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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



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



For the three months ended September 30, 2005



| ̈ | 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: 000-25331



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Critical Path, Inc.



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|                         |  |                               
|------------------------ |  | ------------------------------
|A California Corporation |  | I.R.S. Employer No. 91-1788300



2 Harrison Street,
2ndFloor

San Francisco, California 94105

415-541-2500



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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 ̈



Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  x    No ̈



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



As of October 31, 2005, the Company had outstanding 37,295,837 shares of common stock, $0.001 par value per share (including 40,521 shares of Class A Non-Voting preference shares of our Nova Scotia subsidiary Critical
Path Messaging Co. which can be exchanged at any time for our common stock upon the election of the holder).



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PART I - FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



CRITICAL PATH, INC.

CONDENSED
CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                        |  |                           |            |   |                   |   |            |  
|------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ---------- | - | ----------------- | - | ---------- | -
|                                                                                                                                                        |  | December 31,2004          |            |   | September 30,2005 |  
|                                                                                                                                                        |  | (in thousands; unaudited) |           
|Assets                                                                                                                                                  |  |                           |            |   |                   |   |            |  
|Current assets                                                                                                                                          |  |                           |            |   |                   |   |            |  
|Cash and cash equivalents                                                                                                                               |  | $                         | 23,239     |   |                   | $ | 20,486     |  
|Accounts receivable, net                                                                                                                                |  |                           | 19,667     |   |                   |   | 13,274     |  
|Prepaid and other current assets                                                                                                                        |  |                           | 4,567      |   |                   |   | 3,391      |  
|                                                                                                                                                        |  |                           |            |   |                   |   |            |  
|Total current assets                                                                                                                                    |  |                           | 47,473     |   |                   |   | 37,151     |  
|Property and equipment, net                                                                                                                             |  |                           | 11,379     |   |                   |   | 6,302      |  
|Goodwill                                                                                                                                                |  |                           | 6,613      |   |                   |   | 6,613      |  
|Restricted cash                                                                                                                                         |  |                           | 2,702      |   |                   |   | 278        |  
|Other assets                                                                                                                                            |  |                           | 1,032      |   |                   |   | 1,678      |  
|                                                                                                                                                        |  |                           |            |   |                   |   |            |  
|Total assets                                                                                                                                            |  | $                         | 69,199     |   |                   | $ | 52,022     |  
|                                                                                                                                                        |  |                           |            |   |                   |   |            |  
|Liabilities, mandatorily redeemable preferred stock and shareholders deficit                                                                           |  |                           |            |   |                   |   |            |  
|Current liabilities                                                                                                                                     |  |                           |            |   |                   |   |            |  
|Accounts payable                                                                                                                                        |  | $                         | 4,973      |   |                   | $ | 2,439      |  
|Accrued liabilities                                                                                                                                     |  |                           | 23,207     |   |                   |   | 20,726     |  
|Deferred revenue                                                                                                                                        |  |                           | 9,978      |   |                   |   | 9,489      |  
|Capital lease and other obligations, current                                                                                                            |  |                           | 1,067      |   |                   |   | 137        |  
|Notes payable, current                                                                                                                                  |  |                           | 5,565      |   |                   |   |           |  
|                                                                                                                                                        |  |                           |            |   |                   |   |            |  
|Total current liabilities                                                                                                                               |  |                           | 44,790     |   |                   |   | 32,791     |  
|                                                                                                                                                        |  |                          
|Deferred revenue                                                                                                                                        |  |                           | 173        |   |                   |   | 970        |  
|Embedded derivative liability                                                                                                                           |  |                           | 5,173      |   |                   |   | 2,527      |  
|Notes payable, net of current portion                                                                                                                   |  |                           | 8,875      |   |                   |   | 17,585     |  
|Other liabilities, long-term                                                                                                                            |  |                           |           |   |                   |   | 46         |  
|                                                                                                                                                        |  |                           |            |   |                   |   |            |  
|Total liabilities                                                                                                                                       |  |                           | 59,011     |   |                   |   | 53,919     |  
|                                                                                                                                                        |  |                           |            |   |                   |   |            |  
|Commitments and contingencies (see Note 8)                                                                                                              |  |                           |            |   |                   |   |            |  
|Mandatorily redeemable preferred stock, par value $0.001                                                                                                |  |                           | 122,377    |   |                   |   | 116,874    |  
|                                                                                                                                                        |  |                           |            |   |                   |   |            |  
|Shareholders deficit                                                                                                                                   |  |                           |            |   |                   |   |            |  
|Common stock and additional paid-in-capital, par value $0.001: shares authorized: 200,000 shares issued and outstanding 21,182 and 37,296,
respectively |  |                           | 2,174,496  |   |                   |   | 2,180,595  |  
|Common stock warrants                                                                                                                                   |  |                           | 5,947      |   |                   |   | 5,947      |  
|Unearned compensation                                                                                                                                   |  |                           | (1,353     | ) |                   |   | (716       | )
|Accumulated deficit                                                                                                                                     |  |                           | (2,290,725 | ) |                   |   | (2,300,657 | )
|Accumulated other comprehensive loss                                                                                                                    |  |                           | (554       | ) |                   |   | (3,940     | )
|                                                                                                                                                        |  |                           |            |   |                   |   |            |  
|Total shareholders deficit                                                                                                                             |  |                           | (112,189   | ) |                   |   | (118,771   | )
|                                                                                                                                                        |  |                           |            |   |                   |   |            |  
|Total liabilities, mandatorily redeemable preferred stock and shareholders deficit                                                                     |  | $                         | 69,199     |   |                   | $ | 52,022     |  
|                                                                                                                                                        |  |                           |            |   |                   |   |            |  



The accompanying
notes are an integral part of these Condensed Consolidated Financial Statements.



2



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CRITICAL PATH, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS



|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|-------------------------------------------------------------------------- |  | --------------------------------------------------- | ------- | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                           |  | Three months endedSeptember 30,                     |         |   | Nine months endedSeptember 30, |  
|                                                                           |  | 2004                                                |         |   | 2005                           |   |        | 2004 |  |   | 2005    |  
|                                                                           |  | (in thousands, except per share amounts; unaudited) |        
|Net revenue                                                                |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Software licensing                                                         |  | $                                                   | 4,744   |   |                                | $ | 5,593  |      |  | $ | 14,403  |   |  | $ | 14,810  |  
|Hosted messaging                                                           |  |                                                     | 4,621   |   |                                |   | 3,309  |      |  |   | 12,675  |   |  |   | 12,048  |  
|Professional services                                                      |  |                                                     | 3,092   |   |                                |   | 3,119  |      |  |   | 8,687   |   |  |   | 9,929   |  
|Maintenance and support                                                    |  |                                                     | 5,038   |   |                                |   | 5,059  |      |  |   | 15,825  |   |  |   | 14,842  |  
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Total net revenue                                                          |  |                                                     | 17,495  |   |                                |   | 17,080 |      |  |   | 51,590  |   |  |   | 51,629  |  
|                                                                           |  |                                                     |         |  
|Cost of net revenue                                                        |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Software licensing                                                         |  |                                                     | 1,322   |   |                                |   | 1,364  |      |  |   | 3,941   |   |  |   | 3,606   |  
|Hosted messaging                                                           |  |                                                     | 5,995   |   |                                |   | 3,036  |      |  |   | 18,946  |   |  |   | 11,927  |  
|Professional services                                                      |  |                                                     | 2,667   |   |                                |   | 2,270  |      |  |   | 8,796   |   |  |   | 6,993   |  
|Maintenance and support                                                    |  |                                                     | 1,422   |   |                                |   | 1,442  |      |  |   | 4,193   |   |  |   | 4,542   |  
|Stock-based expense                                                        |  |                                                     |        |   |                                |   | 63     |      |  |   | 5       |   |  |   | 168     |  
|Restructuring and other expenses                                           |  |                                                     |        |   |                                |   |       |      |  |   | 175     |   |  |   |        |  
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Total cost of net revenue                                                  |  |                                                     | 11,406  |   |                                |   | 8,175  |      |  |   | 36,056  |   |  |   | 27,236  |  
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Gross profit                                                               |  |                                                     | 6,089   |   |                                |   | 8,905  |      |  |   | 15,534  |   |  |   | 24,393  |  
|                                                                           |  |                                                     |         |  
|Operating expenses                                                         |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Selling and marketing                                                      |  |                                                     | 5,242   |   |                                |   | 4,206  |      |  |   | 18,216  |   |  |   | 12,780  |  
|Research and development                                                   |  |                                                     | 5,260   |   |                                |   | 2,910  |      |  |   | 16,383  |   |  |   | 11,446  |  
|General and administrative                                                 |  |                                                     | 2,854   |   |                                |   | 2,558  |      |  |   | 9,746   |   |  |   | 9,829   |  
|Stock-based expense                                                        |  |                                                     | 308     |   |                                |   | 292    |      |  |   | 1,561   |   |  |   | 749     |  
|Restructuring expense                                                      |  |                                                     | 2,590   |   |                                |   | 40     |      |  |   | 4,799   |   |  |   | 1,847   |  
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Total operating expenses                                                   |  |                                                     | 16,254  |   |                                |   | 10,006 |      |  |   | 50,705  |   |  |   | 36,651  |  
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Operating loss                                                             |  |                                                     | (10,165 | ) |                                |   | (1,101 | )    |  |   | (35,171 | ) |  |   | (12,258 | )
|                                                                           |  |                                                     |         |  
|Other income (expense), net                                                |  |                                                     | (2,781  | ) |                                |   | 1,357  |      |  |   | 7,448   |   |  |   | 5,598   |  
|Interest income (expense), net                                             |  |                                                     | (342    | ) |                                |   | (918   | )    |  |   | (3,815  | ) |  |   | (2,483  | )
|Loss on extinguishment of debt                                             |  |                                                     | (12,783 | ) |                                |   |       |      |  |   | (12,783 | ) |  |   |        |  
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Loss before provision for income taxes                                     |  |                                                     | (26,071 | ) |                                |   | (662   | )    |  |   | (44,321 | ) |  |   | (9,143  | )
|                                                                           |  |                                                     |         |  
|Provision for income taxes                                                 |  |                                                     | (88     | ) |                                |   | (364   | )    |  |   | (900    | ) |  |   | (789    | )
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss                                                                   |  |                                                     | (26,159 | ) |                                |   | (1,026 | )    |  |   | (45,221 | ) |  |   | (9,932  | )
|                                                                           |  |                                                     |         |  
|Accretion on mandatorily redeemable preferred stock                        |  |                                                     | (4,193  | ) |                                |   | (3,519 | )    |  |   | (10,689 | ) |  |   | (15,311 | )
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss attributable to common shareholders                               |  | $                                                   | (30,352 | ) |                                | $ | (4,545 | )    |  | $ | (55,910 | ) |  | $ | (25,243 | )
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss per share attributable to common shareholders  basic and diluted |  | $                                                   | (1.43   | ) |                                | $ | (0.13  | )    |  | $ | (2.65   | ) |  | $ | (0.83   | )
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Weighted average shares  basic and diluted                                |  |                                                     | 21,171  |   |                                |   | 34,557 |      |  |   | 21,075  |   |  |   | 30,452  |  
|                                                                           |  |                                                     |         |   |                                |   |        |      |  |   |         |   |  |   |         |  



The accompanying
notes are an integral part of these Condensed Consolidated Financial Statements.



3



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CRITICAL PATH, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS



|                                                        |  |                                |         |   |      |   |        |  
|------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------ | -
|                                                        |  | Nine months endedSeptember 30, |        
|                                                        |  | 2004                           |         |   | 2005 |  
|                                                        |  | (in thousands; unaudited)      |        
|Cash flow from operating activities:                    |  |                                |         |   |      |   |        |  
|Net loss                                                |  | $                              | (45,221 | ) |      | $ | (9,932 | )
|Depreciation                                            |  |                                | 7,160   |   |      |   | 5,715  |  
|Stock-based expense                                     |  |                                | 1,566   |   |      |   | 917    |  
|Change in fair value of embedded derivative liabilities |  |                                | (5,297  | ) |      |   | (2,799 | )
|Amortization                                            |  |                                | 246     |   |      |   | 925    |  
|Loss (gain) on fixed asset disposals                    |  |                                | (19     | ) |      |   | 199    |  
|Forgiveness of notes receivable                         |  |                                | 171     |   |      |   |       |  
|Restructuring charges, non-cash                         |  |                                | 2,166   |   |      |   | 1,453  |  
|Changes in assets and liabilities:                      |  |                                |         |   |      |   |        |  
|Accounts receivable                                     |  |                                | (3,543  | ) |      |   | 1,417  |  
|Other assets                                            |  |                                | (1,548  | ) |      |   | (75    | )
|Accounts payable                                        |  |                                | (39     | ) |      |   | (1,188 | )
|Accrued liabilities                                     |  |                                | 2,235   |   |      |   | (1,616 | )
|Deferred revenue                                        |  |                                | 1,139   |   |      |   | 1,481  |  
|                                                        |  |                                |         |   |      |   |        |  
|Net cash used in operating activities                   |  |                                | (25,936 | ) |      |   | (3,503 | )
|                                                        |  |                                |         |   |      |   |        |  
|Cash flow from investing activities                     |  |                                |         |   |      |   |        |  
|Notes receivable from officers                          |  |                                | 240     |   |      |   |       |  
|Restricted cash                                         |  |                                | (2,702  | ) |      |   | 2,500  |  
|Purchases of property and equipment                     |  |                                | (2,448  | ) |      |   | (1,304 | )
|                                                        |  |                                |         |   |      |   |        |  
|Net cash (used in) provided by investing activities     |  |                                | (4,910  | ) |      |   | 1,196  |  
|                                                        |  |                                |         |   |      |   |        |  
|Cash flow from financing activities                     |  |                                |         |   |      |   |        |  
|Proceeds from the issuance of convertible notes, net    |  |                                | 30,165  |   |      |   | 7,000  |  
|Proceeds from the issuance of common stock, net         |  |                                | 1,010   |   |      |   |       |  
|Proceeds from rights offering                           |  |                                | 3,965   |   |      |   |       |  
|Repayment of convertible notes                          |  |                                |        |   |      |   | (5,565 | )
|Payments on line of credit facility                     |  |                                | (2,299  | ) |      |   |       |  
|Principal payments on note and lease obligations        |  |                                | (721    | ) |      |   | (858   | )
|                                                        |  |                                |         |   |      |   |        |  
|Net cash provided by financing activities               |  |                                | 32,120  |   |      |   | 577    |  
|                                                        |  |                                |         |   |      |   |        |  
|Net change in cash and cash equivalents                 |  |                                | 1,273   |   |      |   | (1,730 | )
|Effect of exchange rates on cash and cash equivalents   |  |                                | (106    | ) |      |   | (1,023 | )
|Cash and cash equivalents, beginning of period          |  |                                | 18,984  |   |      |   | 23,239 |  
|                                                        |  |                                |         |   |      |   |        |  
|Cash and cash equivalents, end of period                |  | $                              | 20,152  |   |      | $ | 20,486 |  
|                                                        |  |                                |         |   |      |   |        |  



The accompanying
notes are an integral part of these Condensed Consolidated Financial Statements.



4



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CRITICAL PATH, INC.

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS DEFICIT

(In thousands; unaudited)



|                                                                         |  |                                       |         |   |                                         |   |         |                       |  |                      |           |   |                                               |   |       |       |   |        |   |  |   |            |   |  |   |          |  
|------------------------------------------------------------------------ |  | ------------------------------------- | ------- | - | --------------------------------------- | - | ------- | --------------------- |  | -------------------- | --------- | - | --------------------------------------------- | - | ----- | ----- | - | ------ | - |  | - | ---------- | - |  | - | -------- | -
|                                                                         |  |                                       |         |   |                                         |   |         | Shareholders deficit | 
|                                                                         |  | Mandatorily redeemablepreferred stock |         |   | Commonstock andadditionalpaid incapital |   |         | Commonstockwarrants   |  | Unearnedcompensation |           |   | Accumulateddeficit and othercomprehensiveloss |   |       | Total |  
|                                                                         |  | AmendedSeries D                       |         |   | Series E                                |   |         |                       |  |                      |           |   |                                               |   |       |       |   |        |   | 
|Balance at December 31, 2004                                             |  | $                                     | 59,575  |   |                                         | $ | 62,802  |                       |  | $                    | 2,174,496 |   |                                               | $ | 5,947 |       | $ | (1,353 | ) |  | $ | (2,291,279 | ) |  | $ | (112,189 | )
|Accretion of dividend on mandatorily redeemable preferred stock          |  |                                       | 2,550   |   |                                         |   | 3,439   |                       |  |                      | (5,989    | ) |                                               |   |      |       |   |       |   |  |   |           |   |  |   | (5,989   | )
|Accretion to redemption value for mandatorily redeemable preferred stock |  |                                       | 3,384   |   |                                         |   | 6,400   |                       |  |                      | (9,826    | ) |                                               |   |      |       |   |       |   |  |   |           |   |  |   | (9,826   | )
|Conversion of preferred stock to common stock                            |  |                                       | (10,055 | ) |                                         |   | (11,221 | )                     |  |                      | 21,709    |   |                                               |   |      |       |   |       |   |  |   |           |   |  |   | 21,709   |  
|Common stock issued under Employee Stock Purchase Plan                   |  |                                       |        |   |                                         |   |        |                       |  |                      | 5         |   |                                               |   |      |       |   |       |   |  |   |           |   |  |   | 5        |  
|Issuance of restricted stock, net                                        |  |                                       |        |   |                                         |   |        |                       |  |                      | 200       |   |                                               |   |      |       |   |       |   |  |   |           |   |  |   | 200      |  
|Unearned compensation related to grants of restricted stock              |  |                                       |        |   |                                         |   |        |                       |  |                      |          |   |                                               |   |      |       |   | (255   | ) |  |   |           |   |  |   | (255     | )
|Amortization of unearned compensation                                    |  |                                       |        |   |                                         |   |        |                       |  |                      |          |   |                                               |   |      |       |   | 892    |   |  |   |           |   |  |   | 892      |  
|Foreign currency translation adjustments                                 |  |                                       |        |   |                                         |   |        |                       |  |                      |          |   |                                               |   |      |       |   |       |   |  |   | (3,386     | ) |  |   | (3,386   | )
|Net loss                                                                 |  |                                       |        |   |                                         |   |        |                       |  |                      |          |   |                                               |   |      |       |   |       |   |  |   | (9,932     | ) |  |   | (9,932   | )
|                                                                         |  |                                       |         |   |                                         |   |         |                       |  |                      |           |   |                                               |   |       |       |   |        |   |  |   |            |   |  |   |          |  
|Balance at September 30, 2005                                            |  | $                                     | 55,454  |   |                                         | $ | 61,420  |                       |  | $                    | 2,180,595 |   |                                               | $ | 5,947 |       | $ | (716   | ) |  | $ | (2,304,597 | ) |  | $ | (118,771 | )
|                                                                         |  |                                       |         |   |                                         |   |         |                       |  |                      |           |   |                                               |   |       |       |   |        |   |  |   |            |   |  |   |          |  



The accompanying
notes are an integral part of these Condensed Consolidated Financial Statements.



5



---

CRITICAL PATH, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



Note 1  Basis of Presentation and Summary of Significant Accounting Policies



Basis of Presentation



The consolidated financial statements include the accounts of the Company, and its wholly owned and majority-owned subsidiaries. All significant inter-company balances and transactions have been eliminated in
consolidation.



These interim financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of America for interim financial information, and the rules and regulations of the United States Securities and Exchange Commission (SEC) for interim financial statements
and accounting policies, consistent, in all material respects, with those applied in preparing the Companys audited consolidated financial statements included in its Annual Report on Form 10-K and Form 10-K/A for the fiscal year ended
December 31, 2004. The unaudited financial information furnished herein reflects all adjustments, consisting only of normal recurring adjustments, that in the Companys opinion are necessary for a fair statement of its consolidated
financial position, the results of operations, cash flows and shareholders deficit for the periods presented. This Quarterly Report on Form 10-Q should be read in conjunction with the Companys audited financial statements for the year
ended December 31, 2004, included in the 2004 Form 10-K/A. The condensed consolidated statement of operations for the three and nine months ended September 30, 2005 are not necessarily indicative of results to be expected for any
subsequent periods or for the entire fiscal year ending December 31, 2005.



Liquidity and Capital Resources



The Company has focused on
capital financing initiatives in order to maintain current and planned operations. The Company has operated at a loss since inception and its history of losses from operations and cash flow deficits, in combination with its cash balances, have
raised concerns about the Companys ability to fund its operations. Consequently, in 2003 and 2004 the Company secured additional funds through both debt and equity financing activities that involved the sale of convertible notes and the
completion of a rights offering. Most recently, in December 2004 the Company drew $11.0 million from an $18.0 million round of debt financing and in March 2005, drew down the remaining $7.0 million. The Company is not required to make any payments
of principal or interest under this $18.0 million debt financing until maturity in December 2007. If the Company is unable to increase its revenues or if the Company is unable to reduce the amount of cash used by its operating activities, the
Company may be required to undertake additional restructuring alternatives, or seek additional debt financing although its ability to incur additional indebtedness is subject to certain limitations as discussed in the section below captioned
Ability to incur additional indebtedness.



6



---



With the Companys history of operating
losses and cash used to support operating activities, the primary sources of capital have come from both debt and equity financings that have been completed over the past several years. The Companys principal sources of liquidity include cash
and cash equivalents. As of September 30, 2005, the Company had cash and cash equivalents available for operations totaling $20.5 million, of which $10.8 million was located in accounts outside the United States and is not readily available for
domestic operations. However, the Company intends to pursue the investigation of restructuring its foreign subsidiaries which, if successful, may provide easier access to the repatriation of a greater portion of the cash located in accounts outside
the United States. Additionally, the Company is currently evaluating the newly enacted American Jobs Creation Act of 2004 (the AJCA) and is not yet in a position to decide whether, or to what extent, the AJCA will enable the Company to repatriate
foreign earnings that have not yet been remitted to the United States. As of September 30, 2005, the readily available cash resources in the United States were $9.7 million. In addition, as of September 30, 2005, the Company had $0.3
million of cash classified on its balance sheet as restricted cash which is primarily related to cash collateralized letters of credit primarily related to facility leases. This restricted cash is not readily available for operations.



