Summary of QUEST SOFTWARE INC

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations ("MD&A") should be read in conjunction with the consolidated financial statements and notes to those statements included elsewhere in this Report. Certain statements in this Report, including statements regarding our business strategies, operations, financial condition and prospects are forward-looking statements. Use of the words "believe," "expect," "anticipate," "will," "contemplate," "would" and similar expressions that contemplate future events may identify forward-looking statements.

Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Readers are urged to carefully review and consider the various disclosures made in this Report, including those described under "Risk Factors," and in other filings with the SEC that attempt to advise interested parties of certain risks and factors that may affect our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect management's opinions only as of the date thereof. We do not assume any obligation to revise or update forward-looking statements. Finally, our historic results should not be viewed as indicative of future performance.

Overview

Our Company and Business Model

Quest Software, Inc., together with our subsidiaries ScriptLogic and Vizioncore, delivers innovative products that help IT organizations get enhanced performance from their computing environment. Our product areas are Application Management, Database Management, Windows Management and Virtualization Management. The focus of our products is based upon generating higher levels of performance, manageability and productivity throughout our customers' IT infrastructure and with products and services that enable them to manage the investments they have made within their IT environment.

Our initial core competency as a database management company was built upon deep expertise within the Oracle database platform where we assembled a portfolio of products to manage and speed the development on the platform. As customers required heterogeneous database management tools, we broadened our product portfolio to deliver complementary solutions and expanded our offerings to address other database platforms, including DB2 and SQL Server. Today, most of our database management revenue is derived from products focused on the Oracle platform. In the last several years however, Oracle has increased the functionality of their database products creating a stronger competitive offering which has impaired our license growth for certain products. This has negatively impacted our database management license growth. Our database development product group led by TOAD continues to be the most significant revenue contributor of our Oracle database products. As we were impacted from Oracle's encroachment within the management market we sought to diversify our portfolio and fostered development on Microsoft's SQL Server database platform. Today, our SQL Server management products support backup and recovery, capacity management and performance management for one of Microsoft's strategic platforms. Application deployments typically front large databases, thus the database logically interacts with other elements of the application infrastructure. This logical linkage and reliance on the database led Quest into its next product focal point known as Application Management.

From our acquisition of Foglight Software in January 2000 and then Sitraka in October 2002, to our current offerings for application management, we have made significant investments and evolved the development of products for this market. Foglight remains our flagship product and largest revenue component of our application management offerings. As our customers face the need to manage more complex applications with service oriented architectures, our products for identifying application outages and performance have become important tools. While 2006 was an investment year for our application management products, we released Foglight Version 5.0 in mid-year 2007. In 2008, we expanded the functionality provided by Foglight to enable customers the ability to isolate and manage applications within a virtual environment using the same framework that they are accustomed to within the physical infrastructure.

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After establishing a market presence in both the database and application management markets, we sought to broaden our portfolio further into the Windows management tools market in early 2000 with our acquisition of Fastlane Technologies. In 2004, we acquired Aelita Software. Our acquisition of Aelita, combined with internally developed products, solidified our position as one of Microsoft's leading ISV's. In August of 2007 we acquired ScriptLogic, extending our product footprint to address desktop management, a new market for us. Further, in September 2008 we acquired NetPro Computing, Inc. ("NetPro"), expanding our Active Directory product portfolio. We market and support management tools for five key Microsoft platforms-Windows Server, Active Directory, Exchange, SQL Server and the Microsoft desktop. Our products address both migration and management of the Windows platform. Our migration business comprises a set of products which support migration from other competitive platforms to the comparable Microsoft platform, as well as migrations from earlier to the most current version of Microsoft platforms. In addition, we offer products which complement the core platform tools which are natively used by customers to manage these platforms once they are in a production environment.

As our Windows products emerged and continued to grow in market popularity, the composition of our overall revenue profile changed from being primarily derived from the Oracle database platform tools to a more balanced profile with our Windows products. During 2008 our Windows products represented the predominant portion of our growth.

