<PAGE>

                      SECURITIES AND EXCHANGE COMMISSION

                            Washington, D.C. 20549

                                  FORM 10-Q

              Quarterly Report Pursuant to Section 13 or 15 (d)
                    of the Securities Exchange Act of 1934


For the quarterly period ended                            Commission File Number
June 30, 2001                                             000-26819
-------------                                             ---------


                         WATCHGUARD TECHNOLOGIES, INC.
                         -----------------------------
             (Exact Name of Registrant as Specified in Its Charter)


           Delaware                                       91-1712427
-------------------------------             ------------------------------------
(State or Other Jurisdiction of             (I.R.S. Employer Identification No.)
 Incorporation or Organization)


                        505 Fifth Ave. South, Suite 500
                        -------------------------------
                             Seattle WA 98104-3892
                             ---------------------
              (Address of Principal Executive Offices)  (Zip Code)


      Registrant's telephone number, including area code:  (206) 521-8340
                                                           --------------

                                  Not Applicable
             ----------------------------------------------------
             (Former name, former address and former fiscal year,
                        if changed since last report.)


          Indicate by check mark whether the Registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to the
filing requirements for the past 90 days.  Yes  X    No
                                               ---      ---

          26,953,177 shares of WatchGuard common stock were outstanding as of
August 1, 2001.

                                     Page 1
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.
                         QUARTERLY REPORT ON FORM 10-Q
                      FOR THE QUARTER ENDED JUNE 30, 2001

                               TABLE OF CONTENTS
<TABLE>

<S>      <C>                                                                                                   <C>
PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements.................................................................................   3

         -  Consolidated Balance Sheets as of June 30, 2001 and December 31, 2000.............................   3

         -  Consolidated Statements of Operations for the three and six months ended June 30, 2001 and 2000...   4

         -  Consolidated Statements of Cash Flows for the six months ended June 30, 2001 and 2000.............   5

         -  Notes to Consolidated Financial Statements........................................................   6

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations................  10

Item 3.  Quantitative and Qualitative Disclosures About Market Risk...........................................  30

PART II. OTHER INFORMATION

Item 2.  Changes in Securities and Use of Proceeds............................................................  31

Item 6.  Exhibits and Reports on Form 8-K.....................................................................  31
</TABLE>

                                     Page 2
<PAGE>

                         PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements


                         WATCHGUARD TECHNOLOGIES, INC.
                          CONSOLIDATED BALANCE SHEETS
                          ---------------------------
                       (In thousands, except share data)

<TABLE>
<CAPTION>
                                                                                     June 30,           December 31,
                                                                                       2001                 2000
                                                                                 ---------------      ---------------
<S>                                                                               <C>                  <C>
                                    ASSETS
Current assets:
 Cash and cash equivalents....................................................... $       21,813       $       13,837
 Securities available for sale...................................................         92,255              101,278
 Trade accounts receivable, net..................................................         13,369               15,271
 Inventories, net................................................................          5,132                7,026
 Prepaid expenses and other receivables..........................................          4,215                3,178
                                                                                 ---------------      ---------------
  Total current assets...........................................................        136,784              140,590
Property and equipment, net......................................................          7,539                7,341
Goodwill.........................................................................         30,274               33,947
Other intangibles and other assets...............................................         12,319               14,052
                                                                                 ---------------      ---------------
Total assets..................................................................... $      186,916       $      195,930
                                                                                 ===============      ===============

                     LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
 Accounts payable................................................................ $        5,838       $        7,256
 Accrued expenses................................................................          5,195                4,395
 Deferred revenue................................................................         14,940               11,874
                                                                                 ---------------      ---------------
Total current liabilities........................................................         25,973               23,525

Stockholders' equity:
 Preferred stock, $0.001 par value:
   Authorized shares:  10,000,000
   No shares issued and outstanding..............................................             --                   --
 Common stock, $0.001 par value:
   Authorized shares:  80,000,000
   Shares issued and outstanding:  26,932,054 at June 30, 2001 and
      26,287,072 at December 31, 2000............................................             27                   26
 Additional paid-in capital......................................................        230,842              230,591
 Deferred stock-based compensation...............................................         (3,720)             (12,387)
 Accumulated other comprehensive gain (loss).....................................            279                 (222)
 Accumulated deficit.............................................................        (66,485)             (45,603)
                                                                                 ---------------      ---------------
Total stockholders' equity.......................................................        160,943              172,405
                                                                                 ---------------      ---------------
Total liabilities and stockholders' equity....................................... $      186,916       $      195,930
                                                                                 ===============      ===============
</TABLE>
__________________________________
See accompanying notes.

                                     Page 3
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     -------------------------------------
                     (In thousands, except per share data)


<TABLE>
<CAPTION>
                                                                Three Months Ended                       Six Months Ended
                                                                     June 30,                                June 30,
                                                      ------------------------------------    ------------------------------------
                                                             2001                2000                2001                2000
                                                      ----------------    ----------------    ----------------    ----------------
<S>                                                     <C>                 <C>                 <C>                 <C>
Revenues:
 Product...........................................   $         13,255    $         12,000    $         26,539    $         20,494
 Service...........................................              4,253               1,740               8,071               3,048
                                                      ----------------    ----------------    ----------------    ----------------
    Total revenues.................................             17,508              13,740              34,610              23,542

Cost of revenues:
 Product...........................................              5,425               4,341              10,692               7,432
 Service...........................................              1,558                 557               2,934                 989
                                                      ----------------    ----------------    ----------------    ----------------
    Total cost of revenues.........................              6,983               4,898              13,626               8,421
                                                      ----------------    ----------------    ----------------    ----------------
Gross margin.......................................             10,525               8,842              20,984              15,121

Operating expenses:
 Sales and marketing (1)...........................              7,690               5,967              15,861              11,526
 Research and development (2)......................              4,740               3,262              10,011               5,782
 General and administrative (3)....................              1,865               1,249               3,735               2,404
 Stock-based compensation..........................              2,546                 228               7,066                 464
 Amortization of  goodwill, purchased technology
  and other intangible assets acquired.............              2,724                 368               5,448                 736
 Restructuring charges.............................              2,900                  --               2,900                  --
                                                      ----------------    ----------------    ----------------    ----------------
     Total operating expenses......................             22,465              11,074              45,021              20,912
                                                      ----------------    ----------------    ----------------    ----------------
Operating loss.....................................            (11,940)             (2,232)            (24,037)             (5,791)
Interest income, net...............................              1,622               1,854               3,323               2,717
                                                      ----------------    ----------------    ----------------    ----------------
Loss before income taxes...........................            (10,318)               (378)            (20,714)             (3,074)
                                                      ----------------    ----------------    ----------------    ----------------
Provision for income taxes.........................                 84                  --                 168                  --
                                                      ----------------    ----------------    ----------------    ----------------
Net loss...........................................   $        (10,402)   $           (378)   $        (20,882)   $         (3,074)
                                                      ================    ================    ================    ================
Basic and diluted net loss per share...............   $          (0.39)   $          (0.02)   $          (0.79)   $          (0.14)
                                                      ================    ================    ================    ================
Shares used in calculation of basic and diluted
 net loss per share................................             26,673              23,160              26,467              22,223
                                                      ================    ================    ================    ================
</TABLE>
__________________________________
(1) Sales and marketing expenses exclude amortization of stock-based
    compensation of $104,000 and $48,000 for the three months ended June 30,
    2001 and 2000, respectively and $171,000 and $100,000 for the six months
    ended June 30, 2001 and 2000, respectively.
(2) Research and development expenses exclude amortization of stock-based
    compensation of  $2,431,000 and $160,000 for the three months ended June 30,
    2001 and 2000, respectively and $6,872,000 and $323,000 for the six months
    ended June 30, 2001 and 2000, respectively.
(3) General and administrative expenses exclude amortization of stock-based
    compensation of $11,000 and $20,000 for the three months ended June 30, 2001
    and 2000, respectively and $23,000 and $41,000 for the six months ended June
    30, 2001 and 2000, respectively.

See accompanying notes.

                                     Page 4
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                     -------------------------------------
                                 (In thousands)
<TABLE>
<CAPTION>
                                                                                                 Six Months Ended
                                                                                                     June 30,
                                                                                 ---------------------------------------------
                                                                                         2001                      2000
                                                                                 -------------------      --------------------
<S>                                                                                <C>                      <C>
OPERATING ACTIVITIES:
 Net loss........................................................................ $          (20,882)      $            (3,074)
 Adjustments to reconcile net loss to net cash used in operating activities:
   Depreciation and amortization of property and equipment.......................              1,074                       588
   Amortization of goodwill and other intangible assets..........................              5,448                       736
   Amortization of stock-based compensation......................................              7,066                       464
   Provision for sales returns and allowances....................................              2,097                       879
   Provision for bad debt expense................................................                511                       190
   Non-cash stock based compensation restructuring charges.......................                579                        --
   Changes in operating assets and liabilities:
     (Increase) in trade accounts receivable.....................................               (706)                   (5,998)
     (Increase) decrease in inventories..........................................              1,894                    (3,326)
     (Increase) in prepaid expenses and other receivables........................             (1,037)                   (1,677)
     (Increase) in goodwill, intangibles and other assets........................                (42)                       (7)
     Increase in accrued restructuring charges...................................              1,074                        --
     Increase (decrease) in accounts payable and accrued expenses................             (1,692)                    3,752
     Increase in deferred revenue................................................              3,066                     3,483
                                                                                 -------------------      --------------------
NET CASH USED IN OPERATING ACTIVITIES                                                         (1,550)                   (3,990)

INVESTING ACTIVITIES:
 Purchases of equipment and furniture and other..................................             (1,272)                     (813)
 Proceeds from sale and maturity of marketable securities........................            108,853                    17,618
 Purchases of marketable securities..............................................            (99,329)                 (101,339)
                                                                                 -------------------      --------------------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES..............................              8,252                   (84,534)

FINANCING ACTIVITIES:
 Principal repayments on line of credit and notes payable........................                 --                      (383)
 Proceeds from the sale of common stock, net of expenses.........................                 --                    90,427
 Proceeds from the exercise of common stock options and warrants, and the sale
  of common stock through the employee stock purchase plan.......................              1,274                     2,183
                                                                                 -------------------      --------------------
NET CASH PROVIDED BY FINANCING ACTIVITIES........................................              1,274                    92,227
                                                                                 -------------------      --------------------
NET INCREASE  IN CASH AND CASH EQUIVALENTS.......................................              7,976                     3,703
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD.................................             13,837                     1,903
                                                                                 -------------------      --------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD....................................... $           21,813       $             5,606
                                                                                 ===================      ====================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
 Adjustment to deferred stock based compensation for options cancelled upon
  employee termination under restructuring plan.................................. $            1,392       $                --
</TABLE>

__________________________________
See accompanying notes.

                                     Page 5
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

   Description of Business

   WatchGuard Technologies, Inc. (WatchGuard) is a provider of Internet security
solutions designed to protect enterprises that use the Internet for electronic
commerce and secure communications.

   Interim Financial Information

   The accompanying unaudited financial statements of WatchGuard, which include
the December 31, 2000 balance sheet that was derived from audited financial
statements, have been prepared in accordance with generally accepted accounting
principles for interim financial information and with the instructions to Form
10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of
the information and footnotes required by generally accepted accounting
principles for complete financial statements.  In the opinion of management, the
unaudited financial statements include all adjustments, consisting of normal
recurring accruals, necessary for a fair presentation.  Operating results for
the three-month and six-month periods ended June 30, 2001 are not necessarily
indicative of the results that may be expected for future quarters or for the
year ended December 31, 2001.  The financial statements should be read in
conjunction with the financial statements and related notes for the year ended
December 31, 2000 included in WatchGuard's annual report on Form 10-K, filed
with the Securities and Exchange Commission (SEC) on March 28, 2001.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

   Revenue Recognition

   WatchGuard recognizes revenue in accordance with accounting standards for
software companies, including Statement of Position (SOP) 97-2, "Software
Revenue Recognition," as amended by SOP 98-9, and related interpretations,
including Technical Practice Aids.  In December 1999, the SEC issued Staff
Accounting Bulletin (SAB)  101, "Revenue Recognition in Financial Statements".
SAB 101 summarizes certain of the SEC's views in applying generally accepted
accounting principles to revenue recognition in financial statements.  The SEC
continues to issue further guidance with respect to adoption of specific issues
addressed by SAB 101.  WatchGuard believes its current revenue recognition
policies and practices are consistent with the current accounting standards and
guidance in SAB 101.