Based on the Companys recent financing activities, cash expected to be generated from
operations and recent restructuring activities the Company believes that there is sufficient cash to meet cash operating requirements for the next 12 months as well as the on-going investments in capital equipment to support the Companys
research and development efforts. For the long-term, the Company believes that the operating activities will be able to provide the liquidity and capital resources sufficient to support the Companys business. At September 30, 2005, the
Company had no borrowings under its credit facility with Silicon Valley Bank because the borrowing availability had been eliminated and the Company was required to cash collateralize its letters of credit.



Ability to incur additional indebtedness



Subject to limited exceptions, the Company must seek the consent of its investors in
order to incur any additional indebtedness. Additionally, under the terms of the Companys line of credit, the Company is required to obtain the consent of Silicon Valley Bank to incur additional indebtedness.



Segment Information



The Company does not currently manage its business in a manner that requires it to report financial results on a segment basis. The Company
currently operates in one segment, digital communications software and services, and management uses one measure of profitability. Revenue information on a product and service basis has been disclosed in the Companys statement of operations.



Stock-Based Compensation



Pursuant to the requirements of Statement of Financial Accounting Standards (SFAS)
No. 148,Accounting for Stock-based Compensation  Transition and Disclosure, pro forma information regarding net loss and net loss per share is required to be presented as if the Company had accounted for employee stock option
grants and activities under the Companys Employee Stock Purchase Plan using the fair value method of SFAS No. 123, as amended by SFAS No. 148. Had compensation cost been recognized based on the fair value at the date of grant for
options granted and activities under the Companys Employee Stock Purchase Plan, the pro forma amounts of the Companys net loss and net loss per share would have been as follows:



|                                                                                                          |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | ---------------------------------------- | ------- | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                          |  | Three months endedSeptember 30,          |         |   | Nine months endedSeptember 30, |  
|                                                                                                          |  | 2004                                     |         |   | 2005                           |   |        | 2004 |  |   | 2005    |  
|                                                                                                          |  | (in thousands, except per share amounts) |        
|Net loss attributable to common shares - as reported                                                      |  | $                                        | (30,352 | ) |                                | $ | (4,545 | )    |  | $ | (55,910 | ) |  | $ | (25,243 | )
|Add:                                                                                                      |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Stock-based employee compensation expense included in reported net loss attributable to common shares     |  |                                          | 308     |   |                                |   | 355    |      |  |   | 1,566   |   |  |   | 917     |  
|Deduct:                                                                                                   |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Total stock-based employee compensation expense determined under a fair value based method for all grants |  |                                          | (1,188  | ) |                                |   | (1,278 | )    |  |   | (6,670  | ) |  |   | (3,610  | )
|                                                                                                          |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss attributable to common shares-pro forma                                                          |  | $                                        | (31,232 | ) |                                | $ | (5,468 | )    |  | $ | (61,014 | ) |  | $ | (27,936 | )
|                                                                                                          |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Basic and diluted net loss per share attributable to common shares-as reported                            |  | $                                        | (1.43   | ) |                                | $ | (0.13  | )    |  | $ | (2.65   | ) |  | $ | (0.83   | )
|                                                                                                          |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Basic and diluted net loss per share attributable to common shares-pro forma                              |  | $                                        | (1.48   | ) |                                | $ | (0.16  | )    |  | $ | (2.90   | ) |  | $ | (0.92   | )
|                                                                                                          |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  



7



---

The Company calculated the fair value of each option grant on the date of grant using the Black-Scholes option pricing
model, as prescribed by SFAS No. 123, using the following assumptions:



|                          |  |                                 |   |  |                                |   |  |              |  |              
|------------------------- |  | ------------------------------- | - |  | ------------------------------ | - |  | ------------ |  | -------------
|                          |  | Three months endedSeptember 30, |   |  | Nine months endedSeptember 30,
|                          |  | 2004                            |   |  | 2005                           |   |  | 2004         |  | 2005         
|Risk free interest rate   |  | 3.1                             | % |  | 4.2                            | % |  | 2.4-3.5%     |  | 3.7%-4.2%    
|Expected lives (in years) |  | 4                               |   |  | 4                              |   |  | 4            |  | 4            
|Dividend yield            |  | 0.0                             | % |  | 0.0                            | % |  | 0.0%         |  | 0.0%         
|Expected volatility       |  | 135.4                           | % |  | 130.0                          | % |  | 119.6-138.5% |  | 130.0%-142.0%



The Company calculated the fair value
of the activity under the Employee Stock Purchase Plan using the Black-Scholes option pricing model, as prescribed by SFAS 123, using the following assumptions:



|                          |  |                                  |  |                                 |  |               |  |              
|------------------------- |  | -------------------------------- |  | ------------------------------- |  | ------------- |  | -------------
|                          |  | Three months ended September 30, |  | Nine months ended September 30,
|                          |  | 2004                             |  | 2005                            |  | 2004          |  | 2005         
|Risk free interest rate   |  | 2.31%-3.66%                      |  | 3.7%-4.0%                       |  | 2.31%-3.66%   |  | 2.06%-4.0%   
|Expected lives (in years) |  | 2                                |  | 2                               |  | 2             |  | 2            
|Dividend yield            |  | 0.0%                             |  | 0.0%                            |  | 0.0%          |  | 0.0%         
|Expected volatility       |  | 129.0%-139.8%                    |  | 109.0-129.0%                    |  | 129.0%-139.8% |  | 109.0%-132.9%



Recent Accounting Pronouncements



In June 2005, the Financial Accounting Standards Board (FASB) Staff
issued FASB Staff Position (FSP) Financial Accounting Standard (FAS) No. 150-5, to address whether freestanding warrants and other similar share instruments would be subject to the requirements of FASB Statement No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity. FSP FAS No. 150-5 clarifies the applicability of specific provisions of FAS No. 150 to puttable or mandatorily redeemable warrants and other similar instruments or
shares, and their classification as either liabilities, temporary equity or equity. The guidance in FSP FAS No. 150-5 was effective for reporting periods beginning after June 30, 2005. This FSP, which the Company adopted in the third quarter of
2005, did not have a significant impact on the Companys financial position and results of operations.



In May 2005, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 154,Accounting Changes and Error Corrections. SFAS No. 154 replaces Accounting Principles Board (APB)
No. 20,Accounting Changes, and SFAS No. 3,Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 changes the requirements for the accounting for and reporting of a change in accounting principle and
applies to all voluntary changes in accounting principle. This statement will be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company believes adoption of this new
standard will not have a significant impact on its financial position and results of operations.



In April 2005, the SEC amended the compliance dates for SFAS No. 123R,Shared-Based Payment. The new rule allows public companies to implement SFAS No. 123R at the beginning of their next fiscal year
that begins after June 15, 2005. The Company will be required to adopt SFAS No. 123R in the first quarter of 2006 and begin to recognize stock-based compensation related to employee equity awards in its condensed consolidated statements of
operations using a fair value based method on a prospective basis. Since the Company currently accounts for equity awards granted to its employees using the intrinsic value method under APB No. 25, the Company expects the adoption of SFAS
No. 123R will have a significant adverse impact on its financial position and results of operations.



8



---

In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB No. 107). SAB No. 107 covers key
topics related to the implementation of SFAS No. 123R which include the valuation models, expected volatility, expected option term, income tax effects of SFAS No. 123R, classification of stock-based compensation cost, capitalization of
compensation costs, and disclosure requirements. In addition, SFAS No. 123R requires that the benefits of certain tax deductions in excess of recognized compensation expenses be reported as a financing cash flow, rather than as an operating
cash flow as prescribed under current accounting rules. The Company expects the adoption of SAB No. 107 will have a significant adverse impact on its financial position and results of operations in connection with SFAS No. 123R in the
first quarter of 2006.



In March 2005, the FASB issued FASB Interpretation
No. 47,Accounting for Conditional Asset Retirement Obligations (FIN No. 47). FIN No. 47 clarifies that a company should record a liability for a conditional asset retirement obligation when incurred if the fair value of the
obligation can be reasonably estimated. This interpretation further clarified conditional asset retirement obligation, as used in SFAS No. 143, Accounting for Asset Retirement Obligations, as a legal obligation to perform an asset retirement
activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN No. 47 is effective for companies no later than the end of their fiscal year ending after
December 15, 2005. The Company does not expect the adoption of FIN No. 47 to have an impact on its financial position and results of operations.



In December 2004, the FASB issued SFAS No. 153,Exchange of Nonmonetary Assets, which is an amendment to APB Opinion No. 29. The guidance in APB Opinion
No. 29,Accounting for Nonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in that opinion, however, included certain
exceptions to that principle. This statement amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not
have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The adoption of SFAS No. 153 is not expected to have a material
impact on the Companys financial position or results of operations.



Note 2  Restructuring Activities



The following table
summarizes the strategic restructuring costs incurred by the Company during the nine months ended September 30, 2005.



|                                |  |                    |      |   |                                                     |   |        |       |  |   |        |  
|------------------------------- |  | ------------------ | ---- | - | --------------------------------------------------- | - | ------ | ----- |  | - | ------ | -
|                                |  | Workforcereduction |      |   | Facility andoperationsconsolidationand othercharges |   |        | Total | 
|                                |  | (in thousands)     |     
|Liability at December 31, 2004  |  | $                  | 201  |   |                                                     | $ | 553    |       |  | $ | 754    |  
|Restructuring charge            |  |                    | 342  |   |                                                     |   | 1,505  |       |  |   | 1,847  |  
|Cash payments                   |  |                    | (508 | ) |                                                     |   | (1,733 | )     |  |   | (2,241 | )
|Adjustments                     |  |                    | (35  | ) |                                                     |   | (201   | )     |  |   | (236   | )
|                                |  |                    |      |   |                                                     |   |        |       |  |   |        |  
|Liability at September 30, 2005 |  | $                  |     |   |                                                     | $ | 123    |       |  | $ | 123    |  
|                                |  |                    |      |   |                                                     |   |        |       |  |   |        |  



During 2003 and 2004, the Company
restructured certain of its facility lease obligations, consolidated activities to lower cost locations and eliminated certain employee and contractor positions in an effort to reduce both short-term and long-term cash requirements. During the nine
months ended September 30, 2004, the Company recorded restructuring charges totaling $4.8 million related to these activities, of which $2.6 million was recorded in the three months ended September 30, 2004.



During the nine months ended September 30, 2005, the Company recorded restructuring
expenses totaling $1.8 million, of which $40,000 was recorded during the three months ended September 30, 2005. The restructuring charges recorded during 2005, related to the relocation of the Companys headquarters facility as discussed
below and the balance related to consolidation of data centers and the elimination of certain employee positions.



9



---

On May 5, 2005, the Company entered into the Second Amendment to Lease with PPF Off 345 Spear Street, L.P., to amend
the Lease dated as of November 16 2001, as amended, under which the Company leases its headquarter facilities in San Francisco, California. Under the terms of the second amendment, the Company moved into new office space at 2 Harrison Street,
2ndFloor, San Francisco, California and vacated its facility at 350 The Embarcadero on June 29, 2005. The new
office space into which the Company relocated is comprised of two suites consisting of approximately 22,881 square feet and will be leased for a term of five years, however; the Company has an early termination option whereby the Company can reduce
the occupancy of the premises to one of the two suites after 18 months, subject to certain termination penalties. In connection with the second amendment, the Company made a lease termination payment related to the facility at 350 the Embarcadero
totaling approximately $1.3 million during the three months ended June 30, 2005; however, the annual rent, on a cash basis, for the Companys new headquarter facility will decline from approximately $2.5 million per year to less than
approximately $0.7 million per year on average over the term of the lease.



At
September 30, 2005, the Company carried a remaining restructuring liability of $0.1 million, the majority of which is expected to be utilized by September 30, 2006.



Note 3  Goodwill



At September 30, 2005, the Company had $6.6 million of goodwill. In accordance with SFAS No. 142, the Company ceased amortizing its goodwill in January 2002.



Note 4  Convertible Notes and Promissory Notes



53/4% Convertible Subordinated Notes



On the due date of April 1, 2005, the Company paid $5.7 million to retire the outstanding principal and accrued interest on the 53/4% Convertible Subordinated Notes.



13.9% Notes



In December 2004, the Company issued $11.0 million in principal amount of 13.9% Promissory Notes (the 13.9% Notes) to General Atlantic Partners 74, L.P., Gapstar, LLC,
GAP Coinvestment Partners II, L.P., GAPCO GmbH & Co. KG., Cenwell Limited, Campina Enterprises Limited, Great Affluent Limited, Dragonfield Limited, Lion Cosmos Limited and Richmond III, LLC (collectively the investors). As part
of the financing transaction, the Company issued warrants to purchase 235,712 shares of Series F preferred stock at a per share purchase price of $14 per share, which is equivalent to $1.40 per share on a common equivalent basis.



In March 2005, the Company issued the remaining $7.0 million in principal amount of the 13.9%
Notes to the investors. As part of this financing transaction, the Company also issued warrants to purchase 149,998 shares of Series F preferred stock at a per share purchase price of $14 per share, which is equivalent to $1.40 per share on a common
equivalent basis.



The 13.9% Notes accrue interest at a rate of 13.9% per
annum, however; the Company is not obligated to make interest payments on the notes prior to their maturity date of December 30, 2007. The 13.9% Notes are due and payable on the earlier to occur of the maturity of the 13.9% Notes on
December 30, 2007, when declared due and payable upon the occurrence of an event of default, or a change of control of the Company.



The proceeds from the financing transaction were allocated to the 13.9% Notes and warrants based upon their relative estimated fair values. The estimated fair value of
the warrants issued in connection with the 13.9% Notes has been classified as a derivative instrument and recorded as a liability on the Companys balance sheet in accordance with current authoritative guidance. In accordance with the
provisions of SFAS No. 133, Accounting for



10



---

Derivative Instruments, the Company is required to adjust the carrying value of the instrument to its fair value
at each balance sheet date and recognize any change since the prior balance sheet date as a component of Other Income (Expense).



At September 30, 2005, the 13.9% Notes were carried on the balance sheet as long-term Notes payable as follows (in thousands):



|                                                                                                         |  |   |        |  
|-------------------------------------------------------------------------------------------------------- |  | - | ------ | -
|Proceeds from the issuance of the 13.9% Notes                                                            |  | $ | 18,000 |  
|Less: proceeds allocated to the fair value of the Series F preferred stock warrant derivative instrument |  |   | (2,711 | )
|Add: accretion to redemption value                                                                       |  |   | 595    |  
|Add: accrued interest                                                                                    |  |   | 1,701  |  
|                                                                                                         |  |   |        |  
|Carrying value of 13.9% Notes                                                                            |  | $ | 17,585 |  
|                                                                                                         |  |   |        |  



Note 5  Comprehensive Loss



The components of comprehensive loss are
as follows:



|                                         |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|---------------------------------------- |  | ------------------------------- | ------- | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                         |  | Three months endedSeptember 30, |         |   | Nine months endedSeptember 30, |  
|                                         |  | 2004                            |         |   | 2005                           |   |        | 2004 |  |   | 2005    |  
|                                         |  | (in thousands)                  |        
|Net loss attributable to common shares   |  | $                               | (30,352 | ) |                                | $ | (4,545 | )    |  | $ | (55,910 | ) |  | $ | (25,243 | )
|Foreign currency translation adjustments |  |                                 | (989    | ) |                                |   | (1,729 | )    |  |   | (2,255  | ) |  |   | (3,386  | )
|                                         |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|                                         |  | $                               | (31,341 | ) |                                | $ | (6,274 | )    |  | $ | (58,165 | ) |  | $ | (27,629 | )
|                                         |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  



There were no tax effects allocated to
any components of comprehensive loss during the three and nine months ended September 30, 2004 and 2005.



Note 6  Net Loss per Share Attributed to Common Shareholders



Net loss per common share is calculated as follows:



|                                                                                                                  |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|----------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------- | ------- | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                                  |  | Three months endedSeptember 30,          |         |   | Nine months endedSeptember 30, |  
|                                                                                                                  |  | 2004                                     |         |   | 2005                           |   |        | 2004 |  |   | 2005    |  
|                                                                                                                  |  | (in thousands, except per share amounts) |        
|Net loss attributable to common shares                                                                            |  | $                                        | (30,352 | ) |                                | $ | (4,545 | )    |  | $ | (55,910 | ) |  | $ | (25,243 | )
|Weighted average shares outstanding                                                                               |  |                                          | 21,171  |   |                                |   | 36,034 |      |  |   | 21,298  |   |  |   | 32,089  |  
|Weighted average shares subject to repurchase agreements                                                          |  |                                          |        |   |                                |   | (1,477 | )    |  |   | (223    | ) |  |   | (1,637  | )
|                                                                                                                  |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Shares used in the computation of basic and diluted net loss attributable to common shareholders per common share |  |                                          | 21,171  |   |                                |   | 34,557 |      |  |   | 21,075  |   |  |   | 30,452  |  
|                                                                                                                  |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss attributable to common shareholders per common share                                                     |  | $                                        | (1.43   | ) |                                | $ | (0.13  | )    |  | $ | (2.65   | ) |  | $ | (0.83   | )
|                                                                                                                  |  |                                          |         |   |                                |   |        |      |  |   |         |   |  |   |         |  



As of September 30, 2004 and
2005, there were 119.8 million and 112.5 million, respectively, potential common shares that were excluded from the determination of diluted net loss per share, as the effect of such shares on a weighted average basis is anti-dilutive.



11



---

Note 7  Mandatorily Redeemable Preferred stock



Series D Cumulative Redeemable Convertible Preferred Stock



In December 2001, the Company completed a financing transaction with a group of investors
and their affiliated entities. In connection with this financing transaction, the Company issued 4 million shares of its Series D Cumulative Redeemable Convertible Preferred Stock (Series D preferred stock), in a private offering,
resulting in gross cash proceeds of approximately $30 million, and the simultaneous retirement of approximately $65 million in face value of the Companys outstanding convertible subordinated notes. The investors were led by General Atlantic
Partners LLC and affiliates and included Hutchison Whampoa Limited and affiliates and Vectis Group LLC and affiliates. In addition, General Atlantic LLC was granted warrants to purchase 0.6 million shares of the Companys Common Stock in
connection with this offering.



At issuance, costs of $3.1 million were
recorded as a reduction of the carrying amount of the Series D preferred stock and will accrete over the term of the Series D preferred stock. Additionally, at issuance, the Series D preferred stock was deemed to have an embedded beneficial
conversion feature which was limited to the net proceeds allocable to preferred stock of approximately $42 million. The value of the beneficial conversion feature, at issuance, was initially recorded as a reduction of the carrying amount of the
Series D preferred stock and will accrete over the term of the Series D preferred stock.



The Series D preferred stock issued in the financing transaction ranks senior to all of the Companys Common Stock in priority of dividends, rights of redemption and payment upon liquidation. The fair value
ascribed to the preferred stock was based on actual cash paid by independent investors and the approximate fair value of the 53/4% Notes retired in connection with the offering. The principal terms of the preferred stock included an automatic redemption on November 8, 2006, cumulative dividends at a rate of 8% per year, compounded on a semi-annual
basis and payable in cash or additional shares of Series D preferred stock, conversion into shares of Common Stock calculated based on the Accreted Value which is, the purchase price plus accrued dividends divided by $4.20, and preference in the
return of equity in any liquidation or change of control.



The purchase
agreement provides for a preferential return of equity to the Series D preferred stockholders, before any return of equity to the common shareholders, and also provides for the Series D preferred stockholders to participate on a pro rata basis with
the common shareholders, in any remaining equity, once the preferential return has been satisfied. Under the terms of this provision, the preferential return of equity is equal to the purchase price of the Series D preferred stock plus all dividends
that would have accrued during the term of the preferred stock, even if a change in control occurs prior to the redemption date. The right to receive a preferential return lapses if either: (i) Critical Path is sold for a price per share of
Series D preferred stock, had each such share been converted into Common Stock prior to change in control of at least four times the Accreted Value, or (ii) Critical Paths stock trades on NASDAQ for 60 days prior to the change-in-control
at an average price of not less than four times the Accreted Value. As part of the Companys November 2003 private placement of 10% Senior Secured Convertible Notes, the Company agreed to seek shareholder approval to amend the terms of the
Series D preferred stock to, among other things, amend the Series D preferred stock liquidation preference upon a liquidation and change of control, to eliminate the participation feature, to reduce the conversion price from $4.20 to $1.50 and to
reduce the amount of dividends to which the holders of Series D preferred stock are entitled.



The warrants are exercisable at any time after November 8, 2002 until November 8, 2006 at an exercise price of $4.20, and convert into one share of the Companys Common Stock. A portion of the proceeds
received for the Series D preferred stock was allocated to the warrants and the preferred stock, based upon their relative fair market values. As a result of this allocation, approximately $5.3 million of the proceeds were allocated to the warrants,
which was recorded as a reduction of the carrying value of the Series D preferred stock. Using the Black-Scholes option pricing model, assuming a four-year term, 200% volatility, a risk-free rate of 6.0% and no dividend yield, the fair market value
of the warrants was $6.2 million. As part of the Companys November 2003 private placement of 10% Senior Secured Convertible Notes (Senior Notes), the Company agreed to seek shareholder approval to amend the warrants to reduce the exercise
price per share from $4.20 to $1.50.