As the market for virtualization began to develop we made an investment in Vizioncore during 2005 which served as the cornerstone for our next strategic product line expansion. During 2007 we further built-out this product portfolio with subsequent acquisitions of Invirtus and Provision Networks. In December 2007 we acquired the remaining minority interest in Vizioncore. As customers increase the use of today's Virtualization platforms the market is moving past the early-adopter phase into mainstream production usage in support of server consolidation, disaster recovery and other usage scenarios across the datacenter. The taxonomy of the Virtualization Management market is following the development of paths taken previously where platform companies create the delivery mechanism and partner with other third-party vendors such as Quest to support their platform. Today, the platform market leader is VMware, but with Microsoft and Citrix/ Xensource entering the market, it is expected that "cross-platform" tools will emerge to support the requirements of the datacenter such as provisioning, monitoring, reporting, disaster recovery and the typical functions found in today's physical environment. We believe that the depth and breadth of our management capability across the entire IT stack uniquely positions Quest to become a preferred provider of these tools.

Strategic acquisitions and investments have been a key part of our corporate strategy. During 2008 we spent approximately $144.0 million on five acquisitions and invested $3.2 million in two early stage private companies. This strategic deployment of capital covered many of our existing market segments including Application Management, Windows Management and Virtualization Management.

Our acquisitions of Vizioncore, ScriptLogic, PassGo and NetPro contributed to our revenue growth in 2008. We intend to continue to identify and acquire companies in adjacent or contiguous markets, as we have done in the past. We have also used acquisitions and investments to build upon or extend our core competencies with incremental technology to increase our existing product functionality or complete a key portion of a deliverable on the product roadmap.

We derive revenues from three primary sources: (1) software licenses,
(2) post-contract technical support services ("maintenance") and (3) consulting and training services. Our software licensing model is primarily based on perpetual license fees, and our license fees are typically calculated either on a per-server basis or a per-seat basis.

Maintenance contracts entitle a customer to telephone or internet support and unspecified maintenance releases, updates and enhancements. First-year maintenance contracts are typically sold with the related perpetual software license and renewed on an annual basis thereafter at the customer's option. Annual maintenance

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renewal fees are priced as a percentage of the net initial customer purchase price (which includes both the fee for a perpetual license and first year maintenance). Revenue is allocated to first year maintenance based on vendor-specific objective evidence ("VSOE") of fair value and amortized over the term of the maintenance contract, typically 12 months, although at times we sell maintenance with terms of greater than 12 months.

Services revenues continue to contribute a larger percentage of our total revenues as our installed base of customers grows, through acquisitions and their related maintenance contracts, and through multi-year pre-paid support programs. As our maintenance customer base grows, the maintenance renewal rate has a larger influence on the maintenance revenue growth rate and the amount of new software license revenues has a diminishing effect. Therefore, the growth rate of total revenues does not necessarily correlate directly to the growth rate of new software license revenues in a given period. The primary determinant of changes in our maintenance revenue profile is the rate at which our customers renew their annual maintenance and support agreements. If our maintenance renewal rates were to decline materially, our maintenance revenues, total revenues and cash flows would likely decline materially as well. Although we do not currently expect our maintenance renewal rates to deteriorate, there can be no assurance they will not.

We also provide consulting and training services which relate to the installation and configuration of our products but do not include significant customization to or development of the underlying software code. Revenue allocated to consulting and training services is analyzed based on VSOE of fair value and recognized as the services are performed. Such revenues represented 10.2%, 11.4% and 13.5% of total services revenues for the twelve months ended December 31, 2008, 2007 and 2006, respectively.

