BLUESTONE SOFTWARE INC
10-Q, 2000-11-14
PREPACKAGED SOFTWARE
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<PAGE>


                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

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

                                    FORM 10-Q

(MARK ONE)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000

                                       OR

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

                  For the transition period from _____ to _____

                         Commission file number: 0-26613

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

                            BLUESTONE SOFTWARE, INC.
             (Exact name of registrant as specified in its charter)
<TABLE>
<S>                                                             <C>
                       DELAWARE                                           22-2964141
 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
</TABLE>


                                300 STEVENS DRIVE
                        PHILADELPHIA, PENNSYLVANIA 19113
          (Address of principal executive offices, including zip code)

                                 (610) 915-5000
              (Registrant's telephone number, including area code)


              (Former name, former address and former fiscal year,
                         if changed since last report)


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

                                 Yes /X/ No / /


     As of October 31, 2000, there were 20,825,126 shares of the registrant's
common stock outstanding.


<PAGE>

                                      INDEX

PART I.  FINANCIAL INFORMATION

     Item 1.   CONSOLIDATED FINANCIAL STATEMENTS.

               Consolidated balance sheets as of September 30, 2000 (unaudited)
               and December 31, 1999.

               Consolidated statements of operations (unaudited) for the three
               and nine months ended September 30, 2000 and 1999.

               Consolidated statements of cash flows (unaudited) for the nine
               months ended September 30, 2000 and 1999.

               Notes to consolidated financial statements.

     Item 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
               RESULTS OF OPERATIONS.

     Item 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

PART II. OTHER INFORMATION

     Item 1.   LEGAL PROCEEDINGS.

     Item 2.   CHANGES IN SECURITIES AND USE OF PROCEEDS.

     Item 3.   DEFAULTS UPON SENIOR SECURITIES.

     Item 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

     Item 5.   OTHER INFORMATION.

     Item 6.   EXHIBITS AND REPORTS ON FORM 8-K.

SIGNATURE

                                       2
<PAGE>


         PART I. FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                            Bluestone Software, Inc.
                           Consolidated Balance Sheets
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>
                                             September 30,     December 31,
                                                 2000              1999
                                             -------------     ------------
                                              (unaudited)
<S>                                          <C>               <C>
ASSETS

Current assets:
     Cash and cash equvalents                   $149,084         $ 66,160
     Marketable securities                        37,677                0
     Accounts receivable, net                      9,576            4,079
     Prepaid expenses and other                    2,278            1,043
                                                --------         --------

Total current assets                             198,615           71,282

Investments in non marketable securities           6,043                0

Property, equipment, software, net                 3,477            2,495

Other assets, net                                  9,096              363
                                                --------         --------

Total assets                                    $217,231         $ 74,140
                                                ========         ========

LIABILITIES & STOCKHOLDERS' EQUITY

Current liabilities:
     Current portion of long-term debt          $      0         $    429
     Accounts payable -- trade                     1,363            2,259
     Accrued expenses                              8,345            3,083
     Deferred revenue                              3,737            1,966
                                                --------         --------

Total current liabilities                         13,445            7,737

Long-term debt                                         0              439
                                                --------         --------

Stockholders' equity:
     Common stock                                     21               18
     Common stock warrants                         1,205            1,205
     Deferred stock-based compensation              (878)          (1,133)
     Additional paid-in capital                  257,227          100,790
     Accumulated deficit                         (53,789)         (34,916)
                                                --------         --------

Total stockholders' equity                       203,786           65,964

Total liabilities & stockholders' equity        $217,231         $ 74,140
                                                ========         ========
</TABLE>

        The accompanying notes are an integral part of these statements.

                                       3
<PAGE>

                  Bluestone Software, Inc.
            Consolidated Statements of Operations
        (IN THOUSANDS, EXCEPT PER SHARE INFORMATION)
                         (UNAUDITED)
<TABLE>
<CAPTION>
                                                    Three Months Ended          Nine Months Ended
                                                       September 30,              September 30,
                                                  ----------------------      ----------------------
                                                     2000         1999          2000          1999
                                                  --------      --------      --------      --------
<S>                                                 <C>          <C>           <C>           <C>
Net revenues:
     Software license fees                        $  9,058      $  3,147      $ 21,249      $  7,874
     Services                                        2,544           856         7,006         2,721
                                                  --------      --------      --------      --------

     Total net revenues                             11,602         4,003        28,255        10,595

Cost of revenues:
     Software license fees                             243            54           746           210
     Services                                        2,827           945         8,220         3,412
                                                  --------      --------      --------      --------

     Total cost of revenues                          3,070           999         8,966         3,622
                                                  --------      --------      --------      --------

     Gross profit                                    8,532         3,004        19,289         6,973
                                                  --------      --------      --------      --------

Operating expenses:
     Sales and marketing                            12,725         4,515        29,898        10,701
     Product development                             3,316         1,219         7,169         3,087
     General and administrative                      2,542           989         6,024         3,113
     Write-off of acquired in-process
       research and development                      2,200             0         2,200             0
     Amortization of stock-based compensation           85            85           255           197
     Amortization expense                              534             0           534             0
                                                  --------      --------      --------      --------
     Total operating expenses                       21,402         6,808        46,080        17,098
                                                  --------      --------      --------      --------
     Operating loss                                (12,870)       (3,804)      (26,791)      (10,125)
Interest income (expense), net                       3,099           113         7,918        (1,035)
                                                  --------      --------      --------      --------
Net loss                                            (9,771)       (3,691)      (18,873)      (11,160)
Accretion of preferred stock redemption value            0          (857)            0        (1,636)
                                                  --------      --------      --------      --------
Net loss available to common shareholders         $ (9,771)     $ (4,548)     $(18,873)     $(12,796)
                                                  ========      ========      ========      ========

Basic and diluted net loss per share:
     Net loss                                     $  (0.47)     $  (0.93)     $  (0.94)     $  (3.48)

Accretion of preferred stock redemption value         --           (0.22)         --           (0.51)
                                                  --------      --------      --------      --------
                                                  $  (0.47)     $  (1.15)     $  (0.94)     $  (3.99)
                                                  ========      ========      ========      ========

Shares used in computing net loss per share         20,783         3,968        20,112         3,204
                                                  ========      ========      ========      ========
</TABLE>


        The accompanying notes are an integral part of these statements.


                                       4
<PAGE>

                            Bluestone Software, Inc.
                     Consolidated Statements of Cash Flows
                                 (IN THOUSANDS)
                                  (UNAUDITED)
<TABLE>
<CAPTION>

                                                                         For the Nine Months Ended,
                                                                                September 30,
                                                                         --------------------------
                                                                            2000            1999
                                                                         ---------       ----------
<S>                                                                      <C>             <C>
Operating Activities:
    Net Loss                                                             ($ 18,873)      ($ 11,160)
    Adjustments to reconcile net loss to net
      cash used in operating activities:
      Depreciation and amortization                                          1,278             447
      Write-off of acquired in-process research and development              2,200               0
      Provision for doubtful accounts                                          571             206
      Amortization of stock-based compensation                                 255             197
      Issuance of Bridge loan warrants                                           0           1,100
      Issuance of common stock options to non-employees                          0             191
      Changes in operating assets and liabilities:
        Accounts receivable                                                 (5,987)           (794)
        Prepaid expenses and other assets                                   (1,904)           (190)
        Accounts payable and accrued expenses                                4,172           3,077
        Deferred revenues                                                    1,771          (1,731)
                                                                         ---------       ---------

    Net cash used in operating activities                                  (16,517)         (8,657)
                                                                         ---------       ---------

Investing Activities:
    Purchases of property and equipment                                     (1,696)           (404)
    Net purchases of marketable securities                                 (37,677)              0
    Arjuna acquisition costs, net                                           (3,613)              0
    Purchase of non marketable securities                                   (6,000)              0
                                                                         ---------       ---------

    Net cash used in investing activities                                  (48,986)           (404)
                                                                         ---------       ---------

Financing activities:
    Repayments of long-term debt                                              (868)           (253)
    Proceeds from issuance of preferred stock, net                               0          23,060
    Issuance of common stock, net                                          145,837          54,816
    Net repayments to related party                                            (74)           (161)
    Net proceeds from line of credit                                             0              39
    Proceeds from exercise of common stock options                           3,532             222
                                                                         ---------       ---------

    Net cash provided by financing activities                              148,427          77,723
                                                                         ---------       ---------

    Net increase in cash and cash equivalents                               82,924          68,662
    Cash and cash equivalents, beginning of period                          66,160           2,535
                                                                         ---------       ---------

    Cash and cash equivalents, end of period                             $ 149,084       $  71,197
                                                                         =========       =========

Supplemental cash flow information:
    Cash paid for interest                                               $      63       $     773
Non-cash investing and financing activities:
    Conversion of related party subordinated note to common stock        $       0       $     500
    Conversion of preferred stock and all accrued dividends thereon
      to common stock                                                    $       0       $  41,310
</TABLE>

        The accompanying notes are an integral part of these statements.

