##### Table of Contents

---

UNITED STATES

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 June 30, 2006

Commission File Number 000-26819

WATCHGUARD TECHNOLOGIES, INC.

(Exact Name of Registrant as Specified in Its Charter)



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

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 ̈

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of
accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act (Check one).

Large accelerated
filer ̈Accelerated
filer   x                 Non-accelerated filer ̈

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

34,785,394 shares of WatchGuard common stock were outstanding as of July 31, 2006.



---



1



---

##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2006

TABLE OF CONTENTS



|                                                                                              |  |   
|--------------------------------------------------------------------------------------------- |  | --
|PART I. FINANCIAL INFORMATION                                                                 |  |   
|                                                                                              | 
|ITEM 1.
CONSOLIDATED FINANCIAL STATEMENTS                                                     |  | 3 
|                                                                                              | 
|ITEM 2.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS |  | 14
|                                                                                              | 
|ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  | 27
|                                                                                              | 
|ITEM 4.
CONTROLS AND PROCEDURES                                                               |  | 27
|                                                                                              | 
|PART II. OTHER INFORMATION                                                                    |  |   
|                                                                                              | 
|ITEM 1.
LEGAL PROCEEDINGS                                                                     |  | 27
|                                                                                              | 
|ITEM 1A.
RISK FACTORS                                                                         |  | 28
|                                                                                              | 
|ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                   |  | 38
|                                                                                              | 
|ITEM 6.
EXHIBITS                                                                              |  | 38



2



---

##### Table of Contents

PART I. FINANCIAL INFORMATION



|ITEM1. | CONSOLIDATED FINANCIAL STATEMENTS
|------ | ---------------------------------

WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)



|                                                                                                                                                 |  |                  |          |   |              |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------ |  | ---------------- | -------- | - | ------------ | - | -------- | -
|                                                                                                                                                 |  | December 31,2005 |          |   | June 30,2006 |  
|                                                                                                                                                 |  |                  |          |   | (unaudited)  |  
|ASSETS                                                                                                                                           |  |                  |          |   |              |   |          |  
|Current assets:                                                                                                                                  |  |                  |          |   |              |   |          |  
|Cash and cash equivalents                                                                                                                        |  | $                | 20,390   |   |              | $ | 22,298   |  
|Short-term available-for-sale investments                                                                                                        |  |                  | 54,379   |   |              |   | 48,375   |  
|Trade accounts receivable, net                                                                                                                   |  |                  | 4,883    |   |              |   | 3,173    |  
|Inventories, net                                                                                                                                 |  |                  | 4,093    |   |              |   | 4,532    |  
|Prepaid expenses and other current assets                                                                                                        |  |                  | 2,442    |   |              |   | 2,728    |  
|Short-term restricted cash                                                                                                                       |  |                  | 1,200    |   |              |   | 600      |  
|                                                                                                                                                 |  |                  |          |   |              |   |          |  
|Total current assets                                                                                                                             |  |                  | 87,387   |   |              |   | 81,706   |  
|Property and equipment, net                                                                                                                      |  |                  | 6,197    |   |              |   | 5,986    |  
|Long-term restricted cash                                                                                                                        |  |                  | 1,800    |   |              |   | 1,800    |  
|Long-term available-for-sale investments                                                                                                         |  |                  |         |   |              |   | 2,279    |  
|Goodwill                                                                                                                                         |  |                  | 66,605   |   |              |   | 66,605   |  