   WatchGuard generates revenues through sales of its Firebox and ServerLock
products, including related software licenses, and subscriptions for its
LiveSecurity Service, which includes threat responses, software updates and
maintenance.  Software license revenues are generated from licensing the rights
to use WatchGuard's products directly to end-users, from sublicense fees from
resellers, distributors and from sales of its products to Internet service
providers (ISPs) and other managed service providers that utilize WatchGuard's
products to provide managed security services to their customers.

   Revenues from software license agreements are generally recognized upon
delivery of software if persuasive evidence of an arrangement exists, collection
is probable, the fee is fixed or determinable, and vendor-specific objective
evidence exists to allocate the total fee to undelivered elements of the
arrangement. Vendor-specific objective evidence is typically based on the price
charged when an element is sold separately or, if an element is not sold
separately, on the price established by authorized management, if it is probable
that the price, once established, will not change before market introduction.
WatchGuard uses the residual method, as defined in SOP 98-9, to allocate revenue
to delivered elements once it has established vendor-specific objective evidence
for all undelivered elements.  Under the residual method, any discount in the
arrangement is allocated to the delivered element. WatchGuard provides for
return rights and pricing protection rights for some of its customers.  The
return rights included in these customer agreements are generally limited to a
percentage of purchases by these customers for the previous quarter.  The
pricing protection rights in these agreements are generally limited to 60 to 90
days after notification of a price change.  Revenues are reduced by the
provision for estimated returns and allowances at the time the sale is made. The
reserves are reviewed and revised as needed. A limited number of WatchGuard's
distributors have unlimited stock return and rotation rights.  Revenues from
these distribution arrangements are not recognized until the distributors sell
the products to their customer.  Revenues from LiveSecurity subscriptions are
recognized ratably over the term of the contract, typically one to two years.
WatchGuard's payment terms typically range from 30 to 60 days.

                                     Page 6
<PAGE>

   Principles of Consolidation

   The consolidated financial statements include the accounts of WatchGuard and
its wholly owned subsidiaries.  All significant intercompany accounts and
transactions are eliminated in consolidation.

   Comprehensive Loss

   WatchGuard's investments consist of corporate and government debt securities,
are considered available-for-sale, and are stated at fair value, with unrealized
gains and losses included as a component of stockholders' equity.  During the
three and six month periods ended June 30, 2001, there were no material realized
gains or losses on securities available-for-sale.  All such investments mature
within two years, with the weighted average life of the investment portfolio
being approximately one year.  The following table sets forth the components of
comprehensive loss (in thousands):

<TABLE>
<CAPTION>
                                                           Three Months Ended June 30,               Six Months Ended June 30,
                                                    --------------------------------------    -------------------------------------
                                                           2001                 2000                2001                 2000
                                                    -----------------    -----------------    ----------------    -----------------
   <S>                                               <C>                  <C>                  <C>                 <C>
   Net loss......................................    $        (10,402)    $           (378)    $       (20,882)    $         (3,074)
   Unrealized gain (loss) on investments.........                  11                   38                 501                 (196)
                                                    -----------------    -----------------    ----------------    -----------------
   Comprehensive loss............................    $        (10,391)    $           (340)    $       (20,381)    $         (3,270)
                                                    =================    =================    ================    =================
</TABLE>

   Recent Accounting Pronouncements

   In July 2001 the Financial Accounting Standards Board (FASB) issued SFAS No.
141 "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible
Assets."  SFAS No. 141 requires business combinations completed after June 30,
2001 to be accounted for using the purchase method of accounting, and broadens
the criteria for recording intangible assets separate from goodwill.  Recorded
goodwill and intangibles will be evaluated against this new criteria and may
result in certain intangibles being subsumed into goodwill, or alternatively,
amounts initially recorded as goodwill may be separately identified and
recognized apart from goodwill.  For any business combinations completed after
June 30, 2001 WatchGuard will adopt the provisions of SFAS No. 141 and, in
accordance with SFAS No. 141, will apply the amortization provisions of SFAS No.
142, described below.  SFAS No. 142 requires that goodwill and other indefinite
lived intangibles no longer be amortized to earnings, but instead be reviewed
for impairment and written down and charged to earnings only in the periods in
which the recorded value of goodwill is more than its fair value.  Separatable
intangible assets that do not have indefinite lives will continue to be
amortized over their useful lives.  The provisions of SFAS No. 142 will be
adopted by WatchGuard on January 1, 2002 and are applicable to all existing
goodwill.  We expect the adoption of SFAS No. 142 to have the impact of reducing
our amortization of goodwill commencing January 1, 2002, however, impairment
reviews may result in future periodic write-downs of goodwill.

   In April 2001 the Emerging Issues Task Force reached a consensus on EITF
Issue No. 00-25 "Vender Income Statement Characterization of Consideration from
a Vendor to a Retailer." Under EITF Issue No. 00-25, consideration from a vendor
to a retailer is presumed to be a reduction in the selling price of a vendor's
products, and therefore should be characterized as a reduction of revenue by the
Vendor. This presumption can be overcome, and the consideration characterized as
a cost incurred if, and to the extent that both: the vendor receives an
identifiable benefit from the retailer in return for consideration sufficiently
separable from the arrangement with the vendor; and the vendor has sufficient,
objective, and reliable evidence to estimate the fair value of the benefit. EITF
Issue No. 00-25 is effective for quarters beginning after December 15, 2001.
Upon application of the consensus, if applicable, financial statements for prior
periods presented for comparative purposes must be reclassified to comply with
the new requirements. WatchGuard is currently analyzing certain of its marketing
programs with distributors to determine the effect, if any, of the consensus on
its revenues and expenses.

   Reclassifications

   Certain prior-period items have been reclassified to conform to the current-
period presentation.

                                     Page 7
<PAGE>

NOTE 3 - BALANCE SHEET ACCOUNT DETAIL (in thousands)

   Trade Accounts Receivable, Net

   Trade accounts receivable, net consisted of the following:

                                                June 30,       December 31,
                                                  2001             2000
                                              ------------     ------------
   Trade accounts receivable................. $   15,736       $   16,869
   Reserve for returns and allowances........     (1,667)            (965)
   Allowance for uncollectible accounts......       (700)            (633)
                                              ------------     ------------
                                              $   13,369       $   15,271
                                              ============     ============

   Inventories

   Inventories consisted of the following:

                                                June 30,       December 31,
                                                  2001             2000
                                              ------------     ------------
   Finished goods............................ $    3,879       $    4,077
   Components................................      1,840            3,394
                                              ------------     ------------
                                                   5,719            7,471
   Inventory reserves........................       (587)            (445)
                                              ------------     ------------
                                              $    5,132       $    7,026
                                              ============     ============

NOTE 4 - INTERNATIONAL REVENUES

   WatchGuard licenses and markets its Internet security products and services
throughout the world and operates in a single industry segment.  While certain
expenses for sales and marketing activities are incurred in various geographical
regions, substantially all of WatchGuard's assets are located, and the majority
of its operating expenses are incurred, at its corporate headquarters.  Revenue
information by geographic region is as follows (in thousands):

<TABLE>
<CAPTION>
                                        Three Months Ended June 30,             Six Months Ended June 30,
                                   ------------------------------------   ------------------------------------
                                        2001                2000                2001                2000
                                   ----------------   -----------------   ----------------   -----------------
<S>                                  <C>                <C>                 <C>                <C>
  United States...................  $      7,376        $      5,964       $     14,810       $      10,497
  Rest of World...................        10,132               7,776             19,800              13,045
                                   ----------------   -----------------   ----------------   -----------------
  Total...........................  $     17,508        $     13,740       $     34,610       $      23,542
                                   ================   =================   ================   =================
</TABLE>


NOTE 5 - BUSINESS RESTRUCTURING

   In April 2001, WatchGuard announced a restructuring plan designed to
streamline operations and reduce operating costs. This restructuring plan
included a reduction in workforce and a consolidation of excess facilities, in
addition to other cost-saving strategies. As part of the restructuring plan
WatchGuard has exited the consumer security market which included several
Original Equipment Manufacturer (OEM) agreements to develop product and services
for that market and is streamlining operations in support of new products and
services aimed at business customers.

                                     Page 8
<PAGE>

As a result of this restructuring, WatchGuard recorded a $2.9 million
restructuring charge during the second quarter of 2001.  The restructuring
charge for the three months ended June 30, 2001 included the following (in
thousands):

<TABLE>
<CAPTION>

                                                    Restructuring      Amounts Paid       Accrued
                                                       charges          or charged        Balance
                                                   --------------     --------------     ---------
  <S>                                              <C>                <C>                <C>
  Severance and termination benefits..........     $       1,015      $      1,006       $      9
  Stock-based compensation....................               579               579             --
  Abandoned facilities and other..............             1,306               241          1,065
                                                   --------------     -------------      ---------
  Total.......................................     $       2,900      $      1,826       $  1,074
                                                   ==============     =============      =========
</TABLE>

As part of the reorganization, WatchGuard announced a workforce reduction of
approximately 50 employees, which represented approximately 16% of WatchGuard's
employee base and included employees from all functional areas of the company.
All such employees were terminated prior to June 30, 2001.  Other expenses
associated with the reorganization consist of stock-based compensation expense
associated with the terminated employees having accelerated vesting provisions
in stock and stock options, the discontinuation of the consumer security market
products and the abandonment of facilities and equipment.  Costs that relate to
ongoing operations are not included as restructuring charges.  All restructuring
charges are expected to be paid by December 31, 2001 except for accrued amounts
related to losses for the sublease of abandoned facilities of $727,000 at June
30, 2001 which are expected to be realized through September 2006.  Any revenues
from the consumer security market have been insignificant though June 30, 2001.

NOTE 6 - SUBSEQUENT EVENTS

   In July 2001, WatchGuard offered a voluntary stock option exchange program to
its employees. The plan allowed employees, at their option, to exchange before
August 1, 2001 unexercised stock options with an exercise price equal to or
greater than $15 that were granted to eligible optionees under the 1996 Stock
Option Incentive Plan and the 2000 Stock Option Plan. In addition, if an
employee chose to participate, any option granted to that employee within the
six months preceding August 1, 2001 that had a lower exercise price than any
option tendered was automatically tendered for exchange. In exchange, it is
expected that the employee will be granted on February 2, 2002 a new option to
purchase a number of shares equal to the number of shares underlying the
cancelled option. The exercise price of the replacement option will be equal to
the average of the high and low sales prices of a share of WatchGuard's common
stock as reported on the NASDAQ National Market on February 2, 2002. Except for
relatively minor differences each replacement option will be vested and
exercisable to the same degree as the original option. Pursuant to the offer,
WatchGuard has accepted for cancellation and exchange options to purchase
2,106,347 shares of WatchGuard common stock. For financial reporting purposes
the option exchange program is not considered compensatory, therefore,
WatchGuard does not anticipate recording stock compensation charges as a result
of the implementation of the program.

                                     Page 9
<PAGE>

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

  The following discussion and analysis provides information that we believe is
relevant to an assessment and understanding of WatchGuard's results of
operations and financial condition.  The discussion should be read in
conjunction with the financial statements and the notes to the financial
statements.  References to "we,"  "our" and "us" in this quarterly report refer
to WatchGuard Technologies, Inc.