                                       5
<PAGE>


BLUESTONE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

     NOTE 1. BASIS OF PRESENTATION

     The accompanying unaudited financial statements have been prepared by the
Company and, in the opinion of management, include all adjustments (consisting
of normal recurring adjustments) necessary for the fair presentation of results
for the interim periods presented. These financial statements and notes included
herein should be read in conjunction with the Company's audited financial
statements and notes for the year ended December 31, 1999 included in the
Company's Annual Report on Form 10-K filed with the Securities and Exchange
Commission. The results of operations for the interim periods presented are not
necessarily indicative of the results to be expected for any subsequent quarter
or for the entire year ending December 31, 2000.

     NOTE 2. NET LOSS PER SHARE

     The Company follows SFAS No. 128, "Earnings Per Share," which requires a
dual presentation of "basic" and "diluted" earnings per share ("EPS") on the
face of the statements of operations. Basic EPS is computed by dividing net
income (loss) by the weighted average number of shares of common stock
outstanding for the period. Diluted EPS includes the dilutive effect, if any,
from the potential exercise or conversion of securities like stock options,
which would result in the issuance of additional shares of common stock. For the
three and nine months ended September 30, 1999 and 2000, diluted EPS is equal to
basic EPS as all common stock equivalents were anti-dilutive for all periods
presented.

    NOTE 3. INVESTMENTS IN NON MARKETABLE SECURITIES

     Investments as of September 30, 2000 includes the purchase of 1,000,000
shares of Series B Preferred Stock of S2 Systems, Inc., a strategic partner
and customer of Bluestone for $6.0 million. Bluestone received revenues of
$4.4 million from S2 Systems, Inc. during the nine months ending September
30, 2000.

     NOTE 4. ACCRUED EXPENSES

     Accrued expenses at September 30, 2000 includes $3.9 million in accrued
wages and $499,000 in accrued payroll taxes. Accrued expenses at December 31,
1999 includes $892,000 in accrued wages and $628,000 in accrued payroll taxes.

     NOTE 5. PUBLIC OFFERING

     On February 22, 2000, the Company completed a public offering of 3,500,000
shares of its common stock. Of the 3,500,000 total shares offered, 1,750,000
shares were offered by the Company and 1,750,000 shares were offered by certain
selling stockholders. The Company received proceeds of $145.8 million, net of
underwriting discounts and offering expenses.

     NOTE 6. RECENT PRONOUNCEMENTS

     In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133. "Accounting for
Derivative Instruments and Hedging Activities." This statement establishes
accounting and reporting standards for derivative and hedging activities.
Under the adoption of SFAS No. 133 all derivatives are required to be
recognized in the balance sheet as either assets or liabilities and measured
at fair value. In July 1999, the FASB issued SFAS No. 137, "Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date
of FASB Statement No. 133--an amendment for FASB Statement No. 133,"
deferring the effective date for implementation of SFAS No. 133 to fiscal
years beginning after June 15, 2000. The Company believes the adoption of
SFAS No. 133 will not have an impact on its financial position and results
of operations as the Company has not currently entered into any such
instruments or hedging activities.

     In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements"
("SAB No. 101"). SAB No. 101 summarizes certain of the Staff's views in
applying generally accepted accounting principles to recognition,
presentation and disclosure of revenue in financial statements. Compliance
with SAB No. 101 is required no later than the fourth quarter of the fiscal
years beginning after December 15, 1999. The Company has determined that its
revenue recognition policies are in accordance with SAB No. 101.

     NOTE 7. ARJUNA ACQUISITION

     On July 3, 2000, the Company acquired all of the outstanding share
capital of Arjuna Solutions Limited, a development stage software company
based in Newcastle and London, England. Initial acquisition consideration
consisted of cash of

                                       6
<PAGE>


$3.6 million including approximately $247,000 of acquisition costs, and
277,803 shares of the company's common stock. Additional contingent
consideration is payable upon the completion of certain products by Arjuna on
or before February 1, 2001 or waiver of such delivery conditions and will
consist of approximately $375,000 of cash and 82,725 shares of common stock.

     The acquisition was accounted for under the purchase method of
accounting, whereby the purchase price was allocated to the assets acquired
and the liabilities assumed, based on their fair market values at the
acquisition date. The excess of the purchase price over the estimated fair
market value of the net tangible assets acquired was assigned to identifiable
intangibles and in-process research and development. The Company assigned
$2.2 million to in-process research and development based on an independent
appraisal and such amount was charged to operations in the accompanying
statement of operations during the three months ended September 30, 2000. The
Company also recorded goodwill of $8.5 million, which is being amortized on a
straight-line basis over four years. Pro-forma financial information has not
been provided as it is not materially different than Bluestone historical
financial information.

     IN-PROCESS RESEARCH AND DEVELOPMENT

     In connection with the acquisition of Arjuna, the Company allocated $2.2
million of the purchase price to in-process research and development projects.
This allocation represented the estimated fair value based on risk-adjusted cash
flows related to the incomplete research and development projects. At the date
of acquisition, the development of these projects had not yet reached
technological feasibility and the research and development in progress had no
alternative future uses. Accordingly, these costs were expensed as of the
acquisition date.

     At the acquisition date, Arjuna was conducting design, development,
engineering and testing activities associated with the completion of java-based
wireless transaction platform, as well as new application technologies. The
projects under development at the valuation date represent innovative
technologies that are expected to address emerging market demands for wireless
transaction services.

     At the acquisition date, the technologies under development were 75 to 85
percent complete based on engineering man-month data and technological process.
Arjuna had spent approximately $500,000 on the in-process projects and expected
to spend approximately $1.8 million to compete all phases of the R&D.
Anticipated completion dates ranged from 3 to 9 months, at which times the
Company expects to begin benefiting from developed technologies.

     In making its purchase price allocation, management considered present
value calculations of income, an analysis of project accomplishments and
remaining outstanding items, an assessment of overall contributions, as well
as project risks. The value assigned to purchased in-process technology was
determined by estimating the costs to develop the acquired technology into
commercially viable products, estimating the resulting net cash flows from
the projects, and discounting the net cash flows to their present value. The
revenue projection used to value the in-process research and development was
based on estimates of relevant market sizes and growth factors, expected
trends in technology, and the nature and expected timing of new products
introduction by the Company and its competitors. Projected expenses were
based on management's estimates of cost of sales, operating expenses, and
income taxes from such projects.

     Aggregate revenues from the Arjuna development products were estimated to
grow at a compounded annual growth rate of approximately 36 percent for the
three years following the introduction, assuming the successful completion and
market acceptance of the major R&D programs. The estimated revenues for the
in-process projects were expected to peak within three or four years of
acquisition and then decline sharply as other new products and technologies are
expected to enter the market.


                                       7
<PAGE>

    The rates utilized to discount the net cash flows to their present values
were based on estimated cost of capital calculations. Due to the risks
associated with the projected cash flow forecast, a discount rate of 25 percent
was considered appropriate for the in-process R&D. The selected rate is higher
than the Company's overall weighted average cost of capital due to the inherent
uncertainties surrounding the successful development of the purchased in-process
technology, the useful life of such technology, and the uncertainty of
technological advances that are unknown at this time.

     If these projects are not successfully developed, the sales and
profitability of the combines company may be adversely affected in future
periods. Additionally, the value of other acquired intangible asset may become
impaired.

     NOTE 8. SALE TO HEWLETT-PACKARD COMPANY SUBSEQUENT TO SEPTEMBER 30, 2000

     On October 24, 2000, the Company and Hewlett-Packard Company, reached a
definitive agreement under which Hewlett-Packard Company will acquire the
Company in a stock-for-stock transaction. Under the terms of the agreement,
the Company's stockholders will receive 0.4866 of Hewlett-Packard Company
common stock (after giving effect to a 2 for 1 stock split, in the form of a
stock dividend, of Hewlett-Packard Company shares effective October 27, 2000)
for each share of the Company's common stock. The completion of the
transaction is subject to closing conditions and the approval of the
Company's stockholders.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS

     The following Management's Discussion and Analysis of Financial Condition
and Results of Operations should be read in conjunction with our audited
Financial Statements and Notes thereto for the year ended December 31, 1999
included in our Annual Report on Form 10-K that was filed with the Securities
and Exchange Commission on February 15, 2000.