|Other intangibles, net, and other non-current assets                                                                                             |  |                  | 1,735    |   |              |   | 1,202    |  
|                                                                                                                                                 |  |                  |          |   |              |   |          |  
|Total assets                                                                                                                                     |  | $                | 163,724  |   |              | $ | 159,578  |  
|                                                                                                                                                 |  |                  |          |   |              |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                             |  |                  |          |   |              |   |          |  
|Current liabilities:                                                                                                                             |  |                  |          |   |              |   |          |  
|Accounts payable                                                                                                                                 |  | $                | 4,654    |   |              | $ | 2,340    |  
|Accrued expenses and other liabilities                                                                                                           |  |                  | 6,985    |   |              |   | 7,035    |  
|Short-term accrued restructuring costs                                                                                                           |  |                  | 1,119    |   |              |   | 1,029    |  
|Short-term deferred revenues                                                                                                                     |  |                  | 18,278   |   |              |   | 19,966   |  
|                                                                                                                                                 |  |                  |          |   |              |   |          |  
|Total current liabilities                                                                                                                        |  |                  | 31,036   |   |              |   | 30,370   |  
|Long-term deferred rent                                                                                                                          |  |                  | 1,302    |   |              |   | 1,162    |  
|Long-term accrued restructuring costs                                                                                                            |  |                  | 2,756    |   |              |   | 2,390    |  
|Long-term deferred revenues                                                                                                                      |  |                  | 2,163    |   |              |   | 2,917    |  
|                                                                                                                                                 |  |                  |          |   |              |   |          |  
|Total liabilities                                                                                                                                |  |                  | 37,257   |   |              |   | 36,839   |  
|Stockholders equity:                                                                                                                            |  |                  |          |   |              |   |          |  
|Preferred stock, $0.001 par value:                                                                                                               |  |                  |          |   |              |   |          |  
|Authorized shares: 10,000,000 (800,000 shares designated Series A Cumulative Preferred Stock at June 30, 2006); no shares issued and
outstanding |  |                  |         |   |              |   |         |  
|Common stock, $0.001 par value:                                                                                                                  |  |                  |          |   |              |   |          |  
|Authorized shares: 80,000,000; shares issued and outstanding: 34,239,242 at December 31, 2005 and 34,739,957 at June 30,
2006                    |  |                  | 34       |   |              |   | 34       |  
|Additional paid-in capital                                                                                                                       |  |                  | 273,056  |   |              |   | 276,435  |  
|Deferred stock-based compensation                                                                                                                |  |                  | (217     | ) |              |   |         |  
|Accumulated other comprehensive loss                                                                                                             |  |                  | (250     | ) |              |   | (138     | )
|Accumulated deficit                                                                                                                              |  |                  | (146,156 | ) |              |   | (153,592 | )
|                                                                                                                                                 |  |                  |          |   |              |   |          |  
|Total stockholders equity                                                                                                                       |  |                  | 126,467  |   |              |   | 122,739  |  
|                                                                                                                                                 |  |                  |          |   |              |   |          |  
|Total liabilities and stockholders equity                                                                                                       |  | $                | 163,724  |   |              | $ | 159,578  |  
|                                                                                                                                                 |  |                  |          |   |              |   |          |  