12



---

In July 2004, at a special meeting of shareholders, the Companys shareholders approved proposals to amend and
restate the certificate of determination of preferences of Series D preferred stock (the Amended Series D). As part of this amendment, the automatic redemption date was changed to July 2008 and the dividend accrual rate was reduced to 53/4%. The dividends which had accrued on the Series D preferred stock totaling approximately $12.2 million were
recorded as a reduction to the carrying value of the Amended Series D. This amount was recorded as a reduction of the carrying amount of the Amended Series D and will accrete over the term of the Amended Series D. As of September 30, 2005 if
the holders of Amended Series D preferred stock voluntarily opt to redeem, the conversion value of all Amended Series D preferred stock, as accreted, is $63.1 million. Additionally, the Amended Series D preferred stock contains a liquidation
preference of $22 per share.



In January 2005, the Company converted
approximately 0.6 million shares of Series D preferred stock, plus accrued dividends of $2.0 million, held by the Vectis Group LLC and affiliates into 6.7 million shares of common stock.



The following table sets forth the carrying value and liquidation values of the Amended Series D preferred stock (in thousands):



|                                                                                               |  |   |         |  
|---------------------------------------------------------------------------------------------- |  | - | ------- | -
|Beginning balance-Amended Series D preferred stock at December 31, 2004                        |  | $ | 59,575  |  
|Add amortization and accretion                                                                 |  |   | 5,934   |  
|Less value of Series D preferred stock converted to common stock at September 30, 2005         |  |   | (10,055 | )
|                                                                                               |  |   |         |  
|Carrying value of Amended Series D preferred stock at September 30, 2005                       |  | $ | 55,454  |  
|                                                                                               |  |   |         |  
|Liquidation value of Amended Series D preferred stock at September 30, 2005 (at $22 per share) |  | $ | 77,452  |  
|                                                                                               |  |   |         |  



Series E Redeemable Convertible
Preferred Stock



During the three months ended September 30, 2004,
the Company issued a total of approximately 55.9 million shares of Series E Redeemable Convertible Preferred Stock (Series E preferred stock). In July 2004, the Company issued approximately 30.6 million shares of Series E preferred stock
to convert $45.5 million of the Senior Notes plus accrued interest, issued 21.9 million shares of Series E preferred stock to convert $32.8 million of the 53/4% Notes and issued approximately 0.8 million shares of Series E preferred stock to convert certain holders of Series D preferred stock into Series E preferred stock. In
August 2004, the Company issued approximately 2.6 million shares of Series E preferred stock in connection with its rights offering from which the Company received gross proceeds of approximately $4.0 million.



The Series E preferred stock ranks senior to all preferred and common stock of the Company in
priority of dividends, rights of redemption and payment upon liquidation. The principal terms of the Series E preferred stock include an automatic redemption on July 9, 2008, cumulative dividends at a rate of 53/4% per year, dividends are not paid in cash but are added to the value of the Series E preferred stock on
June 30 and December 31 each year, and conversion into shares of common stock calculated based on the quotient of the Series E accreted value divided by the Series E conversion price, $1.50.



At issuance, the total amount of costs associated with converting the Companys debt
into Series E preferred stock and costs associated with the rights offering, totaling approximately $4.6 million, will accrete over the term of the Series E preferred stock. Additionally, the conversion of the $45.5 million Senior Notes into the
Series E preferred stock was deemed to have a beneficial conversion feature totaling approximately $16.3 million. The value of the beneficial conversion feature, at issuance, was initially recorded as a reduction of the carrying amount of the Series
E preferred stock and will accrete over the term of the Series E preferred stock.



During the nine months ended September 30, 2005, upon receiving notice from certain investors, the Company converted approximately 7.1 million shares of Series E preferred stock and accrued dividends into approximately
7.5 million shares of the Companys Common Stock. As of September 30, 2005, there were approximately 48.8 million shares of Series E preferred stock outstanding.



13



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The carrying value of the Series E preferred stock is as follows (in thousands):



|                                                                                       |  |   |         |  
|-------------------------------------------------------------------------------------- |  | - | ------- | -
|Beginning balance-Series E preferred stock at December 31, 2004                        |  | $ | 62,802  |  
|Add amortization and accretion                                                         |  |   | 9,839   |  
|Less amount allocated to beneficial conversion feature                                 |  |   |        |  
|Less value of Series E preferred stock converted to common stock at September 30, 2005 |  |   | (11,221 | )
|                                                                                       |  |   |         |  
|Carrying value of Series E preferred stock at September 30, 2005                       |  | $ | 61,420  |  
|                                                                                       |  |   |         |  
|Liquidation value of Series E preferred stock at September 30, 2005                    |  | $ | 78,365  |  
|                                                                                       |  |   |         |  



Series F Redeemable Convertible
Preferred Stock



In December 2004, the Companys Board of Directors
authorized the issuance of up to 0.5 million shares of Series F Redeemable Convertible Preferred Stock (Series F preferred stock). The Series F preferred stock will rank equally with the Series E preferred stock, and will rank senior to all other
capital stock with respect to rights on liquidation, dissolution and winding up. The Series F preferred stock will accrue dividends at a simple annual rate of 53/4% of the purchase price of $14.00 (equivalent to $1.40 per share on a common equivalent basis), whether or not declared by the board of directors. Dividends in respect of the
Series F preferred stock will not be paid in cash but will be added to the value of the Series F preferred stock and will be taken into account for purposes of determining the liquidation and change in control preference, conversion rate and voting
rights.



The Company must declare or pay dividends on the Series F
preferred stock when the Company declares or pay dividends to the holders of common stock. Holders of Series F preferred stock are entitled to notice of all shareholders meetings and are entitled to vote on all matters submitted to the
Shareholders for a vote, voting together with the holders of the common stock and all other classes of capital stock entitled to vote, voting as a single class (except where a separate vote is required by the Companys amended and restated
articles of incorporation, its bylaws or California law). The holders of Series F preferred stock will be entitled to vote as a separate class on any amendment to the terms or authorized number of shares of Series F preferred stock, the issuance of
any equity security ranking senior to the Series F preferred stock and the redemption of or the payment of a dividend in respect of any junior security. At any time, holders of Series F preferred stock may elect to convert their Series F preferred
stock into shares of common stock. Each share of Series F preferred Stock is currently convertible into ten shares of common stock. After three years from the date the Series E preferred stock is first issued, the Company may call for redemption of
the Series F preferred stock under certain circumstances. On the fourth anniversary of the date the Series E preferred stock is first issued, the Company must call for redemption of the Series F preferred stock.



At September 30, 2005, no shares of Series F preferred stock were outstanding. Warrants
to purchase 0.4 million shares of Series F preferred stock were issued and outstanding as of September 30, 2005 in connection with the issuance of the 13.9% Notes.



14



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Accretion on Mandatorily Redeemable Preferred Stock



Accretion on mandatorily redeemable preferred stock represents the accrued dividends and accretion of the beneficial conversion features of
our outstanding Series D and E preferred stock as well as the accretion to the redemption value of the outstanding Series D preferred stock. The following table sets forth the accretion on mandatorily redeemable preferred stock for the periods
indicated:



|                                  |  |                                 |       |                                |   |       |  |      |        |  |   |       
|--------------------------------- |  | ------------------------------- | ----- | ------------------------------ | - | ----- |  | ---- | ------ |  | - | ------
|                                  |  | Three months endedSeptember 30, |       | Nine months endedSeptember 30,
|                                  |  | 2004                            |       | 2005                           |   | 2004  |  | 2005
|                                  |  | (in thousands)                 
|Accrued dividends                 |  | $                               | 2,094 |                                | $ | 1,923 |  | $    | 4,673  |  | $ | 5,989 
|Accretion of the redemption value |  |                                 | 2,099 |                                |   | 1,596 |  |      | 6,016  |  |   | 9,322 
|                                  |  |                                 |       |                                |   |       |  |      |        |  |   |       
|                                  |  | $                               | 4,193 |                                | $ | 3,519 |  | $    | 10,689 |  | $ | 15,311
|                                  |  |                                 |       |                                |   |       |  |      |        |  |   |       



The total of mandatorily redeemable
preferred stock accretion for the nine months ended September 30, 2005, as presented in the Condensed Consolidated Statement of Shareholders Deficit totals $15,773,000, and includes $462,000 of accelerated issuance cost accretion associated
with the conversion of shares of the Companys Series E preferred stock to common stock during the first nine months of 2005. This accelerated issuance cost accretion is appropriately excluded from the amounts presented in the table above for
the nine months ended September 30, 2005. For the three months ended September 30, 2005, $132,000 of accelerated issuance cost accretion has been excluded from the table.



Note 8  Commitments and Contingencies



Leases



The Company leases office space and equipment under noncancelable operating and capital leases with various expiration dates through 2014. Rent expense for the nine months ended September 30, 2005 totaled $2.9
million. Future minimum lease payments under noncancelable operating and capital leases are as follows:



|                                                       |  |                |     |                 |   |      
|------------------------------------------------------ |  | -------------- | --- | --------------- | - | -----
|                                                       |  | CapitalLeases  |     | OperatingLeases
|                                                       |  | (In thousands)
|Year Ending December 31                                |  |                |     |                 |   |      
|2005 (remaining three months ending December 31, 2005) |  | $              | 29  |                 | $ | 774  
|2006                                                   |  |                | 90  |                 |   | 2,708
|2007                                                   |  |                | 18  |                 |   | 2,062
|2008                                                   |  |                |    |                 |   | 1,761
|2009                                                   |  |                |    |                 |   | 1,371
|2010 and beyond                                        |  |                |     |                 |   | 356  
|                                                       |  |                |     |                 |   |      
|Total minimum lease payments                           |  | $              | 137 |                 | $ | 9,032
|                                                       |  |                |     |                 |   |      



In connection with the Companys
acquisition of Critical Path Pacific in September 2002, the Company assumed a capital lease with a termination date of August 2006. During 2004, the Company negotiated the early termination of this capital lease and made final capital lease payments
totaling approximately $0.2 million during the third quarter of 2005.



Other
Contractual Obligations



The Company entered into other contractual
obligations which total $4.4 million at September 30, 2005. These obligations are primarily associated with the future purchase of equipment and software, the maintenance of hardware and software products being utilized within engineering and
hosted operations, and the management of data center operations and network infrastructure storage for the Companys hosted operations. These obligations are expected to be completed over the next 2 years, including $3.0 million in the fourth
quarter of 2005.



Relocation of San Francisco Offices



During the first quarter of 2005, we recorded a restructuring charge totaling $1.6 million,
of which, $1.3 million is related to the relocation of our headquarters facility as discussed below and the balance related to consolidation of data centers and the elimination of certain employee positions.



15



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On May 5, 2005, the Company entered into the Second Amendment to Lease with PPF Off 345 Spear Street, L.P., to amend
the Lease dated as of November 16 2001, as amended, under which the Company leases its headquarter facilities in San Francisco, California. Under the terms of the second amendment, the Company moved into new office space at 2 Harrison Street,
2ndFloor, San Francisco, California and vacated its facility at 350 The Embarcadero on June 29, 2005. The new
office space into which the Company relocated is comprised of two suites consisting of approximately 22,881 square feet and will be leased for a term of five years, however; the Company has an early termination option whereby the Company can reduce
the occupancy of the premises to one of the two suites after 18 months. In connection with the second amendment, the Company made a lease termination related to the facility at 350 the Embarcadero payment totaling approximately $1.3 million during
the three months ended June 30, 2005; however, the annual rent, on a cash basis, for the Companys new headquarter facility will decline from approximately $2.5 million per year to less than approximately $0.7 million per year on average
over the term of the lease.



Service Level Agreements



Certain net revenues are derived from contractual relationships that typically have one to
three year terms. Certain agreements require minimum performance standards regarding the availability and response time of email services. If these standards are not met, such contracts are subject to termination and the Company could be subject to
monetary penalties.



Litigation and Investigations



The Company is a party to lawsuits in the normal course of its business. Litigation in
general, and securities and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. Other than as described below,
the Company is not a party to any other material legal proceedings.



Securities Class Action in Southern District of New York. Beginning in July 2001, a number of securities class action complaints were filed against us, and certain of our former officers and directors and underwriters connected with
our initial public offering (IPO) of common stock in the U.S. District Court for the Southern District of New York (In re Initial Public Offering Sec. Litig.). The purported class action complaints were filed by individuals who allege that they
purchased our common stock at the initial and secondary public offerings between March 29, 1999 and December 6, 2000. The complaints allege generally that the prospectus under which such securities were sold contained false and misleading
statements with respect to discounts and excess commissions received by the underwriters as well as allegations of laddering whereby underwriters required their customers to purchase additional shares in the aftermarket in exchange for
an allocation of IPO shares. The complaints seek an unspecified amount in damages on behalf of persons who purchased our common stock during the specified period. Similar complaints have been filed against 55 underwriters and more than 300 other
companies and other individuals. The over 1,000 complaints have been consolidated into a single action. We have reached an agreement in principle with the plaintiffs to resolve the cases. The proposed settlement involves no monetary payment and no
admission of liability. However, the settlement is subject to approval by the Court. The Company had not recorded a liability against this claim as of September 30, 2005.



Cable & Wireless Liquidating Trust. In August 2004, we received a demand letter from the Cable & Wireless
Liquidating Trust, or the Trust, notifying us of the Trusts claim that Cable & Wireless, USA, Inc. made preferential payment to us of approximately $1.1 million within the 90-day preference period before Cable & Wireless
filed for bankruptcy. We do not believe that we received any preferential payments from Cable & Wireless and communicated our position to the Trust in a letter dated September 3, 2004. To our knowledge, no formal proceedings have been
commenced based on this dispute. However, the Company intends to defend itself vigorously if the Trust pursues this claim. The Company had not recorded a liability against this claim as of September 30, 2005.



16



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Indemnifications. The Company provides general indemnification provisions in its license agreements. In these
agreements, the Company generally states that it will defend or settle, at its own expense, any claim against the customer by a third party asserting a patent, copyright, trademark, trade secret or proprietary right violation related to any products
that the Company has licensed to the customer. The Company agrees to indemnify its customers against any loss, expense or liability, including reasonable attorneys fees, from any damages alleged against the customer by a third party in its
course of using products sold by the Company. The Company has not received any claims under this indemnification and does not know of any instances in which such a claim may be brought against the Company in the future.



Under California law, in connection with the Companys charter documents and
indemnification agreements the Company entered into with its executive officers and directors, the Company must indemnify its current and former officers and directors to the fullest extent permitted by law. The indemnification covers any expenses
and liabilities reasonably incurred in connection with the investigation, defense, settlement or appeal of legal proceedings. The Company has made payments in connection with the indemnification of officers and directors in connection with past
lawsuits and governmental investigations.



Note 9  Subsequent Event



On October 6, 2005, members of the Companys management met
with the Nasdaq Listing Qualifications Panel to discuss the Companys failure to meet Nasdaqs minimum market value and minimum closing bid price requirements. The panel is expected to render a decision shortly with respect to the
Companys continued listing on the Nasdaq National Market. Such decision could result in the continued listing of the Companys stock, an extension of time to achieve compliance with Nasdaq Marketplace Rules, or immediate
delisting from the Nasdaq National Market. As a follow-up to the meeting with the Listing Qualifications Panel, the Company has submitted a plan to Nasdaq that, if approved by Nasdaq and the Company executes upon, the Company believes will
allow it to regain compliance with the applicable Nasdaq Marketplace Rules and, as a result, remain listed on the Nasdaq National Market. The Company will remain listed on the Nasdaq National Market, pending the decision of the Listing
Qualifications Panel.



On October 12, 2005, the Company received a letter
from Nasdaq, notifying it that the Companys failure to regain compliance with the minimum closing bid price requirement serves as an additional basis for the delisting of the Companys common stock from the Nasdaq
National Market. The Company believes that it can address this requirement through a reverse split that was approved by its shareholders on November 16, 2004. The Company intends to make a determination whether to execute a reverse
stock split upon the final decision of Nasdaqs Listing Qualifications Panel with whom Critical Path met on October 6, 2005.



If the Company is delisted from the Nasdaq National Market, the Company expects that its common stock will trade on the Over-the-Counter (OTC) Bulletin Board.



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



This Quarterly Report on Form 10-Q and the
following disclosures contain forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, as amended and in effect from time to time. The words
anticipates, expects, intends, plans, believes, seek, proposed, and estimate and similar expressions are intended to identify forward-looking statements.
These are statements that relate to future periods and include statements regarding our ability to operate in the future, our ability to obtain funding, the adequacy of funds to meet anticipated operating needs, our future strategic, operational and
financial plans, possible financing, strategic or business combination or divestiture transactions, anticipated or projected revenues, margins, expenses and operational growth, markets and potential customers for our products and services, the
continued seasonality of our business, plans related to sales strategies and global sales efforts, the anticipated benefits of our relationships with strategic partners, growth of our competition, our ability to compete, investments in product
development, anticipated restructuring and costs associated with our leases for our current facilities, our litigation strategy, use of future earnings, the features, benefits and performance of our current and future products and services, plans to
reduce operating costs through continued expense reduction, the anticipated



17



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effect of the transition of our hosted messaging environment from an out-sourced model to one that we perform
in-house, the effect of the repayment of debt, our ability to improve our internal control over financial reporting, our continued listing on the Nasdaq Stock Market, the hearing process with the Nasdaq Listing Qualifications Panel, our intention to
execute on the proposed plan of compliance submitted to Nasdaq, including a reverse stock split, our listing on the OTC Bulletin Board in the event we are delisted from the Nasdaq Stock Market, and our belief as to our ability to successfully emerge
from the restructuring and refocusing of our operations. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Factors that might cause future results to
differ materially from those projected in the forward-looking statements include, but are not limited to, our management of expenses and restructuring activities, failure to obtain additional financing on favorable terms or at all, the effect of the
conversion of our preferred stock, the liquidation preference of our preferred stock, the accrual of dividends for our preferred stock, risks associated with our internal controls over financial reporting and our ability to address any material
weaknesses in our internal controls over financial reporting, risks associated with an inability to maintain continued compliance with Nasdaq National Market listing requirements and delisting actions by such market, difficulties of forecasting
future results due to our evolving business strategy, failure to meet sales and revenue forecasts, the emerging nature of the market for our products and services, turnover within and integration of senior management, board of directors members and
other key personnel, difficulties in our strategic plans to exit certain products and services offerings, failure to expand our sales and marketing activities, potential difficulties associated with strategic relationships, investments and
uncollected bills, general economic conditions in markets in which we do business, risks associated with our international operations, inability to predict future trading prices of our common stock which have fluctuated significantly in the past,
foreign currency fluctuations, unplanned system interruptions and capacity constraints, software defects, and those discussed in Additional Factors That May Affect Future Operating Results and elsewhere in this report. Readers are
cautioned not to place undue reliance on these forward-looking statements. The forward-looking statements speak only as of the date hereof. We expressly disclaim any obligation to publicly release the results of any revisions to these
forward-looking statements to reflect events or circumstances after the date of this filing.



All references to Critical Path, we, our, or the Company mean Critical Path, Inc. and its subsidiaries, except where it is clear from the context that such terms mean
only the parent company and excludes subsidiaries.



This Quarterly Report
on Form 10-Q includes numerous trademarks and registered trademarks of Critical Path. Products or service names of other companies mentioned in this Quarterly Report on Form 10-Q may be trademarks or registered trademarks of their respective
owners.



Overview



We deliver software and services that enable the rapid deployment of highly scalable
value-added solutions for messaging and identity management. Our messaging and identity management solutions help organizations expand the range of digital communications services they provide while helping to reduce overall costs. Our messaging
solutions, which are available both as licensed software and as hosted services, provide integrated access to a broad range of communication and collaboration applications from wireless devices, web browsers, desktop clients, and voice systems. Our
identity management solutions are designed to reduce the burden on helpdesks, simplify the deployment of key security infrastructure, enable compliance with new regulatory mandates and help reduce the cost and effort of deploying applications and
services to distributed organizations, mobile users, suppliers and customers.



Our target markets for our messaging and identity management solutions include wireless carriers and service providers as well as enterprises and government agencies. We generate most of our revenues from telecommunications operators and
from large enterprises. We believe wireless carriers, Internet service providers, or ISPs, and fixed-line service providers purchase our products and services primarily to offer new services to their subscribers. While they may also purchase our
products and services to lower their cost of operating existing services or infrastructure, their spending is often tied to the level of investment they are willing to make on new revenue-generating services. Large enterprises typically buy our
products and services to reduce their costs of operations particularly for handling distributed workforces or consolidations of multiple organizations, improve the security of their infrastructure, facilitate compliance with new regulatory mandates,
and to enable new applications to be deployed for their employees or users.



18



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We generate revenues from four primary sources:



Software license sales. Our messaging applications, which are marketed as components
of our Memova Messaging offering, are usually sold as a perpetual license on a per-user basis, one for each person who might access the capabilities provided by the software. Our identity management software is usually sold as a perpetual license
according to the number of data elements and different business systems being managed. These layered applications are usually licensed per user. Our Memova Anti-Abuse offering is usually sold as a term license on a per product basis and we expect
that our Memova Mobile offering will generally be sold on a term licence basis.



Hosted messaging services. For our hosted messaging services, customers pay initial setup fees and regular monthly, quarterly or annual subscriptions for the services they would like to be able to access.



Professional services. We offer a range of different services designed to help our
customers make more effective use of our products and services, including installation, migration, training services and custom engineering. Our licensed messaging and identity management software may require integration with customers
existing infrastructure. In addition, our consultants offer expertise and experience in designing and delivering new services, features and functions.



Maintenance and support services. We offer a variety of software support and maintenance plans that enable customers of our licensed software to receive expedited
technical support and access to new releases of our software. Most customers initially subscribe to these services when purchasing our software and then renew their subscriptions on a regular basis.