     The information in this discussion contains forward-looking statements.
Forward-looking statements involve known and unknown risks, uncertainties and
other factors which may cause our actual results, performance or achievements or
industry results to be materially different from any future results, performance
or achievements expressed or implied by these forward-looking statements. Such
factors include those described in "Risk Factors." The forward-looking
statements included in this report may prove to be inaccurate. In light of the
significant uncertainties inherent in these forward-looking statements, you
should not consider this information to be a guarantee by us or any other person
that our objectives and plans will be achieved.

OVERVIEW

     We are a leading provider of software for enterprise interaction
management, which enables businesses to extend information over the World
Wide Web in a controlled manner and to support high volumes of users and
interactions. Our flagship product, Total-e-Server, which is the foundation
of our Total-e-Business product suite, is a framework for Java Web
application servers and is currently in Release 7.2. In 1998, we decided to
focus on internally developed software products and curtail the licensing and
services related to third party products. Beginning in March 1998, we
increased our sales and marketing efforts and hired new management. We hired
a significant number of sales personnel throughout the country in order to
develop a nationwide presence and generate increased revenue. The positioning
and feature set of the Sapphire/Web product was shifted from a low-cost
development tool to an enterprise-wide software solution for Internet
applications. In January 1999, we released Bluestone XML-Server, which
represented a new generation of specialized Web application server focused on
Internet commerce. In December 1999, we released Bluestone Total-e-Business,
an e-business platform that provides the infrastructure, integration, content
management, personalization and e-commerce components that companies utilize
to conduct their businesses on the Internet. In June 2000, we released our
Total-e-B2B, Total-e-B2C, Total-e-Mobile and Total-e-Global products that
are based on our Total-e-Business platform.

     We generate revenue from two principal sources: license fees for our
software products and professional services and support revenue derived from
consulting, training and maintenance services related to our software products.
During the three months ended September 30, 2000 four of our customers
individually accounted for


                                       8
<PAGE>

greater than 10% of our total revenues. During the nine months ended September
30, 2000, one customer accounted for greater than 10% of our total revenues. Our
top 10 customers represented 81.2% of total revenues during the three months
ended September 30, 2000 and 53.4% of total revenues during the nine months
ended September 30, 2000. In the future, we expect to continue to have
individual customers account for a significant portion of our revenues during a
given period.

     SOFTWARE LICENSE FEES. Typically, our end-user customers pay an
up-front, one-time fee for a perpetual license of our software. The amount of
the fee is generally based on the number of sites, developer seats and server
interactions. Pricing models based on enterprise-wide deployment or the
number of processors are also available. We also sell annual and multi-year
licenses to independent software vendors that allow for the integration of
our products into their software. We generally require a written license
contract that typically provides for payment within 30-90 days of contract
signing. Certain multi-year license contracts contain payment terms that
extend beyond one year. Pursuant to the American Institute of Certified
Public Accountants' Statement of Position 97-2, any amounts due under
contract beyond one year are not deemed to be fixed or determinable and
therefore are deferred and recognized as revenue when the payments become due.

     Prior to 1998, software licenses were principally the result of direct
sales to end-users. Beginning in 1998, we began to focus on channel sales and
marketing. This has resulted in significant sales of products through
independent software vendors, resellers and systems integrators. We believe that
these alliances have increased our exposure in the marketplace. Furthermore, we
have experienced, and expect to continue to experience, significant variation in
the size of individual licensing transactions, ranging from small sales of
perpetual developer licenses to large, multi-year licensing arrangements with
independent software vendors.

     We generally recognize license fee revenue when a formal agreement exists,
delivery of the product has occurred, no production, modification, customization
or implementation obligations remain, the license fee is deemed fixed or
determinable and collectibility is probable. Revenue from arrangements with
distributors and resellers is not recognized until our product is delivered to
the end-user.

     SERVICES REVENUE. Services revenue consists principally of revenue derived
from consulting services provided to customers during implementation and
integration of our software products, training of customers' employees and fees
for ongoing maintenance, which consists of customer technical support services
and unspecified product upgrades/enhancements on a when-and-if-available basis.
Consulting and training services are typically delivered on a time and material
basis. We recognize services revenue as the services are performed. Maintenance
revenue is generally invoiced in advance and is recognized ratably over the term
of the maintenance agreement, which is generally 12 months.

     COST OF SOFTWARE LICENSE FEES. Cost of software license fees consists
primarily of the costs associated with the purchase of product CDs and related
documentation and duplication costs. Cost of licenses also includes the cost of
third-party software products embedded in our product offerings.

     COST OF SERVICES. Cost of services consist primarily of salary and benefit
costs of our consulting, support and training organizations, as well as the
costs of outside consultants engaged to meet customer demand, and are expensed
when incurred.

     SALES AND MARKETING. We license our products primarily through our indirect
channels and direct sales force. Sales and marketing expenses consist primarily
of personnel costs, commissions to employees, office facilities, travel and
promotional events such as trade shows, advertising and public relations
programs.

     PRODUCT DEVELOPMENT. We maintain an in-house development staff to enhance
our existing products and to develop new ones. Product development expenditures
are generally charged to operations as incurred. Statement of Financial
Accounting Standards No. 86 requires the capitalization of certain software
development costs subsequent to the establishment of technological feasibility.
We establish technological feasibility upon the completion of a working model.
To date, we have expensed all software development costs due to the minimal
level of development costs incurred subsequent to the establishment of
technological feasibility.

     GENERAL AND ADMINISTRATIVE. General and administrative expenses include our
personnel and other costs of our corporate, finance, human resources and
information services activities.


                                       9
<PAGE>

     WRITE OFF OF ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT. We are
recording a one-time charge in an amount equal to the market value of the
in-process research and development that was acquired when we purchased
Arjuna Solutions Limited (see notes to financial statements).

     STOCK-BASED COMPENSATION. The amount by which the fair market value of our
common stock exceeded the exercise price of stock options on the date of grant
is recorded as deferred compensation and is amortized to stock-based
compensation expense as the options vest.

     AMORTIZATION EXPENSE. We are recording an expense for the amortization of
goodwill associated with our acquisition of Arjuna Solutions Limited which is
being amortized equally over a four year period.

THREE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 1999

SOFTWARE LICENSE FEES

     License fees were $9.1 million and $3.1 million for the three months ended
September 30, 2000 and 1999, respectively. This increase of 187.8% was primarily
due to an increased presence in the market, as well as an increase in the number
of licenses with independent software vendors, which has increased the amount of
license revenue per customer during the third quarter of 2000 versus the same
period in 1999.

SERVICES REVENUE

     Services revenue was $2.5 million and $856,000 for the three months ended
September 30, 2000 and 1999, respectively, an increase of 197.2%. Services
revenue increased between the two periods primarily due to five large consulting
engagements that were performed and concluded during the third quarter of 2000,
as well as an increase of maintenance revenues due to a larger base of installed
software.

GROSS MARGIN-LICENSE FEES

     Our license fee gross margin remained relatively consistent at 97.3% for
the three months ended September 30, 2000 compared to 98.3% for the same
period in 1999.

GROSS MARGIN-SERVICES REVENUE

     Our services gross margin remained relatively consistent at (11.1)% for
the three months ended September 30, 2000 compared to (10.4)% for the same
period in 1999. Our services gross margin remained negative primarily due to
the hiring and training of additional internal personnel and external
consultants to support our growing installed base of customers and
anticipated increases in future revenues, as well as the training of our
existing internal and external consultants on our Total-e-Business products.
We anticipate that our services gross margin will improve and will be
approaching a breakeven point towards the end of the fourth quarter of 2000.

SALES AND MARKETING

     Sales and marketing expenses were $12.7 million and $4.5 million for the
three months ended September 30, 2000 and 1999, respectively, an increase of
181.8%. Of this increase, $2.7 million was due to increases in payroll and
related costs, $540,000 in recruiting costs, $622,000 in training costs and
$638,000 in travel and entertainment costs as a result of the growth in the
number of sales personnel, $982,000 in office and occupancy expense due to
the expansion of our sales offices throughout the United States and Europe,
$900,000 was due to increased trade show, direct mail, advertising and public
relations expenses, and $1 million was due to increased commissions expense
as a result of higher sales volume. We also incurred increases in variable
marketing expenses due to increased printing and collateral and outside
service providers. We intend to continue to aggressively increase our
spending on sales and marketing because we believe that our sales and
marketing efforts are essential for us to increase our market position and
our product acceptance. The average number of sales and marketing employees
for the three months ended September 30, 2000 was 142 compared to 64 for the
three months ended September 30, 1999. These costs as a percentage of revenue
were 109.7% and 112.8% for the three months ended September 30, 2000 and
1999, respectively.