Forward-Looking Statements

  Our disclosure and analysis in this quarterly report on Form 10-Q contain
forward-looking statements, which provide our current expectations or forecasts
of future events. We use words such as "anticipates," "believes," "expects,"
"future" and "intends," and similar expressions, to identify forward-looking
statements, but the absence of these words does not mean that the statement is
not forward-looking. Forward-looking statements include statements about our
plans, objectives, expectations and intentions and other statements that are not
historical facts. They are subject to known and unknown risks and uncertainties
and inaccurate assumptions that could cause our actual results to differ
materially from those expected or implied by the forward-looking statements. Our
actual results could differ materially from those anticipated in the forward-
looking statements for many reasons, including the risks described under
"Factors Affecting Our Operating Results, Our Business and Our Stock Price."
You should not unduly rely on these forward-looking statements, which apply only
as of the date of this quarterly report.  We undertake no obligation to update
any forward-looking statements to reflect new information, circumstances or
events after the date of this report.

Overview

   WatchGuard is a leading provider of Internet security solutions designed to
protect enterprises that use the Internet for electronic commerce and secure
communications. Our award-winning products and services include firewalls for
access control, virtual private networks, or VPNs, for secure communications and
our new ServerLock products for server content and application security. Our
core market includes small- to medium-sized enterprises, or SMEs, large
Internet-distributed enterprises, or IDEs, with ultra-high-speed connections
supporting VPNs between the IDEs and their geographically dispersed branch
offices and telecommuters, small and home offices, or SOHOs, with broadband
connections, and telecommuters. Our recent acquisition of Qiave Technologies
Corporation allowed us to expand our product line with a software-based solution
designed to protect server content and applications from unauthorized and
unintentional access and manipulation. Our innovative subscription-based
LiveSecurity Service delivers threat responses, software updates, expert
editorials, support flashes and virus alerts over the Internet, which enables
enterprises to protect their data and communications in a continuously changing
environment, with minimal effort.

   Since our inception, we have invested heavily in the development of our
products as follows:

   . In September 1996, we introduced our initial Firebox security appliance and
     began selling our products both domestically and internationally.

   . In 1998, we launched our managed security offering for Internet service
     providers and other managed service providers and introduced our second-
     generation security appliance, which added significant functionality to our
     existing product lines.

   . In February 1999, we launched the broadcast portion of our LiveSecurity
     Service.

   . In October 1999, we acquired BeadleNet, LLC, a developer of Internet
     security solutions for SOHOs.

   . In January 2000, we announced the introduction of our security solutions
     for SOHOs and telecommuters, which we began shipping in the first quarter
     of 2000.

                                    Page 10
<PAGE>

   . In October 2000, we acquired Qiave, a developer of digital information
     security systems, which allowed us to expand our product line with
     ServerLock, which protects server content and applications against
     unauthorized or unintentional changes.

   . In February 2001, we announced the introduction of our ServerLock for NT
     products, which we began shipping in the first quarter of 2001.

   . In May and June 2001, we introduced higher performance third-generation
     security appliances including ones targeted at the larger enterprise and
     the large IDE markets.

   . In July 2001, we announced the introduction of our ServerLock for Solaris
     product and our AppLock/Web product for securing web sites.

Sources of Revenues and Revenue Recognition Policy

   We generate revenues through

   . sales of products and service subscriptions indirectly through our
     distribution network at a discount from list price;

   . sales of products and service subscriptions directly and, from time to
     time, indirectly through our distributors, to our service provider
     customers at volume pricing rates; and

   . sales of service subscription renewals directly to our end-users.

   Product revenues include the perpetual software license fees for our Firebox
System and the sale of our security appliance as part of our security solutions;
the sales of software options, such as user expansion and VPN software
management modules; and the sales of our network operations center, or NOC,
security suite software license as part of LiveSecurity for MSS; and the sales
of our new ServerLock products for server content and application security.

   Service revenues include the annual fee for our LiveSecurity Service, which
is sold as part of our security solution, and for LiveSecurity subscription
renewals from our enterprise customers and end-users. These services provide
access to our LiveSecurity Service for product updates, security threat
responses, general security information and technical support. These services
also provide our service provider customers access to the LiveSecurity Service
and the ability to manage and update a specific number of their customers'
security appliances.

   We recognize revenues only when a contract or agreement has been executed,
delivery has occurred, the fee is fixed and determinable and we believe
collection is probable.  While we generally recognize product revenues upon
shipment, revenues on product sales for two of our major distributors are
recorded when these distributors have sold the product to their customers.
Service subscription revenues are recognized ratably on a monthly basis,
generally over periods ranging between one and two years.

   In April 2001 the Emerging Issues Task Force reached a consensus on EITF
Issue No. 00-25 "Vender Income Statement Characterization of Consideration from
a Vendor to a Retailer." Under EITF Issue No. 00-25, consideration from a vendor
to a retailer is presumed to be a reduction in the selling price of a vendor's
products, and therefore should be characterized as a reduction of revenue by the
Vendor. This presumption can be overcome, and the consideration characterized as
a cost incurred if, and to the extent that both: the vendor receives an
identifiable benefit from the retailer in return for consideration sufficiently
separable from the arrangement with the vendor; and the vendor has sufficient,
objective, and reliable evidence to estimate the fair value of the benefit. EITF
Issue No. 00-25 is effective for quarters beginning after December 15, 2001.
Upon application of the consensus, if applicable, financial statement for prior
periods presented for comparative purposes must be reclassified to comply with
the new requirements. WatchGuard is currently analyzing certain of its marketing
programs with distributors to determine the effect, if any, of the consensus on
its revenues and expenses.

                                    Page 11
<PAGE>

Results of Operations

The following table provides financial data for the periods indicated as a
percentage of total revenues:

<TABLE>
<CAPTION>
                                                            Three Months Ended June 30,         Six Months Ended June 30,
                                                            ---------------------------        ---------------------------
                                                               2001              2000             2001             2000
                                                            ---------          --------        ---------         ---------
<S>                                                          <C>               <C>               <C>               <C>
Revenues:
 Product..............................................         75.7%             87.3%            76.7%             87.1%
 Service..............................................         24.3              12.7             23.3              12.9
                                                            ---------          --------        ---------         ---------
    Total revenues....................................        100.0             100.0            100.0             100.0

Cost of revenues:
 Product..............................................         31.0              31.6             30.9              31.6
 Service..............................................          8.9               4.0              8.5               4.2
                                                            ---------          --------        ---------         ---------
    Total cost of revenues............................         39.9              35.6             39.4              35.8
                                                            ---------          --------        ---------         ---------
Gross margin..........................................         60.1              64.4             60.6              64.2

Operating expenses:
 Sales and marketing..................................         43.9              43.4             45.8              49.0
 Research and development.............................         27.1              23.7             28.9              24.6
 General and administrative...........................         10.7               9.1             10.8              10.2
 Stock-based compensation.............................         14.5               1.7             20.4               2.0
 Amortization of  goodwill, purchased technology and
  other intangible assets acquired....................         15.6               2.7             15.7               3.1
 Restructuring charges................................         16.6               0.0              8.4               0.0
                                                            ---------          --------        ---------         ---------
    Total operating expenses..........................        128.3              80.6            130.1              88.9
                                                            ---------          --------        ---------         ---------
Operating loss........................................        (68.2)            (16.2)           (69.5)            (24.6)
Interest income, net..................................          9.3              13.5              9.6              11.5
                                                            ---------          --------        ---------         ---------
Loss before income taxes..............................        (58.9)             (2.8)           (59.8)            (13.1)
Provision for income taxes............................          0.5               0.0              0.5               0.0
                                                            ---------          --------        ---------         ---------
Net loss..............................................        (59.4)%            (2.8)%          (60.3)%           (13.1)%
                                                            =========          ========        =========         =========
</TABLE>

  Beginning late in the fourth quarter of 2000 and continuing through the second
quarter of 2001 we saw a general global downturn in spending by business on
information technology which has affected the demand for our products and
services. We generated revenues of $17.5 million in the second quarter of 2001,
an increase of 27% from $13.7 million in revenues for the second quarter of 2000
and an increase of 2% from $17.1 million in revenues for the first quarter of
2001. Our net loss for the second quarter of 2001 was ($10.4 million), or
($0.39) per share, compared to a net loss of ($378,000), or ($0.02) per share,
for the second quarter of 2000 and a net loss of ($10.5 million), or ($0.40) per
share in the first quarter of 2001. Our net loss remained relatively flat in the
second quarter of 2001 as compared to the first quarter of 2001 despite
continued weak economic conditions and the deferral or decrease in information
technology capital spending worldwide. The net loss included $8.2 million of
non-cash and restructuring charges for the second quarter 2001 and $7.2 million
of non-cash charges for the first quarter of 2001.

  In April 2001, we announced a restructuring plan designed to streamline
operations and reduce costs. We have streamlined WatchGuard's operations to
focus on our core business of firewalls, VPNs and server security for business
customers. As part of this reorganization we have exited the consumer security
market which included various OEM agreements to develop products and services
for that market and reduced our staff by approximately 50 people, or 16% of our
workforce. We have also consolidated our development and product marketing
activities into product-specific areas to better focus on our business
customers. We believe that the staff reduction, which impacted all functional
areas of the company, will allow us to reduce our break-even point to better
drive towards profitability. We will continue to invest in the research and
development efforts necessary to ensure we maintain our

                                    Page 12
<PAGE>

leadership position in providing enterprises with Internet security and VPN
solutions that are easy to install and manage. As a result of this
restructuring, WatchGuard recorded a $2.9 million restructuring charge during
the second quarter of 2001.


Three Months Ended June 30, 2001 and 2000

Revenues

  Total revenues, which consist of product revenues and service revenues,
increased from $13.7 million in the three months ended June 30, 2000 to $17.5
million in the three months ended June 30, 2001, an increase of 27%. This
increase in total revenues was primarily due to increases in sales volume caused
by increased distribution in the European, Asia/Pacific and North American
markets.  Total international revenues represented approximately 57% of total
revenues in the three months ended June 30, 2000 and 58% in the three months
ended June 30, 2001. In the second quarter of 2000, no one customer accounted
for more than 10% of total revenues.  However, in the three months ended June
30, 2001, global revenues from one of our distributors, Ingram Micro, Inc., were
$2.6 million, or approximately 15% of revenues and revenues from another
distributor, Tech Data, were $1.7 million, or approximately 10% of revenues.

  Product revenues include: (1) perpetual software license fees for our Firebox
System and the sale of our security appliance as part of our security solutions;
(2) sales of software options, such as user expansion and VPN software
management modules; (3) sales of our NOC, security suite software license as
part of LiveSecurity for MSS; and (4) sales from our new ServerLock product
line, which is based on technology acquired in conjunction with our purchase of
Qiave.  Product revenues increased from $12.0 million in the three months ended
June 30, 2000 to $13.3 million in the three months ended June 30, 2001, an
increase of 10%. Product revenues as a percentage of total revenues decreased
from 87% in the three months ended June 30, 2000 to 76% in the three months
ended June 30, 2001 due to a lower growth rate associated with slowing economic
conditions and due to an increase in service revenues from an increased base of
customers renewing their LiveSecurity subscriptions .  Given the current
economic uncertainty and slowdown in capital spending, it is difficult to
predict revenue levels in future quarters, which may be more variable than
usual.

  Service revenues include the annual fee for our LiveSecurity broadcast
service, which is sold as part of the Firebox System and LiveSecurity for MSS.
Service revenues increased from $1.7 million in the three months ended June 30,
2000 to $4.3 million in the three months ended June 30, 2001, an increase of
144%.  As a percentage of total revenues, service revenues increased from 13% in
the three months ended June 30, 2000 to 24% in the three months ended June 30,
2001, which reflects an increased base of customers renewing their LiveSecurity
service subscriptions, and a reduced growth rate for product sales.

  We have established a returns and allowances reserve to address the return
rights and pricing protection rights of some of our customers.  The provision
for sales returns and allowances was $670,000, or 5% of total revenues before
returns and allowances, in the three months ended June 30, 2000 and $845,000, or
5% of total revenues, before returns and allowances, in the three months ended
June 30, 2001.  The provision as a percent of revenue remained relatively flat
in the second quarter of 2001 as compared to the second quarter of 2000 and
reflects normal returns for restocking rights and the estimated return rates of
current products that may originate from new products introduced during the
second quarter of 2001. We expect to continue to introduce new products each
year, which may impact our reserve for sales returns and allowances.