See accompanying notes.



3



---

##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)



|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------ |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                   |  | Three Months Ended June 30, |        |   | Six Months Ended June 30, |  
|                                                                   |  | 2005                        |        |   | 2006                      |   |        | 2005 |  |   | 2006   |  
|Revenues:                                                          |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Product                                                            |  | $                           | 12,878 |   |                           | $ | 8,390  |      |  | $ | 22,009 |   |  | $ | 19,263 |  
|Service                                                            |  |                             | 7,445  |   |                           |   | 8,078  |      |  |   | 14,929 |   |  |   | 15,795 |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Total revenues                                                     |  |                             | 20,323 |   |                           |   | 16,468 |      |  |   | 36,938 |   |  |   | 35,058 |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Cost of revenues:                                                  |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Product (1)                                                        |  |                             | 5,265  |   |                           |   | 3,626  |      |  |   | 9,348  |   |  |   | 8,194  |  
|Service (1)                                                        |  |                             | 1,457  |   |                           |   | 1,835  |      |  |   | 2,928  |   |  |   | 3,539  |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Total cost of revenues                                             |  |                             | 6,722  |   |                           |   | 5,461  |      |  |   | 12,276 |   |  |   | 11,733 |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Gross margin                                                       |  |                             | 13,601 |   |                           |   | 11,007 |      |  |   | 24,662 |   |  |   | 23,325 |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Operating expenses:                                                |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Sales and marketing (1)                                            |  |                             | 7,607  |   |                           |   | 6,630  |      |  |   | 15,553 |   |  |   | 13,731 |  
|Research and development (1)                                       |  |                             | 4,821  |   |                           |   | 4,734  |      |  |   | 9,264  |   |  |   | 10,167 |  
|General and administrative (1)                                     |  |                             | 3,368  |   |                           |   | 3,444  |      |  |   | 6,124  |   |  |   | 7,771  |  
|Amortization of other intangible assets                            |  |                             | 243    |   |                           |   | 243    |      |  |   | 487    |   |  |   | 486    |  
|Restructuring charges                                              |  |                             |       |   |                           |   | 92     |      |  |   |       |   |  |   | 92     |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Total operating expenses                                           |  |                             | 16,039 |   |                           |   | 15,143 |      |  |   | 31,428 |   |  |   | 32,247 |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Operating loss                                                     |  |                             | (2,438 | ) |                           |   | (4,136 | )    |  |   | (6,766 | ) |  |   | (8,922 | )
|Interest and other income, net                                     |  |                             | 488    |   |                           |   | 814    |      |  |   | 940    |   |  |   | 1,534  |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Loss before income taxes                                           |  |                             | (1,950 | ) |                           |   | (3,322 | )    |  |   | (5,826 | ) |  |   | (7,388 | )
|Income tax provision                                               |  |                             | 29     |   |                           |   | 30     |      |  |   | 71     |   |  |   | 48     |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Net loss                                                           |  | $                           | (1,979 | ) |                           | $ | (3,352 | )    |  | $ | (5,897 | ) |  | $ | (7,436 | )
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Basic and diluted net loss per share                               |  | $                           | (0.06  | ) |                           | $ | (0.10  | )    |  | $ | (0.17  | ) |  | $ | (0.22  | )
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Shares used in calculation of basic and diluted net loss per share |  |                             | 33,792 |   |                           |   | 34,535 |      |  |   | 33,755 |   |  |   | 34,410 |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|                                                                   |  |                             |        |  
|(1)    Includes stock-based compensation as follows:               |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|                                                                   |  |                             |        |  
|Cost of revenues:                                                  |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Product                                                            |  | $                           | 10     |   |                           | $ | 5      |      |  | $ | 10     |   |  | $ | 13     |  
|Service                                                            |  |                             | 52     |   |                           |   | 28     |      |  |   | 52     |   |  |   | 63     |  
|Sales and marketing                                                |  |                             | 252    |   |                           |   | 158    |      |  |   | 252    |   |  |   | 393    |  
|Research and development                                           |  |                             | 415    |   |                           |   | 151    |      |  |   | 415    |   |  |   | 403    |  
|General and administrative                                         |  |                             | 238    |   |                           |   | 416    |      |  |   | 238    |   |  |   | 957    |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Total                                                              |  | $                           | 967    |   |                           | $ | 758    |      |  | $ | 967    |   |  | $ | 1,829  |  
|                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  

See accompanying notes.



4



---

##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)