                                       10
<PAGE>

PRODUCT DEVELOPMENT

     Product development expenses were $3.3 million and $1.2 million for the
three months ended September 30, 2000 and 1999, respectively, an increase of
172.0%. These increases were associated with the development and enhancement of
our Bluestone Total-e-Business products and were due to an increase in payroll
and related costs of $1.1 million, hiring costs of $100,000, an increase in
sub-contract expense of $343,000 related to outside consultants involved in
development projects and an increase of $277,000 in office and occupancy
expenses due to the growth in our development personnel. Average development
headcount for the three months ended September 30, 2000 and 1999 was 65 and 34,
respectively. We believe that our continued increases in product development
investment are essential for us to maintain our market and technological
competitiveness. These costs as a percentage of revenue were 28.6% and 30.5% for
the three months ended September 30, 2000 and 1999, respectively.

GENERAL AND ADMINISTRATIVE

     General and administrative expenses were $2.5 million and $1.0 million
for the three months ended September 30, 2000 and 1999, respectively, an
increase of 157.0%. Of this increase $502,000 was due to increases in payroll
and related costs, $371,000 was due to an increase in office and occupancy
expense in order to accommodate our expanding personnel size, $164,000 was
due to increases in our insurance costs related to new directors and officers
insurance, $64,000 was due to increases in public reporting costs and $42,000
was due to increases in sub-contracting expenses for temporary employees.
General and administrative expenses as a percentage of revenue were 21.9% and
24.7% for the three months ended September 30, 2000 and 1999, respectively.
The average number of general administrative employees for the three months
ended September 30, 2000 was 44 compared to 33 for the three months ended
September 30, 1999. We expect that our general administrative expenses will
continue to increase to the extent we continue to expand geographically and
add personnel and administrative resources to support the growth of our
business.

WRITE OFF OF ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT

    The write off of acquired in-process research and development was $2.2
million for the three months ended September 30, 2000. This expense was
related to our purchase of Arjuna Solutions Limited, a development stage
software company (see notes to financial statements).

AMORTIZATION OF STOCK-BASED COMPENSATION

     Amortization of stock-based compensation was $85,000 for each of the three
months ended September 30, 2000 and 1999. Deferred compensation of $1.4 million
arose due to the issuance of stock options at exercise prices below the fair
market value of our common stock for accounting purposes related to the hiring
of key employees and directors during the third quarter of 1999. Deferred
compensation is included as a component of stockholders' equity and is being
amortized by charges to operations over the vesting periods of the options. As
of September 30, 2000, we had an aggregate of $878,000 of deferred compensation
to be amortized through June 30, 2003.

AMORTIZATION EXPENSE

     Amortization expense was $534,000 for the three months ended September
30, 2000. This expense arose due to the goodwill associated with our purchase
of Arjuna Solutions Limited, which is being amortized on a straight-line
basis over a four year period.

INTEREST INCOME (EXPENSE), NET

     Net interest income was $3.1 million for the three months ended September
30, 2000 and net interest income was $113,000 for the three months ended
September 30, 1999. The additional interest income was due to interest earned on
a higher cash balance during the third quarter of 2000 as compared to the third
quarter of 1999 resulting from $54.8 million of net proceeds generated from our
initial public offering of common stock in September 1999 and $145.8 million of
net proceeds generated from our follow-on public offering in February 2000.


                                       11
<PAGE>

NINE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 1999

SOFTWARE LICENSE FEES

     License fees were $21.2 million and $7.9 million for the nine months ended
September 30, 2000 and 1999, respectively. This increase of 169.9% was primarily
due to an increased presence in the market, as well as an increase in the number
of licenses with independent software vendors, which has increased the amount of
license revenue per customer during the first nine months of 2000 versus the
same period in 1999.

SERVICES REVENUE

     Services revenue was $ 7.0 million and $2.7 million for the nine months
ended September 30, 2000 and 1999, respectively, an increase of 157.5%. Services
revenue increased between the two periods primarily due to eight large
consulting engagements performed during the first nine months of 2000, as well
as an increase in maintenance revenues due to a larger base of installed
software.

GROSS MARGIN-LICENSE FEES

     Our license fee gross margin remained relatively consistent at 96.5% for
the nine months ended September 30, 2000 compared to 97.3% for the same
period in 1999. This slight decrease was primarily due to an increase in the
cost of third-party software products embedded in our product offerings in
2000.

GROSS MARGIN-SERVICES REVENUE

     Our services gross margin improved to (17.3)% for the nine months ended
September 30, 2000 from (25.4)% for the same period in 1999. Our services
gross margin remained negative however in 2000 primarily due to the hiring
and training of additional internal personnel and external consultants to
support our growing installed base of customers and anticipated increases in
future revenues, as well as the training of our existing internal and
external consultants on our Total-e-Business products. We anticipate that our
services gross margin will improve and will be approaching a breakeven point
towards the end of the fourth quarter of 2000.

SALES AND MARKETING

     Sales and marketing expenses were $29.9 million and $10.7 million for
the nine months ended September 30, 2000 and 1999, respectively, an increase
of 179.4%. Of this increase, $6.2 million was due to increases in payroll and
related costs, $1.1 million in recruiting costs, $860,000 in training
expenses and $1.6 million in travel and entertainment costs as a result of
the growth in the number of sales personnel, $2.1 million in office and
occupancy expense due to the expansion of our sales offices throughout the
U.S. and Europe, $1.3 million in sub-contractor's expense for the use of
outside consultants, $2.6 million was due to increased trade show, direct
mail, advertising, promotion and public relations expenses, and $2.0 million
was due to increased commissions expense as a result of higher sales volume.
We also incurred increases in variable marketing expenses due to increased
printing and collateral and outside service providers in order to increase
market awareness and gain market acceptance of our products. We intend to
continue to aggressively increase our spending on sales and marketing because
we believe that our sales and marketing efforts are essential for us to
increase our market position and our product acceptance. The average number
of sales and marketing employees for the nine months ended September 30, 2000
was 128 compared to 54 for the nine months ended September 30, 1999. These
costs as a percentage of revenue were 105.8% and 101.0% for the nine months
ended September 30, 2000 and 1999, respectively.

PRODUCT DEVELOPMENT

     Product development expenses were $7.2 million and $3.1 million for the
nine months ended September 30, 2000 and 1999, respectively, an increase of
132.2%. These increases were associated with the development and enhancement of
our Bluestone Total-e-Business products and were due to an increase in payroll
and related costs of $2.4 million, $188,000 in recruiting costs and an increase
in sub-contractor expense of $655,000 related to outside consultants involved in
development projects and an increase of office and occupancy expense of
$505,000. Average development headcount for the nine months ended September 30,
2000 and 1999 was 58 and 30, respectively. We believe that our continued product
development investment is essential for us to maintain


                                       12
<PAGE>

our market and technological competitiveness. These costs as a percentage of
revenue were 25.4% and 29.1% for each of the nine months ended September 30,
2000 and 1999 respectively.

GENERAL AND ADMINISTRATIVE

     General and administrative expenses were $6.0 million and $3.1 million for
the nine months ended September 30, 2000 and 1999, respectively, an increase of
93.5%. Of this increase $657,000 of payroll related expenses, $599,000 in office
and occupancy expenses, $165,000 of recruiting expenses were due to increased
personnel to support the growth of our business. Additionally, $420,000 of
additional insurance costs related to new directors and officers insurance, an
increase of $299,000 in public operating costs and an increase of $191,000 in
professional fees was incurred. The average number of general and administrative
employees for the nine months ended September 30, 2000 was 42 compared to 31 for
the nine months ended September 30, 1999. General and administrative expenses as
a percentage of revenue were 21.3% and 29.4% for the nine months ended September
30, 2000 and 1999, respectively.

WRITE OFF OF ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT

     The write off of acquired in-process research and development was $2.2
million for the nine months ended September 30, 2000. This expense was
related to our purchase of Arjuna Solutions Limited, a development stage
software company (see notes to financial statements).

AMORTIZATION OF STOCK-BASED COMPENSATION

     Amortization of stock-based compensation was $255,000 and $197,000 for the
nine months ended September 30, 2000 and 1999, respectively. Deferred
compensation of $1.4 million arose due to the issuance of stock options at
exercise prices below the fair market value of our common stock for accounting
purposes related to the hiring of key employees and directors during the third
quarter of 1999. Deferred compensation is included as a component of
stockholders' equity and is being amortized by charges to operations over the
vesting periods of the options.

AMORTIZATION EXPENSE

    Amortization expense was $534,000 for the nine months ended September 30,
2000. This expense arose due to the goodwill associated with our purchase of
Arjuna Solutions Limited, which is being amortized on a straight-line basis
over a four year period.