We believe that wireless carriers and service providers are increasingly seeking to offer
more differentiated services and diversify into new markets. In addition, enterprises and government agencies are faced with similar needs to deliver a broader range of information services while reducing the costs of operating such services and
ensuring that privacy and security are maintained. We believe this provides a growth opportunity for the messaging and directory infrastructure market. However, the growth of this market and our business is also faced with many challenges, including
the emerging nature of the market, the demand for licensed solutions for messaging and identity management products and outsourced messaging services, rapid technological change, competition and the recent decline in worldwide technology
spending.



Restructuring
Initiatives



We have operated at a loss since our inception and as of
September 30, 2005, we had an accumulated deficit of approximately $2.3 billion, which includes a $1.3 billion charge for impairment of goodwill and other long-lived assets that we recorded in fiscal year 2000. We have undertaken numerous
restructuring initiatives in an effort to align our operating structure not only to the business and economic environments through which we have operated but also in response to our changing business in an effort to generate net income. For
example:



| |  |  | During 2001, we evaluated our various products, services, facilities and the business plan under which we were operating. In connection with this review, we implemented and
substantially completed a strategic restructuring plan that involved reorganizing and refocusing our product and service offerings, a reduction in workforce and a facilities and operations consolidation. By the end of 2001, we had divested all of
the products and services deemed to be non-core to our continuing operations, reduced headcount by 44%, reduced the number of facilities by 65% and implemented other cost cutting measures, resulting in a significant reduction in overall operating
expenses.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | During 2002, we restructured to reduce our expense levels to be consistent with the then current business climate and eliminated 39 positions and terminated additional leases.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | During 2003, we continued our restructuring initiatives in an effort to further reduce our operating expense levels and reduce our long-term cash obligations. We further
consolidated office locations, restructured certain of our facility leases, reduced our global workforce by approximately 190 positions and outsourced certain positions and services to lower cost service providers.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



19



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| |  |  | During 2004, we expanded our restructuring activities in an effort to reduce both short-term and long-term cash requirements by focusing our business on messaging solutions for
service providers. These activities included the reduction of fixed costs through the restructuring of contracts, consolidation of certain activities to offices in Toronto, Canada and Dublin, Ireland from higher cost areas such as the San Francisco
Bay area, the elimination of approximately 20% of our workforce and the reduced use of third party contractors. This effort began in August 2004 and continued into 2005.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | During the nine months ended September 30, 2005, we recorded a restructuring charges totaling $1.8 million, of which, $1.3 million is related to the relocation of our
headquarters facility as discussed below and the balance is related to consolidation of data centers and the elimination of certain employee positions.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



On May 5, 2005, we entered into the Second Amendment to Lease with PPF Off 345 Spear Street, L.P., to amend the Lease dated as of
November 16, 2001, as amended, under which we lease our headquarter facilities in San Francisco, California. Under the terms of the second amendment, we moved into new office space at 2 Harrison Street, 2ndFloor, San Francisco, California and vacated our facility at 350 The Embarcadero on June 29, 2005. The new office space into which we relocated
is comprised of two suites consisting of approximately 22,881 square feet and will be leased for a term of five years, however; we have an early termination option whereby we can reduce the occupancy of the premises to one of the two suites after 18
months. In connection with the second amendment, we made a lease termination payment totaling approximately $1.3 million related to our former headquarter facility at 350 the Embarcadero during the three months ended June 30, 2005; however, the
annual rent, on a cash basis, for our new headquarter facility will decline from approximately $2.5 million per year to less than approximately $0.7 million per year on average over the term of the lease.



In addition to these formal restructuring initiatives, we have sought to aggressively manage
our cost structure, identifying incremental savings where possible. We intend to continue to aggressively manage our expenses while maintaining strong service levels to our customers. At September 30, 2005, we had a $0.1 million liability
related to our restructuring activities, the majority of which we expect will be paid by September 30, 2006.



Nasdaq Listing Issues



On April 12, 2005, the Nasdaq Stock Market Inc. (Nasdaq) issued us notice that we were not in compliance with the minimum closing bid price requirement. On June 7, 2005, we received notice from Nasdaq that we were not in
compliance with the minimum market value requirement and on September 7, 2005, we received a follow-up letter notifying us that our failure to regain compliance with the minimum market value requirement serves a basis for the delisting of our common
stock from the Nasdaq National Market. On October 6, 2005, members of our management met with the Nasdaq Listing Qualifications Panel to discuss the our failure to meet Nasdaqs minimum market value and minimum closing bid price
requirements. The panel is expected to render a decision shortly with respect to our continued listing on the Nasdaq National Market. Such decision could result in the continued listing of our stock, an extension of time to achieve
compliance with Nasdaq Marketplace Rules, or immediate delisting from the Nasdaq National Market. As a follow-up to the meeting with the Listing Qualifications Panel, we have submitted a plan to Nasdaq that, if approved by Nasdaq and we
execute upon, we believe will allow us to regain compliance with the applicable Nasdaq Marketplace Rules and, as a result, remain listed on the Nasdaq National Market. We will remain listed on the Nasdaq National Market, pending the decision of the
Listing Qualifications Panel.



On October 12, 2005, we received a letter
from Nasdaq, notifying us that our failure to regain compliance with the minimum closing bid price requirement serves as an additional basis for the delisting of our common stock from the Nasdaq National Market. We
believe that we can address this requirement through a reverse split that was approved by our shareholders on November 16, 2004. We intend to make a determination whether to execute a reverse stock split upon the final decision of
Nasdaqs Listing Qualifications Panel with whom we met on October 6, 2005. If we are delisted from the Nasdaq National Market, we expect that our common stock will trade on the Over-the-Counter (OTC) Bulletin Board.



Critical Accounting Policies



There have been no material changes to our critical accounting policies and estimates as
disclosed in our Annual Report on Form 10-K for the year ended December 31, 2004.



Liquidity and Capital Resources



We have focused on capital
financing initiatives in order to maintain current and planned operations. We have operated at a loss since inception and our history of losses from operations and cash flow deficits, in combination with our cash balances, raise concerns about our
ability to fund our operations. Consequently, in 2003 and 2004 we secured additional funds through both debt and equity financing activities that involved the sale of convertible notes and the completion of a rights offering. Most recently, in
December 2004 we drew $11.0 million from an $18.0 million round of debt financing and in March 2005, we drew down the remaining $7.0 million. We are not required to make any payments of principal or interest under this $18.0 million debt financing
until maturity in December 2007. If we are unable to increase our revenues or if we are unable to reduce the amount of cash used by our operating activities, we may be required to undertake additional restructuring alternatives, or seek additional
debt financing although our ability to incur additional indebtedness is subject to certain limitations as discussed in the section below captioned Ability to incur additional indebtedness.



20



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The following table sets forth our net losses attributable to common shareholders and the cash provided by (used in) our
operating activities for the periods indicated:



|                                                    |  |                                  |         |   |        |   |        |                                 |  |   |        |  |      |   |  |      |         |   |   |   |         |   |  |   |        |  |     |  
|--------------------------------------------------- |  | -------------------------------- | ------- | - | ------ | - | ------ | ------------------------------- |  | - | ------ |  | ---- | - |  | ---- | ------- | - | - | - | ------- | - |  | - | ------ |  | --- | -
|                                                    |  | Three months ended September 30, |         |   | Change |   |        | Nine months ended September 30, |  |   | Change | 
|                                                    |  | 2004                             |         |   | 2005   |   |        | $                               |  | % |        |  | 2004 |   |  | 2005 |         |   | $ |   | %       |  
|                                                    |  | (in thousands)                   |        
|Net loss attributable to common shareholders        |  | $                                | (30,352 | ) |        | $ | (4,545 | )                               |  | $ | 25,807 |  | -85  | % |  | $    | (55,910 | ) |   | $ | (25,243 | ) |  | $ | 30,667 |  | -55 | %
|Net cash (used in) provided by operating activities |  |                                  | (3,857  | ) |        |   | 4,484  |                                 |  |   | 8,341  |  | -216 | % |  |      | (25,936 | ) |   |   | (3,503  | ) |  |   | 22,433 |  | -86 | %



With our history of operating losses
and cash used to support our operating activities, our primary sources of capital have come from both debt and equity financings that we have completed over the past several years. Our principal sources of liquidity include our cash and cash
equivalents. As of September 30, 2005, we had cash and cash equivalents available for operations totaling $20.5 million, of which $10.8 million was located in accounts outside the United States and which is not readily available for our
domestic operations. However, we intend to pursue the restructuring our foreign subsidiaries which, if successful, may provide us easier access to the repatriation of a greater portion of the cash located in accounts outside the United States.
Additionally, we are currently evaluating the newly enacted American Jobs Creation Act of 2004 (the AJCA) and are not yet in a position to decide whether, or to what extent, the AJCA will enable us to repatriate foreign earnings that have not yet
been remitted to the United States. Accordingly, our readily available cash resources in the United States as of September 30, 2005 were $9.7 million. In addition, as of September 30, 2005, we had $0.3 million of cash classified on our
balance sheet as restricted cash which is primarily related to cash collateralized letters of credit primarily related to facility leases. This restricted cash is not readily available for operations.



Based on our recent financing activities, cash expected to be generated from operations and
recent restructuring activities we believe that there is sufficient cash to meet cash operating requirements for the next 12 months as well as the on-going investments in capital equipment to support our research and development efforts. For the
long-term, we believe that our operating activities will be able to provide the liquidity and capital resources sufficient to support our business. At September 30, 2005, we had no borrowings under our credit facility with Silicon Valley Bank
because the borrowing availability had been eliminated and we were required to cash collateralize our letters of credit.



21



---

Cash and cash equivalents



The following table sets forth our cash and cash equivalents balances as of the dates indicated:



|                          |  |                   |        |                    |   |        |   |   |        |   |  |     |  
|------------------------- |  | ----------------- | ------ | ------------------ | - | ------ | - | - | ------ | - |  | --- | -
|                          |  | December 31, 2004 |        | September 30, 2005 |   | Change |  
|                          |  |                   |        | $                  |   |        | % |  
|                          |  | (in thousands)    |       
|Cash and cash equivalents |  | $                 | 23,239 |                    | $ | 20,486 |   | $ | (2,753 | ) |  | -12 | %



Total cash and cash equivalents
decreased primarily as a result of the cash used to support our operating activities partially offset by cash provided by both our investing and financing activities as set forth in the table below (in thousands):



|                                                      |  |   |        |  
|----------------------------------------------------- |  | - | ------ | -
|Beginning balance at December 31, 2004                |  | $ | 23,239 |  
|                                                      | 
|Net cash used in operating activities                 |  |   | (3,503 | )
|Net cash provided by investing activities             |  |   | 1,196  |  
|Net cash provided by financing activities             |  |   | 577    |  
|                                                      |  |   |        |  
|Net decrease in cash and cash equivalents             |  |   | (1,730 | )
|Effect of exchange rates on cash and cash equivalents |  |   | (1,023 | )
|                                                      |  |   |        |  
|Ending balance at September 30, 2005                  |  | $ | 20,486 |  
|                                                      |  |   |        |  



Net cash used in operating
activities. Our operating activities used $3.5 million of cash during the nine months ended September 30, 2005. This cash was used to support our net loss of $9.9 million, adjusted for non-cash items, including: depreciation and
amortization of $6.6 million, decreases in the fair value of embedded derivative liabilities of $2.8 million and stock-based expenses of $0.9 million. Cash was used in operating activities associated with a $1.6 million decrease in accrued
liabilities and a $1.2 million decrease in accounts payable. Cash was provided for operating activities by a $4.3 million decrease in accounts receivable and a $1.5 million increase in deferred revenue.



Our primary source of operating cash flow is the collection of accounts receivable from our
customers and the timing of payments to our vendors and service providers. We measure the effectiveness of our collections efforts by an analysis of the average number of days our accounts receivable are outstanding, or DSOs. The following table
sets forth our accounts receivable balances and DSOs as of the dates indicated:



|                         |  |                                      |        |                    |   |        |   |   |        |   |  |     |  
|------------------------ |  | ------------------------------------ | ------ | ------------------ | - | ------ | - | - | ------ | - |  | --- | -
|                         |  | December 31, 2004                    |        | September 30, 2005 |   | Change |  
|                         |  |                                      |        | $                  |   |        | % |  
|                         |  | (dollars in thousands; DSOs in days) |       
|Accounts receivable, net |  | $                                    | 19,667 |                    | $ | 13,274 |   | $ | (6,393 | ) |  | -33 | %
|DSOs (a)                 |  |                                      | 91     |                    |   | 70     |   |   | (21    | ) |  | -23 | %

---

|(a) | DSOs equal accounts receivable, net, at the end of the quarter, divided by the quotient of total net revenue for the respective quarterly period, divided by 90.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



Accounts receivable balances and DSOs decreased primarily as a
result of improved collections performance, particularly in Europe.



Our
accrued liabilities decreased $1.6 million during the nine months ended September 30, 2005 primarily as a result of liabilities we have paid that were accrued for at December 31, 2004, and the declining cost of net revenues and operating
expenses due to recent restructuring activities. Deferred revenue has increased during the nine months ended September 30, 2005 primarily as a result of the deferral of revenue from sales of our Memova Anti-Abuse offerings during the period due
to the term nature of the end user licenses underlying the offering.



22



---

A number of non-cash items, such as: depreciation and amortization, stock-based expenses and certain restructuring
charges have been charged to expense and impacted our net losses during the three and nine months ended September 30, 2005. To the extent these non- cash items increase or decrease in amount and increase or decrease our future operating
results, there will be no corresponding impact on our cash flows. Our operating cash flows will be impacted in the future based on our operating results, our ability to collect our accounts receivable on a timely basis, and the timing of payments to
our vendors for accounts payable.



We face restrictions on our ability to use
cash held outside of the United States for purposes other than the operation of each of our respective foreign subsidiaries that hold that cash. For example, our ability to use cash held in a given European subsidiary for any reason other than the
operation of such subsidiary may be subject to local laws that could prevent the transfer of cash from Europe to any other foreign or domestic account. Additionally, we are exposed to foreign currency exchange rate risk inherent in our sales
commitments, anticipated sales, contracts with vendors, and working capital, as a significant portion or our worldwide operations have a functional currency other than the United States dollar. The impact of future exchange rate fluctuations cannot
be predicted adequately. To date, we have not sought to hedge the risks associated with fluctuations in exchange rates.



Revenue generated from the sale of our products and services may not increase to a level that exceeds our expenses or could fluctuate significantly as a result of changes
in customer demand or acceptance of future products. Although we expect to continue to review our operating expenses, if we are not successful in achieving cost reductions or generating sufficient revenues, our cash flow from operations will be
negatively impacted.



Net cash used by investing activities. Our
investing activities provided $1.2 million of cash during the nine months ended September 30, 2005 primarily as a result of the release of restricted cash which collateralized the letter of credit for our facility at 350 The Embarcadero in San
Francisco. The cash provided from the release of this letter of credit was partially offset by purchases of equipment primarily used to support the hosted messaging operations infrastructure and research and development efforts. We will be required
to continue to make investments in capital equipment during 2005 to support our on-going research and development efforts and hosted data center expansion plans. We expect to fund these purchases through the use of our available cash resources and
through leasing arrangements, if available, on terms we find acceptable.



Cash provided by financing activities. Our financing activities provided $0.6 million of cash during the nine months ended September 30, 2005 primarily as a result of the $7.0 million we drew in March 2005 from the $18.0
million round of debt financing we closed in December 2004 partially offset by the cash used to retire our then outstanding 53/4% Convertible Subordinated Notes and payments of capital leases.



Ability to incur additional indebtedness



Subject to limited exceptions, we must seek the consent of our investors in order to incur any additional indebtedness. Additionally, under the terms of our line of
credit, we are required to obtain a consent from Silicon Valley Bank to incur additional indebtedness.



We have no present understandings, commitments or agreements for any material acquisitions of, or investments in, other complementary businesses, products or technologies. We continually evaluate potential
acquisitions of, or investments in, other businesses, products and technologies, and may in the future utilize our cash resources or may require additional equity or debt financing to accomplish any acquisitions or investments. These alternatives
could increase liquidity through the infusion of investment capital by third-party investors or decrease our liquidity as a result of our seeking to fund expansion into these markets. Such expansions might also cause an increase in capital
expenditures and operating expenses.



23



---

Contractual Obligations and Commitments



The table below sets forth our significant cash obligations
and commitments as of September 30, 2005.



|                                       |  |                |         |                                     |   |                                 |  |      |       |      |   |            |  |   |         |  |   |       |  |   |    
|-------------------------------------- |  | -------------- | ------- | ----------------------------------- | - | ------------------------------- |  | ---- | ----- | ---- | - | ---------- |  | - | ------- |  | - | ----- |  | - | ---
|                                       |  | Total          |         | Three monthsendingDecember 31, 2005 |   | Fiscal year ending December 31,
|                                       |  |                |         | 2006                                |   | 2007                            |  | 2008 |       | 2009 |   | Thereafter
|                                       |  | (in thousands)
|Mandatorily redeemable preferred stock |  | $              | 166,932 |                                     | $ |                                |  | $    |      |      | $ |           |  | $ | 166,932 |  | $ |      |  | $ |   
|13.9% Notes                            |  |                | 26,792  |                                     |   |                                |  |      |      |      |   | 26,792     |  |   |        |  |   |      |  |   |   
|Operating lease obligations            |  |                | 9,032   |                                     |   | 774                             |  |      | 2,708 |      |   | 2,062      |  |   | 1,761   |  |   | 1,371 |  |   | 356
|Capital lease obligations              |  |                | 137     |                                     |   | 29                              |  |      | 90    |      |   | 18         |  |   |        |  |   |      |  |   |   
|Other purchase obligations (a)         |  |                | 4,359   |                                     |   | 3,033                           |  |      | 1,136 |      |   | 190        |  |   |        |  |   |      |  |   |   
|                                       |  |                |         |                                     |   |                                 |  |      |       |      |   |            |  |   |         |  |   |       |  |   |    
|                                       |  | $              | 204,696 |                                     | $ | 3,836                           |  | $    | 3,934 |      | $ | 29,062     |  | $ | 168,153 |  | $ | 1,371 |  | $ | 356
|                                       |  |                |         |                                     |   |                                 |  |      |       |      |   |            |  |   |         |  |   |       |  |   |    

---

|(a) | Represent certain contractual obligations related to licensed software, maintenance contracts and network infrastructure storage costs.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------



Results of Operations



In view of the rapidly evolving nature of our business, prior acquisitions, organizational restructuring, and limited operating history, we
believe that period over period comparisons of revenues and operating results, including gross profit margin and operating expenses as a percentage of total net revenues, are not meaningful and should not be relied upon as indications of future
performance. We do not believe that our historical fluctuations in revenues, expenses or personnel are indicative of future results.



24



---

The following table sets forth our results of operations for the three and nine months ended September 30, 2004 and
2005.