|                                                                                                          |  |                           |         |   |      |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | ------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                                          |  | Six Months Ended June 30, |        
|                                                                                                          |  | 2005                      |         |   | 2006 |  
|Operating activities:                                                                                     |  |                           |         |   |      |   |         |  
|Net loss                                                                                                  |  | $                         | (5,897  | ) |      | $ | (7,436  | )
|Adjustments to reconcile net loss to net cash used in operating activities:                               |  |                           |         |   |      |   |         |  
|Noncash expenses:                                                                                         |  |                           |         |   |      |   |         |  
|Depreciation and amortization of property and equipment                                                   |  |                           | 1,303   |   |      |   | 1,397   |  
|Amortization of other intangible assets                                                                   |  |                           | 487     |   |      |   | 486     |  
|Stock-based compensation                                                                                  |  |                           | 967     |   |      |   | 1,829   |  
|Changes in operating assets and liabilities:                                                              |  |                           |         |   |      |   |         |  
|Trade accounts receivable, net                                                                            |  |                           | 951     |   |      |   | 1,710   |  
|Inventories, net                                                                                          |  |                           | (1,761  | ) |      |   | (439    | )
|Prepaid expenses and other current assets                                                                 |  |                           | 116     |   |      |   | (286    | )
|Other assets                                                                                              |  |                           | (175    | ) |      |   | 46      |  
|Accounts payable                                                                                          |  |                           | (790    | ) |      |   | (2,314  | )
|Accrued expenses, other liabilities and deferred rent                                                     |  |                           | 1,130   |   |      |   | (90     | )
|Accrued restructuring costs                                                                               |  |                           | (484    | ) |      |   | (456    | )
|Deferred revenues                                                                                         |  |                           | 116     |   |      |   | 2,442   |  
|                                                                                                          |  |                           |         |   |      |   |         |  
|Net cash used in operating activities                                                                     |  |                           | (4,037  | ) |      |   | (3,111  | )
|                                                                                                          |  |                           |         |   |      |   |         |  
|Investing activities:                                                                                     |  |                           |         |   |      |   |         |  
|Purchases of property and equipment                                                                       |  |                           | (413    | ) |      |   | (1,186  | )
|Proceeds from maturities of marketable securities                                                         |  |                           | 41,572  |   |      |   | 41,376  |  
|Purchases of marketable securities                                                                        |  |                           | (32,835 | ) |      |   | (37,539 | )
|                                                                                                          |  |                           |         |   |      |   |         |  
|Net cash provided by investing activities                                                                 |  |                           | 8,324   |   |      |   | 2,651   |  
|                                                                                                          |  |                           |         |   |      |   |         |  
|Financing activities:                                                                                     |  |                           |         |   |      |   |         |  
|Proceeds from stock option exercises and issuances of common stock under the employee stock purchase plan |  |                           | 356     |   |      |   | 1,768   |  
|Change in restricted cash                                                                                 |  |                           |        |   |      |   | 600     |  
|                                                                                                          |  |                           |         |   |      |   |         |  
|Net cash provided by financing activities                                                                 |  |                           | 356     |   |      |   | 2,368   |  
|                                                                                                          |  |                           |         |   |      |   |         |  
|Net increase in cash and cash equivalents                                                                 |  |                           | 4,643   |   |      |   | 1,908   |  
|Cash and cash equivalents at beginning of period                                                          |  |                           | 4,660   |   |      |   | 20,390  |  
|                                                                                                          |  |                           |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                                                |  | $                         | 9,303   |   |      | $ | 22,298  |  
|                                                                                                          |  |                           |         |   |      |   |         |  
|Supplemental disclosure of cash flow information:                                                         |  |                           |         |   |      |   |         |  
|Cash (refunded) paid for income taxes                                                                     |  | $                         | (16     | ) |      | $ | 3       |  
|                                                                                                          |  |                           |         |   |      |   |         |  

See accompanying notes.



5



---

##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1  DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

Description of Business

WatchGuard Technologies, Inc. (WatchGuard) is a leading provider of
Internet security solutions designed to protect small- to medium-sized enterprises that use the Internet for e-commerce and secure communications.

Interim Financial Information

The accompanying unaudited consolidated financial statements of WatchGuard have been
prepared in accordance with accounting principles generally accepted in the United States 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 and six months ended June 30, 2006 are not necessarily indicative of the results that may be expected for future quarters or for the year ending December 31, 2006. The
financial statements should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2005 included in WatchGuards annual report on Form 10-K, filed with the Securities and
Exchange Commission (SEC) on March 16, 2006.

NOTE 2  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

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

Revenue Recognition

WatchGuard generates revenues through sales of its Firebox products, licenses and subscriptions for related software options and services, and subscriptions for its LiveSecurity Service which includes access to technical support, software
updates (if and when available), early-warning vulnerability alerts and expert instruction and training. Software license revenues are generated from licensing the rights to use WatchGuards products directly to end-users, from sublicense fees
from resellers and distributors and from sales of WatchGuards managed security solution products to Internet service providers and other service providers that utilize WatchGuards products to provide managed security services to their
customers.

WatchGuard recognizes revenue in accordance with accounting standards for software companies, including Statement of Position
(SOP) No. 97-2, Software Revenue Recognition, as amended by SOP 98-9, and related interpretations, including Technical Practice Aids and Securities and Exchange Commission (SEC) Topic 13, Revenue Recognition of the
codification of the Staff Accounting Bulletins (SAB). Topic 13 summarizes certain of the SECs views in applying generally accepted accounting principles to revenue recognition in financial statements. Accordingly, WatchGuard recognizes revenue
when there is persuasive evidence that an arrangement exists, delivery has occurred, collection is probable, and the fee is fixed or determinable. WatchGuard believes its revenue recognition policies and practices are consistent with the accounting
standards.