Cost of Revenues and Gross Margin

  Total cost of revenues, which includes product and service costs, increased
from $4.9 million in the three months ended June 30, 2000 to $7.0 million in the
three months ended June 30, 2001, an increase of 43%.  As a percentage of total
revenues, cost of revenues increased from 36% in the three months ended June 30,
2000 to 40% in the three months ended June 30, 2001.  Gross margins are impacted
by various factors, including the volume discount levels contained in our
channel customer agreements, the cost of our Firebox appliances, the mix of
product and service sales, which may include hardware and software products and
service subscriptions or both, the cost of royalties associated with our
products, and the costs of our technical support organization and LiveSecurity
Service.

  Cost of product revenues, which includes the cost of manufacturing our
security appliance, product packaging and third-party product licensing fees,
increased from $4.3 million in the three months ended June 30, 2000 to $5.4
million in the three

                                    Page 13
<PAGE>

months ended June 30, 2001, an increase of 25%. The increase was primarily due
to greater sales volume. As a percentage of total revenues, cost of product
revenues decreased from 32% in the three months ended June 30, 2000 to 31% in
the three months ended June 30, 2001. Cost of product revenues as a percentage
of total product revenues increased from 36% in the three months ended June 30,
2000 to 41% in the three months ended June 30, 2001. The increase in cost of
product revenues as a percentage of product revenues reflects promotional
programs on certain existing Firebox products established to facilitate the
introduction of several new products during the quarter ended June 30, 2001. The
increase also reflects a change in product mix, in which the sales volume of
some of our lower-margin products increased on a relative basis from the second
quarter of 2000 to the second quarter of 2001. We expect product mix changes,
which will result from the addition of software products such as ServerLock, to
have a positive impact on gross margins. Cost savings and product mix changes
that improve gross margins, however, may be offset in the short term by
heightened price competition. In addition, we recently introduced several new
products as mentioned above and plan to introduce additional new products in the
future. In the near term, we expect our gross margins to increase slightly as we
sell our new product lines. We expect gross margins to gradually improve during
the latter half of 2001 and into 2002 as a result of increased revenues
generated from sales of higher-margin software products and expected reductions
in manufacturing costs.

  Cost of service revenues, which includes the costs of our technical support
organization and costs associated with our LiveSecurity Service, increased from
$557,000 in the three months ended June 30, 2000 to $1.6 million in the three
months ended June 30, 2001, an increase of 180%.  As a percentage of total
revenues, cost of service revenues increased from 4% in the three months ended
June 30, 2000 to 9% in three months ended June 30, 2001.  As a percentage of
total service revenues, cost of service revenues increased from 32% in the
second quarter of 2000 to 37% in the second quarter of 2001.  This increase
reflects an investment in our customer support organization to assist the
growing number of customers who are implementing VPNs in a more complex
environment, as well as a broader customer base.  We expect service costs to
continue to increase in total dollar amount as our user base expands.  In the
longer term, as revenues from LiveSecurity subscriptions increase and account
for a greater percentage of total revenues, we expect our service margins to
increase.

Operating Expenses

  Sales and Marketing.   Sales and marketing expenses include salaries,
commissions and employee-related expenses and certain variable marketing
expenses, including distributor promotional costs, public relations costs,
marketing collateral and trade show expenses.  Total sales and marketing
expenses increased from $6.0 million in the three months ended June 30, 2000 to
$7.7 million in the three months ended June 30, 2001, an increase of 29%.  As a
percentage of total revenues, sales and marketing expenses increased from 43% in
the three months ended June 30, 2000 to 44% in the three months ended June 30,
2001.  The dollar increase in sales and marketing expenses was primarily due to
recruiting and supporting a greater number of current and prospective resellers
and distributors and to increased efforts to establish brand recognition of our
products and services.  Specifically, the increase was due to an increase in
variable marketing costs from $1.8 million to $3.2 million related to specific
marketing activities during the second quarter of 2001 designed to increase
brand awareness and to marketing development programs for our channel customers.

  Because we expect our sales and marketing expenses, as well as the other
expenses we describe below, to increase at a slower rate than revenues, we
expect to see a gradual reduction over time in each of these types of expenses
as a percentage of total revenues. We will, however, continue to invest in sales
and marketing programs designed to increase distribution.

  Research and Development.   Research and development expenses include
salaries, noncapitalized equipment and software tools, depreciation from capital
equipment and software, nonrecurring costs associated with our security
appliance prototypes and payments to designers and contractors.  Research and
development expenses increased from $3.3 million in the three months ended June
30, 2000 to $4.7 million in the three months ended June 30, 2001, an increase of
45%.  As a percentage of total revenues, research and development expenses
increased from 24% in the three months ended June 30, 2000 to 27% in the three
months ended June 30, 2001.  The increase in research and development expenses
reflects the growth of our research and development organization to expand and
enhance our Firebox System and LiveSecurity for MSS product lines and ServerLock
products, and our efforts to respond to new and emerging worldwide Internet
security threats through our LiveSecurity Service.  Specifically, major
components of the increase included:

  . an increase in payroll and related expenses from $1.9 million to $2.9
    million, a portion of which is related to the research and development costs
    of our ServerLock products originating from our acquisition of Qiave; and

  . an increase in consulting and security appliance prototype engineering costs
    from $813,000 to $939,000, reflecting increased expenses for the
    introduction of our Firebox III product line.

                                    Page 14
<PAGE>

  We expect to continue to increase our research and development expenses in
total dollar amounts to enhance and expand our current product offerings,
develop new products and enhance our rapid response team, which analyzes and
addresses Internet security threats, and our advisory council, which provides
continuing education and editorials on Internet security.

  General and Administrative.   General and administrative expenses include
costs of executive, human resource, finance and administrative support
functions, provision for uncollectible accounts and legal and accounting
professional services.  General and administrative expenses increased from $1.2
million in the three months ended June 30, 2000 to $1.9 million in the three
months ended June 30, 2001, an increase of 49%.  As a percentage of total
revenues, general and administrative expenses increased from 9% in the three
months ended June 30, 2000 to 11% in the three months ended June 30, 2001.  The
dollar increase in general and administrative expenses reflects the expansion of
our infrastructure to manage the growth of our operations and costs associated
with being a public company, an increase in payroll and related expenses and
increases in other general and administrative areas such as bad debt.

  Stock-based Compensation.  Stock-based compensation expenses arise from
amortization of previously deferred stock-based compensation over the vesting
periods of the common stock subject to repurchase and stock options.  Stock-
based compensation expense was $228,000 in the three months ended June 30, 2000
and $2.5 million in the three months ended June 30, 2001.  The allocation of the
stock-based compensation expense associated with the functional operating
expense categories of sales and marketing, research and development, and general
and administrative was $48,000, $160,000 and $20,000 in the three months ended
June 30, 2000 and $104,000, $2.4 million, and $11,000 in the three months ended
June 30, 2001.

  Deferred stock-based compensation is recorded as a component of stockholders'
equity as the difference between the exercise price of options and the fair
value of our common stock on the date of grant, and for the value of common
stock subject to repurchase that we issued in connection with our 1999
acquisition of BeadleNet and our October 2000 acquisition of Qiave.  We recorded
$19.3 million of deferred stock-based compensation in 2000 in connection with
the Qiave acquisition, which included charges related to the issuance of common
stock subject to repurchase and the assumption of unvested Qiave employee stock
options outstanding at the time of the merger.  We recorded $912,000 of deferred
stock-based compensation in 1999, which included charges related to the
BeadleNet acquisition.

  Amortization of goodwill and other intangible assets acquired. Amortization of
goodwill and other intangibles consists of the amortization of goodwill and
other intangibles related to our acquisitions of BeadleNet in 1999 and Qiave in
2000.  The intangible assets recorded in connection with the above acquisitions,
including goodwill and purchased technology, are being amortized on a straight-
line basis over useful lives ranging from two to five years.  We recorded
amortization charges related to these assets of $368,000 in the three months
ended June 30, 2000, and $2.7 million in the three months ended June 30, 2001.
The increase in amortization in 2001 resulted primarily from recording
amortization of intangibles associated with our acquisition of Qiave in October
2000.

  Restructuring charges.  In April 2001, WatchGuard announced a restructuring
plan designed to streamline operations and reduce operating costs. This
restructuring plan included the reduction in workforce and a consolidation of
excess facilities, in addition to other cost-saving strategies. As part of the
restructuring plan WatchGuard has exited the consumer security market which
included several OEM agreements to develop products and services for that market
and is streamlining operations in support of new products and services aimed at
business customers. As a result of this restructuring, WatchGuard recorded a
$2.9 million restructuring charge for the three months ended June 30, 2001.

Interest Income

  Interest income is generated from the investment of proceeds from the sale of
common stock in our initial public offering in 1999 and our public offering in
February 2000.  Interest income decreased from $1.9 million in the three months
ended June 30, 2000 to $1.6 million in the three months ended June 30, 2001.
This decrease resulted from both a decrease in the average balance of invested
funds and a decrease in the average rates of return.

Income Taxes

  Income tax expense of $84,000 for the three months ended June 30, 2001
primarily relates to our provision for foreign income taxes associated with our
international operations.  We have experienced losses since inception, resulting
in a net

                                    Page 15
<PAGE>

operating loss carryforward position for federal income tax purposes of
approximately $132.7 million as of June 30, 2001. These carryforwards, if not
utilized, will begin to expire in 2011, and may be subject to limitations under
Section 382 of the Internal Revenue Code.

Six Months Ended June 30, 2001 and 2000

Revenues

  Total revenues increased from $23.5 million in the six months ended June 30,
2000 to $34.6 million in the six months ended June 30, 2001, an increase of 47%.
In the six months ended June 30, 2000, revenues from one of our distributors,
Ingram Micro, Inc., were $2.6 million, or approximately 11% of total revenues,
while revenues from another distributor, Tech Data, were $2.5 million, or
approximately 11% of total revenues.  In the six months ended June 30, 2001,
revenues from one of our distributors, Ingram Micro, Inc., were $4.9 million, or
approximately 14% of revenues and revenues from another distributor, Tech Data,
were $3.4 million, or approximately 10% of revenues .  The increase in total
revenues was primarily due to distribution sales volume increases in the
European, Asia/Pacific and North American markets.  Total international revenues
represented approximately 55% of total revenues in the six months ended June 30,
2000 and 57% in the six months ended June 30, 2001.

  Product revenues increased from $20.5 million in the six months ended June 30,
2000 to $26.5 million in the six months ended June 30, 2001, an increase of 29%.
As a percentage of total revenues, product revenues decreased from 87% in the
six months ended June 30, 2000 to 77% in the six months ended June 30, 2001
reflecting a lower growth rate associated with slowing economic conditions.

  Service revenues increased from $3.0 million in the six months ended June 30,
2000 to $8.1 million in the six months ended June 30, 2001, an increase of 165%.
As a percentage of total revenues, service revenues increased from 13% in the
six months ended June 30, 2000 to 23% in the six months ended June 30, 2001
reflecting a growing customer base, increased renewals of LiveSecurity
subscription, as well as slower growth rate of product revenues discussed above.

  The provision for sales returns and allowances was $879,000, or 4% of total
revenues, in the six months ended June 30, 2000 and $2.1 million, or 6% of total
revenues, in the six months ended June 30, 2001. The increase in the provision
as a percentage of total revenues reflects the expected return rates of current
products that may originate due to the introduction of new products during the
second quarter of 2001.  We expect to continue to introduce new products each
year, which may impact our reserve for sales returns and allowances.

Cost of Revenues

  Cost of revenues increased from $8.4 million in the six months ended June 30,
2000 to $13.6 million in the six months ended June 30, 2001, an increase of 62%.
As a percentage of total revenues, cost of revenues increased from 36% in the
six months ended June 30, 2000 to 39% in the six months ended June 30, 2001.
The dollar increases in cost of revenues were primarily due to increases in
sales volume.