|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|------------------------------------------------------------------------ |  | ---------------------------------------- | ------- | - | ------ | - | ------ | ------------------------------- |  | - | ------ | - |  | ---- | - |  | ---- | ------- | - | - | - | ------- | - |  | - | ------- | - |  | ---- | -
|                                                                         |  | Three months ended September 30,         |         |   | Change |   |        | Nine months ended September 30, |  |   | Change |  
|                                                                         |  | 2004                                     |         |   | 2005   |   |        | $                               |  |   | %      |   |  | 2004 |   |  | 2005 |         |   | $ |   |         | % | 
|                                                                         |  | (in thousands, except per share amounts) |        
|NET REVENUE                                                              |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|SW licensing                                                             |  | $                                        | 4,744   |   |        | $ | 5,593  |                                 |  | $ | 849    |   |  | 18   | % |  | $    | 14,403  |   |   | $ | 14,810  |   |  | $ | 407     |   |  | 3    | %
|Hosted messaging                                                         |  |                                          | 4,621   |   |        |   | 3,309  |                                 |  |   | (1,312 | ) |  | -28  | % |  |      | 12,675  |   |   |   | 12,048  |   |  |   | (627    | ) |  | -5   | %
|Professional services                                                    |  |                                          | 3,092   |   |        |   | 3,119  |                                 |  |   | 27     |   |  | 1    | % |  |      | 8,687   |   |   |   | 9,929   |   |  |   | 1,242   |   |  | 14   | %
|Maintenance and support                                                  |  |                                          | 5,038   |   |        |   | 5,059  |                                 |  |   | 21     |   |  | 0    | % |  |      | 15,825  |   |   |   | 14,842  |   |  |   | (983    | ) |  | -6   | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|Total net revenue                                                        |  |                                          | 17,495  |   |        |   | 17,080 |                                 |  |   | (415   | ) |  | -2   | % |  |      | 51,590  |   |   |   | 51,629  |   |  |   | 39      |   |  | 0    | %
|                                                                         |  |                                          |         |   |        |   |        |                                
|COST OF NET REVENUE                                                      |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|SW licensing                                                             |  |                                          | 1,322   |   |        |   | 1,364  |                                 |  |   | 42     |   |  | 3    | % |  |      | 3,941   |   |   |   | 3,606   |   |  |   | (335    | ) |  | -9   | %
|Hosted messaging                                                         |  |                                          | 5,995   |   |        |   | 3,036  |                                 |  |   | (2,959 | ) |  | -49  | % |  |      | 18,946  |   |   |   | 11,927  |   |  |   | (7,019  | ) |  | -37  | %
|Professional services                                                    |  |                                          | 2,667   |   |        |   | 2,270  |                                 |  |   | (397   | ) |  | -15  | % |  |      | 8,796   |   |   |   | 6,993   |   |  |   | (1,803  | ) |  | -20  | %
|Maintenance and support                                                  |  |                                          | 1,422   |   |        |   | 1,442  |                                 |  |   | 20     |   |  | 1    | % |  |      | 4,193   |   |   |   | 4,542   |   |  |   | 349     |   |  | 8    | %
|Stock-based expense                                                      |  |                                          |        |   |        |   | 63     |                                 |  |   | 63     |   |  | 0    | % |  |      | 5       |   |   |   | 168     |   |  |   | 163     |   |  | 3260 | %
|Restructuring and other expenses                                         |  |                                          |        |   |        |   |       |                                 |  |   |       |   |  | 0    | % |  |      | 175     |   |   |   |        |   |  |   | (175    | ) |  | -100 | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|Total cost of net revenue                                                |  |                                          | 11,406  |   |        |   | 8,175  |                                 |  |   | (3,231 | ) |  | -28  | % |  |      | 36,056  |   |   |   | 27,236  |   |  |   | (8,820  | ) |  | -24  | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|GROSS PROFIT                                                             |  |                                          | 6,089   |   |        |   | 8,905  |                                 |  |   | 2,816  |   |  | 46   | % |  |      | 15,534  |   |   |   | 24,393  |   |  |   | 8,859   |   |  | 57   | %
|                                                                         |  |                                          |         |   |        |   |        |                                
|OPERATING EXPENSES                                                       |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|Selling and marketing                                                    |  |                                          | 5,242   |   |        |   | 4,206  |                                 |  |   | (1,036 | ) |  | -20  | % |  |      | 18,216  |   |   |   | 12,780  |   |  |   | (5,436  | ) |  | -30  | %
|Research and development                                                 |  |                                          | 5,260   |   |        |   | 2,910  |                                 |  |   | (2,350 | ) |  | -45  | % |  |      | 16,383  |   |   |   | 11,446  |   |  |   | (4,937  | ) |  | -30  | %
|General and administrative                                               |  |                                          | 2,854   |   |        |   | 2,558  |                                 |  |   | (296   | ) |  | -10  | % |  |      | 9,746   |   |   |   | 9,829   |   |  |   | 83      |   |  | 1    | %
|Stock-based expense                                                      |  |                                          | 308     |   |        |   | 292    |                                 |  |   | (16    | ) |  | -5   | % |  |      | 1,561   |   |   |   | 749     |   |  |   | (812    | ) |  | -52  | %
|Restructuring expense                                                    |  |                                          | 2,590   |   |        |   | 40     |                                 |  |   | (2,550 | ) |  | -98  | % |  |      | 4,799   |   |   |   | 1,847   |   |  |   | (2,952  | ) |  | -62  | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|Total operating expenses                                                 |  |                                          | 16,254  |   |        |   | 10,006 |                                 |  |   | (6,248 | ) |  | -38  | % |  |      | 50,705  |   |   |   | 36,651  |   |  |   | (14,054 | ) |  | -28  | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|OPERATING LOSS                                                           |  |                                          | (10,165 | ) |        |   | (1,101 | )                               |  |   | 9,064  |   |  | -89  | % |  |      | (35,171 | ) |   |   | (12,258 | ) |  |   | 22,913  |   |  | -65  | %
|                                                                         |  |                                          |         |   |        |   |        |                                
|Other income (expense), net                                              |  |                                          | (2,781  | ) |        |   | 1,357  |                                 |  |   | 4,138  |   |  | -149 | % |  |      | 7,448   |   |   |   | 5,598   |   |  |   | (1,850  | ) |  | -25  | %
|Interest income (expense)                                                |  |                                          | (342    | ) |        |   | (918   | )                               |  |   | (576   | ) |  | 168  | % |  |      | (3,815  | ) |   |   | (2,483  | ) |  |   | 1,332   |   |  | -35  | %
|Loss on extinguishment of debt                                           |  |                                          | (12,783 | ) |        |   |       |                                 |  |   | 12,783 |   |  | -100 | % |  |      | (12,783 | ) |   |   |        |   |  |   | 12,783  |   |  | -100 | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|Loss before provision for income taxes                                   |  |                                          | (26,071 | ) |        |   | (662   | )                               |  |   | 25,409 |   |  | -97  | % |  |      | (44,321 | ) |   |   | (9,143  | ) |  |   | 35,178  |   |  | -79  | %
|Provision for income taxes                                               |  |                                          | (88     | ) |        |   | (364   | )                               |  |   | (276   | ) |  | 314  | % |  |      | (900    | ) |   |   | (789    | ) |  |   | 111     |   |  | -12  | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|NET LOSS                                                                 |  |                                          | (26,159 | ) |        |   | (1,026 | )                               |  |   | 25,133 |   |  | -96  | % |  |      | (45,221 | ) |   |   | (9,932  | ) |  |   | 35,289  |   |  | -78  | %
|Accretion on mandatorily redeemable preferred stock                      |  |                                          | (4,193  | ) |        |   | (3,519 | )                               |  |   | 675    |   |  | -16  | % |  |      | (10,689 | ) |   |   | (15,311 | ) |  |   | (4,622  | ) |  | 43   | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|NET LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS                             |  | $                                        | (30,352 | ) |        | $ | (4,545 | )                               |  | $ | 25,808 |   |  | -85  | % |  | $    | (55,910 | ) |   | $ | (25,243 | ) |  | $ | 30,667  |   |  | -55  | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|Basic and diluted net loss per share attributable to common shareholders |  | $                                        | (1.43   | ) |        | $ | (0.13  | )                               |  | $ | 1.30   |   |  | -91  | % |  | $    | (2.65   | ) |   | $ | (0.83   | ) |  | $ | 1.82    |   |  | -69  | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  
|Weighted average shares - basic and diluted                              |  |                                          | 21,171  |   |        |   | 34,557 |                                 |  |   | 13,386 |   |  | 63   | % |  |      | 21,075  |   |   |   | 30,452  |   |  |   | 9,377   |   |  | 44   | %
|                                                                         |  |                                          |         |   |        |   |        |                                 |  |   |        |   |  |      |   |  |      |         |   |   |   |         |   |  |   |         |   |  |      |  



NET REVENUE



Total net revenues decreased slightly during the three months ended
September 30, 2005 as compared to the three months ended September 30, 2004 primarily as a result of decreased revenue from our hosted messaging solutions, which was partially offset by increased revenue from our software licenses. Total
net revenues remained relatively



25



---

unchanged during the nine months ended September 30, 2005 as compared to the nine months ended September 30,
2004 primarily as a result of increased revenue from our professional services and software licenses, which was almost equally offset by decreased revenue from our hosted messaging solutions and maintenance and support services.



We currently expect total net revenues to decrease during the three months ending
December 31, 2005 as compared to the three months ended December 31, 2004 reflecting year-over-year decline in hosted revenues and, based upon analysis of current sales pipelines, we are not expecting the same seasonal strength in other
revenues that we have historically experienced during the fourth quarter.



| |  |  | Software licensing. Software license revenue increased during the three and nine months ended September 30, 2005 as compared to the three and nine months ended
September 30, 2004 primarily due to(i) increased license sales of our identity management software, which is marketed as a component of our Memova Messaging offering, and(ii) revenue recognized from sales of our Memova
Anti-Abuse offering which we did not offer during the nine months ended September 30, 2004. These increases were partially offset by decreased revenue from licenses of our messaging software platform.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Hosted messaging. Hosted messaging revenue decreased during the three months ended September 30, 2005 as compared to the three months ended September 30,
2004 primarily due to recognition of revenue during the three months ended September 30, 2004 that was previously deferred pending final acceptance of our hosted email service with Virgin.net. There was no similar deferred revenue to be
recognized during the three months ended September 30, 2005.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Hosted messaging revenue decreased during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004 primarily as a result of customers reducing or terminating their
usage of our hosted messaging solutions however, this decrease is partially offset by revenue recognized from our hosted messaging service with T-Mobile in 2005 until expiration of the contract on March 31, 2005. While these services were being
provided to T-Mobile during the three and nine months ended September 30, 2004, we had not received final acceptance from T-Mobile on the installation of the service and therefore did not recognize any revenue from T-Mobile during such periods. We
currently expect hosted messaging revenues for the three months ending December 31, 2005 to approximate the $3.0 million range.



| |  |  | Professional services. Although professional services revenue remained relatively unchanged for the three months ended September 30, 2005 as compared to the three
months ended September 30, 2004, it increased during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004 primarily as a result of increased revenue from services projects in Europe and
delivery of previously developed professional service solutions during the three and nine months ended September 30, 2005. During the nine months ended September 30, 2005, one client in Europe accounted for approximately 18% of
professional services revenue.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Maintenance and support. Although maintenance and support revenue remained relatively unchanged for the three months ended September 30, 2005 as compared to the
three months ended September 30, 2004, it decreased during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004 primarily due to late renewals in early 2004 which generated increased revenue
in 2004 which did not recur in 2005 and certain customers either not renewing maintenance or renewing at lower rates partially offset by new maintenance revenue associated with new license contracts.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



During the three months ended September 30, 2005, we had one customer which accounted
for 10% of our total revenue and during the three months ended June 30, 2005, we also had one customer which accounted for 13% of our total revenue. Additionally during the three months ended March 31, 2005, we had one customer which accounted
for approximately 9% of our total revenue. These customers are not related. During the three month periods ended March 31, June 30 and September 30, 2004, we had no customers which accounted for 10% or more of our total revenue.



26



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The following table sets forth our total revenues and percent of revenue by region for the three and nine months ended
September 30, 2004 and 2005:



|                       |  |                                  |        |  |        |   |  |                                 |        |  |        |   |  |      |      |   |      |     |   |   |   |        |   |     |   |  |   |        |  |     |   |  |   |        |   |  |     |  
|---------------------- |  | -------------------------------- | ------ |  | ------ | - |  | ------------------------------- | ------ |  | ------ | - |  | ---- | ---- | - | ---- | --- | - | - | - | ------ | - | --- | - |  | - | ------ |  | --- | - |  | - | ------ | - |  | --- | -
|                       |  | Three months ended September 30, |        |  | Change |   |  | Nine months ended September 30, |        |  | Change |  
|                       |  | 2004                             |        |  | 2005   |   |  | $                               |        |  | %      |   |  | 2004 |      |   | 2005 |     |   | $ |   |        | % |    
|                       |  | (in thousands)                   |       
|North America          |  | $                                | 5,028  |  | 29     | % |  | $                               | 4,587  |  | 27     | % |  | $    | (441 | ) |      | -9  | % |   | $ | 16,493 |   | 32  | % |  | $ | 13,214 |  | 26  | % |  | $ | (3,279 | ) |  | -20 | %
|                       |  |                                  |        |  |        |   |  |                                 |        |  |        |   |  |      |      |   |      |     |   |   |   |        |   |     |   |  |   |        |  |     |   |  |   |        |   |  |     |  
|Europe                 |  |                                  | 11,801 |  | 67     | % |  |                                 | 11,917 |  | 70     | % |  |      | 116  |   |      | 1   | % |   |   | 32,705 |   | 63  | % |  |   | 36,507 |  | 71  | % |  |   | 3,802  |   |  | 12  | %
|Latin America          |  |                                  | 345    |  | 2      | % |  |                                 | 365    |  | 2      | % |  |      | 20   |   |      | 6   | % |   |   | 1,029  |   | 2   | % |  |   | 891    |  | 2   | % |  |   | (138   | ) |  | -13 | %
|Asia pacific           |  |                                  | 321    |  | 2      | % |  |                                 | 211    |  | 1      | % |  |      | (110 | ) |      | -34 | % |   |   | 1,363  |   | 3   | % |  |   | 1,017  |  | 2   | % |  |   | (346   | ) |  | -25 | %
|                       |  |                                  |        |  |        |   |  |                                 |        |  |        |   |  |      |      |   |      |     |   |   |   |        |   |     |   |  |   |        |  |     |   |  |   |        |   |  |     |  
|Subtotal international |  |                                  | 12,467 |  | 71     | % |  |                                 | 12,493 |  | 73     | % |  |      | 26   |   |      | 0   | % |   |   | 35,097 |   | 68  | % |  |   | 38,415 |  | 74  | % |  |   | 3,318  |   |  | 9   | %
|                       |  |                                  |        |  |        |   |  |                                 |        |  |        |   |  |      |      |   |      |     |   |   |   |        |   |     |   |  |   |        |  |     |   |  |   |        |   |  |     |  
|                       |  | $                                | 17,495 |  | 100    | % |  | $                               | 17,080 |  | 100    | % |  | $    | (415 | ) |      | -2  | % |   | $ | 51,590 |   | 100 | % |  | $ | 51,629 |  | 100 | % |  | $ | 39     |   |  | 0   | %
|                       |  |                                  |        |  |        |   |  |                                 |        |  |        |   |  |      |      |   |      |     |   |   |   |        |   |     |   |  |   |        |  |     |   |  |   |        |   |  |     |  



Although international revenues
remained relatively unchanged for the three months ended September 30, 2005 as compared to the three months ended September 30, 2004, international revenues increased in total and as a proportion of our total revenue for the nine months
ended September 30, 2005 as compared to the nine months ended September 30, 2004 primarily due to growing demand within our existing European customer base and revenue recognized from our hosted messaging services. Revenue in North America
decreased in total and as a proportion of our total revenue for the three and nine months ended September 30, 2005 as compared to the three and nine months ended September 30, 2004 primarily due to decreased sales of hosted messaging
services as a result of customers terminating or reducing their hosted messaging services as well as decreased maintenance and support revenues.



COST OF NET REVENUE AND GROSS MARGIN



Cost of net revenue decreased for the three and nine months ended September 30, 2005 as compared to the three and nine months ended September 30, 2004 primarily
as a result of reduced hosted messaging and professional services costs.



| |  |  | Software licensing. Software license cost of revenue consists primarily of third-party royalty costs. Although software license cost of revenues remained relatively
unchanged during the three months ended September 30, 2005 as compared to September 30, 2004, software license cost of revenues decreased during the nine months ended September 30, 2005 as compared to the nine months ended
September 30, 2004. This decrease is primarily due to an increased proportion of revenue from our lower cost Memova Anti-Abuse products which is replacing sales of the lower margin third party products which we resell.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Hosted messaging. Hosted messaging cost of revenue consists primarily of costs incurred in the delivery and support of hosted messaging services, including employee
related costs, depreciation and amortization expenses, Internet co-location and connection fees, hardware maintenance costs as well as other direct and allocated costs. Hosted messaging costs decreased during the three and nine months ended
September 30, 2005 as compared to the three and nine months ended September 30, 2004 primarily due to decreased outsourcing and equipment rental costs partially offset by increased employee related costs as a result of the transition to
performing our hosted services in-house rather than being outsourced, which was one of the restructuring activities undertaken in 2004 and which continued into the nine months of 2005. This net decrease was also partially offset by the expensing of
$0.6 million of previously deferred costs which were recognized in cost of revenue during the three months ended March 31, 2005 related to our hosted messaging service with T-Mobile. There were no deferred costs recognized related to T-Mobile
during the three or nine months ended September 30, 2004.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Professional services. Professional services cost of revenue consists primarily of employee related and third party contractor costs providing installation, migration,
training services and custom engineering for both our hosted messaging and licensed solutions as well as other direct and allocated costs. Professional services costs decreased for the three and nine months ended September 30, 2005 as compared
to the three and nine months ended September 30, 2004 primarily due to a decrease in employee related costs as a result of our restructuring activities during 2004 and a decrease in the use of third-party contractors.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



27



---

| |  |  | Maintenance and support. Maintenance and support cost of revenues consists primarily of employee related and third party contractor costs related to the customer
support functions for both our hosted messaging and licensed solutions as well as other direct and allocated costs. Maintenance and support costs increased during the three and nine months ended September 30, 2005 as compared to the three and
nine months ended September 30, 2004 primarily due to an increase in employee related costs.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Stock-based expense. Stock-based expense represents the charges recorded in connection with modifications made to employee stock option plans, stock option grants to
non-employee contractors and warrants issued to third parties as well as amortization of restricted stock-based compensation given to employees. Stock-based expenses increased during the three and nine months ended September 30, 2005 as
compared to the three and nine months ended September 30, 2004 primarily as a result of increased amortization of costs related to grants of restricted stock to certain employees during the latter half of 2004.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our total gross margin, which is gross profit divided by total net revenue, increased to 52%
for the three months ended September 30, 2005 from 35% for the three months ended September 30, 2004. Total gross margin for the nine months ended September 30, 2005 increased to 47% from 30% for the nine months ended
September 30, 2004. These increases are primarily due to the decreases in our net cost of revenue as discussed above.



OPERATING EXPENSES



Total operating expenses decreased primarily due to reduced selling and marketing, research and development expenses, stock-based expenses and restructuring
expenses.



| |  |  | Sales and marketing. Sales and marketing expenses consist primarily of employee costs, including commissions, as well as travel and entertainment, third party
contractor costs, advertising, public relations, other marketing related costs as well as other direct and allocated costs.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Sales and marketing expenses decreased during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004 primarily as a result of a
$0.5 million decrease in employee-related expenses and a $0.1 million decrease in travel and entertainment expenses primarily due to the termination of employees through our restructuring activities. Our sales and marketing staff decreased by 17
employees to an average of 48 employees for the three months ended September 30, 2005 from an average of 65 employees for the three months ended September 30, 2004. Additionally, facility related costs decreased $0.2 million and
third-party contractor expenses decreased $0.1 million during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Sales and marketing expenses decreased during the nine months ended September 30, 2005 as compared to the nine months
ended September 30, 2004 primarily as a result of a $3.2 million decrease in employee-related expenses and a $0.5 million decrease in travel and entertainment expenses primarily as a result of the termination of employees through our
restructuring activities. Our sales and marketing staff decreased by 25 employees to an average of 50 employees for the nine months ended September 30, 2005 from an average of 75 employees for the nine months ended September 30, 2004.
Additionally, facility related costs decreased $0.7 million and third-party contractor expenses decreased $0.3 million during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004.



While our sales and marketing staff has decreased year over year, we are
currently expecting to increase our sales and marketing staff in certain key regions to support sales of our new Memova consumer offerings.



| |  |  | Research and development. Research and development expense consist primarily of employee related costs, depreciation and amortization of capital equipment associated
with research and development activities, facility related costs, third-party contractor costs as well as other direct and allocated costs.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



28



---

Research and development expenses decreased during the three months ended September 30, 2005 as
compared to the three months ended September 30, 2004 primarily as a result of a $1.1 million decrease in employee-related expenses and a decrease of $0.4 million in third party contractor costs, primarily as a result of our restructuring
activities which focused our development efforts on our core messaging products. Our research and development staff decreased by 32 employees, most of whom were involved in the development of non-core solutions, to an average of 85 employees for the
three months ended September 30, 2005 from an average of 117 employees for the three months ended September 30, 2004. Additionally, depreciation expense decreased $0.9 million during the three months ended September 30, 2005 as
compared to the three months ended September 30, 2004 primarily as a result of the acceleration of depreciation in earlier periods on certain assets related to a messaging provisioning platform after it was determined the assets would be taken
out of service before the end of their originally estimated useful life.



Research and development expenses decreased during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004 primarily as a result of a $2.7 million decrease in
employee related expenses and a decrease of $1.3 million in third party contractor costs, primarily as a result of our restructuring activities which focused our development efforts on our core messaging products. Our research and development staff
decreased by 40 employees, most of whom were related to development of non-core solutions, to an average of 88 employees for the nine months ended September 30, 2005 from an average of 128 employees for the nine months ended September 30,
2004. Additionally, depreciation expense decreased $0.5 million during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004 primarily as a result of the acceleration of depreciation in
earlier periods on certain assets related to a messaging provisioning platform after it was determined the assets would be taken out of service before the end of their originally estimated useful life and the expiration of the useful life of other
assets used in our research and development efforts.



We are
considering increasing our investment in research and development related to our Memova consumer offerings.



| |  |  | General and administrative. General and administrative expense consist primarily of employee-related costs, fees for outside professional services, insurance and other
direct and allocated indirect costs.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



General
and administrative expenses decreased during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004 primarily due to a $0.2 million decrease in outside accounting fees.



General and administrative expenses increased slightly during the nine
months ended September 30, 2005 as compared to the nine months ended September 30, 2004, primarily due to a $1.2 million increase in accounting related fees related to our Sarbanes-Oxley 404 compliance project which was partially offset by
a $0.4 million decrease in employee related costs, a $0.6 million decrease in connection with the severance agreement for our former chief executive officer during 2004 and a $0.1 million decrease in bad debt expenses reflecting our decreased
accounts receivable balance at September 30, 2005. General and administrative staff decreased by 2 employees to an average of 55 employees for the nine months ended September 30, 2005 from an average of 57 employees for the nine months
ended September 30, 2004.



Included in general and
administrative expenses are costs related to the initial implementation and compliance with the requirements of Sarbanes-Oxley 404 (section 404) for the fiscal year ended December 31, 2004. Excluding our own time and resources, our initial
costs to comply with section 404, excluding costs related to the audit of our financial statements, were approximately $2.1 million. For the fiscal year ended December 31, 2004, the total external costs of compliance with section 404 and our
financial statement audit totaled approximately $3.0 million as compared to approximately $0.6 million for 2003. The 2004 external costs of compliance were incurred primarily in the last half of 2004 and the first half of 2005. As a result of our
on-going compliance with section 404 and remediation of material weaknesses and significant deficiencies resulting from our initial compliance efforts, we expect that general and administrative expenses will increase in future periods.