Our primary expenses are our personnel costs, which include compensation, benefits and payroll related taxes, which are a function of our world-wide headcount. We estimate that these personnel related costs represented approximately 67% of total expenses in 2008. Our headcount grew by approximately 130 over the course of 2008 primarily as a result of acquisitions. Total share-based compensation expense and related payroll taxes increased from $17.5 million in 2007 to $18.2 million in 2008, representing a 4.1% year-over-year increase, due primarily to the fact that no option awards were granted from September 2006 through December 2007 due to the restatement of our historical financial results. Our option granting activity resumed in the first quarter of 2008.

We invest a significant portion of our cash flows into research and development to design, develop and enhance a wide variety of products and technologies to drive future license revenues and the anticipated related maintenance renewals. We have also used cash for acquisitions as a strategy to obtain incremental products and technology that will be attractive to our customers and to move into additional markets to enhance our growth. While we are primarily a direct-sales driven organization that expends significant selling costs to secure new customer license sales and the follow-on maintenance revenue stream, the additions of ScriptLogic and Vizioncore enhances our ability to sell our products through distributors and resellers.

Our foreign currency gains or losses are predominantly attributable to translation gains or losses on the re-measurement of our net balances of monetary assets and liabilities in our foreign subsidiaries, including accounts receivable and cash, which were primarily denominated in the Euro, and to a lesser extent, the British Pound and Canadian Dollar. The foreign currency translation adjustments to these balance sheet items are calculated by comparing the currency spot rates at the end of a quarter to the spot rates at the end of the previous quarter. On this basis, we recorded, within other income, net, a net loss of $7.5 million in 2008 and a net gain of $4.4 million in 2007.

Our 2008 Results

As discussed in more detail throughout our MD&A, for the year ended December 31, 2008 compared to the year ended December 31, 2007, we delivered the following financial performance:

� Total revenues increased by $104.4 million, or 16.5% to $735.4 million;

� Total expenses increased by $91.4 million, or 16.2% to $654.0 million;

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� Income from operations increased by $13.0 million, or 19.1% to $81.3 million;

� Diluted earnings per share increased by 6.8% to $0.64.

The increase in our total revenues was primarily driven by increased sales of our Windows Management products and related services primarily in the Americas and our EMEA region. Fiscal 2008 total revenues were also impacted by the weakening U.S. Dollar relative to certain non-US Dollar currencies, primarily the Euro, contributing approximately 2% of the increase in total revenues.

The increase in total expenses was primarily due to increased personnel costs, which include compensation, benefits and payroll related taxes, which are a function of our worldwide headcount. We estimate that these personnel related costs represented approximately 67% of total expenses in the twelve months ended December 31, 2008 and 2007. Our full-time employee headcount at the end of fiscal 2008 was 3,477 compared to 3,346 at the end of fiscal 2007. Our full-time employee headcount in locations outside of the United States was approximately 1,650 at the end of both fiscal 2008 and 2007. During the year ended December 31, 2008, we terminated approximately 200 employees under our cost management initiatives and added approximately 200 employees from acquisitions. Fiscal 2008 total expenses were also impacted by the weakening U.S. Dollar in the year ended December 31, 2008 relative to 2007 for several currencies including the Euro, Canadian Dollar, Russian Ruble and Australian Dollar. Since certain of our international expenses are denominated in these non-US Dollar currencies, this contributed approximately 8% of the increase in total expenses.

The increase in income from operations is primarily due to higher revenues and to our cost management initiatives undertaken in fiscal 2008. We implemented various cost management initiatives in fiscal 2008 with the goal of improving our annual operating margins. These initiatives included workforce reductions across all functions and geographies in the second and fourth quarters of 2008, and the affected employees were provided cash separation packages. The cost savings associated with this process began to be realized in the third and fourth quarters of 2008. The severance cost recorded and paid in the year ended December 31, 2008 associated with these terminations was approximately $3.1 million.