  Cost of product revenues increased from $7.4 million in the six months ended
June 30, 2000 to $10.7 million in the six months ended June 30, 2001, an
increase of 44%.  The increase was primarily due to greater sales volume.  As a
percentage of total revenues, cost of product revenues decreased from 32% in the
six months ended June 30, 2000 to 31% in the six months ended June 30, 2001.
Cost of product revenues as a percentage of total product revenues increased
from 36% in the six months ended June 30, 2000 to 40% in the six months ended
June 30, 2001.  The increase in cost of product revenues as a percentage of
product revenues reflects promotional programs on certain existing Firebox
products established to facilitate the introduction of several new products
during the six months ended June 30, 2001.  The increase also reflects a change
in product mix, in which the sales volume of some of our lower-margin products
increased on a relative basis from the six month period ended June 30, 2000 as
compared to the six month period ended June 30, 2001.

  Cost of service revenues increased from $989,000 in the six months ended June
30, 2000 to $2.9 million in the six months ended June 30, 2001, an increase of
197%. As a percentage of total revenues, cost of service revenues increased from
4% in the six months ended June 30, 2000 to 8% in the six months ended June 30,
2001.  As a percentage of total service revenues, cost of service revenues
increased from 32% in the six months ended June 30, 2000 to 36% in the six
months ended June 30, 2001.  This increase reflects an investment in our
customer support organization to assist the growing number of

                                    Page 16
<PAGE>

customers who are implementing VPNs in a more complex environment, as well as a
broader customer base. We expect service costs to continue to increase in total
dollar amount as our user base expands. In the longer term, as revenues from
LiveSecurity subscriptions increase and account for a greater percentage of
total revenues, we expect our service margins to increase.

Operating Expenses

  Sales and Marketing.   Sales and marketing expenses increased from $11.5
million in the six months ended June 30, 2000 to $15.9 million in the six months
ended June 30, 2001, an increase of 38%.  As a percentage of total revenues,
sales and marketing expenses decreased from 49% in the six months ended June 30,
2000 to 46% in the six months ended June 30, 2001.  The dollar increase in sales
and marketing expenses was primarily due to recruiting, training and supporting
our domestic and international resellers and distributors and, to a lesser
extent, to establishing brand recognition of our products and services.
Specifically, major components of the increase included:

  . an increase in payroll and related expenses from $4.7 million to $5.5
    million;

  . an increase in variable marketing costs from $4.1 million to $5.9 million;
    and

  . an increase in travel and related expenses from $1.6 million to $1.8
    million.

  The decrease in sales and marketing expenses as a percentage of total revenues
reflects both a general increase in the productivity of and efficiencies in
managing our indirect channel network and realization of our previous
investments to expand distribution, capture market share and establish brand
recognition of our products.

  Research and Development.   Research and development expenses increased from
$5.8 million in the six months ended June 30, 2000 to $10.0 million in the six
months ended June 30, 2001, an increase of 73%.  As a percentage of total
revenues, research and development expenses increased from 25% in the six months
ended June 30, 2000 to 29% in the six months ended June 30, 2001.  The dollar
increase in research and development expenses reflects the growth of our
research and development organization to expand our enterprise product line and
our efforts in researching and evaluating new and emerging security threats for
our LiveSecurity broadcast service.  Specifically, major components of the
increase included:

  . an increase in payroll and related expenses from $3.7 million to $6.1
    million, a portion of which is related to the research and development costs
    of our ServerLock products originating from our acquisition of Qiave; and

  . an increase in consulting and security appliance prototype engineering costs
    from $1.1 million to $1.7 million.

  General and Administrative.   General and administrative expenses increased
from $2.4 million in the six months ended June 30, 2000 to $3.7 million in the
six months ended June 30, 2001, an increase of 55%.  As a percentage of total
revenues, general and administrative expenses increased from 10% in the six
months ended June 30, 2000 to 11% in the six months ended June 30, 2001.  The
dollar increase in general and administrative expenses reflects the expansion of
our infrastructure to manage the growth of our operations, and primarily relates
to an increase in payroll and related expenses.  Specifically, major components
of the increase included:

  . an increase in payroll and related expenses from $1.2 million to $1.7
    million; and

  . an increase in bad debt expense from $139,000 to $511,000. As a percent of
    total revenues, bad debt expenses increased from 0.6% in the six months
    ended June 30, 2000 to 1.5% in the six months ended June 30, 2001,
    reflecting both an increase in risk associated with a broader customer base
    and the uncertain economy.

  Stock-based Compensation.   Amortization of deferred compensation expense was
$464,000 in the six months ended June 30, 2000 and $7.1 million in the six
months ended June 30, 2001.  The allocation of the stock-based compensation
expense associated with the functional operating expense categories of sales and
marketing, research and development, and general and administrative for the six
months ended June 30, 2000 was $100,000, $323,000 and $41,000, respectively, and
was $171,000, $6.9 million, and $23,000, respectively, for the six months ended
June 30, 2001.

                                    Page 17
<PAGE>

Interest Income

  Interest income is generated from the investment of proceeds from the sale of
common stock in our initial public offering in 1999 and our public offering in
February 2000.  Interest income increased from $2.7 million in the six months
ended June 30, 2000 to $3.3 million in the six months ended June 30, 2001.  The
increase resulted primarily from the full six month period's investment of of
the proceeds of our public offering in 2000, in addition to the investment of
the proceeds from our initial public offering in 1999.

Quarterly Results of Operations

  The following tables provide our unaudited results of operations both in
dollar amounts and expressed as a percentage of total revenues for each quarter
in the five-quarter period ended June 30, 2001.  In our opinion, this unaudited
information has been prepared on the same basis as our audited consolidated
financial statements.  This information includes all adjustments, consisting
only of normal recurring adjustments, necessary for a fair presentation of the
information for the quarters presented, when read in conjunction with our
consolidated financial statements and the notes to the consolidated financial
statements.  The results of operations for any quarter are not necessarily
indicative of our future results.

<TABLE>
<CAPTION>
                                                                                Three Months Ended
                                                        -----------------------------------------------------------------
                                                        June 30,      Mar. 31,       Dec. 31,      Sept. 30,     June 30,
                                                          2001          2001           2000          2000         2000
                                                        --------      --------       --------       -------      -------
<S>                                                     <C>           <C>            <C>            <C>          <C>
                                                                                  (In thousands)
Consolidated Statement of Operations Data:

Revenues:
 Product...........................................     $ 13,255      $ 13,284       $ 16,734       $14,782      $12,000
 Service...........................................        4,253         3,818          3,192         2,453        1,740
                                                        --------      --------       --------       -------      -------
  Total revenues...................................       17,508        17,102         19,926        17,235       13,740

Cost of revenues:
 Product...........................................        5,425         5,267          6,137         5,363        4,341
 Service...........................................        1,558         1,376          1,174           824          557
                                                        --------      --------       --------       -------      -------
  Total cost of revenues...........................        6,983         6,643          7,311         6,187        4,898
                                                        --------      --------       --------       -------      -------
Gross margin.......................................       10,525        10,459         12,615        11,048        8,842

Operating expenses:
 Sales and marketing...............................        7,690         8,171          6,838         5,849        5,967
 Research and development..........................        4,740         5,271          4,704         3,413        3,262
 General and administrative........................        1,865         1,870          1,895         1,703        1,249
 Stock-based compensation..........................        2,546         4,520          7,750           193          228
 Amortization of goodwill, purchased technology
  and other intangible assets acquired.............        2,724         2,724          7,123           368          368
 Restructuring charges.............................        2,900            --             --            --           --
                                                        --------      --------       --------       -------      -------
  Total operating expenses.........................       22,465        22,556         28,310        11,526       11,074
                                                        --------      --------       --------       -------      -------
Operating loss.....................................      (11,940)      (12,097)       (15,695)         (478)      (2,232)
Interest income, net...............................        1,622         1,701          1,986         1,812        1,854
                                                        --------      --------       --------       -------      -------
Income (loss) before income taxes..................      (10,318)      (10,396)       (13,709)        1,334         (378)
Provision for income taxes.........................           84            84            215            --           --
                                                        --------      --------       --------       -------      -------
Net income (loss)..................................     $(10,402)     $(10,480)      $(13,924)      $ 1,334      $  (378)
                                                        ========      ========       ========       =======      =======
</TABLE>

                                    Page 18
<PAGE>

<TABLE>
<CAPTION>
                                                                                Three Months Ended
                                                        -----------------------------------------------------------------
                                                        June 30,      Mar. 31,       Dec. 31,      Sept. 30,     June 30,
                                                          2001          2001           2000          2000         2000
                                                        --------      --------       --------       -------      -------
<S>                                                     <C>           <C>            <C>            <C>          <C>
Consolidated Statement of Operations Data:

Revenues:
 Product...........................................         75.7 %        77.7 %         84.0 %        85.8 %       87.3 %
 Service...........................................         24.3          22.3           16.0          14.2         12.7
                                                        --------      --------       --------       -------      -------
  Total revenues...................................        100.0         100.0          100.0         100.0        100.0

Cost of revenues:
 Product...........................................         31.0          30.8           30.8          31.1         31.6
 Service...........................................          8.9           8.0            5.9           4.8          4.1
                                                        --------      --------       --------       -------      -------
  Total cost of revenues...........................         39.9          38.8           36.7          35.9         35.6
                                                        --------      --------       --------       -------      -------
Gross margin.......................................         60.1          61.2           63.3          64.1         64.4

Operating expenses:
 Sales and marketing...............................         43.9          47.8           34.3          33.9         43.4
 Research and development..........................         27.1          30.8           23.6          19.8         23.7
 General and administrative........................         10.7          10.9            9.5           9.9          9.1
 Stock-based compensation..........................         14.5          26.5           38.9           1.1          1.7
 Amortization of goodwill, purchased technology
  and other intangible assets acquired.............         15.6          15.9           35.7           2.1          2.7
 Restructuring charges.............................         16.6           0.0            0.0           0.0          0.0
                                                        --------      --------       --------       -------      -------
  Total operating expenses.........................        128.3         131.9          142.1          66.9         80.6
                                                        --------      --------       --------       -------      -------
Operating loss.....................................        (68.2)        (70.7)         (78.8)         (2.8)       (16.2)
Interest income, net...............................          9.3           9.9           10.0          10.5         13.5
                                                        --------      --------       --------       -------      -------
Income (loss) before income taxes..................        (58.9)        (60.8)         (68.8)          7.7         (2.8)
Provision for income taxes.........................          0.5           0.5            1.1           0.0          0.0
                                                        --------      --------       --------       -------      -------
Net income (loss)..................................        (59.4)%       (61.3)%        (69.9)%         7.7 %       (2.8)%
                                                        ========      ========       ========       =======      =======
</TABLE>

   As discussed above, we believe that global economic challenges and
constrained corporate information technology spending have slowed the demand for
our products and services. Like most companies in the technology sector, we
experienced a downturn in revenues from the fourth quarter of 2000 to the second
quarter of 2001. Revenues for the first and second quarters of 2001 were $17.1
million and $17.5 million, respectively, and were significantly lower than
revenues of $19.9 million which were recorded for the fourth quarter of 2000.
However, during the second quarter of 2001 we were able to improve revenues
slightly. Both revenues and our quarterly operating results for 2001 were
negatively impacted by the economic slowdown worldwide and an overall reduction
in capital spending. Revenue levels in future quarters are difficult to predict
given the current business climate, however, and may be more variable than
usual.

   Our product gross margins have decreased slightly over the past year.  Gross
margins in the first six months of 2001 were negatively impacted by promotional
programs on certain existing Firebox products established to facilitate the
introduction of several new products during the six months ended June 30, 2001.
Gross margins were also negatively impacted by lower sales volumes and our sales
product mix, in which lower-margin products comprised a greater percentage of
overall revenues.  In addition, competitive selling pressures in future quarters
could adversely impact on our gross margins.  Finally, we have continued to make
significant investments in our customer support organization, leading to an
overall increase in the cost of service revenues.  While these investments had a
negative short-term impact on our gross margins during recent quarters, we
believe they are required to meet the needs of our expanding customer base, and
that service margins will improve as our LiveSecurity subscription base expands.