29



---

| |  |  | Stock-based expense. Stock-based expense represents the charges recorded in connection with modifications made to employee stock option plans, stock option grants to
non-employee contractors, warrants issued to third parties as well as amortization of certain stock-based compensation given to employees. Stock-based expenses for the nine months ended September 30, 2005 decreased primarily as a result of the
charges we recorded in connection with the severance agreement between us and our former chief executive officer in 2004.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Restructuring expense. Restructuring expense consists primarily of costs associated with employee severance benefits, the consolidation of facilities and operations
and exiting from the sale of non-core products as a result of our restructuring actions. The following table provides additional information with respect to the types of restructuring charges included in our operating expenses for the periods
indicated.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                                       |  |                                  |       |        |   |    |                                 |   |        |   |  |      |   |      |   |       |  |   |       |  |   |        |   |  |     |  
|-------------------------------------- |  | -------------------------------- | ----- | ------ | - | -- | ------------------------------- | - | ------ | - |  | ---- | - | ---- | - | ----- |  | - | ----- |  | - | ------ | - |  | --- | -
|                                       |  | Three months ended September 30, |       | Change |   |    | Nine months ended September 30, |   | Change |  
|                                       |  | 2004                             |       | 2005   |   | $  |                                 |   | %      |   |  | 2004 |   | 2005 |   | $     |  |   | %     | 
|                                       |  | (in thousands)                   |      
|Employee severance benefits            |  | $                                | 2,074 |        | $ | 31 |                                 | $ | (2,043 | ) |  | -99  | % |      | $ | 3,869 |  | $ | 342   |  | $ | (3,527 | ) |  | -90 | %
|Facility and operations consolidations |  |                                  | 516   |        |   | 9  |                                 |   | (507   | ) |  | -98  | % |      |   | 889   |  |   | 1,444 |  |   | 555    |   |  | 58  | %
|Non-core product divestitures          |  |                                  |      |        |   |   |                                 |   |       |   |  | 0    | % |      |   | 41    |  |   | 61    |  |   | 20     |   |  | 49  | %
|                                       |  |                                  |       |        |   |    |                                 |   |        |   |  |      |   |      |   |       |  |   |       |  |   |        |   |  |     |  
|                                       |  | $                                | 2,590 |        | $ | 40 |                                 | $ | (2,550 | ) |  | -98  | % |      | $ | 4,799 |  | $ | 1,847 |  | $ | (2,952 | ) |  | -62 | %
|                                       |  |                                  |       |        |   |    |                                 |   |        |   |  |      |   |      |   |       |  |   |       |  |   |        |   |  |     |  



Total restructuring
expense decreased during the three and nine months ended September 30, 2005 as compared to the three and nine months ended September 30, 2004 primarily as a result of the reduced cost of employee severance benefits as the number of
positions eliminated was reduced. Facility and operations consolidation restructuring costs decreased during the three months ended September 30, 2005 primarily as a result of completing the consolidation of our data centers. Facility and
operations consolidation restructuring costs increased during the nine months ended September 30, 2005, primarily due to the $1.3 million lease termination payment as discussed in the above section captioned Restructuring
Initiatives. At September 30, 2005, we had a $0.1 million liability related to our restructuring activities, the majority of which we expect will be paid by December 31, 2005.



OTHER INCOME (EXPENSE), NET



Other income (expense), net consists primarily of gains and losses on foreign exchange transactions and changes in the fair value of the
derivatives in our preferred stock instruments. In accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 133,Accounting for Derivative Instruments, we are required to adjust the carrying value of the
derivatives to their fair value at each balance sheet date and recognize any change since the prior balance sheet date as a component of other income or expense. The following table sets forth the components of other income (expense), net for the
periods indicated.



30



---

|                                                                     |  |                                  |        |   |        |   |       |                                 |  |        |       |   |  |      |   |  |      |       |   |  |   |       |  |   |        |   |  |      |  
|-------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ------ | - | ----- | ------------------------------- |  | ------ | ----- | - |  | ---- | - |  | ---- | ----- | - |  | - | ----- |  | - | ------ | - |  | ---- | -
|                                                                     |  | Three months ended September 30, |        |   | Change |   |       | Nine months ended September 30, |  | Change |      
|                                                                     |  | 2004                             |        |   | 2005   |   |       | $                               |  |        | %     |   |  | 2004 |   |  | 2005 |       | $ |  |   | %     | 
|                                                                     |  | (in thousands)                   |       
|Foreign exchange gain (loss)                                         |  | $                                | 1,281  |   |        | $ | 1,681 |                                 |  | $      | 400   |   |  | 31   | % |  | $    | 2,265 |   |  | $ | 2,855 |  | $ | 590    |   |  | 26   | %
|Writeoff of option to purchase company                               |  |                                  |       |   |        |   |      |                                 |  |        |      |   |  | 0    | % |  |      | (312  | ) |  |   |      |  |   | 312    |   |  | -100 | %
|Gain (loss) from changes in the fair value of derivative instruments |  |                                  | (4,263 | ) |        |   | (125  | )                               |  |        | 4,138 |   |  | -97  | % |  |      | 5,297 |   |  |   | 2,231 |  |   | (3,066 | ) |  | -58  | %
|Other                                                                |  |                                  | 201    |   |        |   | (199  | )                               |  |        | (400  | ) |  | -199 | % |  |      | 198   |   |  |   | 512   |  |   | 314    |   |  | 159  | %
|                                                                     |  |                                  |        |   |        |   |       |                                 |  |        |       |   |  |      |   |  |      |       |   |  |   |       |  |   |        |   |  |      |  
|                                                                     |  | $                                | (2,781 | ) |        | $ | 1,357 |                                 |  | $      | 4,138 |   |  | -149 | % |  | $    | 7,448 |   |  | $ | 5,598 |  | $ | (1,850 | ) |  | -25  | %
|                                                                     |  |                                  |        |   |        |   |       |                                 |  |        |       |   |  |      |   |  |      |       |   |  |   |       |  |   |        |   |  |      |  



Other income (expense), net, increased
during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004 primarily as a result of the value of the derivative instruments increasing less during the three months ended September 30,
2005 than during the three months ended September 30, 2004 resulting in a reduction of the loss year-over-year. Other income (expense), net, decreased during the nine months ended September 30, 2005 as compared to the nine months ended
September 30, 2004 primarily as a result of the value of the derivative instruments decreasing during the nine months ended September 30, 2005 than during the nine months ended September 30, 2004 resulting in a reduction of the gain
year-over-year.



Our Series D preferred stock issued in 2001 and warrants to
purchase shares of our Series F preferred stock issued in December 2004 and March 2005 contain derivative instruments. In accordance with the provisions of SFAS No. 133,Accounting for Derivative Instruments, we are required to adjust
the carrying value of the instruments to their fair value at each balance sheet date and recognize any change since the prior balance sheet date as a component of other income or expense. The estimated fair value of these derivative instruments at
September 30, 2005 was $2.5 million.



INTEREST INCOME (EXPENSE)



Interest income consists primarily of
interest earnings on cash and cash equivalents and interest expense consists primarily of the interest expense and amortization of issuance costs related to the 13.9% Notes issued in December 2004 and March 2005, as well as interest on certain
capital leases and other long-term obligations. The following table sets forth the components of interest expense for the periods indicated.



|                                               |  |                                  |      |   |        |   |      |                                 |  |   |        |   |  |      |   |  |      |        |   |   |   |        |   |  |   |        |   |  |      |  
|---------------------------------------------- |  | -------------------------------- | ---- | - | ------ | - | ---- | ------------------------------- |  | - | ------ | - |  | ---- | - |  | ---- | ------ | - | - | - | ------ | - |  | - | ------ | - |  | ---- | -
|                                               |  | Three months ended September 30, |      |   | Change |   |      | Nine months ended September 30, |  |   | Change |  
|                                               |  | 2004                             |      |   | 2005   |   |      | $                               |  |   | %      |   |  | 2004 |   |  | 2005 |        |   | $ |   |        | % | 
|                                               |  | (in thousands)                   |     
|Interest Income                                |  | $                                | 125  |   |        | $ | 101  |                                 |  | $ | (24    | ) |  | -19  | % |  | $    | 297    |   |   | $ | 371    |   |  | $ | 74     |   |  | 25   | %
|Senior Notes                                   |  |                                  | (113 | ) |        |   |     |                                 |  |   | 113    |   |  | -100 | % |  |      | (2,130 | ) |   |   |       |   |  |   | 2,130  |   |  | -100 | %
|53/4% Notes                                    |  |                                  | (127 | ) |        |   |     |                                 |  |   | 127    |   |  | -100 | % |  |      | (1,225 | ) |   |   |       |   |  |   | 1,225  |   |  | -100 | %
|13.9% Notes                                    |  |                                  |     |   |        |   | (670 | )                               |  |   | (670   | ) |  | 0    | % |  |      |       |   |   |   | (1,693 | ) |  |   | (1,693 | ) |  | 0    | %
|Amortization of debt issuance costs            |  |                                  | (69  | ) |        |   | (217 | )                               |  |   | (148   | ) |  | 214  | % |  |      | (291   | ) |   |   | (659   | ) |  |   | (368   | ) |  | 126  | %
|Line of credit facility                        |  |                                  | (100 | ) |        |   | (12  | )                               |  |   | 88     |   |  | -88  | % |  |      | (285   | ) |   |   | (189   | ) |  |   | 96     |   |  | -34  | %
|Capital leases and other long-term obligations |  |                                  | (58  | ) |        |   | (120 | )                               |  |   | (62    | ) |  | 107  | % |  |      | (181   | ) |   |   | (313   | ) |  |   | (132   | ) |  | 73   | %
|                                               |  |                                  |      |   |        |   |      |                                 |  |   |        |   |  |      |   |  |      |        |   |   |   |        |   |  |   |        |   |  |      |  
|                                               |  | $                                | (342 | ) |        | $ | (918 | )                               |  | $ | (576   | ) |  | 168  | % |  | $    | (3,815 | ) |   | $ | (2,483 | ) |  | $ | 1,332  |   |  | -35  | %
|                                               |  |                                  |      |   |        |   |      |                                 |  |   |        |   |  |      |   |  |      |        |   |   |   |        |   |  |   |        |   |  |      |  



Interest expense, net, increased
during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004 primarily as a result of the interest and amortization of debt issuance costs related to the 13.9% Notes issued in December 2004 and
March 2005. Interest expense, net, decreased during the nine months



31



---

ended September 30, 2005 as compared to the nine months ended September 30, 2004 primarily as a result of the
conversion of the 10% Senior Convertible Notes (Senior Notes) to shares of Series E preferred stock in July 2004 and the retirement of the 53/4% Notes on April 1, 2005 partially offset by interest and amortization of debt issuance costs related to the 13.9% Notes issued in December 2004 and March 2005.



LOSS ON EXTINGUISHMENT OF DEBT



In November 2003, we executed an agreement to exchange approximately $32.8 million in face
value convertible notes payable, held by a group of investors led by the Cheung Kong Group, for approximately 21.9 million shares of Series E preferred stock. At a special meeting in July 2004, we received shareholder approval for this
transaction. As a result of the conversion, a non-cash charge of $12.8 million equal to the fair value of the Series E preferred stock less the carrying value of the related convertible notes payable, net of unamortized issuance costs, was recorded
as of the date of the exchange as loss on extinguishment of debt.



PROVISION FOR INCOME TAXES



The provision for
income taxes represents the tax on the income generated by certain of our European subsidiaries operations. No current provision or benefit for United States federal or state income taxes has been recorded as we have incurred net operating losses
for income tax purposes since our inception. Additionally, no deferred provision or benefit for federal or state income taxes has been recorded as we are in a net deferred tax asset position for which a full valuation allowance has been provided due
to uncertainty of realization.



ACCRETION ON
MANDATORILY REDEEMABLE PREFERRED STOCK



Accretion on mandatorily redeemable
preferred stock represents the accrued dividends and accretion of the beneficial conversion features of our outstanding Series D and E preferred stock as well as the accretion to the redemption value of the outstanding Series D preferred stock (see
Note 7  Mandatorily Redeemable Preferred Stock). The following table sets forth the components of the accretion on mandatorily redeemable preferred stock for the periods indicated.



|                                  |  |                                  |       |        |   |       |                                 |   |        |   |  |      |   |      |   |        |  |   |        |  |   |       |  |    |  
|--------------------------------- |  | -------------------------------- | ----- | ------ | - | ----- | ------------------------------- | - | ------ | - |  | ---- | - | ---- | - | ------ |  | - | ------ |  | - | ----- |  | -- | -
|                                  |  | Three months ended September 30, |       | Change |   |       | Nine months ended September 30, |   | Change |  
|                                  |  | 2004                             |       | 2005   |   | $     |                                 |   | %      |   |  | 2004 |   | 2005 |   | $      |  | % |       
|                                  |  | (in thousands)                   |      
|Accrued dividends                 |  | $                                | 2,094 |        | $ | 1,923 |                                 | $ | (171   | ) |  | -8   | % |      | $ | 4,673  |  | $ | 5,989  |  | $ | 1,316 |  | 28 | %
|Accretion of the redemption value |  |                                  | 2,099 |        |   | 1,596 |                                 |   | (503   | ) |  | -24  | % |      |   | 6,016  |  |   | 9,322  |  |   | 3,306 |  | 55 | %
|                                  |  |                                  |       |        |   |       |                                 |   |        |   |  |      |   |      |   |        |  |   |        |  |   |       |  |    |  
|                                  |  | $                                | 4,193 |        | $ | 3,519 |                                 | $ | (674   | ) |  | -16  | % |      | $ | 10,689 |  | $ | 15,311 |  | $ | 4,622 |  | 43 | %
|                                  |  |                                  |       |        |   |       |                                 |   |        |   |  |      |   |      |   |        |  |   |        |  |   |       |  |    |  



ADDITIONAL FACTORS
THAT MAY AFFECT FUTURE OPERATING RESULTS



We have a history of losses, expect continuing losses and may never achieve profitability.



We have not achieved profitability in any period and may continue to incur net losses in accordance with generally accepted accounting principles for the foreseeable
future. In addition, we intend to continue to spend resources on maintaining and strengthening our business, and this may, in the near term, cause our operating expenses to increase and our operating results to decline.



In past quarters, we have spent heavily on technology and infrastructure development. We may
continue to spend substantial financial and other resources to further develop and introduce new messaging solutions, and to improve our sales and marketing organizations, strategic relationships and operating infrastructure. We expect that our cost



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of revenues, sales and marketing expenses, general and administrative expenses, operations, research and customer support
expenses and depreciation and amortization expenses could continue to increase in absolute dollars and may increase as a percent of revenues. In addition, in future periods we may incur significant non-cash charges related to stock-based
compensation. If revenues do not correspondingly increase, our operating results could decline. If we continue to incur net losses in future periods, we may not be able to retain employees, or fund investments in capital equipment, sales and
marketing programs, and research and development to successfully compete. We also may never obtain sufficient revenues to exceed our cost structure and achieve profitability. If we do achieve profitability, we may not be able to sustain or increase
profitability in the future. This may also, in turn, cause the price of our common stock to demonstrate volatility and/or continue to decline.



We may not be able to maintain our listing on the Nasdaq National Market, and if we fail to do so, the price and liquidity of our common stock may
decline.



The Nasdaq Stock Market has quantitative maintenance criteria
for the continued listing of common stock on the Nasdaq National Market. The current requirements affecting us include (i) having total assets of at least $50 million, (ii) having total revenue of $50 million, (iii) maintaining a
minimum market value of our common stock of $15 million, and (iv) maintaining a minimum closing bid price per share of $1.00. On September 7, 2005, the Nasdaq Stock Market Inc. issued us a letter that we failed to regain compliance with
the minimum market value requirement. On October 12, 2005, we received notice from the Nasdaq Stock Market Inc. that we were not in compliance with the minimum closing bid price requirement. As a result of these notices, we are faced with
delisting proceedings. On October 6, 2005, members of our management team met with the Nasdaq Listing Qualifications Panel to discuss our failure to meet the continued listing requirements. The Panel may determine to immediately delist our
stock from the Nasdaq National Market or grant us an extension of time to regain compliance with the continued listing requirements. Even if we are able to regain compliance with these requirements for continued listing, we may nevertheless in the
future be unable to comply with these or the other quantitative maintenance criteria or any of the other Nasdaq National Markets listing requirements or other rules, or other markets listing requirements to the extent our stock is listed
elsewhere, in the future. If we are delisted from the Nasdaq National Market, we expect our common stock to be listed on the Over-the-Counter (OTC) Bulletin Board. However, trading on the OTC Bulletin Board requires an application to be submitted by
registered market makers and not by us. If one or more market makers do not submit this application and our stock is not listed on the OTC Bulletin Board, it could have a material adverse effect on the market price of, and the liquidity of the
trading market for, our common stock.



Our failure to continue to
carefully manage expenses could require us to use substantial resources and cause our operating results to decline.



In the past, our management of operational expenses, including the restructurings of our operations, have placed significant strain on managerial, operational and
financial resources and contributed to our history of losses. In addition, we may need to improve or replace our existing operational, customer service and financial systems, procedures and controls and/or incur incremental costs of compliance with
legislation, such as the Sarbanes-Oxley Act of 2002. Any failure to properly manage these systems and procedural transitions or these incremental compliance costs could impair our ability to attract and service customers, and could cause us to incur
higher operating costs and delays in the execution of our business plan. If we cannot manage restructuring activities and expenses effectively, our business and operating results could decline.



Certain of our cash resources are not readily
available for our operations.



We face restrictions on our ability to
use cash that we currently hold outside of the United States for purposes other than the operation of each of our respective foreign subsidiaries that hold such cash. For example, our ability to use cash held in a given European subsidiary for any
reason other than the operation of that subsidiary may result in certain tax liabilities and are subject to local laws that could prevent the transfer of cash from that subsidiary to any other foreign or domestic account. At September 30, 2005,
approximately $10.8 million was held outside of the United States. Our inability to utilize this cash could slow our ability to grow our business and reach our business objectives. We may also be forced to incur certain costs, such as tax
liabilities, to be able to use this cash for



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domestic operations, which could cause our expenses to increase and our operating results to decline. In addition,
approximately $0.3 of our cash is restricted, primarily to support our letters of credit related to certain facility leases and is therefore unavailable for our operating activities.



We may need to raise additional capital and may need to initiate other operational strategies to continue our
operations.



In the future, we may be required to raise additional
funds, particularly if we are unable to generate positive cash flow as a result of our operations. Such financing may not be available in sufficient amounts or on terms acceptable to us. Furthermore, we would need to obtain consent from holders of
two-thirds in principal amount of our outstanding 13.9% Notes in order to incur certain types of indebtedness. Additionally, we face a number of challenges in operating our business, including our ability to overcome viability concerns held by our
current and prospective customers given our recent capital needs and the amount of resources necessary to maintain worldwide operations. Concerns about our long-term viability may cause our stock price to fall and impair our ability to raise
additional capital and may create a concern among our current and future customers and vendors as to whether we will be able to fulfill our contractual obligations. As a result, current and future customers may determine not to do business with us,
which would cause our revenues to decline.



The conversion of our
preferred stock would result in a substantial number of additional shares of common stock outstanding, which could decrease the price of our common stock.



Our preferred stock can be converted into common stock at anytime in the discretion of the holder of preferred stock. For example, during
the three months ended September 30, 2005, at the request of certain holders of our Series E preferred stock, we converted approximately 2.1 million shares of Series E preferred stock into approximately 2.2 million shares of common
stock. As of September 30, 2005, there were approximately 3.5 million shares of Series D preferred stock outstanding, which were convertible into approximately 42.0 million shares of common stock. In addition, we have approximately
48.8 million shares of Series E preferred stock outstanding, which are convertible as of September 30, 2005, at the option of the holders, into approximately 52.2 million shares of common stock. On May 5, 2005, we filed a
registration statement pursuant to a demand from holders of Series E preferred stock to register 28.6 million shares of common stock issuable upon conversion of their shares of Series E preferred stock. We also have outstanding warrants to
purchase 385,710 shares of Series F preferred stock which, if exercised, would initially be convertible into approximately 3.9 million shares of common stock. Any conversion of our preferred stock into common stock would increase the number of
additional shares of common stock that may be sold into the market, which could substantially decrease the price of our common stock.



Our preferred stock carries a substantial liquidation preference, which could significantly impact the return to common equity holders upon an
acquisition.



After any necessary payments have been made to the
holders of $18 million in principal amount of our 13.9% Notes, in the event of liquidation, dissolution, winding up or change of control of Critical Path, the holders of Series E preferred stock would be entitled to receive $1.50 per share of Series
E preferred stock plus all accrued dividends on such shares before any proceeds from the liquidation, dissolution or winding up is paid with respect to any other series or class of our capital stock. Accordingly, at September 30, 2005, the
approximately 48.8 million shares of Series E preferred stock outstanding had an aggregate liquidation preference of approximately $78.4 million. The aggregate amount of the preference will increase as the shares of Series E preferred stock
accrue dividends based on simple interest at an annual rate of 53/4%. After all of the then outstanding shares
of Series E preferred stock have received payment of their liquidation preference, the holders of Series D preferred stock would be entitled to receive the greater of $13.75 per share of Series D preferred stock plus all accrued dividends on such
shares (which, as of September 30, 2005, would result in an aggregate liquidation preference of approximately $63.1 million) or $22 per share (which currently would equal a liquidation preference of $77.5 million) before any proceeds from the
liquidation, dissolution, winding up or change in control is paid to holders of our common stock. Holders of our common stock will not receive any proceeds from a liquidation, winding up or dissolution, including from a change of control, until
after the liquidation preferences of our Series E preferred stock and our Series D preferred stock are paid in full. Consequently, although we would likely be required under applicable law to obtain the separate class approval of the holders of our
common stock for a change of control or the sale of all or substantially all of the shares of Critical Path, it is possible that such a transaction could result in all or substantially all of the proceeds of such transaction being distributed to the
holders of our Series E preferred stock and Series D preferred stock.



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From time to time we engage in discussions with or receive proposals from third parties relating to potential
acquisitions or strategic transactions that could constitute a change of control. While we have not engaged in any transaction of this type in the past, we will in the future continue to evaluate potential business combinations or strategic
transactions which, if consummated, may constitute a change of control and trigger the liquidation preferences described above.



As the preferred stock accrues dividends, the number of shares of common stock issuable upon conversion will increase, which may increase the dilution to our
holders of common stock and further decrease the price of our common stock.



Currently, shares of Series D preferred stock and shares of Series E preferred stock accrue dividends at a rate of 53/4% per year. If the maximum amount of dividends accrue on the outstanding shares of Series D and Series E preferred stock prior to the automatic call for redemption date, the number of shares of common stock issuable upon conversion
will increase by approximately 14.1 million shares to approximately 108.3 million shares of common stock.