INTEREST INCOME (EXPENSE), NET

     Net interest income was $7.9 million for the nine months ended September
30, 2000 and net interest expense was $1.0 million for the nine months ended
September 30, 1999. The net interest income was due to interest earned on a
higher cash balance during the first nine months of 2000 as compared to the
first nine months of 1999 resulting from $54.8 million of net proceeds generated
from our initial public offering of common stock in September 1999 and $145.8
million of net proceeds generated from our follow-on public offering in February
2000.

LIQUIDITY AND CAPITAL RESOURCES

     In February 2000, we completed our secondary public offering of shares
of our common stock. Of the 3,500,000 total shares offered, 1,750,000 shares
were offered by the Company and 1,750,000 shares were offered by certain
selling stockholders. We realized net proceeds from the offering of $145.8
million. In September 1999, we completed our initial public offering of
4,000,000 shares of our common stock, realizing net proceeds of $54.8
million. Prior to these offerings, we financed our operations and met our
capital expenditure requirements primarily through sales of preferred stock,
bank loans, equipment loans and funds generated from operations. From April
1997 through May 1999, we raised approximately $41.6 million of venture
capital funding in order to expand the sales and marketing and product
development efforts of the business. As of September 30, 2000 our primary
sources of liquidity consisted of cash, cash equivalents and short term
marketable securities totaling approximately $186.8 million and available
borrowings under our two revolving lines of credit which are secured by
substantially all of our assets. As of September 30, 2000, we had a total of
$2.0 million of available borrowings under both the $3.0 million and $500,000
revolving lines of credit.

                                       13
<PAGE>

We did not have an outstanding balance on either line of credit. The reduced
borrowing availability is due to several outstanding letters of credit.
Borrowings under the $3.0 million revolving line of credit are subject to a
borrowing base of 80% of eligible domestic accounts receivable and borrowings
under the $500,000 revolving line of credit are subject to a borrowing base of
90% of eligible foreign accounts receivable. Interest is payable monthly at a
rate of prime plus .5% on both lines of credit.

     Net cash used in operating activities was $16.5 and $8.7 million for the
nine months ended September 30, 2000 and 1999, respectively. The cash used in
operating activities in the first nine months of 2000 was attributable primarily
to net losses of $18.9 million, offset by certain non-cash items and changes in
operating assets and liabilities. The cash used in operating activities for the
nine months ended September 30, 1999 was attributable primarily to net losses of
$11.2 million offset by certain non-cash items and increases in working capital
items.

     Net cash used in investing activities was $49.0 million and $404,000 for
the nine months ended September 30, 2000 and 1999, respectively. The cash
used in investing activities for the nine months ended September, 2000
related primarily to the purchase of short term marketable securities, the
purchase of 1,000,000 shares of Series B Preferred Stock of S2 Systems, Inc.,
a strategic partner of Bluestone, for $6.0 million, $3.6 million related to
the Arjuna Solutions Limited acquisition and the purchase of fixed assets of
$1.7 million. The cash used in investing activities for the nine months ended
September 30, 1999 related to purchases of computers and software for
internal use.

     Net cash provided by financing activities was $148.4 million for the
nine months ended September 30, 2000. During the nine months ended September
30, 2000, net proceeds of $145.8 million was provided from the follow on
public offering of shares of our common stock. Additionally, we received
proceeds of $3.5 million from the exercise of common stock options and made
repayments of $868,000 of long-term debt. Net cash provided by financing
activities for the nine months ended September 30, 1999 was $77.7 million.
This was primarily due to net proceeds of $54.8 million provided from our
initial public offering of common stock and the sale of 9,191,176 shares of
Series C convertible preferred stock for net proceeds of $23.1 million.

     We plan to continue to expand our operations throughout the U.S. and
internationally within the next 12 months and we expect to continue to incur
increases in our sales and marketing, product development and general and
administrative expenditures to support such growth. These expenditures will
use large amounts of cash. Furthermore, we have committed to pay
approximately $375,000 as additional deferred consideration to certain former
stockholders of Arjuna Solutions Limited if certain products are delivered to
Bluestone by Arjuna Solutions Limited by no later than February 1, 2001 or if
we waive the delivery requirements. We believe that our existing capital
resources are sufficient to meet our capital requirements for at least the
next 12 months.

RISK FACTORS

     THIS SECTION HIGHLIGHTS SPECIFIC RISKS WITH RESPECT TO AN INVESTMENT IN OUR
BUSINESS. INVESTING IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. WE ALSO
CAUTION YOU THAT THIS REPORT INCLUDES FORWARD-LOOKING STATEMENTS THAT ARE BASED
ON MANAGEMENT'S BELIEFS AND ASSUMPTIONS AND ON INFORMATION CURRENTLY AVAILABLE
TO MANAGEMENT.


RISKS ASSOCIATED WITH THE PROPOSED MERGER WITH HEWLETT-PACKARD

     On October 24, 2000 we entered into an agreement and plan of merger with
Hewlett-Packard Company. The proposed stock for stock merger is subject to
customary closing conditions, including the approval by Bluestone stockholders.
Hewlett-Packard filed a Form S-4 registration statement on November 9, 2000 with
the Securities and Exchange Commission which contains a preliminary proxy
statement of Bluestone and which describes the proposed merger in detail,
including the risks posed by such proposed transaction. Such risks include but
are not limited to the following:

     -    The value of Hewlett-Packard common stock to be received by Bluestone
          stockholders in exchange for their Bluestone common stock will
          fluctuate and is affected by factors different from the factors
          affecting the price of our shares;

     -    Hewlett-Packard and Bluestone may encounter difficulties in
          integrating their operations or achieving the desired benefits of the
          acquisition;

                                       14
<PAGE>

     -    Certain directors and officers have interests in the proposed merger
          that differ form the interests of the other Bluestone stockholders;

     -    The failure to consummate the merger could negatively impact our stock
          price, future business and operations;

     -    The merger may cause our customers to delay or later purchasing
          decisions and/or cause strategic partners to alter or sever their
          relationship with Bluestone;

     -    The merger may adversely our ability to attraqct and retain key
          employees; and

     -    If we fail to obtain certain required consents and waivers, third
          parties may terminate or alter their existing contracts with
          Bluestone.

WE HAVE HAD RECENT LOSSES AND MAY INCUR FUTURE LOSSES THAT MAY DEPRESS OUR STOCK
PRICE.


     We have incurred significant net losses since 1996, including losses of
approximately $11.6 million and $15.1 million for the years ended December 31,
1998 and 1999, respectively and $18.9 million for the nine months ended
September 30, 2000. Our losses have resulted in an accumulated deficit of
approximately $53.8 million as of September 30, 2000. Any significant shortfall
of revenues in relation to our expectations or any material delay of customer
orders would have an immediate adverse effect on our business, operating results
and financial condition. Additionally, our planned acceleration of expenditures
may have an adverse effect on our operating results. We may not be profitable in
any future period and our net losses may increase in the next several quarters.
Our future operating results will depend on many factors, including:

     -    the overall growth rate for the markets in which we compete;

     -    the level of market acceptance of, and demand for, our software
          products;

     -    the level of product and price competition;

     -    our ability to establish strategic marketing relationships, develop
          and market new and enhanced products, and control costs;

     -    our ability to expand our direct sales force and indirect distribution
          channels;

     -    our ability to integrate acquired businesses and product lines;

     -    our ability to develop and maintain awareness of our brands; and

     -    our ability to attract, train and retain consulting, technical and
          other key personnel.

LACK OF GROWTH OR DECLINE IN INTERNET USAGE OR THE LACK OF ACCEPTANCE OF
COMMERCE CONDUCTED VIA THE INTERNET COULD BE DETRIMENTAL TO OUR FUTURE OPERATING
RESULTS.

     Our products enhance companies' ability to transact business and conduct
operations utilizing the Internet. Therefore, our future sales and any future
profits are substantially dependent upon the widespread acceptance and use of
the Internet as an effective medium of commerce by consumers and businesses.
Rapid growth in the use of the Internet and other online services is a recent
development and we are unsure whether that acceptance and use will continue to
develop or that a sufficiently broad base of consumers will adopt and continue
to use the Internet and other online services as a medium of commerce. To be
successful, we must rely on consumers and businesses, who have historically used
traditional means of commerce to purchase products, accepting and utilizing new
ways of conducting business and exchanging information over the Internet.