                                    Page 19
<PAGE>

   We also have continued to make investments in our sales and marketing
organization, as reflected in the increased expenditure levels during the first
six months of 2001. In addition, our second quarter 2001 operating expenses
included significant restructuring charges associated with our restructuring
plan. Other significant increases in operating expenses during the first six
months of 2001, including research and development, stock-based compensation,
and the amortization of intangibles, were primarily related to our acquisition
of Qiave in October 2000. While our operating expenses, excluding amortization
of goodwill, intangibles and stock-based compensation, and restructuring charges
continued to increase in dollar amounts through the first quarter of 2001, we
did reduce these expenses by approximately $1.0 million in the second quarter of
2001 as compared to the first quarter of 2001. These expenses also continued to
decrease as a percentage of total revenues until the fourth quarter of 2000.
Increased operating expenses as a percentage of total revenues during the first
and second quarters of 2001, compared to previous quarters, resulted from the
lower revenues discussed above.

   In light of the current economic slowdown and the uncertainty of market
conditions, we have implemented programs to increase efficiencies and reduce
costs within all areas of our organization, in an effort to better align our
expenses with near-term revenue projections.  These programs include the
reduction in workforce discussed earlier, as well as a consolidation of excess
facilities and related fixed asset charges.   Our quarterly operating results
have fluctuated significantly in the past and will probably continue to
fluctuate.

Liquidity and Capital Resources

   We have financed our operations primarily through proceeds from private
placements of preferred stock and, more recently, proceeds from our initial
public offering in July 1999 and our follow-on public offering in February 2000.
To date, net proceeds from our private placements and public offerings have
totaled approximately $144.0 million.

  As of June 30, 2001, we had $114.1 million in cash, cash equivalents and
securities available for sale, invested primarily in high-quality money market
accounts and marketable securities.  We believe that the market risk arising
from our holdings of these financial instruments is not material. We currently
have outstanding a $3.0 million unconditional letter of credit we issued in
September 2000 to our landlord in conjunction with our building lease for our
corporate headquarters.  Currently, our letter of credit is collateralized by
investments with our bank.  Our working capital as of June 30, 2001 was $110.8
million.

  Operating activities

  Our operating activities resulted in net cash outflows of $4.0 million in the
six months ended June 30, 2000 and $1.6 million in the three months ended June
30, 2001.  The operating cash outflows during these periods resulted primarily
from significant investments in sales and marketing and research and
development, all of which led to operating losses.  Cash used in operating
activities was net of non-cash charges totaling $2.9 million for the three
months ended June 30, 2000 and $16.8 million for the six months ended June 30,
2001.  These non-cash charges were primarily associated with the amortization of
goodwill and other intangibles, depreciation and amortization of capital assets,
provisions for bad debts and sales returns and allowances, and compensation
charges resulting from the issuance of stock options and common stock subject to
repurchase by WatchGuard.  Cash utilized by working capital components for
operating activities was $3.8 million for the six months ended June 30, 2000 and
cash provided by working capital components for operating activities was $2.6
million for the six months ended June 30, 2001.   In the six-month period ended
June 30, 2001, there were large fluctuations within some major working capital
components, as described below:

  (a) Net receivables decreased from $15.3 million at December 31, 2000 to $13.4
      million at June 30, 2001, reflecting the decrease in revenues from $19.9
      million for the three months ended December 31, 2000 to $17.5 million for
      the three months ended June 30, 2001. Days sales outstanding, or DSOs,
      were 69 days at both December 31, 2000 and June 30, 2001, calculated on a
      quarterly basis. DSOs are impacted by the payment terms contained in our
      customer contracts, risks associated with the uncertain economy, linearity
      in revenues in any particular quarter and the amount of deferred revenue
      contained in the receivable balance that has not been recognized as
      revenue. Based on the current sales mix, the resulting timing differences
      arising from varying payment terms in our customer agreements, the
      linearity of revenues in any particular quarter and the growth of deferred
      revenue, we expect our DSOs to generally range from 55 days to 70 days.
      However, any change in these factors could negatively impact expected DSO
      results.

                                    Page 20
<PAGE>

  (b) Sales reserves for returns and allowance reserves were $965,000 at
      December 31, 2000 and $1.7 million at June 30, 2001, reflecting our
      estimate of returns and allowances associated with the return rights and
      price protection rights of some of our customers. We increased the sales
      reserve during the six months ended June 30, 2001 to reflect the potential
      for increased returns and pricing adjustments associated with new products
      introduced in the second quarter of 2001. The reserve will continue to
      fluctuate from time to time depending on the timing of product
      introductions and pricing program changes.

  (c) Net inventories decreased from $7.0 million at December 31, 2000 to $5.1
      million at June 30, 2001. The overall decrease reflects consumption of
      Firebox component inventory to support promotional programs on certain
      existing Firebox products. These promotional programs were established to
      facilitate the introduction of several new products during the six months
      ended June 30, 2001. We maintain a reserve for inventory obsolescence and
      will continue to analyze the adequacy of our reserves on a periodic basis.

  (d) Prepaid expenses and other receivables increased from $3.2 million at
      December 31, 2000 to $4.2 million at June 30, 2001, primarily due to an
      increase in prepaid product royalty costs and deposits with suppliers for
      future inventory purchases.

  (e) Accounts payable and accrued expenses decreased from $11.7 million at
      December 31, 2000 to $11.0 million at June 30, 2001.  This decrease
      resulted primarily from the timing of inventory purchases and other
      expenditures during the fourth quarter of 2000 as compared to the period
      ended June 30, 2001.

  (f) Deferred revenue increased from $11.9 million at December 31, 2000 to
      $14.9 million at June 30, 2001, an increase of 26%. This increase reflects
      the deferral of revenue from bundled LiveSecurity subscriptions included
      in new product revenues and renewals of LiveSecurity subscriptions from a
      growing customer base.

  Investing activities

  Cash used in investing activities was $84.5 million in the six months ended
June 30, 2000 and cash provided by investing activities was $8.3 million in the
six months ended June 30, 2001.  These activities primarily relate to short-term
investing activity of the proceeds received from our public offerings, and
capital expenditures for equipment and furniture.

  Financing activities

  Cash provided by financing activities totaled $92.2 million in the six months
ended June 30, 2000 and $1.3 million in the six months ended June 30, 2001.  We
received $90.4 million in proceeds from a public offering in the first quarter
of 2000.   We received cash in both periods from the exercise of employee stock
options and the purchase of common stock through our employee stock purchase
plan.

  We believe that existing cash and securities balances will be sufficient to
meet our anticipated cash needs for working capital, capital expenditures and
potential acquisitions or technology investments for at least the next 12
months. However, if the underlying assumed levels of spending for the potential
acquisition of or investment in complementary businesses or technologies prove
to be inaccurate, we may need to seek additional funding before that time
through public or private financings or other arrangements.

                                    Page 21
<PAGE>

Unaudited Pro Forma Operating Results

   Our management reviews our operating results on a pro forma basis in making
operating decisions, and we believe pro forma results provide additional
meaningful information.  The following table provides our pro forma results for
the three and six month periods ended June 30, 2000 and 2001.

<TABLE>
<CAPTION>
                                                           Three Months Ended June 30,     Six Months Ended June 30,
                                                          ----------------------------    ----------------------------
                                                               2001           2000            2001            2000
                                                          ------------    ------------    ------------    ------------
<S>                                                       <C>             <C>             <C>              <C>
Net loss...............................................   $    (10,402)   $       (378)   $    (20,882)   $     (3,074)
Adjustments to reconcile net loss in the financial
 statements to pro forma net income (loss):
       Stock-based compensation........................          2,546             228           7,066             464
       Amortization of goodwill, purchased technology
        and other intangibles assets acquired..........          2,724             368           5,448             736

       Restructuring charges...........................          2,900              --           2,900              --
                                                          ------------    ------------    ------------    ------------
Pro forma net income (loss)............................   $     (2,232)   $        218    $     (5,468)   $     (1,874)
                                                          ============    ============    ============    ============
 Pro forma net income (loss) per share:
     Basic.............................................   $      (0.08)   $       0.01    $      (0.21)   $      (0.08)
                                                          ============    ============    ============    ============
     Diluted...........................................   $      (0.08)   $       0.01    $      (0.21)   $      (0.08)
                                                          ============    ============    ============    ============
 Shares used in computation of pro forma net income
  (loss) per share:
     Basic.............................................         26,673          23,160          26,467          22,223
                                                          ============    ============    ============    ============
     Diluted...........................................         26,673          27,446          26,467          22,223
                                                          ============    ============    ============    ============
</TABLE>

____________________

Pro forma information is presented for informational purposes only and is not
prepared in accordance with generally accepted accounting principles.  Pro forma
results exclude:

  . the amortization of goodwill, purchased technology and other intangibles
    arising from WatchGuard's acquisition of BeadleNet, LLC in October 1999 and
    Qiave Technologies Corporation in October 2000; and

  . non-cash stock-based compensation expenses originating from employee stock
    options granted at less than fair value, stock options granted to
    consultants and certain restricted common stock and common stock subject to
    repurchase issued in connection with the BeadleNet, LLC and Qiave
    Technologies Corporation acquisitions; and

  . restructuring charges.

                                    Page 22
<PAGE>

FACTORS AFFECTING OUR OPERATING RESULTS, OUR BUSINESS AND OUR STOCK PRICE

  In addition to the other information contained in this quarterly report, you
should carefully read and consider the following risk factors. If any of these
risks actually occur, our business, financial condition or operating results
could be harmed and the trading price of our common stock could decline.

We have incurred losses in the past and may not achieve or sustain consistent
profitability, which could result in a decline in the value of our common stock.

   Since inception through the second quarter of 2001, we have incurred net
losses and experienced negative cash flows from operations in each quarter,
except for the third quarter of 2000. As of June 30, 2001, we had an accumulated
deficit of approximately $66.5 million. Although our revenues have increased
each year since we began operations, we do not believe that the historical
percentage growth rate of our revenues will be sustainable as our revenue base
increases and we may not achieve or sustain profitability in future periods.
While we introduced certain cost-saving measures in the second quarter of 2001
in response to the current economic downturn we expect that over time we will
have to increase our operating expenses in connection with

  . expanding into new product markets;

  . continuing to develop our technology;

  . expanding into new geographic markets;

  . hiring additional personnel;

  . upgrading our information and internal control systems; and

  . integrating acquisitions of businesses, products and technologies and
    pursuing additional strategic acquisitions.

If we are unable to achieve or sustain profitability in future quarters, the
trading price of our common stock could decline.

Our operating results fluctuate and could fall below expectations of securities
analysts and investors, resulting in a decline in our stock price.

   Our quarterly and yearly operating results have varied widely in the past and
will probably continue to fluctuate. For this reason, we believe that period-
to-period comparisons of our operating results may not be meaningful. In
addition, our limited operating history makes predicting our future performance
difficult. In the fourth quarter of 2000 and the first quarter of 2001, our
operating results fell below the expectations of securities analysts and
investors and our operating results for a future quarter or year may again fail
to meet market expectations. This could result in a decline in our stock price.

   Beginning late in the fourth quarter of 2000 and continuing through the
second quarter of 2001, we saw a general economic downturn in the U.S. economy,
and more recently, the worldwide economy, which has affected the demand for our
products and services. We do not know how long this economic downturn will last
or how severe it will become. We also cannot predict the extent of the impact of
the economic downturn in the United States on economies in other countries and
geographic regions in which we conduct business. To the extent that this
downturn continues or spreads to other geographic regions, the Internet security
industry and demand for our products and services are likely to be adversely
affected and could result in a decline in our stock price.

   We base our spending levels for product development, sales and marketing and
other operating expenses largely on our expected future revenues. Because our
expenses are largely fixed for a particular quarter or year, we may be unable to
adjust our spending in time to compensate for any unexpected quarterly or annual
shortfall in revenues. A failure to so adjust our spending in time also could
cause operating results to fall below the expectations of securities analysts
and investors, resulting in a decline in our stock price.

Because many potential customers remain unaware of the need for Internet
security or may perceive it as costly and difficult to implement, our products
and services may not achieve market acceptance.