For software that is delivered electronically in conjunction with a product sale, the delivery criterion discussed in the
preceding paragraph is considered to have been met when the product has been delivered, and additionally, when the customer has been provided with access codes that allow the customer to take immediate possession of the software on its product
pursuant to an agreement or purchase order for the product.

Most of WatchGuards Firebox products and certain software products
include an initial period of service subscription bundled in the product price. Because there is a timing difference between when products and service subscriptions are delivered, the related revenues must be allocated to each element using the
residual method, as defined in SOP 98-9, if vendor-specific objective evidence of fair value for undelivered elements of the arrangement (typically services) has been established. Under the residual method, the amounts allocated to the
undelivered elements (typically services) are equal to their fair value as established by vendor-specific objective evidence. The residual revenues in the arrangement are then allocated to the delivered elements (typically products). Vendor-specific
objective evidence of fair value is based on the price charged when an element is sold separately or, if an element is not yet sold separately, on the price established by authorized



6



---

##### Table of Contents

management if it is probable that the price, once established, will not change before the element is separately introduced into the marketplace.

WatchGuard recognizes revenues allocated to products, including software license fees, using either the sell through or sell in method of revenue
recognition as determined both by the sales support provided to customers within a market and by the contractual arrangement with each channel customer. When the channel customer is a distributor with unlimited stock returns and rotation rights, or
when WatchGuard actively engages in activities to assist in selling distributor inventory to channel customers, product revenues are not recognized until the distributors sell the products to their channel customers (the sell through
method). Otherwise, revenue is recognized upon delivery of the products to the channel customer (the sell in method). Revenues from LiveSecurity Service subscriptions and other services are recognized ratably over the term of the
subscription, ranging from 3 to 30 months. Our standard payment terms range from 30 to 60 days. WatchGuard offers term discounts to certain of its larger customers.

During the first quarter of 2005, WatchGuard negotiated changes in contractual obligations with certain channel customers in North America, Australia and New Zealand which provided such customers with unlimited return
rights for products sold after the change date. The changes were triggered by the need to offer promotional programs to give WatchGuard the flexibility in the respective markets to be more competitive, responsive and effective. As a result of these
contract changes, WatchGuard converted these customers to a sell through method beginning in the first quarter of 2005. During the second quarter of 2006, WatchGuard converted certain channel customers in the United Kingdom and
Germany-Austria-Switzerland to the sell through method in order to offer more varied promotional programs in those locations. When a channel customer is converted from the sell in method to the sell through method of revenue recognition, revenue can
no longer be recognized when product is sold to the channel customer, but instead, is recognized when the channel customer sells it through to its own customers. In addition, because revenue from products in that channel customers inventory
was already recognized in prior periods, revenue on individual inventory items sold subsequent to the conversion can only be recognized after the converted channel customer has disposed of its inventory predating the conversion. As of March 31,
2006, the converted customers in Europe held inventory for which WatchGuard had already recognized revenues in the amount of $2.2 million. During the second quarter of 2006, these customers sold through approximately $1.9 million of these
inventories with approximately $300,000 carried over to future quarters. While the conversion of customers from a sell in method to a sell through method of revenue recognition resulted in a reduction of revenues during the quarter of conversion,
the total effect of this reduction cannot be measured reliably due to a change in customer buying patterns upon conversion to the sell through method.

WatchGuard provides allowances for estimated returns and return rights and pricing protection rights which are offered to most customers. A customers return rights are generally limited to the lesser of its
on-hand inventory or a percentage of the customers purchases for the previous quarter. Pricing protection rights, offered to many of WatchGuards customers, 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 sales are made based on historical experience.

WatchGuard also provides allowances for promotional rebates offered to its customers. Promotional rebates vary by type and term and are earned by customers in accordance with various conditions. WatchGuard accounts for promotional rebates
given to customers in accordance with the Emerging Issues Task Force (EITF) Issue No. 01-09, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendors Product, which requires that sales
incentives given to customers or resellers be accounted for as a reduction of revenue unless a vendor receives an identifiable benefit that is separable from the customers purchase of WatchGuards products and has a fair value that can be
reasonably estimated; in which case, the sales incentive is accounted for as an expense. WatchGuard accrues allowances for rebates to the maximum amount possible unless there are sufficient historical trends which would indicate a lower rate of
accrual is appropriate.