In September 2008, we acquired NetPro for purchase consideration of approximately $79.0 million. In January 2008, we acquired PassGo Technologies Limited ("PassGo"), a privately held, UK-based leader in access and identity management solutions, for purchase consideration of approximately $52.2 million. With our acquisition of PassGo, Quest is better able to help businesses further leverage Active Directory to manage user groups and passwords in environments that include Unix and other systems in addition to Windows. We also completed three other acquisitions during fiscal 2008. See Note 4 of our Notes to Consolidated Financial Statements for additional details about our acquisitions.

Recently Issued Accounting Pronouncements

See Note 1 of our Notes to Consolidated Financial Statements for information regarding recently issued accounting pronouncements.

Critical Accounting Policies and Estimates

Our consolidated financial statements are based on the selection and application of generally accepted accounting principles, which require us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates and any such differences may be material to our financial statements. We believe that the policies set forth below may involve a higher degree of judgment and complexity in their application than our other accounting policies and represent the critical accounting policies and estimates used in the preparation of our financial statements. If different assumptions or conditions were to prevail, the results

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could be materially different from our reported results. Historically, our assumptions, judgments and estimates relative to our critical accounting policies and estimates have not differed materially from actual results. Our significant accounting policies are presented within Note 1 of our Notes to Consolidated Financial Statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the related disclosures.

Revenue Recognition

Our revenue recognition policy is one of our critical accounting policies because revenue is a key component of our results of operations and is based on complex rules that require us to make significant judgments and estimates. In applying our revenue recognition policy we must determine which portions of our revenue are recognized currently (generally perpetual software licenses) and which portions must be deferred (generally maintenance, consulting and training services). In addition, we analyze various factors including our pricing policies, the credit-worthiness of our customers, accounts receivable aging data and contractual terms and conditions in helping us make judgments about revenue recognition. Changes in judgments with respect to any of these factors could materially impact the timing and amount of revenue and costs recognized.

We recognize revenue pursuant to the requirements of Statement of Position 97-2, "Software Revenue Recognition" ("SOP 97-2"), issued by the American Institute of Certified Public Accountants ("AICPA"), as amended by SOP 98-9, Modification of SOP 97-2, "Software Revenue Recognition, With Respect to Certain Transactions" and the related Technical Practice Aids of the AICPA. In accordance with SOP 97-2, we cannot recognize any revenue before all of the following criteria are met: (1) there is persuasive evidence of an arrangement; (2) we deliver the products; (3) fees are fixed or determinable and license agreement terms are free of contingencies or uncertainties that may alter the agreement such that it may not be complete and final; and (4) collection is probable.

We initially capture value for our products by selling a perpetual software license to end customers. The fee for the first year of maintenance is included in, or bundled with, the perpetual software license at the time of initial sale. As such, the combination at initial sale of a perpetual software license and one year of maintenance represents a "multiple-element" arrangement for revenue recognition purposes.

When all four of our revenue recognition criteria are met, the multiple-element aspect of our arrangements means the only revenue recognized upfront, at the time of initial sale, is the residual revenue allocated to the perpetual software license. The revenue associated with the fair value of the undelivered maintenance and/or consulting and training services included in the initial sale is deferred and is subsequently recorded to revenue ratably over the support term and as such services are performed, respectively. The fair value of the undelivered elements is determined based on VSOE of fair value.

Revenue for our standalone sales of annual maintenance renewals in years two, three and beyond is recognized ratably over the support term. Sales of maintenance for multiple annual periods are treated similarly.

Revenue from our consulting and training services is generally recognized as the services are performed in accordance with the underlying service contracts.

Our maintenance VSOE of fair value is determined by reference to the prices our end customers pay for this support when it is sold separately; that is, when we enter into an arms length, annual renewal transaction with end customers where the only offering sold is maintenance. These standalone maintenance renewal transactions are typically one year in duration and are priced as a targeted percentage of the initial, discounted purchase price which includes both the upfront license fee and the first year of maintenance. We bill maintenance renewal transactions in advance of the services provided. We also offer end customers the right to purchase maintenance for multiple annual periods at discounted prices beyond the first year as they will be paying cash upfront, well in advance of the multi-year services performed.

