------- --------- ---------
(24) (192) 20
--------- --------- ---------
$ 19 $ 851 $ 119
--------- --------- ---------
--------- --------- ---------
</TABLE>

Deferred income taxes are provided for temporary differences in recognizing
certain income and expense items for financial and tax reporting purposes.
Significant components of the Company's deferred tax assets and liabilities
consist of the following (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1996
--------- ---------
<S> <C> <C>
Deferred tax assets (liabilities):
Reserves and allowances......................................................................... $ 209 $ 201
Tax depreciation differences.................................................................... 10 (2)
--------- ---------
Net deferred tax assets........................................................................... $ 219 $ 199
--------- ---------
--------- ---------
</TABLE>

F-12
<PAGE>
DAOU SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

7. INCOME TAXES (CONTINUED)
The reconciliation of income tax computed at the federal statutory rate to
the total provision for income taxes is as follows:

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------
1994 1995 1996
---------- ---------- ----------
<S> <C> <C> <C>
Tax at federal statutory rate........................................................ 34.0% 34.0% 34.0%
Nondeductible expenses............................................................... 8.2 2.3 16.7
Other, including compensatory stock options.......................................... -- 4.4 8.2
--- --- ---
42.2% 40.7% 58.9%
--- --- ---
--- --- ---
</TABLE>

8. BENEFIT PLAN

The Company sponsors the DAOU Systems, Inc. 401(k) Salary Savings Plan which
covers employees who meet certain age and service requirements. Employees may
contribute a portion of their earnings each plan year subject to certain
Internal Revenue Service limitations. The Company made elective contributions to
the Plan of $2,000, $13,000 and $16,000 for the years ended December 31, 1994,
1995 and 1996, respectively.

F-13
<PAGE>
- -------------------------------------------
-------------------------------------------
- -------------------------------------------
-------------------------------------------

NO PERSON HAS BEEN AUTHORIZED IN CONNECTION WITH THE OFFERING MADE HEREBY TO
GIVE ANY INFORMATION OR TO MAKE ANY REPRESENTATION NOT CONTAINED IN THIS
PROSPECTUS AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATION MUST NOT BE
RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR ANY UNDERWRITER. THIS
PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF ANY OFFER
TO BUY ANY OF THE SECURITIES OFFERED HEREBY TO ANY PERSON OR BY ANYONE IN ANY
JURISDICTION IN WHICH IT IS UNLAWFUL TO MAKE SUCH OFFER OR SOLICITATION. NEITHER
THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY
CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THE INFORMATION CONTAINED HEREIN IS
CORRECT AS OF ANY DATE SUBSEQUENT TO THE DATE HEREOF.

--------------

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
-----
<S> <C>
Prospectus Summary............................. 3
Risk Factors................................... 5
The Company.................................... 11
Use of Proceeds................................ 11
Dividend Policy................................ 11
Capitalization................................. 12
Dilution....................................... 13
Selected Financial Data........................ 14
Management's Discussion and Analysis of
Financial Condition and Results of
Operations................................... 15
Business....................................... 20
Management..................................... 28
Certain Transactions........................... 34
Principal Stockholders......................... 36
Description of Capital Stock................... 38
Shares Eligible for Future Sale................ 40
Underwriting................................... 42
Legal Matters.................................. 43
Experts........................................ 43
Additional Information......................... 43
Index to Financial Statements.................. F-1
</TABLE>

--------------

UNTIL MARCH 9, 1997 (25 DAYS AFTER THE DATE OF THIS PROSPECTUS), ALL DEALERS
EFFECTING TRANSACTIONS IN THE COMMON STOCK OFFERED HEREBY, WHETHER OR NOT
PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS.
THIS IS IN ADDITION TO THE OBLIGATIONS OF DEALERS TO DELIVER A PROSPECTUS WHEN
ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR
SUBSCRIPTIONS.

2,000,000 SHARES

[LOGO]

COMMON STOCK

------------

PROSPECTUS
------------

ALEX. BROWN & SONS
INCORPORATED

COWEN & COMPANY

HAMBRECHT & QUIST

February 12, 1997

- -------------------------------------------
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