   We believe that many potential customers, particularly SMEs, are not fully
aware of the need for Internet security products and services, particularly
those products designed for server content and application security.
Historically, only

                                    Page 23
<PAGE>

enterprises having substantial resources have developed or purchased Internet
security solutions. Also, there is a perception that Internet security is costly
and difficult to implement. We will therefore not succeed unless the market
understands the need for Internet security and we can convince our potential
customers of our ability to provide this security in a cost-effective and
administratively feasible manner. Although we have spent, and will continue to
spend, considerable resources educating potential customers about the need for
Internet security and the benefits of our products and services, our efforts may
be unsuccessful.

If potential customers do not accept our Firebox and ServerLock  products and
related LiveSecurity services, our business will not succeed.

   We currently expect all future revenues to be generated through sales of our
Firebox and ServerLock products and related LiveSecurity services, including
subscription fees, and we cannot succeed if the market does not accept these
products and services. Our success depends on our ability and the ability of our
distribution network, which includes distributors, value-added resellers and
ISPs and other managed service providers, to obtain and retain customers. Some
of our Firebox products and related LiveSecurity services, and all of our
ServerLock products, however, are relatively new and unproven. The broadcast
portion of our LiveSecurity solution has been available only since February 1999
and our ServerLock products were launched under the WatchGuard brand only in
February 2001. To receive our LiveSecurity Service, enterprises will be required
to pay an annual subscription fee, either to us or, if they obtain the
LiveSecurity Service through one of our channel customers, to the channel
partner. We are not aware of any other Internet security product that allows
enterprises to keep their security solution current by receiving software
updates and comprehensive security information over the Internet. Enterprises
may be unwilling to pay a subscription fee to keep their Internet security up to
date. Because our LiveSecurity Service is relatively new, we cannot accurately
predict the rate at which our customers will renew their annual subscriptions.
In addition, most businesses implementing security services have traditionally
managed their own Internet security rather than using the services of third-
party service providers. As a result, our products and services and the
outsourcing of Internet security to third parties may not achieve significant
market acceptance.

Seasonality and concentration of revenues at the end of the quarter could cause
our revenues to fall below the expectations of securities analysts and
investors, resulting in a decline in our stock price.

   The growth rate of our domestic and international sales has been and may
continue to be lower in the summer months, when businesses often defer
purchasing decisions. Also, as a result of customer buying patterns and the
efforts of our sales force to meet or exceed quarterly and year-end quotas,
historically we have received a substantial portion of a quarter's sales orders
and earned a substantial portion of a quarter's revenues during its last month
and, more recently, in the latter half of the last month. If expected revenues
at the end of any quarter are delayed, our revenues for that quarter could fall
below the expectations of securities analysts and investors, resulting in a
decline in our stock price.

The integration of Qiave and any future acquisitions may be costly, difficult
and disruptive.

   In October 2000, we acquired Qiave Technologies Corporation, a privately held
provider of digital information security products. As part of our business
strategy, we may acquire other companies, products or technologies. The Qiave
acquisition, and any future acquisitions, will subject us to numerous
operational and financial risks and difficulties, including

  . loss of key personnel;

  . difficulties in assimilating the acquired company's technologies, products,
    personnel and operations;

  . disruption of our ongoing business and diversion of management attention;

  . assumption of known and unknown liabilities, higher-than-expected
    acquisition and integration costs and charges against earnings;

  . potentially dilutive issuances of equity securities; and

  . inability of our sales force, consultants and development staff to adapt to
    new product lines.

   We may be unable to successfully integrate Qiave or any future acquisition.
In addition, we may not gain any substantial benefit from the Qiave acquisition
or from any businesses, products or technologies that we acquire in the future,
notwithstanding the significant expenditure of time and financial, personnel and
other resources.

                                    Page 24
<PAGE>

If our third-party channel customers fail to perform, our ability to sell our
products and services will be limited.

   We sell most of our products and services through our distribution network,
and we expect our success to continue to depend in large part on their
performance. Our channel customers have the ability to sell products and
services that are competitive with ours, to devote more resources to those
competitive products or to cease selling our products and services altogether.
Two channel customers, Ingram Micro and Tech Data, together accounted for 25% of
our revenues for the second quarter of 2001 and 24% of our revenues for the six
months ended June 30, 2001. The loss of one of these distributors, a reduction
in their sales, a reduction in our share of their sales of internet security
products, or a loss or reduction in sales involving one or more other channel
customers, particularly if the reduction results in increased sales of
competitive products, could harm our business.

If we are unable to compete successfully in the highly competitive market for
Internet security products and services, our business will fail.

   The market for Internet security products is intensely competitive and we
expect competition to intensify in the future.  An increase in competitive
pressures in our market or our failure to compete effectively may result in
pricing reductions, reduced gross margins and loss of market share.  Currently,
the primary competitors in our industry include Cisco Systems, Inc., Check Point
Software Technologies Ltd., Nokia Corporation and SonicWALL Inc.  Other
competitors offering security products include hardware and software vendors
such as Netscreen Technologies Inc., Lucent Technologies, Inc. and Network
Associates, Inc., operating system vendors such as Microsoft Corporation,
Novell, Inc. and Sun Microsystems, Inc. and a number of smaller companies.  Many
of our competitors have longer operating histories, greater name recognition,
larger customer bases and significantly greater financial, technical, marketing
and other resources than we do.  In addition, our current and potential
competitors may establish cooperative relationships among themselves or with
third parties that may further enhance their resources.  As a result, they may
be able to adapt more quickly to new technologies and customer needs, devote
greater resources to the promotion or sale of their products and services,
initiate or withstand substantial price competition, take advantage of
acquisition or other opportunities more readily or develop and expand their
product and service offerings more quickly.  In addition, our competitors may
bundle products competitive with ours with other products that they may sell to
our current or potential customers.  These customers may accept these bundled
products rather than separately purchasing our products.

Product returns or retroactive price adjustments could exceed our allowances,
which could adversely affect our operating results.

   We provide some of our channel customers with product return rights for stock
rotation. We also provide some of our channel customers with price protection
rights for their inventories, which they may exercise if we lower our prices for
those products. We may experience significant returns and price adjustments for
which we may not have adequate allowances. The short life cycles of our products
and the difficulty of predicting future sales increase the risk that new product
introductions or price reductions by us or our competitors could result in
significant product returns or price adjustments. In September 1998, for
example, when we introduced the Firebox II security appliance, we experienced an
increase in returns of previous products and product versions.  Provisions for
returns and allowances for the years ended December 31, 1998, 1999, and 2000,
were $1.7 million, $1.1 million and $1.9 million, or 13%, 5% and 3% of total
revenues before returns and allowances.  The provision for returns and
allowances was $879,000 or 4% of total revenues before returns and allowances
for the six month period ended June 30, 2000 and $2.1 million, or 6% of total
revenues before returns and allowances, for the six month period ended June 30,
2001. This increase in the provision for the six month period ended June 30,
2001 reflects the expected return rates of current products that may originate
from the introduction of our new Firebox III family of products during the
second quarter of 2001.  While we increased our provision for returns and
allowances during the six month period ended June 30, 2001 to reflect the
potential for increased returns and pricing adjustments associated with new
products introduced in the second quarter of 2001 and products we expect to
introduce in subsequent months, the provision may still be inadequate.

Failure to address strain on our resources will result in our inability to
effectively manage our business.

   In the second quarter of 2001, we implemented a restructuring plan to
streamline operations and reduce costs and better align our infrastructure to
near-term revenue volumes.  Our current systems, management and resources will
be inadequate, however, if we once again grow. Our business has grown rapidly in
size and complexity in the past. This rapid expansion placed significant strain
on our administrative, operational and financial resources and resulted in ever-
increasing responsibilities for our management personnel. We will be unable to
effectively manage our business if we are unable to timely and successfully
alleviate the strain on our resources caused by rapid growth.

                                    Page 25
<PAGE>

We may be unable to adequately expand our operational systems to accommodate
growth, which could harm our ability to deliver our products and services.

   Our operational systems have not been tested at the customer volumes that may
be required in the future. We may encounter performance difficulties when
operating with a substantially greater number of customers. In implementing our
LiveSecurity products and services, we have experienced periodic interruptions
affecting all or a portion of our systems, and we believe that interruptions
will continue to occur from time to time. These interruptions could harm our
ability to deliver our products and services. An inability to add software and
hardware or to develop and upgrade existing technology or operational systems to
handle increased traffic may cause unanticipated system disruptions, slower
response times and poor customer service, including problems filling customer
orders.

Rapid changes in technology and industry standards could render our products and
services unmarketable or obsolete, and we may be unable to introduce new
products and services timely and successfully.

   To succeed, we must continually change and improve our products in response
to rapid technological developments and changes in operating systems, Internet
access and communications, application and networking software, computer and
communications hardware, programming tools, computer language technology and
hacker techniques. We may be unable to successfully and timely develop these new
products and services or achieve and maintain market acceptance. The development
of new, technologically advanced products and services is a complex and
uncertain process requiring great innovation and the ability to anticipate
technological and market trends. Because Internet security technology is
complex, it can require long development and testing periods. Releasing new
products and services prematurely may result in quality problems, and releasing
them late may result in loss of customer confidence and market share. In the
past, we have on occasion experienced delays in the scheduled introduction of
new and enhanced products and services, and we may experience delays in the
future. When we do introduce new or enhanced products and services, we may be
unable to manage the transition from the older products and services to minimize
disruption in customer ordering patterns, avoid excessive inventories of older
products and deliver enough new products and services to meet customer demand.

We may be required to defend lawsuits or pay damages in connection with the
alleged or actual failure of our products and services.

   Because our products and services provide and monitor Internet security and
may protect valuable information, we may face claims for product liability, tort
or breach of warranty relating to our products and services. Anyone who
circumvents our security measures could misappropriate the confidential
information or other property of end-users using our products and services or
interrupt their operations. If that happens, affected end-users or channel
customers may sue us. In addition, we may face liability for breaches caused by
faulty installation and implementation of our products by end-users or channel
customers. Although we attempt to reduce the risk of losses from claims through
contractual warranty disclaimers and liability limitations, these provisions may
be unenforceable. Some courts, for example, have found contractual limitations
of liability in standard software licenses to be unenforceable because the
licensee does not sign them. Defending a suit, regardless of its merit, could be
costly and could divert management attention. Although we currently maintain
business liability insurance, this coverage may be inadequate or may be
unavailable in the future on acceptable terms, if at all.

A breach of security could harm public perception of our products and services.

   We will not succeed unless the marketplace is confident that we provide
effective Internet security protection. Even networks protected by our software
products may be vulnerable to electronic break-ins and computer viruses. If an
actual or perceived breach of Internet security occurs in an end-user's systems,
regardless of whether the breach is attributable to us, the market perception of
the efficacy of our products and services could be harmed. This could cause us
or our channel customers to lose current and potential customers or cause us to
lose potential channel customers. Because the techniques used by computer
hackers to access or sabotage networks change frequently and generally are not
recognized until launched against a target, we may be unable to anticipate these
techniques.

If we are unable to prevent attacks on our internal network system by computer
hackers, public perception of our products and services will be harmed.

   Because we provide Internet security, we are a significant target of computer
hackers. We have experienced attacks by computer hackers in the past and expect
attacks to continue. If attacks on our internal network system are successful,
public perception of our products and services will be harmed.

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<PAGE>

We may be unable to adequately protect our operational systems from damage,
failure or interruption, which could harm our reputation and our ability to
attract and retain customers.

   Our operations, customer service, reputation and ability to attract and
retain customers depend on the uninterrupted operation of our operational
systems. Although we utilize limited off-site backup facilities and take other
precautions to prevent damage, failure or interruption of our systems, our
precautions may be inadequate. Any damage, failure or interruption of our
computer or communications systems could lead to service interruptions, delays,
loss of data and inability to accept and fill customer orders and provide
customers with the LiveSecurity Service.

We may be unable to deliver our products and services if we cannot continue to
license third-party technology that is important for the functionality of our
products.

   Our success will depend in part on our continued ability to license
technology that is important for the functionality of our products. A
significant interruption in the supply of a third-party technology could delay
our development and sales until we can find, license and integrate equivalent
technology. This could damage our brand and result in loss of current and
potential customers. Although we believe that we could find other sources for
the technology we license, alternative technologies may be unavailable on
acceptable terms, if at all. We depend on our third-party licensors to deliver
reliable, high-quality products, develop new products on a timely and cost-
effective basis and respond to evolving technology and changes in industry
standards. We also depend on the continued compatibility of our third-party
software with future versions of our products.