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Our consulting and training services VSOE of fair value is determined by reference to our established pricing and discounting practices for these services when sold separately. Our consulting and training services are typically sold as time-and-materials based contracts that range from five to fifteen days in duration. We sell consulting and training services both standalone and as part of multiple-element arrangements.

Our VSOE of fair value is impacted by estimates and judgments that, if significantly different, could materially impact the timing and amount of revenue recognized in current and future periods. These estimates and judgments include, among other items:

� the ability to identify and validate VSOE of fair value for undelivered elements via the use of sampling techniques;

� the impact on sampling results of customer negotiating pressure on renewal rates;

� the impact on sampling results of maintenance renewals on deals originally sold via indirect channels;

� the fair value of that undelivered element for sampled transactions; and

� the economic impact of combining multiple renewal rate negotiations relative to varying products with varying purchase dates, into a single, new coterminous maintenance.

Historically, we have been able to establish VSOE of fair value for maintenance, consulting and training services but we may modify our pricing and discounting practices in the future. This could result in changes to our VSOE of fair value for these undelivered elements. If this were to occur, our future revenue recognition for multiple-element arrangements would differ significantly from our historical results. If we were unable to support at all through VSOE the fair value of our maintenance, consulting or training services, the entire amount of revenue from our initial, upfront sale of both a perpetual software license bundled with one year of maintenance and any consulting and training services would be deferred and recognized ratably over the life of the contract.

If we cannot objectively determine the fair value of any undelivered element (hardware, software, specific upgrade rights, etc.) in a bundled software and services arrangement, we defer revenue until all elements are delivered and services are performed, or until fair value can be objectively determined for any remaining undelivered elements.

In addition to perpetual software licenses, we sell a small amount of time-based software licenses (or term licenses) each year wherein customers pay a single fee for the right to use the software and receive maintenance for a defined period of time. Approximately 2% of 2008 license revenue was generated by these time-based software licenses. All license and support revenues on these term licenses are deferred and recognized ratably over the license term.

We license our products primarily through our direct sales force, our telesales force and, increasingly, indirect channels including value added resellers and distributors. For our direct sales, we utilize written contracts as the means to establish the terms and conditions upon which our products and services are sold to our end customers. For our indirect sales transactions, we accept orders from our resellers and distributors when they have existing orders from an end customer. Indirect sales through resellers are a growing proportion of our transaction volume. These transactions are generally handled via processes and policies that are similar to an end customer sale. We utilize written contracts coupled with purchase orders as the means to establish the terms and conditions of these indirect sales transactions.

Substantially all of our software license arrangements do not include acceptance provisions. Since such acceptance provisions are not contained in our software license arrangements as standard provisions and the

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incidence of returns in accordance with such acceptance provisions cannot be reasonably estimated, if a contract does include such a provision we recognize revenue upon the earlier of receipt of written customer acceptance or expiration of the acceptance period.

We evaluate arrangements with governmental entities containing "fiscal funding" or "termination for convenience" provisions, when such provisions are required by law, to determine the probability of possible cancellation. We consider multiple factors, including the history with the customer in similar transactions, and the planning, budgeting and approval processes undertaken by the governmental entity. If we determine upon execution of these arrangements that cancellation is not likely, we then recognize revenue once all of the criteria described above have been met. If such a determination cannot be made, revenue is recognized upon the earlier of cash receipt or approval of the applicable funding provision by the governmental entity.

We assess whether fees are fixed or determinable at the time of sale and recognize revenue if all other requirements have been met. Our standard payment terms require payment within 30 days but may vary based on the country in which the agreement is executed. We generally deem payments that are due within 6 months to be fixed and determinable based on collections history and thereby satisfy the required revenue recognition criteria.

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