Stock-Based Compensation

Effective January 1, 2006, WatchGuard adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based
Payment (SFAS 123(R)), using the modified prospective transition method. SFAS 123(R) requires measurement of compensation cost for all stock-based awards at fair value on the date of grant and recognition of compensation cost over the service
period for awards expected to vest. WatchGuard determines the fair value of its stock options using the Black-Scholes valuation model, which is consistent with the valuation technique previously utilized to estimate the fair value of
WatchGuards stock options in footnote disclosures required under SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123). The fair value of WatchGuards restricted stock is determined based on the number of
shares granted and the quoted price of its common stock. WatchGuard recognizes expenses associated with stock option and restricted stock awards over the respective service period, which generally equals the vesting period, net of estimated
forfeitures, using the straight-line method. The estimation of stock awards that will ultimately vest requires



7



---

##### Table of Contents

judgment, and to the extent actual results or updated estimates differ from current estimates, such amounts will be recorded as a cumulative adjustment in
the period estimates are revised.

Prior to the adoption of SFAS 123(R), WatchGuard accounted for its employee stock option and restricted
stock awards using the intrinsic value method prescribed under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations as permitted by SFAS 123. Accordingly, compensation
cost for stock option and restricted stock awards was measured as the excess, if any, of the quoted market price of WatchGuards common stock at the measurement date (or the balance sheet date, if the measurement date had not yet occurred) over
the amount, if any, required to be paid by the employee. Compensation cost was charged to expense over the vesting period of each respective award using the accelerated method of expense recognition. To the extent stock awards were forfeited prior
to vesting, the corresponding previously recognized expense was reversed as an offset to operating expenses. Also, to the extent stock options awards were subject to a repricing, exchange offer, other modifications or performance criteria, such
awards were subject to variable accounting treatment. Measurement date was defined as the grant date for all stock awards other than variable stock options and variable restricted stock awards. Measurement date for variable stock options and
variable restricted stock awards was the date both the number of shares and purchase (exercise) price, if any, were known. Changes in the quoted market price of WatchGuards common stock were reflected as an adjustment to stock-based
compensation expense for variable awards in the periods in which the changes occurred, until the date both the number of shares and purchase price, if any, were known.

Stock-based compensation expense recognized for the three and six months ended June 30, 2006 included compensation expense for all share-based payments granted prior to, but not yet vested, as of January 1,
2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and compensation expense for all share-based payments granted after January 1, 2006, based on the grant date fair value estimated in
accordance with the provisions of SFAS 123(R). Results for prior periods have not been restated in accordance with the modified prospective transition method.

WatchGuard recorded stock-based compensation expenses during the three months ended June 30, 2005, in connection with the repricing of its stock options and the grant of restricted stock awards. Repriced options
represent those granted under WatchGuards voluntary stock option exchange program offered to employees in May 2005. Restricted stock awards represent those granted under WatchGuards Director and Section 16 Officer Stock Ownership
Program implemented in April 2005 as well as grants to non-employee directors in the form of annual board compensation. No compensation expense was recorded by WatchGuard in that period in connection with its Employee Stock Purchase Plan (ESPP) as
the purchase price of the stock was not less than 85% of the lower of fair market value of its common stock at the beginning of each offering period or at the end of each purchase period. In accordance with SFAS 123, WatchGuard disclosed its net
loss and net loss per share for the three and six months ended June 30, 2005 as if it had applied the fair value-based method in measuring stock-based compensation expense for its share-based compensation plans.