We may be unable to deliver our products and services if component manufacturers
fail to supply component parts with acceptable quantity, quality and cost.

   We obtain the component parts for our hardware from a variety of
manufacturers. While our component vendors have produced parts for us in
acceptable quantities and with acceptable quality and cost in the past, they may
be unable to do so in the future. Companies in the electronics industry
regularly experience lower-than-required component allocations, and the industry
is subject to frequent component shortfalls. Although we believe that we could
find additional or replacement sources for our hardware components, our
operations could be disrupted if we have to add or switch to a replacement
vendor or if our component supply is interrupted for an extended period. This
could result in loss of customer orders and revenue.


We may be unable to adequately protect our proprietary rights, which may limit
our ability to compete effectively.

   Despite our efforts to protect our proprietary rights, unauthorized parties
may misappropriate or infringe on our trade secrets, copyrights, trademarks,
service marks and similar proprietary rights. We face additional risk when
conducting business in countries that have poorly developed or inadequately
enforced intellectual property laws. While we are unable to determine the extent
to which piracy of our software products exists, we expect piracy to be a
continuing concern, particularly in international markets and as a result of the
growing use of the Internet.

   If we fail to obtain and maintain patent protection for our technology, we
may be unable to compete effectively. We have 12 patents pending, but our patent
applications may not result in issued patents. Even if we secure a patent, the
patent may not provide meaningful protection. In addition, we rely on unpatented
proprietary technology. Because this proprietary technology does not have patent
protection, we may be unable to meaningfully protect this technology from
unauthorized use or misappropriation by a third party. In addition, our
competitors may independently develop similar or superior technologies or
duplicate any unpatented technologies that we have developed, which could
significantly reduce the value of our proprietary technology or threaten our
market position.

Intellectual property claims and litigation could subject us to significant
liability for damages and invalidation of our proprietary rights.

   In the future, we may have to resort to litigation to protect our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of the proprietary rights of others. Any litigation,
regardless of its success, would probably be costly and require significant time
and attention of our key management and technical personnel. Litigation could
also force us to

  . stop or delay selling, incorporating or using products that incorporate the
    challenged intellectual property;

  . pay damages;

  . enter into licensing or royalty agreements, which may be unavailable on
    acceptable terms; or

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<PAGE>

  . redesign products or services that incorporate infringing technology.

Although we have not been sued for intellectual property infringement, we may
face infringement claims from third parties in the future. The software industry
has seen frequent litigation over intellectual property rights, and we expect
that participants in the Internet security industry will be increasingly subject
to infringement claims as the number of products, services and competitors grows
and functionality of products and services overlaps.

Undetected product errors or defects could result in loss of revenues, delayed
market acceptance and claims against us.

   Our products and services may contain undetected errors or defects,
especially when first released. Despite extensive testing, some errors are
discovered only after a product has been installed and used by customers. Any
errors discovered after commercial release could result in loss of revenues or
claims against us or our channel customers.

Governmental controls over the export or import of encryption technology could
cause us to lose sales.

   Any additional governmental regulation of imports or exports or failure to
obtain required export approval of our encryption technologies could adversely
affect our international and domestic sales. The United States and various other
countries have imposed controls, export license requirements and restrictions on
the import or export of some technologies, especially encryption technology. In
addition, from time to time governmental agencies have proposed additional
regulation of encryption technology, such as requiring the escrow and
governmental recovery of private encryption keys. Additional regulation of
encryption technology could delay or prevent the acceptance and use of
encryption products and public networks for secure communications. This, in
turn, could result in decreased demand for our products and services.
In addition, some foreign competitors are subject to less stringent controls on
exporting their encryption technologies. As a result, they may be able to
compete more effectively than we can in the U.S. and international Internet
security markets.

If we do not retain our key employees, our ability to execute our business
strategy will be impaired.

   Our future success will depend largely on the efforts and abilities of our
senior management and our key development, technical, operations, information
systems, customer support and sales and marketing personnel, and on our ability
to retain them. These employees are not obligated to continue their employment
with us and may leave us at any time.

If we do not expand our international operations and successfully overcome the
risks inherent in international business activities, the growth of our business
will be limited.

   Our ability to grow will depend in part on the expansion of our international
sales and operations, which are expected to continue to account for a
significant portion of our revenues. Sales to customers outside of the United
States accounted for approximately 35% of our revenues in 1998, 50% in 1999, 55%
in 2000, and 57% for the six months ended June 30, 2001. The failure of our
channel customers to sell our products internationally would limit our ability
to increase our revenues. In addition, our international sales are subject to
the risks inherent in international business activities, including

  . cost of customizing products for foreign countries;

  . export and import restrictions, such as those affecting encryption
    commodities and software or those requiring local content;

  . difficulties in acquiring and authenticating customer information;

  . reduced protection of intellectual property rights and increased liability
    exposure; and

  . regional economic and political conditions.

   Our international sales currently are U.S. dollar-denominated. As a result,
an increase in the value of the U.S. dollar relative to foreign currencies has
made and may continue to make our products less competitive in international
markets.

We may need additional capital and our ability to secure additional funding is
uncertain.

   Our future revenues may be insufficient to support the expenses of our
operations and the expansion of our business. We may therefore need additional
equity or debt capital. We may seek additional funding through

  . public or private equity financings, which could result in significant
    dilution to stockholders;

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<PAGE>

  . public or private debt financings; and

  . capital lease transactions.

We believe that existing cash and cash equivalent balances will be sufficient to
meet our capital required for at least the next 12 months. Our capital
requirements will depend on several factors, however, including

  . the rate of market acceptance of our products and services;

  . our ability to expand our customer base;

  . the growth of our sales and marketing capabilities; and

  . the cost of any acquisitions we may complete.

Financing may be unavailable to us when needed or on acceptable terms.

Our stock price is volatile.

   The trading price of our common stock could be subject to fluctuations for a
number of reasons, including

  . actual or anticipated variations in quarterly or annual operating results;

  . changes in analysts' earnings projections or recommendations;

  . failure to meet analysts' revenue or earnings projections;

  . our inability to successfully implement our business strategy;

  . changes in business conditions affecting our customers, our competitors and
    us; and

  . changes in accounting standards that adversely affect our revenues and
    earnings.

   In recent years, moreover, the stock market in general and the market for
Internet-related technology companies in particular have experienced extreme
price and volume fluctuations, often unrelated to the operating performance of
the affected companies. Our common stock has experienced, and is likely to
continue to experience, these fluctuations in price, regardless of our
performance.

Changes in or interpretations of accounting rules may adversely impact future
and past results of operations.

   We prepare our financial statements in conformity with accounting principles
generally accepted in the United States. These principles have changed
frequently and are subject to ongoing change and interpretation by the Financial
Accounting Standards Board, the Securities and Exchange Commission and other
agencies and organizations. A change in generally accepted accounting principles
could significantly affect our reported results of operations or the reporting
of transactions completed before a change is announced, which could require us
to restate our prior published financial statements. Accounting standards that
impact the technology and software sectors in which we operate and that are
currently under review include:

  . rules relating to revenue recognition, including rules affecting the
    recognition of revenue from the sale of software or related services;

  . rules relating to the classification of cost related to marketing programs,
    which may impact sales discounts, cost of sales or marketing expenses. As an
    example, in April 2001 the Emerging Issues Task Force reached a consensus on
    EITF Issue No. 00-25 "Vender Income Statement Characterization of
    Consideration from a Vendor to a Retailer." Under EITF Issue No. 00-25,
    consideration from a vendor to a retailer is presumed to be a reduction in
    the selling price of a vendor's products, and therefore should be
    characterized as a reduction of revenue by the Vendor. This presumption can
    be overcome, and the consideration characterized as a cost incurred if, and
    to the extent that both: the vendor receives an identifiable benefit from
    the retailer in return for consideration sufficiently separable from the
    arrangement with the vendor; and the vendor has sufficient, objective, and
    reliable evidence to estimate the fair value of the benefit. EITF Issue No.
    00-25 is effective for quarters beginning after December 15, 2001. Upon
    application of the consensus, if applicable, financial statement for prior
    periods presented for comparative purposes must be reclassified to comply
    with the new requirements. WatchGuard is currently analyzing certain of
    its marketing programs with distributors to determine the effect, if any, of
    the consensus on its revenues and expenses.

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<PAGE>

  . accounting for goodwill. In July 2001 The Financial Accounting Standards
    Board (FASB) issued SFAS No. 142, "Goodwill and Other Intangible Assets."
    SFAS No. 142 requires that goodwill and other indefinite lived intangibles
    no longer be amortized to earnings, but instead be reviewed for impairment
    and written down and charged to earnings only in the periods in which the
    recorded value of goodwill is more than its fair value. Separatable
    intangible assets that do not have indefinite lives will continue to be
    amortized over their useful lives. The provisions of this statement will be
    adopted by WatchGuard on January 1, 2002. We expect the adoption of SFAS No.
    142 to have the impact of reducing our amortization of goodwill commencing
    January 1, 2002, however, impairment reviews may result in future periodic
    write-downs of goodwill.

  . accounting for stock-based compensation for employees and nonemployees.

   Any changes to these accounting principles or the way they are interpreted or
applied could significantly affect our reported financial results or the way in
which we conduct business.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   Interest Rate Risk

   We do not hold derivative financial instruments or derivative equity
securities in our investment portfolio.  Our cash equivalents and debt
securities available for sale consist of high-quality securities, as specified
in our investment policy guidelines.  Our policy limits the amount of credit
exposure to any one issue or issuer to a maximum of 20% of the total portfolio
or $5 million per issuer, with the exception of treasury securities and money
market funds, which are exempt from this size limitation.  Our policy limits all
investments to those that mature in two years or less, and our investments have
an average maturity of one year or less.  These securities are subject to
interest-rate risk and will decrease in value if interest rates increase.  The
fair value of our investment portfolio or related income would not be
significantly impacted by a 100-basis-point increase or decrease in interest
rates, due primarily to the short-term nature of most of our investment
portfolio.

   Foreign Currency Risk

   All of our sales and the majority of our expenses are currently denominated
in U.S. dollars.  As a result, we have not experienced significant foreign
exchange gains and losses.  While we conducted some transactions in foreign
currencies during the second quarter of 2001 and expect to continue to do so in
the future, we do not anticipate that foreign exchange gains or losses will be
material to WatchGuard.  Although we have not engaged in foreign currency
hedging to date, we may do so in the future.

                                    Page 30
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                          PART II.  OTHER INFORMATION

ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS

(d)  Use of Proceeds
     ---------------

     On February 15, 2000 our registration statement on Form S-1 for our public
offering, file number 333-95049, became effective.  The offering terminated as a
result of all of the shares offered being sold.  After accounting for
approximately $5.3 million in underwriting discounts and commissions and
$600,000 in other expenses, we received proceeds of approximately $90.4 million.


ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

(a)  Exhibits
     --------

       3.1     Restated Certificate of Incorporation of WatchGuard Technologies,
               Inc. (incorporated by reference to Exhibit 3.1 to WatchGuard's
               Registration Statement on Form S-1 (file number 333-78813), filed
               July 30, 1999).

       3.2     Restated Bylaws of WatchGuard Technologies, Inc. (incorporated by
               reference to Exhibit 3.2 to WatchGuard's Registration Statement
               on Form S-1 (file number 333-78813), filed July 30, 1999).

      10.1     Employment Agreement between Jim Cady and WatchGuard
               Technologies, Inc., dated July 1, 2001.

(b)  Reports on Form 8-K
     -------------------

     No reports on Form 8-K were filed during the quarter ended June 30, 2001.

                                    Page 31
<PAGE>

                                   SIGNATURES

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.


August 13, 2001
                                           WATCHGUARD TECHNOLOGIES, INC


                                           By: /s/ Michael E. McConnell
                                               ------------------------
                                               Michael E. McConnell

                                               Senior Vice President, Chief
                                                Financial Officer and Treasurer
                                                (Principal Financial and
                                                Accounting Officer)





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