     In addition, the Internet may not be accepted as a viable commercial
marketplace for a number of reasons, including potentially inadequate
development of the necessary network infrastructure or delayed development of
enabling technologies and Web performance improvements. If the Internet
continues to experience significant growth in the number of users, frequency of
use or an increase in bandwidth requirements, the Internet's infrastructure may
not be able to support the demands placed upon it. In addition, the Internet
could lose its viability due to delays in the development or adoption of new
standards and protocols required to handle increased levels of Internet
activity, or due to increased governmental regulation. If Congress, or other



                                       15
<PAGE>

governing bodies both within and outside the United States, decides to alter
materially the current approach to, and level of, regulation of the Internet, we
may need to adapt our technology. Any required adaptation could cause us to
spend significant amounts of time and money. If use of the Internet does not
continue to grow or grows more slowly than expected, if the infrastructure for
the Internet does not effectively support growth that may occur, if government
regulations change, or if the Internet does not become a viable commercial
marketplace, our business could suffer.

WE DEPEND ON OUR SOFTWARE PRODUCTS AND IF THE MARKET FOR THESE PRODUCTS DOES NOT
CONTINUE TO GROW, OUR BUSINESS COULD BE MATERIALLY ADVERSELY AFFECTED.

     Software license revenues from our software products were $11.7 million or
74% of total revenues in 1999 and $21.2 million or 75.2% of total revenues in
the first nine months of 2000. We expect to continue to be dependent upon our
software products in the future, and any factor adversely affecting the market
for Web application server and e-business platform software in general, or our
software in particular, would adversely affect our ability to generate revenues.
The market for Web application server and e-business platform software is
competitive, highly fragmented and characterized by rapid technological change.
Our future financial performance will depend in large part on the successful
development, introduction and customer acceptance of our new products and
product enhancements in a timely and cost effective manner. We expect to
continue to commit significant resources to market and further develop our
software products and enhance the brand awareness of our products. The market
for our software may not continue to grow or may grow at a slower rate than we
expect. Furthermore, the market may not accept our products. If this market
fails to grow or grows more slowly than we anticipate, or if the market fails to
accept our products, our business could suffer.

IF THE MARKET'S ACCEPTANCE AND ADOPTION OF JAVA AND XML SERVER TECHNOLOGIES DOES
NOT CONTINUE, OUR FUTURE RESULTS MAY SUFFER.

    The foundation of our Total-e-Business product suite is Total-e-Server, our
web application server which is 100% Pure Java. Java is a programming language
developed by Sun Microsystems. Therefore, the continued acceptance of our
products in the marketplace depends on Java's acceptance as a standard
programming language. If Sun Microsystems were to make significant changes to
the Java language or fail to correct defects and limitations in its products,
our ability to continue to improve and ship our products could be impaired. In
the future, our customers may also require the ability to deploy our products on
platforms for which technically acceptable Java implementations either do not
exist or are not available on commercially reasonable terms.

     In January 1999, we introduced a product based on a document format for the
Web called XML, or extensible mark-up language. We cannot be sure that XML
technology will be adopted as a standard, that XML-based products will achieve
broad market acceptance, that our XML products will be accepted or that other
superior technologies will not be developed. The failure of XML technology to
become a standard or the failure of our XML products to achieve broad acceptance
could adversely affect our ability to generate revenues. The XML server
technology is one of several competing technologies used in information exchange
and Internet commerce. We intend to continue to invest substantial resources in
our XML products.

INTENSE COMPETITION AND INCREASING CONSOLIDATION IN OUR INDUSTRY COULD CREATE
STRONGER COMPETITORS AND HARM OUR BUSINESS.

     The market for our products is intensely competitive, highly fragmented,
characterized by rapid technological change and significantly affected by new
product introductions. Acquisitions of several of our competitors by large
software companies and other market activities of industry participants have
increased the competition in our market. Our competitors consist of a number of
private and public companies including, among others: BEA Systems which acquired
WebLogic; IBM; Microsoft; Oracle; and Sun Microsystems, which acquired
NetDynamics and the rights to Netscape's Application Server. In addition, we
face competition from in-house software developers who may develop some or all
of the functionality that our products provide. Many of our competitors have
longer operating histories, significantly greater financial, technical,
marketing and other resources, greater name recognition, a broader range of
products to offer and a larger installed base of customers than us, any of which
could provide them with a significant competitive advantage.

     We expect to face increased competition in the future from our current
competitors. In addition, new competitors, or alliances among existing and
future competitors, may emerge and rapidly gain significant market share. We
also may face increased competition from existing large business application
software vendors that may broaden their product offerings to include Web
application server software. Their significant installed


                                       16
<PAGE>

customer bases and abilities to offer a broad solution and price these new
products as incremental add-ons to existing systems could provide them with a
significant competitive advantage.

OUR CUSTOMERS ARE CONCENTRATED AND THE LOSS OF ONE OF OUR LARGEST CUSTOMERS
COULD CAUSE OUR REVENUES TO DROP QUICKLY AND UNEXPECTEDLY.

     Our top ten customers for the year ended December 31, 1999 and the nine
months ended September 30, 2000 in the aggregate accounted for approximately
56.0% and 53.4%, respectively, of our revenues. One customer accounted for more
than 10% of our revenues for the year ended December 31, 1999 and one customer
accounted for more than 10% of our revenues for the nine months ended September
30, 2000. We expect that a small number of customers will continue to account
for a substantial portion of revenues in any given quarter in the foreseeable
future, although it is unusual for the same customer to account for a
substantial amount of revenues in each of several quarters. As a result, our
inability to secure major customers during a given period or the loss of any one
major customer could cause our revenues to drop quickly and unexpectedly.

IF WE FAIL TO DEVELOP NEW PRODUCTS AND SERVICES IN THE FACE OF OUR INDUSTRY'S
RAPIDLY EVOLVING TECHNOLOGY, OUR FUTURE RESULTS MAY BE ADVERSELY AFFECTED.

     Due to the recent emergence of the Internet and the Web as a forum for
conducting business, the market for Web application server systems and
e-business platforms in which we participate is subject to rapid technological
change, changing customer needs, frequent new product introductions and evolving
industry standards that may render existing products and services obsolete. Our
growth and future operating results will depend in part upon our ability to
enhance existing applications and develop and introduce new applications or
components that:

     -    meet or exceed technological advances in the marketplace;

     -    meet changing customer requirements;

     -    achieve market acceptance;

     -    integrate successfully with third party software; and

     -    respond to competitive products.

     Our product development and testing efforts have required, and are expected
to continue to require, substantial investment. We may not possess sufficient
resources to continue to make the necessary investments in technology. In
addition, we may not successfully identify new software opportunities and
develop and bring new software to market in a timely and efficient manner. If we
are unable, for technological or other reasons, to develop and introduce new and
enhanced software in a timely manner, we may lose existing customers and fail to
attract new customers, resulting in a decline in revenues.

OUR STOCK PRICE MAY FLUCTUATE WIDELY.

     Prior to our initial public offering in September 1999, there was no public
market for our common stock. Since then, the market price of our common stock
has fluctuated, and it may continue to fluctuate substantially, due to:

     -    quarterly fluctuations in operating results;

     -    announcements of new products or product enhancements by us or our
          competitors;

     -    technological innovations by us or our competitors;

     -    general market conditions or market conditions specific to our or our
          customers' industries; and

     -    changes in earnings estimates or recommendations by analysts.

     Stock prices of Internet-related companies have been highly volatile. Our
current stock price may not be indicative of the price that will prevail in the
trading market. In the past, following periods of volatility in the market price
of a company's securities, securities class action litigation has at times been
instituted against that


                                       17
<PAGE>


company. If we become subject to securities litigation, we could incur
substantial costs and experience a diversion of management's attention and
resources.

THE UNPREDICTABILITY OF OUR QUARTERLY OPERATING RESULTS MAY ADVERSELY AFFECT THE
TRADING PRICE OF OUR COMMON STOCK.

     Quarterly fluctuations in operating results may be caused by:

     -    changes in the growth rate of Internet usage;

     -    fluctuations in the demand for our products and services;

     -    the level of product and price competition in our markets;

     -    the timing and market acceptance of new product introductions and
          upgrades by us or our competitors;

     -    our success in expanding our customer support and marketing and sales
          organizations;

     -    the size and timing of individual transactions;

     -    delays in, or cancellations of, customer implementations;

     -    customers' budget constraints;

     -    the level of product development expenditures;

     -    our ability to control costs; and

     -    general economic conditions.

     Many of these factors are not in our control. In addition, we also
experience seasonality which causes us to typically recognize a
disproportionately greater amount of our revenues for any fiscal year in our
fourth quarter and a disproportionately lesser amount in our first quarter, due
largely to sales force quota practices in the software industry and to customer
budgeting processes.

OUR FAILURE TO SUCCESSFULLY INTEGRATE ACQUISITIONS COULD ADVERSELY AFFECT
OUR BUSINESS.