Due to our evolving business strategy and the nature of the markets in which we compete, our future revenues are difficult to predict and our quarterly operating
results may fluctuate.



We cannot accurately forecast our revenues as a
result of our evolving business strategy and the emerging nature of the messaging and directory infrastructure market. Forecasting is further complicated by recent strategic and operational restructurings and may continue to be complicated by future
such restructurings. In addition, our reliance on large dollar value transactions, as well as market fluctuations, can complicate our ability to forecast accurately. For example, we announced in recent guidance that current sales pipelines do not
necessarily support prediction of a sequential increase in fourth quarter revenues, which is inconsistent with typical seasonal patterns. Our revenues in some past quarters fell and could continue to fall short of expectations if we experience
delays or cancellations of even a small number of orders. We often offer volume-based pricing, which may affect our operating margins. A number of factors are likely to cause fluctuations in operating results, including, but not limited
to:



| |  |  | the demand for licensed solutions for messaging, and identity management products;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | the demand for outsourced messaging services generally and the use of messaging and identity management infrastructure products and services in particular;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to attract and retain qualified personnel with industry expertise, particularly sales personnel;
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | our ability to attract and retain customers and maintain customer satisfaction;
| | - |  | -------------------------------------------------------------------------------



| |  |  | the ability to upgrade, develop and maintain our systems and infrastructure and to effectively respond to the rapid technology change of the messaging and identity management
infrastructure market;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the budgeting and payment cycles of our customers and potential customers;
| | - |  | --------------------------------------------------------------------------



| |  |  | the amount and timing of operating costs and capital expenditures relating to expansion of business and infrastructure;
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to quickly handle and alleviate technical difficulties or system outages;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | the announcement or introduction of new or enhanced services by competitors;
| | - |  | ----------------------------------------------------------------------------



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| |  |  | general economic and market conditions and their affect on our operations and the operations of our customers; and
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | the effect of war, terrorism and any related conflicts or similar events worldwide.
| | - |  | -----------------------------------------------------------------------------------



In addition to the factors set forth above, our GAAP financial results have been and will continue to be impacted by the extent to which we
incur non-cash charges associated with stock-based arrangements with employees and non-employees. In particular, during the year ended December 31, 2004, we incurred stock-based compensation expense of $1.9 million and $0.9 million for the nine
months ended September 30, 2005 relating to the issuance of common stock and the grant of options and warrants to employees and non-employees. Grants of options and warrants also may be dilutive to existing shareholders.



Our revenues and operating results have declined and could continue to decline as a result of
the elimination of product or service offerings. Future decisions to eliminate revise or limit any other offerings of a product or service would involve other factors that could cause our revenues to decline and our expenses to increase, including
the expenditure of capital, the realization of losses, further reductions in our workforce, facility consolidation or the elimination of revenues along with the associated costs.



As a result of the foregoing, we do not believe that period-to-period comparisons of operating results are a good indication of future
performance. It is likely that operating results in some quarters will be below market expectations. In this event, the price of our common stock is likely to prove volatile and/or subject to further declines.



We have in the past, and will continue in the future, to evaluate the performance of
our business operations and, where appropriate, invest further in certain business operations, and reduce investment or divest other business operations.



In the past, due to the underperformance of some of our business operations, we have elected to divest or discontinue certain of these
business operations through termination, sale or other disposition. Furthermore, we may choose to divest certain business operations based on our managements perception of their future growth, even if such operations have been profitable
historically. Decisions to eliminate or limit certain business operations have involved in the past, and could in the future involve, the expenditure of capital, consumption of management resources, realization of losses, transition and wind-up
expenses, further reduction in workforce, facility consolidation and the elimination of revenues along with associated costs, any of which could cause our operating results to decline and may fail to yield the expected benefits.



We have identified material weaknesses in our disclosure controls and procedures and
our internal control over financial reporting, which, if not remedied effectively, could have an adverse effect on the trading price of our common stock and otherwise seriously harm our business.



Management through, in part, the documentation, testing and assessment of our internal
control over financial reporting pursuant to the rules promulgated by the SEC under Section 404 of the Sarbanes-Oxley Act of 2002 and Item 308 of Regulation S-K has concluded that our disclosure controls and procedures and our internal
control over financial reporting had material weaknesses as of December 31, 2004. We have taken actions to begin to address those material weaknesses. Management filed its final report relating to its assessment of the effectiveness of internal
control over financial reporting on May 2, 2005. Our inability to remedy our material weaknesses promptly and effectively could have a material adverse effect on our business, results of operations and financial condition, as well as impair our
ability to meet our quarterly and annual reporting requirements in a timely manner. These effects could in turn adversely affect the trading price of our common stock. Prior to the remediation of these material weaknesses, there remains risk that
the transitional controls on which we currently rely will fail to be sufficiently effective, which could result in a material misstatement of our financial position or results of operations and require a restatement. In addition, even if we are
successful in strengthening our controls and procedures, such controls and procedures may not be adequate to prevent or identify irregularities or facilitate the fair presentation of our financial statements or SEC reporting.



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Failure or circumvention of our controls and procedures could seriously harm our
business.



We are making significant changes in our internal control
over financial reporting and our disclosure controls and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, and not absolute, assurances that the
objectives of the system are met. In addition, the effectiveness of our remediation efforts and of our internal controls is subject to limitations, including the assumptions used in identifying the likelihood of future events and the inability to
eliminate misconduct completely. As a result, our remediation efforts to improve our internal control over financial reporting may not prevent all improper acts or ensure that all material information will be made known to management in a timely
fashion. In addition, because substantial additional costs may be necessary to implement these remedial measures, our limited resources may cause a further delay in remediating all of our material weaknesses. The failure or circumvention of our
controls, policies and procedures or of our remediation efforts could have a material adverse effect on our business, results of operations and financial condition.



We may be unable to grow our business through effective sales and marketing, which could cause our operating results to
decline.



Our ability to increase revenues will depend on our ability
to successfully recruit, train and retain experienced and effective sales and marketing personnel and for our personnel to achieve results once they are employed with us. Competition for experienced and effective personnel in certain markets is
intense and we may not be able to hire and retain personnel with relevant experience. The complexity and implementation of our messaging and identity management infrastructure products and services require highly trained sales and marketing
personnel to educate prospective customers regarding the use and benefits of our products and services. Current and prospective customers, in turn, must, in some cases, be able to educate their end-users. Any delays or difficulties encountered in
our staffing and training efforts would impair our ability to attract new customers and enhance our relationships with existing customers, and ultimately, grow revenues. This would also adversely impact the timing and extent of our revenues from
quarter to quarter and overall or could jeopardize sales altogether. Because we have experienced turnover in our sales force and have fewer resources than many of our competitors, our sales and marketing organizations may not be able to compete
successfully against the sales and marketing organizations of our competitors. Moreover, our competitors frequently have larger and more established sales forces calling upon potential customers with more frequency. In addition, certain of our
competitors have longer and closer relationships with the senior management of customers who decide whose technologies and solutions to deploy. If we do not successfully operate and grow our sales and marketing activities, our revenues and operating
results could decline and the price of our common stock could continue to decline.



Unplanned system interruptions and capacity constraints could reduce our ability to provide messaging services and could harm our business reputation.



Our customers have, in the past, experienced some interruptions in our hosted messaging service. We believe that these interruptions will
continue to occur from time to time. Our ability to retain existing customers and attract new customers will suffer and our revenues will decline if we experience frequent or long system interruptions that result in the unavailability or reduced
performance of systems or networks or reduce our ability to provide email services. We expect to experience occasional temporary capacity constraints due to unanticipated sharply increased traffic, which may cause unanticipated system disruptions,
slower response times, impaired quality and degradation in levels of customer service. If this were to continue to happen, our ability to retain existing customers and attract new customers could suffer dramatically and our revenues would
decline.



We have entered into hosted messaging agreements with some customers
that require minimum performance standards, including standards regarding the availability and response time of messaging services. If we fail to meet these standards, our customers could terminate their relationships with us and we could be subject
to contractual monetary penalties.



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A limited number of customers and markets account for a high percentage of our revenues and if we lose a major
customer, are unable to attract new customers, or the markets which we serve suffer financial difficulties, our revenues could decline.



We expect that sales of our products and services to a limited number of customers will continue to account for a high percentage of our
revenue for the foreseeable future. For example, for the nine months ended September 30, 2005, our top ten customers accounted for approximately 39% of our total revenues and for the years ended December 31, 2002, 2003 and 2004, our top 10
customers accounted for approximately 31%, 27% and 34%, respectively, of our total revenues. During the three months ended September 30, 2005, we had one customer which accounted for 10% of our total revenue. Our future success depends on our
ability to retain our current customers, and to attract new customers, in our target markets. The loss of one or several major customers, whether through termination of agreements, acquisitions or bankruptcy, could significantly reduce our revenues.
Our agreements with our customers typically have terms of one to three years often with automatic one-year renewals and can be terminated without cause upon certain notice periods that vary among our agreements and range from a period of 30 to 120
days notice.



In addition, a number of our customers, particularly for our
hosted services business and in the technology industry, have also suffered from falling revenue. For example, the telecommunications industry during the nine months ended September 30, 2005, accounted for approximately 35% of the revenues from
our top ten customers whereas for the fiscal years ended December 31, 2002, 2003 and 2004 it accounted for approximately 44%, 52% and 57%, respectively, of the revenues from our top ten customers. The relative financial performance of our
customers will continue to impact our sales cycles and our ability to attract new business. Worldwide technology spending has also decreased in recent quarters across all industries. If our customers terminate their agreements for any reason before
the end of the contract term, the loss of the customer would reduce our current and future revenues. Also, if we are unable to enter into agreements with new customers and develop business with our existing customers, our business will not grow and
we will not generate additional revenues.



Our sales cycle is lengthy, and
any delays or cancellations in orders in a particular quarter could cause our operating results to be below expectations, which may cause our stock price to decline.



Because we sell complex and sophisticated technology, our sales cycle, in particular with respect to our software solutions, can be long and
unpredictable, often taking between four to 18 months. Because of the nature of our product and service offerings it can take many months of customer education and product evaluation before a purchase decision is made. Further, and particularly with
regard to newer subscription based offerings, the deployment process following customer trials can add several months prior to the generation of revenue. In addition, many factors can influence the decision to purchase our product and service
offerings including budgetary constraints and decreases in capital expenditures, quarterly fluctuations in operating results of customers and potential customers, the emerging and evolving nature of the internet-based services and wireless services
markets. Furthermore, general global economic conditions, and weakness in global securities markets, continuing recessionary spending levels, and a protracted slowdown in technology spending in particular, have further lengthened and affected our
sales cycle. Such factors have led to and could continue to lead to delays and postponements in purchasing decisions and in many cases cancellations of anticipated orders. Any delay or cancellation in sales of our products or services could cause
our operating results to be lower than those projected and cause our stock price to decline.



If we are unable to successfully compete in our product market, our ability to retain our customers and attract new customers could decline.



Because we have a variety of messaging and directory infrastructure products and services, we encounter different competitors at each level
of our products and services. Our primary competitors of our messaging solutions include Sun Microsystems iPlanet, OpenWave Systems, Inc., Mirapoint, Inc., IronPort Systems, Inc., Comverse, Inc. and Microsoft Corporation and in the market for
mobile email services, we primarily compete with Intellisync Corporation, Visto, Inc., Seven Networks, Inc. and Oz Communications, Inc. In the identity management market, we compete primarily with Sun Microsystems iPlanet, Microsoft
Corporation, IBM Corporation, Siemens Corporation, Computer Associates and Novell Corporation. Our competitors for customers seeking outsourced hosted messaging solutions include Outblaze Limited and BlueTie, Inc. If we are unable to successfully
compete in our product market, our ability to retain our customers and attract new customers could decline.



We believe that some of the competitive factors affecting the market for messaging and identity management infrastructure solutions include:



| |  |  | breadth of platform features and functionality of our offerings and the sophistication and innovation of competitors;
| | - |  | ---------------------------------------------------------------------------------------------------------------------



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| |  |  | total cost of ownership and operation;
| | - |  | --------------------------------------



| |  |  | scalability, reliability, performance and ease of expansion and upgrade;
| | - |  | ------------------------------------------------------------------------



| |  |  | ease of integration to customers existing systems; and
| | - |  | -------------------------------------------------------



| |  |  | flexibility to enable customers to manage certain aspects of their systems internally and leverage outsourced services in other cases when resources, costs and time to market
reasons favor an outsourced offering.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We believe competition
will continue to be fierce and further increase as our market grows and attracts new competition, current competitors aggressively pursue customers, increase the sophistication of their offerings and as new participants enter the market. Many of our
current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we do and may enter into strategic or commercial
relationships with larger, more established and better-financed companies. Any delay in our development and delivery of new services or enhancement of existing services would allow our competitors additional time to improve their service or product
offerings, and provide time for new competitors to develop and market messaging and directory infrastructure products and services and solicit prospective customers within our target markets. Increased competition could result in pricing pressures,
reduced operating margins and loss of market share, any of which could cause our financial results to decline.



We have experienced significant turnover of senior management and our current management team has been together for a limited time, which could slow the growth of our business and cause our operating results to
decline.



Throughout 2004 we announced a series of changes in our
management that included the departure of many senior executives, and there have also been many changes in our board of directors. Two of our directors joined us in 2005 and many of the members of our current board of directors and senior executives
joined us in 2004. Further, we may continue to make additional changes to our senior management team. If our new management team is unable to accomplish our business objectives, our ability to grow our business and successfully meet operational
challenges could be severely impaired. We do not have long-term employment agreements with any of our executive officers. It is possible that this high turnover at our senior management levels may also continue for a variety of reasons. The loss of
the services of one or more of our key senior executive officers could also affect our ability to successfully implement our business objectives, which could slow the growth of our business and cause our operating results to decline. For these
reasons, our shareholders may lose confidence in our management team and decide to dispose of our common stock, which could cause the price of our common stock to decline.



We depend on strategic relationships with our customers and others and the loss of such relationships could cause our revenues to
decline.



We depend on strategic relationships with our customers and
others to expand distribution channels and opportunities and to undertake joint marketing efforts. Our ability to increase revenues depends upon aggressively marketing our services through new and existing strategic relationships.



We also depend on the ability of our customers to aggressively sell and market our services
to their end-users. If we lose any strategic relationships, fail to fully exploit our relationships, or fail to develop new strategic relationships, we could encounter increased difficulty in selling our products and services.



We may not be able to respond to the rapid
technological change of the messaging industry.



The messaging industry
is characterized by rapid technological change, changes in user and customer requirements and preferences, and the emergence of new industry standards and practices that could render our existing services,



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proprietary technology and systems obsolete. We must continually develop or introduce and improve the performance,
features and reliability of our services, particularly in response to competitive offerings. Our success depends, in part, on our ability to enhance our existing email and messaging services and to develop new services, functionality and technology
that address the increasingly sophisticated and varied needs of prospective customers. If we do not properly identify the feature preferences of prospective customers, or if we fail to deliver email features that meet the standards of these
customers, our ability to market our service successfully and to increase revenues could be impaired. The development of proprietary technology and necessary service enhancements entails significant technical and business risks and requires
substantial expenditures and lead-time. We may not be able to keep pace with the latest technological developments. We may also be unable to use new technologies effectively or adapt services to customer requirements or emerging industry
standards.



Limitations of our director and officer liability insurance
may cause us to use our capital resources, which could cause our financial results to decline or slow our growth.



Our current director and officer liability insurance may not be adequate for the liabilities and expenses potentially incurred in connection with future claims. To the
extent liabilities, expenses or settlements exceed the limitations or are outside of the scope of coverage, our business and financial condition could materially decline. Under California law, in connection with our charter documents and
indemnification agreements we entered into with our executive officers and directors, we must indemnify our current and former officers and directors to the fullest extent permitted by law. The indemnification covers any expenses and liabilities
reasonably incurred in connection with the investigation, defense, settlement or appeal of legal proceedings. We have made payments and may continue to make payments in connection with the indemnification of officers and directors in connection with
lawsuits and possibly pending investigations. However, it is unlikely that our director and officer liability insurance will be available to cover such payments.



We may experience difficulty in attracting and retaining key personnel, which may negatively affect our ability to develop new products or services or retain and
attract customers.



The loss of the services of key personnel may
create a negative perception of our business and adversely affect our ability to achieve our business goals. Our success also depends on our ability to recruit, retain and motivate highly skilled sales and marketing, operational, technical and
managerial personnel. Competition for these people is intense and we may not be able to successfully recruit, train or retain qualified personnel. If we fail to do so, we may be unable to develop new products or services or continue to provide a
high level of customer service, which could result in the loss of customers and revenues. In addition, volatility and declines in our stock price may also affect our ability to retain key personnel, all of whom have been granted stock-based
incentive compensation. Over the past year we have reduced our work force and eliminated jobs to balance the size of our employee base with anticipated revenue levels. Reductions in our workforce could make it difficult to motivate and retain
remaining employees or attract needed new employees, and could also affect our ability to deliver products and solutions in a timely fashion and to provide a high level of customer service and support.



We do not have long-term employment agreements with any of our key personnel. In addition, we
do not maintain key person life insurance on our employees and have no plans to do so. The loss of the services of one or more of our current key personnel could make it difficult to successfully implement our business objectives.



If we are not successful in implementing strategic plans for our operations, our
expenses may not be offset by our corresponding sales and our financial results could significantly decline.



In 2002, we incurred a number of restructuring charges related to the resizing of our business. These efforts included additional facilities and equipment lease
terminations, continuing expense management and headcount reductions. In 2003, we continued to restructure our operations including consolidating some office locations and reducing our global workforce by approximately 175 positions, or
approximately 30% of the workforce. In 2004, we expanded our restructuring activities in an effort to reduce both short-term and long-term cash requirements. These activities included the reduction of fixed costs through the restructuring of
contracts, consolidation of certain activities to offices in Toronto, Canada and Dublin, Ireland from higher cost areas such as the San Francisco Bay area and the elimination of approximately 20% of employee positions and reduced use of third party
contractors. Most recently, during the first six months of 2005, we restructured the lease for, and relocated, our headquarter facilities. We



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expect to continue to make determinations about the strategic future of our business and operations, and our ability to
execute on such plans effectively could affect our future operations. A failure to execute successfully on such plans and to plan appropriately could cause our expenses to continue to outpace our revenues and our financial condition to significantly
decline.



We may experience a decrease in market demand due to the slowed
global economy, which has been further stymied by the concerns of terrorism, war and social and political instability.



Economic growth has slowed significantly in the United States and internationally. In addition, terrorist attacks across the world and turmoil and war in the Middle East
have increased the uncertainty in the global economy and may further add to the decline in the international business environment. A substantial portion of our business is derived from international sales, and the continued decline in the global
economy could have a more severe impact on our financial results than on the results of some of our competitors. The effects of terrorist attacks, particularly in Europe where we derive a significant portion of our revenue, and other similar events
and the war in Iraq could contribute further to the slowdown of the already slumping market demand for goods and services, including digital communications software and services. If the global economy continues to decline as a result of the recent
economic, political and social turmoil, or if there are further terrorist attacks in the United States or elsewhere, or as a result of war in the Middle East and elsewhere, we may experience decreases in the demand for our products and services,
which may cause our operating results to decline.



We may face continued
technical, operational and strategic challenges preventing us from successfully integrating acquired businesses.



Acquisitions involve risks related to the integration and management of acquired technology, operations and personnel. The integration of acquired businesses has been and
will continue to be a complex, time consuming and expensive process, which may disrupt and distract our management. With respect to integration, we must operate as a combined organization utilizing common information and communication systems,
operating procedures, financial controls and human resources practices. In addition to the added costs of the acquisitions, we may not ultimately achieve the anticipated benefits from such acquisitions.



We currently license many third-party technologies and may need to license further
technologies, which could delay and increase the cost of product and service developments.



We intend to continue to license certain technologies from third parties and incorporate them into our products and services, including web server technology, virus and anti-spam solutions, storage and encryption
technology and billing and customer tracking solutions. The market is evolving and we may need to license additional technologies to remain competitive. We may not be able to license these technologies on commercially reasonable terms or at all. To
the extent we cannot license needed technologies or solutions, we may have to devote our resources to the development of such technologies, which could delay and increase the cost of product and service developments.



In addition, we may fail to integrate successfully any licensed or hosted technology into our
services. These third-party in-licenses may expose us to increased risks, including risks related to the integration of new technology, potential patent and copyright infringement issues, the diversion of resources from the development of
proprietary technology, and an inability to generate revenues from new technology sufficient to offset associated acquisition and maintenance costs. In addition, an inability to obtain needed licenses could delay product and service development
until equivalent technology can be identified, licensed and integrated. Any delays in services or integration problems could hinder our ability to retain and attract customers and cause our business and operating results to suffer.



Changes in the regulatory environment for the
operation of our business or those of our customers could pose risks.



Few laws currently apply directly to activity on the Internet and the messaging business; however, new laws are proposed and other laws made applicable to Internet communications every year. In particular, the operations of our business
faces risks associated with privacy, confidentiality of user data and communications, consumer protection, taxation, content, copyright, trade secrets, trademarks, antitrust, defamation and other legal issues. In particular,



41



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legal concerns with respect to communication of confidential data have affected our financial services and health care
customers due to newly enacted federal legislation. The growth of the industry and the proliferation of Internet-based messaging devices and services may prompt further legislative attention to our industry and thus invite more regulatory control of
our business. The imposition of more stringent protections or new regulations and application of laws to our business could burden our company and those with which we do business. Any decreased generalized demand for our services or the loss of, or
decrease, in business by a key partner due to regulation or the expense of compliance with any regulation, could either increase the costs associated with our business or affect revenue, either of which could cause our financial condition or
operating results to decline. Certain of our service offerings include operations subject to the Digital Millennium Copyright Act of 1998 and the European Unions recent privacy directives. Our efforts to remain in compliance with DMCA and the
EU privacy directives may not be sufficient. New legislation and case law may also affect our products and services and the manner in which we offer them, which could cause our revenues to decline.