     We acquired Arjuna Solutions Limited in July 2000 and we may acquire
other complementary product lines, technologies and businesses as part of our
growth strategy. Although we may make such acquisitions, we may not be able
to successfully integrate them with our business in a timely manner. Our
failure to successfully address the risks associated with such acquisitions,
if consummated, could have a material adverse effect on our business and our
ability to develop and market products. The success of any acquisitions will
depend on our ability to:

     -    successfully integrate and manage the acquired operations;

     -    retain the key employees of the acquisition targets;

     -    develop, integrate and market products and product enhancements based
          on the acquired products and technologies; and

     -    control costs and expenses, as well as demands on our management,
          associated with the potential acquisitions.

     If we are not able to successfully integrate acquired product lines,
technologies or businesses with our business, we may incur substantial costs and
delays or other operational, technical or financial problems. In addition, our
failure to successfully integrate acquisitions may divert management's attention
from our existing business and may damage our relationships with key clients and
employees. To finance future acquisitions, we may issue equity securities that
could be dilutive to our stockholders. We may also incur debt and additional
amortization expenses related to goodwill and other intangible assets as a
result of future acquisitions. The


                                       18
<PAGE>

interest expense related to this debt and additional amortization expense may
significantly reduce our profitability and could have a material adverse effect
on our business, financial condition and operating results.

WE NEED TO MANAGE OUR GROWTH EFFECTIVELY OR WE MAY NOT SUCCEED.

     We are a growing company. Our ability to manage our growth will depend in
large part on our ability to generally improve and expand our operational and
sales and marketing capabilities, to develop the management skills of our
managers and supervisors, many of whom have been employed by us for a relatively
short time, and to train, motivate and manage both our existing employees and
the additional employees that may be required. Additionally, we may not
adequately anticipate all of the demands that growth may impose on our systems,
procedures and structure. Any failure to adequately anticipate and respond to
these demands or manage our growth effectively would have a material adverse
effect on our future prospects.

THE DEVELOPMENT OF INTERNATIONAL OPERATIONS WILL CAUSE US TO FACE ADDITIONAL
RISKS.

     In the first quarter of 2000, we established a U.K. subsidiary and opened a
branch office in London, England. In the third quarter we established a branch
office in Sweden and an independent distributorship in Italy. We may continue to
expand our international operations and international sales and marketing
efforts. We have limited experience in marketing, selling and distributing our
products and services internationally. International operations, including
operations in those regions that we are targeting, are subject to the following
risks:

     -    recessions in foreign economies;

     -    political and economic instability;

     -    fluctuations in currency exchange rates;

     -    difficulties and costs of staffing and managing foreign operations;

     -    potentially adverse tax consequences;

     -    reduced protection for intellectual property rights in some countries;
          and

     -    changes in regulatory requirements.

OUR FAILURE TO MAINTAIN ONGOING SALES THROUGH A LIMITED NUMBER OF INDIRECT
CHANNELS MAY RESULT IN LOWER REVENUES.

     We derive a significant portion of our license revenues through a limited
number of independent software vendors, systems integrators, distributors and
resellers. Although we intend to increase our marketing and direct sales
efforts, we expect that a limited number of these indirect channels will
continue to account for a significant portion of our revenues in any given
quarter in the foreseeable future. To be successful, we must continue to foster
and maintain our existing indirect channels, as well as develop new
relationships. The loss of, or reduction in orders through, existing indirect
channels or the failure to develop new indirect channel relationships could
cause our revenues to decline and have a material adverse effect on our
business.

IF WE LOSE OUR KEY PERSONNEL, OR FAIL TO ATTRACT AND RETAIN ADDITIONAL
PERSONNEL, THE SUCCESS AND GROWTH OF OUR BUSINESS MAY SUFFER.

     A significant portion of our senior management team has been in place for a
relatively short period of time. Our success will depend to a significant extent
on their ability to gain and maintain the trust and confidence of our other
employees and to work effectively as a team.

     Our future success will also depend significantly on our ability to
attract, integrate, motivate and retain additional highly skilled technical,
managerial, sales, marketing, and services personnel. Competition for skilled
personnel is intense, and we may not be successful in attracting, motivating and
retaining the personnel required to grow and operate profitably. Failure to
attract, integrate, motivate and retain highly skilled personnel could adversely
affect our business, especially our ability to develop new products and enhance
existing products.


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<PAGE>


THE LENGTHY AND VARIABLE SALES CYCLES OF OUR SOFTWARE PRODUCTS COULD CAUSE
SIGNIFICANT FLUCTUATION IN OUR QUARTERLY RESULTS.

     Our software products are generally used for mission-critical or
enterprise-wide purposes and involve a significant commitment of resources by
our customers. A customer's decision to license our software generally involves
the evaluation of the available alternatives by a significant number of
personnel in various functional and geographic areas, each often having specific
and conflicting requirements. Accordingly, we typically must expend substantial
resources educating prospective customers about the value of our software
solutions. For these reasons, the length of time between the date of initial
contact with the potential customer and the execution of a software license
agreement typically ranges from three to six months, and is subject to delays
over which we have little or no control. As a result, our ability to forecast
the timing and amount of specific sales is limited and the delay or failure to
complete one or more large license transactions could cause our operating
results to vary significantly from quarter to quarter.

THE FAILURE TO IMPLEMENT SUCCESSFULLY OUR SOFTWARE PRODUCTS COULD RESULT IN
DISSATISFIED CUSTOMERS AND DECREASED SALES.

     Implementation of our software products often involves a significant
commitment of financial and other resources by our customers. The customer's
implementation cycle can be lengthy due to the size and complexity of their
systems and operations. In addition, our customers rely heavily on third party
systems integrators to assist them with the installation of our software. Our
failure or the failure of our alliance partners, our customers or our third
party integrators to implement successfully our software could result in
dissatisfied customers which could adversely affect our reputation.

WE MAY REQUIRE FUTURE ADDITIONAL FUNDING TO STAY IN BUSINESS.

     Over time, we may require additional financing for our operations.
Additionally, we periodically review other companies' product lines and
technologies for potential acquisition. Any material acquisitions or joint
ventures could require additional financing. This additional financing may not
be available to us on a timely basis if at all, or, if available, on terms
acceptable to us. Moreover, additional financing may cause dilution to existing
stockholders.

CAPACITY RESTRICTIONS COULD REDUCE THE DEMAND AND UTILITY OF OUR PRODUCTS.

     Concurrency restrictions can limit Internet deployment and use capacity.
The boundaries of our Total-e-Server software, Bluestone XML server and
Bluestone Total-e-Business capacity, in terms of numbers of concurrent users or
interactions, are unknown because, to date, no customer or testing environment
has reached these boundaries. These boundaries may, at some future time, be
reached and, when reached, may be insufficient to enable our customers to
achieve their desired levels of information deployment and exchange. We may lose
customers or fail to gain new customers if any of our products' capacity
boundary limits the ability of our customers to achieve expected levels of
information deployment and exchange or Internet commerce transactions.

OUR LIMITED ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS COULD IMPAIR OUR
ABILITY TO COMPETE EFFECTIVELY.

     Our success and ability to compete are substantially dependent on our
internally developed technologies and trademarks, which we protect through a
combination of copyright, trademark and trade secret laws, confidentiality
procedures and contractual provisions.

     Despite our efforts to protect our proprietary rights, unauthorized parties
may attempt to copy aspects of our products or obtain and use information that
we regard as proprietary. Policing unauthorized use of our products is difficult
and, though we are unable to determine the extent to which piracy of our
software products exists, we expect software piracy to be a problem. In
addition, the laws of some foreign countries do not protect our proprietary
rights to the same extent as the laws of the United States. Furthermore, our
competitors may independently develop technology similar to ours.

     The number of intellectual property claims in our industry may increase as
the number of competing products grows and the functionality of products in
different industry segments overlaps. Although we are not aware that any of our
products infringe upon the proprietary rights of third parties, there can be no
assurance that third


                                       20
<PAGE>


parties will not claim infringement by us with respect to current or future
products. Any of these claims, with or without merit, could be time consuming to
address, result in costly litigation, cause product shipment delays or require
us to enter into royalty or license agreements. These royalty or license
agreements might not be available on terms acceptable to us or at all, which
could have a material adverse effect on our business.

OUR FAILURE TO OBTAIN OR MAINTAIN THIRD PARTY LICENSES COULD HARM OUR BUSINESS.

     We have in the past resold, and may in the future resell, under license,
certain third party software that enables our software to interact with other
software systems or databases. In addition, we license certain software
technology used to develop our software. The loss or inability to maintain any
of these software licenses could result in delays or reductions in product
shipments until equivalent software could be identified and licensed or
compiled, which could adversely affect our business.

WE MAY BE SUBJECT TO FUTURE PRODUCT LIABILITY CLAIMS AND OUR PRODUCTS'
REPUTATIONS MAY SUFFER.

     Many of our installations involve projects that are critical to the
operations of our customers' businesses and provide benefits that may be
difficult to quantify. Any failure in a customer's system could result in a
claim for substantial damages against us, regardless of our responsibility for
the failure. Although our license agreements with our customers typically
contain provisions designed to limit contractually our liability for damages
arising from negligent acts, errors, mistakes or omissions, it is possible that
these provisions will not be enforceable in certain instances or would otherwise
not protect us from liability for damages. Although we maintain general
liability insurance coverage, this coverage may not continue to be available on
reasonable terms or at all, or may be insufficient to cover one or more large
claims.

     We have entered into and plan to continue to enter into agreements with
strategic alliance partners whereby we license our software products for
integration with the alliance partners' software. If an alliance partner's
software fails to meet customer expectations or causes a failure in its
customer's systems, the reputation of our software products could be materially
and adversely affected even if our software products performed in accordance
with their functional specifications.

OUR EXECUTIVE OFFICERS AND DIRECTORS AND THEIR AFFILIATES OWN A LARGE PERCENTAGE
OF OUR VOTING STOCK AND WILL HAVE THE ABILITY TO MAKE DECISIONS THAT COULD
ADVERSELY AFFECT OUR STOCK PRICE.

     Currently, our executive officers, directors and their affiliates
beneficially own approximately 33% of the outstanding shares of common stock. As
a result, these stockholders are able to influence to a substantial degree all
matters requiring stockholder approval and, thereby, our management and affairs.
Matters that require stockholder approval include:

     -    election of directors;

     -    approval of mergers or consolidations; and

     -    sale of all or substantially all of our assets.

OUR CHARTER AND BYLAWS AND DELAWARE LAW CONTAIN PROVISIONS THAT COULD DISCOURAGE
A TAKEOVER EVEN IF BENEFICIAL TO STOCKHOLDERS.

     Our charter and our bylaws, in conjunction with Delaware law, contain
provisions that could make it more difficult for a third party to obtain control
of Bluestone even if doing so would be beneficial to stockholders. For example,
our charter provides for a classified board of directors and restricts the
ability of stockholders to call a special meeting. Our bylaws allow the board of
directors to expand its size and fill any vacancies without stockholder
approval.

FUTURE SALES OF OUR COMMON STOCK MAY DEPRESS OUR STOCK PRICE.

     The market price of our common stock could decline as a result of sales by
our existing stockholders or the perception that those sales may occur. These
sales could also make it more difficult for us to raise funds through equity
offerings in the future at a time and at a price that we think is appropriate.


                                       21
<PAGE>

     The holders of a significant amount of our common stock, as well as the
holders of outstanding warrants, are entitled to registration rights with
respect to their common stock or the common stock underlying their
convertible securities or are eligible to sell the common stock pursuant to
Rule 144. If these holders, by exercising their registration rights or
through sales pursuant to Rule 144, cause a large number of securities to be
registered and sold in the public market, these sales could have an adverse
effect on the market price for our common stock. If we were to include, in a
registration statement initiated by us, shares held by these holders pursuant
to the exercise of their registration rights, these sales may have an adverse
effect on our ability to raise needed capital.

YEAR 2000 PROBLEMS MAY DISRUPT OUR BUSINESS.

     We have not experienced any material internal Year 2000 problems to date.
While our software products are not time/date sensitive, many of the third party
software applications run by our customers are time/date sensitive. We have not
been advised and are not otherwise aware of any material Year 2000 problems
experienced by our customers to date. We have, however, in the past resold third
party software that may not be Year 2000 compliant. While we have not been made
aware of any material Year 2000 problems relating to the hardware and software
used by our customers in connection with our products to date, these problems
may exist. Should any of these problems develop, they may have a material
adverse effect on our business, operating results and financial condition. In
addition, we utilize software, computer technology and other services internally
developed and provided by third party vendors that may have Year 2000 issues.
Although we have not experienced any of these problems to date, the failure of
our internal computing systems or of systems provided by third party vendors to
be Year 2000 compliant could materially adversely affect our business.

     Our costs related to Year 2000 compliance, which thus far have not been
material could ultimately be significant if Year 2000 problems surface. In the
event that we experience disruptions as a result of any Year 2000 problems, our
business could be seriously harmed. Additionally our insurance coverage may not
cover or be adequate to offset these and other business risks related to the
Year 2000.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Until the first quarter of 2000, we developed our products in the U.S.
and sold them primarily in North America. As a result, our historical
financial results were not affected by factors such as changes in foreign
currency exchange rates or weak economic conditions in foreign markets. Since
the first quarter of 2000, we established a U.K. subsidiary, acquired Arjuna
Solutions Limited in Newcastle, England, opened branch offices in London,
England and Sweden, established an independent distributorship in Italy and
generated approximately $800,000 of revenue from international operations to
date. Such revenue was denominated in U.S. dollars. In the future, we may
increase our international operations which could increase our exposure to
these factors.

     Our holdings of financial instruments are comprised of a mix of
corporate debt, government securities and commercial paper. All such
instruments are classified as securities available for sale. Our portfolio
represents funds held temporarily pending use in our business and operations.
We seek reasonable assuredness of the safety of principal and market
liquidity by investing in rated fixed income securities while at the same
time seeking to achieve a favorable rate of return. Our market risk exposure
consists principally of exposure to changes in interest rates. Our holdings
are also exposed to the risks of changes in the credit quality of issuers. We
typically invest in the shorter end of the maturity spectrum. We believe that
there is no material market risk exposure relating to these investments.

PART II.  OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS.

     None.

ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS.

        (c) Issuance of unregistered securities

On July 3, 2000, the Company acquired all of the outstanding share capital of
Arjuna Solutions Limited. Initial acquisition consideration consisted in part of
277,803 shares of common stock issued to the shareholders of Arjuna. Additional
consideration, consisting in part of 82,725 shares of common stock, is payable
upon the earlier of completion by Arjuna of certain products on or before
February 1, 2001 or waiver of the delivery date or requirements by the Company.
Our shares were issues pursuant to exemptions from registration under Regulation
D and S under the Securities Act of 1933, as amended since the issuance of
shares was made to a limited number of non-U.S. persons.

         (d)  Use of Proceeds


                                       22
<PAGE>

     On September 23, 1999, the Securities and Exchange Commission declared
effective our registration statement on Form S-1 (File No. 333-82213) relating
to our initial public offering of our common stock. We received net proceeds of
approximately $54.8 million after deducting underwriting discounts and offering
expenses. Although we cannot distinguish the net proceeds from our initial
public offering from the net proceeds from our prior financing activities, the
net proceeds of $145.8 million from our follow-on public offering in February
2000, or other cash on hand at September 30, 1999, we used $20.9 million in cash
for operating activities since September 30, 1999 (approximately the date of
closing of our initial public offering) and believe that approximately 69.0% of
such amount was used for sales and marketing activities, 14.0% was used for
product development and 17.0% was used for general corporate purposes.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.

         None.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

         None.

ITEM 5.  OTHER INFORMATION.

         None.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K.

         (a)  Exhibits:

          2.1      Agreement for the sale and purchase of the entire issued
                   share capital of Arjuna Solutions Limited between Bluestone,
                   Bluestone Software Europe Limited and Vendors of Arjuna
                   Solutions Limited dated July 3, 2000.

         10.1      Stock Purchase and Investor Rights Agreement between
                   Bluestone and S2 Systems, Inc. dated August 18, 2000.

         10.2      Lease for Irwin Road facility in Mount Laurel, New Jersey
                   between Bluestone and Partners Creek, II LLC dated
                   August 9, 2000.

         10.3      Licence Agreement for the Supply of Office Facilities between
                   Bluestone and Regus (UK) Ltd. dated February 7, 2000.

         10.4      Licence Agreement for the Supply of Office Facilities between
                   Citibase Plc and Arjuna Solutions Limited dated
                   September 15, 2000.

         27.1      Financial Data Schedule (in electronic format only).

         (b)  Reports on Form 8-K:

                   None.


                                       23

<PAGE>

                                    SIGNATURE


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

                                               BLUESTONE SOFTWARE, INC.


                Dated: November 14, 2000       By: /s/ S. Craig Huke
                                                   -----------------------------
                                                   S. Craig Huke
                                                   EXECUTIVE VICE-PRESIDENT &
                                                   CHIEF FINANCIAL OFFICER

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