In addition, the applicability of laws and regulations directly applicable to the businesses
of our customers, particularly customers in the fields of banking and health care, will continue to affect us. The security of information about our customers end-users continues to be an area where a variety of laws and regulations with
respect to privacy and confidentiality are enacted. As our customers implement the protections and prohibitions with respect to the transmission of end user data, our customers will look to us to assist them in remaining in compliance with this
evolving area of regulation. In particular the Gramm-Leach-Bliley Act contains restrictions with respect to the use and protection of banking records for end-users whose information may pass through our system and the Health Insurance Portability
and Accountability Act contains provisions that require our customers to ensure the confidentiality of their customers health care information.



Finally, the Sarbanes-Oxley Act of 2002 and new rules subsequently implemented by the Securities and Exchange Commission have required changes in corporate governance
practices of public companies. In addition to final rules and rule proposals already made by the Securities and Exchange Commission, the Nasdaq Stock Market has adopted revisions to its requirements for listed companies. We are currently reviewing
all of our accounting policies and practices, legal disclosure and corporate governance policies under the new legislation, including those related to our relationships with our independent registered public accounting firm, enhanced financial
disclosures, internal controls, board and board committee practices, corporate responsibility and loan practices, and intend fully to comply with such laws. We expect these new rules and regulations to make it more difficult for us to attract and
retain qualified executive officers and qualified members of our board of directors, particularly to serve on our various committees of the Board including, in particular, the audit committee.



We may have liability for Internet content and we may
not have adequate liability insurance.



As a provider of messaging and
directory services, we face potential liability for defamation, negligence, copyright, patent or trademark infringement and other claims based on the nature and content of the materials transmitted via our services. We do not screen the content
generated by our users or their customers, and we could be exposed to liability with respect to this content. Furthermore, some foreign governments, such as Germany, have enforced laws and regulations related to content distributed over the Internet
that are more strict than those currently in place in the United States. In some instances, we may be subject to criminal liability in connection with Internet content transmission.



Our current insurance may not cover claims of these types or may not be adequate to indemnify us for all liability that may be imposed.
There is a risk that a single claim or multiple claims, if successfully asserted against us, could exceed the total of our coverage limits. There also is a risk that a single claim or multiple claims asserted against us may not qualify for coverage
under our insurance policies as a result of coverage exclusions that are contained within these policies. Should either of these risks occur, capital contributed by our shareholders might need to be used to settle claims. Any imposition of
liability, particularly liability that is not covered by insurance or is in excess of insurance coverage could result in substantial out-of-pocket costs to us, or could result in the imposition of criminal penalties.



Unknown software defects could disrupt our services
and harm our business and reputation.



Our software products are inherently complex. Additionally, our product and service offerings depend on complex



42



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software, both internally developed and licensed from third parties. Complex software often contains defects or errors in
translation, particularly when first introduced or when new versions are released or localized for international markets. We may not discover software defects in our products or that affect new or current services or enhancements until after they
are deployed. Despite testing, it is possible that defects may occur in the software. These defects could cause service interruptions, which could damage our reputation or increase service costs, cause us to lose revenue, delay market acceptance or
divert development resources.



If our
system security is breached, our reputation could suffer and our revenues could decline.



A fundamental requirement for online communications is the secure transmission of confidential information over public networks. Third parties may attempt to breach our security or that of our customers. If these
attempts are successful, customers confidential information, including customers profiles, passwords, financial account information, credit card numbers or other personal information could be breached. We may be liable to our customers
for any breach in security and a breach could harm our reputation. We rely on encryption technology licensed from third parties. Our servers are vulnerable to computer viruses, physical or electronic break-ins and similar disruptions, which could
lead to interruptions, delays or loss of data. We may be required to expend significant capital and other resources to license encryption technology and additional technologies to protect against security breaches or to alleviate problems caused by
any breach. Failure to prevent security breaches may make it difficult to retain and attract customers and cause us to spend additional resources that could cause our operating results to decline.



We rely on trademark, copyright, trade secret laws, contractual restrictions and
patents to protect our proprietary rights, and if these rights are not sufficiently protected, our ability to compete and generate revenue could be harmed.



We rely on a combination of trademark, copyright and trade secret laws, contractual restrictions, such as confidentiality agreements and
licenses, and patents to establish and protect our proprietary rights, which we view as critical to our success. Our ability to compete and grow our business could suffer if these rights are not adequately protected. Despite the precautionary
measures we take, unauthorized third parties may infringe or copy portions of our services or reverse engineer or obtain and use information that we regard as proprietary, which could harm our competitive position and market share. In addition, we
have several patents pending in the United States and may seek additional patents in the future. However, the status of United States patent protection in the software industry is not well defined and will evolve as the U.S. Patent and Trademark
Office grants additional patents. We do not know if our patent applications or any of our future patent applications will be issued with the scope of the claims sought, if at all, or whether any patents we have received or will receive will be
challenged or invalidated.



Our
proprietary rights may not be adequately protected because:



| |  |  | laws and contractual restrictions may not prevent misappropriation of our technologies or deter others from developing similar technologies;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | policing unauthorized use of our products and trademarks is difficult, expensive and time-consuming, and we may be unable to determine the extent of this unauthorized use; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | end user license provisions in our contracts that protect us against unauthorized use, copying, transfer and disclosure of the licensed program may be unenforceable.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



In addition, the laws of some foreign countries may not protect
proprietary rights to the same extent as do the laws of the United States. Our means of protecting proprietary rights in the United States or abroad may not be adequate and competitors may independently develop similar technology. Additionally, we
cannot be certain that our products do not infringe issued patents that may relate to our products. In addition, because patent applications in the United States are not publicly disclosed until the patent is issued, applications may have been filed
which relate to our software products.



43



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If we do not successfully address the risks inherent in the conduct of our international operations, our revenues
and financial results could decline.



Revenues from international sales
accounted for 74% of our revenues in the nine months ended September 30, 2005 and 54%, 62% and 68% of our revenues in 2002, 2003 and 2004, respectively. We intend to continue to operate in international markets and to spend significant
financial and managerial resources to do so. If revenues from international operations do not exceed the expense of establishing and maintaining these operations, our business and our ability to increase revenue and improve our operating results
could suffer. We have limited experience in international operations and may not be able to compete or operate effectively in international markets. We face certain risks inherent in conducting business internationally, including:



| |  |  | difficulties and costs of staffing and managing international operations;
| | - |  | -------------------------------------------------------------------------



| |  |  | fluctuations in currency exchange rates and imposition of currency exchange controls;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | differing technology standards and language and translation issues;
| | - |  | -------------------------------------------------------------------



| |  |  | difficulties in collecting accounts receivable and longer collection periods;
| | - |  | -----------------------------------------------------------------------------



| |  |  | changes in regulatory requirements, including U.S. export restrictions on encryption technologies;
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | political and economic instability;
| | - |  | -----------------------------------



| |  |  | potential adverse tax consequences; and
| | - |  | ---------------------------------------



| |  |  | significantly reduced protection for intellectual property rights in some countries.
| | - |  | ------------------------------------------------------------------------------------



Any of these factors could harm our international operations and, consequently, our business and consolidated operating results.
Specifically, failure to successfully manage international growth could result in higher operating costs than anticipated or could delay or preclude altogether our ability to generate revenues in key international markets.



The debt and significant equity ownership by the General Atlantic Investors and the
Cheung Kong Investors may limit the ability of our other shareholders to influence significant corporate decisions which could delay or prevent a change of control or depress our stock price.



As of September 30, 2005, the General Atlantic Investors beneficially own approximately
29.2% of our outstanding securities (which represents approximately 17.9% of the voting power) and the Cheung Kong Investors beneficially own approximately 20.5% of our outstanding securities (which represents approximately 19.3% of the voting
power). In addition, the holders of our Series D preferred stock, which is controlled by the General Atlantic Investors, are entitled to elect one director and the Cheung Kong Investors have the right to nominate one director. Currently, one of our
directors is affiliated with General Atlantic Investors and one of our directors is affiliated with the Cheung Kong Investors. As a result, the General Atlantic Investors and the Cheung Kong Investors, although not affiliated, may have the ability,
acting together, to control the outcome of shareholder votes, including votes concerning the election of a majority of our directors, approval of merger transactions involving us and the sale of all or substantially all of our assets or other
business combination transactions, charter and bylaw amendments and other significant corporate actions, which could delay or prevent a change in control or depress our stock price.



The General Atlantic Investors and the Cheung Kong Investors also hold a significant portion of our outstanding 13.9% Notes, which require
us to obtain their consent before taking certain corporate actions (for example, incurring indebtedness or selling assets) that would not otherwise require the consent of our shareholders. As a result, we may not be able to execute a transaction
favored by management if we are not able to obtain their consent.



44



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The debt and significant equity ownership by the General Atlantic Investors and the Cheung Kong Investors may
result in potential conflicts of interests, which could adversely affect the holders of our common stock, delay a change in control and depress our stock price.



The debt and significant equity ownership by each of the General Atlantic Investors and the Cheung Kong Investors could create conflicts of
interest between these majority shareholders and our other shareholders and between the General Atlantic Investors and the Cheung Kong Investors. For example, the General Atlantic Investors and the Cheung Kong Investors may only approve a change in
control transaction that results in the payment of their liquidation preference even if our other shareholders oppose the transaction, which could depress the price of our common stock. Alternatively, the General Atlantic Investors and the Cheung
Kong Investors may prevent or delay a corporate transaction that is favored by our other shareholders. In addition, it is also possible that the risk that the General Atlantic Investors and the Cheung Kong Investors may disagree on approving a
significant corporate transaction, for example a change in control transaction, could limit the number of potential partners willing to pursue such a transaction with us or limit the price that investors might be willing to pay for future shares of
our common stock.



The use of our net operating losses could be limited if
an ownership change occurred during the preceding three-year period.



The use of our net operating losses could be limited if an ownership change occurred during the preceding three-year period as a result of, for example, the issuance of Series E preferred stock upon conversion of the 10% notes,
the amendment to the terms of the Series D preferred stock or the exercise of the subscription rights. In general, under applicable federal income tax rules, an ownership change is considered to have occurred if the percentage of the
value of our stock owned by our 5% shareholders increased by more than 50 percentage points over the lowest percentage of the value of our stock owned by such shareholders over the preceding three-year period.



Due to the fact that a full valuation allowance has been provided for the net deferred tax
asset relating to our net operating losses, we have never analyzed whether events such as the issuance of Series E preferred stock upon conversion of the 10% notes, the amendment to the terms of the Series D preferred stock and/or the exercise of
the subscription rights in the rights offering caused us to undergo an ownership change for federal income tax purposes. If such an ownership change were considered to have occurred, our use of our pre-change net operating losses would generally be
limited annually to the product of the long-term tax-exempt rate as of the time the ownership change occurred and the value of our stock immediately before the ownership change. (The current long-term tax-exempt rate is 4.72%.) This could increase
our federal income tax liability if we generate taxable income in the future. There can be no assurance that the Internal Revenue Service would not be able to successfully assert that we have undergone one or more ownership changes in the preceding
three-year period.



Our stock price has demonstrated volatility and
overall declines during recent quarters and continued volatility in the stock market may cause further fluctuations and/or decline in our stock price.



The trading price of our common stock has and may continue to experience volatility, wide fluctuations and declines. For example, during the three months ended
September 30, 2005, the closing sale prices of our common stock on the Nasdaq National Market ranged from $0.61 to $0.31. More recently, on November 7, 2005, the closing sale price of our common stock was $0.44. Our stock price may further
decline or fluctuate in response to any number of factors and events, such as announcements related to technological innovations, intense regulatory scrutiny and new corporate and securities and other legislation, strategic and sales relationships,
new product and service offerings by us or our competitors, litigation outcomes, changes in senior management, changes in financial estimates and recommendations of securities analysts, the operating and stock price performance of other companies
that investors may deem comparable, news reports relating to trends in our markets and the market for our stock, media interest in accounting scandals and corporate governance questions, overall market conditions and domestic and international
economic factors unrelated to our performance. In addition, the stock market in general, particularly with respect to technology stocks, has experienced extreme volatility and a significant cumulative decline in recent quarters. This volatility and
decline has affected many companies, including our company, irrespective of the specific operating performance of such companies. These broad market influences and fluctuations may adversely affect the price of our stock, and our ability to remain
listed on the Nasdaq National Market, regardless of our operating performance or other factors.



45



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A decline in our stock price could result in securities class action litigation against us that could divert
managements attention and harm our business.



We have been in the
past and may in the future be subject to shareholder lawsuits, including securities class action lawsuits. In the past, securities class action litigation has often been brought against a company after periods of volatility in the market price of
securities. In the future, we may be a target of similar litigation. Securities litigation could result in substantial costs and divert our managements attention and resources, which in turn could harm our ability to execute our business
plan.



Our articles of incorporation and
bylaws contain provisions that could delay or prevent a change in control.



Our articles of incorporation and bylaws contain provisions that could delay or prevent a change in control of our company. These provisions could limit the price that investors might be willing to pay in the future for shares of our common
stock. Some of these provisions:



| |  |  | authorize the issuance of preferred stock that can be created and issued by our board of directors without prior shareholder
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | approval, commonly referred to as blank check preferred stock, with rights senior to those of our common stock;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | prohibit shareholder action by written consent; and
| | - |  | ---------------------------------------------------



| |  |  | establish advance notice requirements for submitting nominations for election to our board of directors and for proposing matters that can be acted upon by shareholders at a
meeting.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In March 2001, we adopted a shareholder rights plan or
poison pill. This plan could cause the acquisition of our company by a party not approved by our board of directors to be prohibitively expensive.



In addition, the General Atlantic Investors and the Cheung Kong Investors own a sufficient amount of our securities to be able to control the outcome of matters submitted
to a vote of our shareholders, which could have the effect of discouraging or impeding an acquisition proposal.



Changes in accounting rules for employee stock options could significantly impact our GAAP financial results.



Accounting policies affecting many aspects of our business, including rules relating to
employee stock option grants, have recently been revised or are under review. The FASB and other agencies have finalized changes to U.S. generally accepted accounting principles that will require us, starting in the first quarter of 2006, to record
a charge to earnings for employee stock option grants and other equity incentives although we may elect to become subject to these accounting principles before we are required to. We may have significant and ongoing accounting charges resulting from
option grant and other equity incentive expensing that could reduce our overall net income. In addition, since we historically have used equity-related compensation as a component of our total employee compensation program, the accounting change
could make the use of equity-related compensation less attractive to us and therefore make it more difficult to attract and retain employees.



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



The following table presents the hypothetical changes in fair value in the 13.9% Notes at
September 30, 2005. The value of the instrument is sensitive to changes in interest rates. The modeling technique used measures the change in fair values arising from hypothetical parallel shifts in the yield curve of plus or minus 50 basis
points (bps), 100 bps and 150 bps over a twelve-month time horizon. The base value represents the estimated traded fair market value of the notes.



46



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|            |  |                                                                         |       |                          |   |                                                                         |  |   |        |  |         |       |         |   |       |  |   |       |  |   |      
|----------- |  | ----------------------------------------------------------------------- | ----- | ------------------------ | - | ----------------------------------------------------------------------- |  | - | ------ |  | ------- | ----- | ------- | - | ----- |  | - | ----- |  | - | -----
|            |  | Valuation of borrowing given aninterest rate decrease of X basis points |       | No changein interestrate |   | Valuation of borrowing given aninterest rate increase of X basis points
|            |  | 150 bps                                                                 |       | 100 bps                  |   | 50 bps                                                                  |  |   | 50 bps |  | 100 bps |       | 150 bps
|            |  | (in thousands)                                                         
|13.9% Notes |  | $                                                                       | 6,525 |                          | $ | 6,517                                                                   |  | $ | 6,508  |  | $       | 6,500 |         | $ | 6,492 |  | $ | 6,484 |  | $ | 6,475



As of September 30, 2005, we had
cash and cash equivalents of $20.5 million and no investments in marketable securities and our long-term obligations consisted of our $18.0 million three year, 13.9% Notes due December 2007 and certain fixed rate capital leases. Accordingly, an
immediate 10% change in interest rates would not affect our long-term obligations or our results of operations.



A significant portion of our international operations has a functional currency other than the United States dollar. Accordingly, we are exposed to foreign currency exchange rate risk inherent in our sales
commitments, anticipated sales, and assets and liabilities of these operations. Fluctuations in exchange rates may harm our results of operations and could also result in exchange losses. The impact of future exchange rate fluctuations cannot be
predicted with any certainty; however, our exposure to foreign currency exchange rate risk is primarily associated with fluctuations in the Euro. We realized a net gain on foreign exchange of $2.9 million during the nine months ended
September 30, 2005. To date, we have not sought to hedge the risks associated with fluctuations in exchange rates.



ITEM 4. CONTROLS AND PROCEDURES



Evaluation of Disclosure Controls and Procedures



We maintain disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) of the Securities
Exchange Act of 1934 (the Exchange Act), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the
time periods specified in United States Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as
appropriate, to allow timely decisions regarding required disclosure.



As of the
end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our disclosure committee and management, including the chief executive officer and the chief financial officer, of the
effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(b) and 15d-15(b). Based upon, and as of the date of this evaluation, the chief executive officer and the chief financial
officer concluded that our disclosure controls and procedures were not effective because we have not yet remediated the material weaknesses discussed in our Annual Report on Form 10-K/A as filed on May 2, 2005 for the year ended
December 31, 2004. Specifically, as of December 31, 2004, we did not maintain effective controls over (i) lack of expertise and resources to analyze and apply generally accepted accounting principles to significant non-routine
transactions, (ii) inadequate controls over period-end financial reporting processes, (iii) inadequate segregation of duties and (iv) inadequate controls over access to financial applications and data, based on criteria established
inInternal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In light of these material weaknesses described more fully in our Form 10-K/A, we performed additional
analysis and other post-closing procedures to ensure our consolidated financial statements are prepared in accordance with generally accepted accounting principles (GAAP). Accordingly, management believes that the financial statements included in
this report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.



The certifications of our principal executive officer and principal financial officer required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 are
attached as exhibits to this Quarterly Report on Form 10-Q. The disclosures set forth in this Item 4 contain information concerning the evaluation of our disclosure controls and procedures, internal control over financial reporting and changes
in internal control over financial reporting referred to in those certifications. Those certifications should be read in conjunction with this Item 4 for a more complete understanding of the matters covered by the certifications.



47



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Proposed Changes in Internal Control Over Financial Reporting



Our management has discussed the material weaknesses as previously disclosed in Item 9A
in our Annual Report on Form 10-K/A for the year ended December 31, 2004 and other deficiencies with our audit committee. In an effort to remediate the identified material weaknesses and other deficiencies, we intend to implement remedial
measures, including, but not limited to the following:



| |  |  | engaging expert resources to assist with worldwide tax planning and compliance and to review our overall corporate structure;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------



| |  |  | engaging consultants to assist in the application of GAAP to complex issues on a quarterly basis;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | hiring additional accounting personnel to focus on our ongoing remediation initiatives and compliance efforts;
| | - |  | --------------------------------------------------------------------------------------------------------------



| |  |  | implementing consistent accounting and professional services time reporting systems worldwide;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | improving our documentation and training related to policies and procedures for the controls related to our significant accounts and processes;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | improving our documentation and training regarding revenue recognition procedures and reviews;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | improving control and monitoring over access to data and information systems;
| | - |  | -----------------------------------------------------------------------------



| |  |  | re-allocating and/or relocating duties of finance personnel to enhance segregation of duties; and
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | implementing consistent financial application systems (including but not limited to general ledger, purchasing, fixed asset and time tracking systems) on a worldwide basis.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Changes in Internal Control
Over Financial Reporting



During the first quarter of 2005, we began
requiring passwords, which are changed every 90 days, to access critical systems and financial applications.



In connection with the financial reporting process for the three month period ended September 30, 2005, we have taken the following actions in an effort to remediate our material weaknesses, as previously
disclosed in Item 9A in our Annual Report on Form 10-K/A for the year ended December 31, 2004, by December 31, 2005. With respect to our identified material weaknesses:



We have engaged an external third party as our expert resource to assist us in the application of generally accepted
accounting principles to our significant non-routine accounting transactions.



In addition to requiring password changes to access critical systems and financial applications, we have: (i) implemented monthly reviews of our employees access to critical systems and financial
applications; and (ii) implemented change control procedures with respect to our critical systems and financial applications.



There were no other significant changes in our internal control over financial reporting that occurred during the financial reporting process for the three months ended
September 30, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



48



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PART II - OTHER INFORMATION



ITEM 1. LEGAL PROCEEDINGS



None.



ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS



(a) Sales of Unregistered Equity Securities



None.



(c) Issuer Purchases of Equity Securities



None.



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



(a) Exhibits



|31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------



|31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------



|32.1* | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|----- | -------------------------------------------------------------------------------------------------------------------------------------------------



|32.2* | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|----- | -------------------------------------------------------------------------------------------------------------------------------------------------

---

|* | In accordance with Item 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8238 and 34-47986, Final Rule: Managements Reports on Internal Control Over Financial
Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed filed for purpose of Section 18
of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



49



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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.



CRITICAL PATH, INC.By:

/s/ James A. ClarkJames A. ClarkExecutive Vice President and Chief
Financial Officer (Duly Authorized Officer and Principal
Financial and Accounting Officer)




Date: November 9, 2005



50



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Exhibit Index



|31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------



|31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------



|32.1* | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|----- | -------------------------------------------------------------------------------------------------------------------------------------------------



|32.2* | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|----- | -------------------------------------------------------------------------------------------------------------------------------------------------

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|* | In accordance with Item 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8238 and 34-47986, Final Rule: Managements Reports on Internal Control Over Financial
Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed filed for purpose of Section 18
of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.
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