The following table summarizes stock-based compensation expense for stock awards and purchases under WatchGuards ESPP for the three and six months
ended June 30, 2005 and June 30, 2006 (in thousands):



|                           |  |                             |     |                           |   |      |  |      |     |  |   |      
|-------------------------- |  | --------------------------- | --- | ------------------------- | - | ---- |  | ---- | --- |  | - | -----
|                           |  | Three Months Ended June 30, |     | Six Months Ended June 30,
|                           |  | 2005                        |     | 2006                      |   | 2005 |  | 2006
|Cost of revenues:          |  |                             |     |                           |   |      |  |      |     |  |   |      
|Product                    |  | $                           | 10  |                           | $ | 5    |  | $    | 10  |  | $ | 13   
|Service                    |  |                             | 52  |                           |   | 28   |  |      | 52  |  |   | 63   
|Sales and marketing        |  |                             | 252 |                           |   | 158  |  |      | 252 |  |   | 393  
|Research and development   |  |                             | 415 |                           |   | 151  |  |      | 415 |  |   | 403  
|General and administrative |  |                             | 238 |                           |   | 416  |  |      | 238 |  |   | 957  
|                           |  |                             |     |                           |   |      |  |      |     |  |   |      
|Total                      |  | $                           | 967 |                           | $ | 758  |  | $    | 967 |  | $ | 1,829
|                           |  |                             |     |                           |   |      |  |      |     |  |   |      



8



---

##### Table of Contents

The application of SFAS 123(R) had the following effect on reported results for the three and six months
ended June 30, 2006, relative to amounts that would have been reported using the intrinsic value method under previous accounting (in thousands, except per share amounts):



|                                                   |  |                                 |        |   |                                |   |        |  
|-------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | -
|                                                   |  | Three Months EndedJune 30, 2006 |        |   | Six Months Ended June 30, 2006 |  
|Operating loss                                     |  | $                               | (2,485 | ) |                                | $ | (741   | )
|Loss before income taxes                           |  |                                 | (2,485 | ) |                                |   | (741   | )
|Net loss                                           |  |                                 | (2,485 | ) |                                |   | (741   | )
|Net loss per share, basic and diluted              |  | $                               | (0.07  | ) |                                | $ | (0.02  | )
|Shares used in basic and diluted per share amounts |  |                                 | 34,535 |   |                                |   | 34,410 |  

No income tax benefit was realized from stock option exercises during the three and six months
ended June 30, 2006. In accordance with SFAS 123(R), WatchGuard presents excess tax benefits from the exercise of stock options, if any, as financing cash flows rather than operating cash flows. For the three and six months period ended
June 30, 2006, the adoption of SFAS 123(R) did not have an effect on cash flows from operations and financing activities.

At
June 30, 2006, WatchGuard had $2.8 million of unrecognized compensation expense related to its unvested stock options and restricted stock awards. The weighted-average period over which WatchGuard expects to recognize this expense is
approximately 1.3 years.

Prior to the adoption of SFAS 123(R), WatchGuard recorded deferred compensation as a separate component of
stockholders equity. In accordance with the provisions of SFAS 123(R), on January 1, 2006, WatchGuard reclassified the balance in deferred compensation of $217,000 to additional paid-in capital on its consolidated balance sheet.

Valuation Assumptions for Stock Options

WatchGuard estimates the fair value of its stock options using the Black-Scholes valuation model. For options granted prior to, but not yet vested as of January 1, 2006, WatchGuard estimated their fair value
using the multiple option approach, and is amortizing their stock-based compensation using the accelerated method. For options granted after January 1, 2006, WatchGuard estimates their fair value using the single option approach and amortizes
their stock-based compensation using the straight-line method.

The following assumptions were used to estimate the fair value of options
granted and share purchase rights under WatchGuards ESPP for the three and six months ended June 30, 2005 and 2006:

Stock
Options



|                                          |  |                             |   |  |                           |   |  |      |   |  |      |  
|----------------------------------------- |  | --------------------------- | - |  | ------------------------- | - |  | ---- | - |  | ---- | -
|                                          |  | Three Months Ended June 30, |   |  | Six Months Ended June 30, |  
|                                          |  | 2005                        |   |  | 2006                      |   |  | 2005 |   |  | 2006 |  
|Weighted-average expected volatility      |  | 74.7                        | % |  | 68.1                      | % |  | 74.7 | % |  | 69.5 | %
|Weighted-average expected life (in years) |  | 4.0                         |   |  | 4.0                       |   |  | 4.0  |   |  | 4.5  |  
|Weighted-average dividend rate            |  | 0.0                         | % |  | 0.0                       | % |  | 0.0  | % |  | 0.0  | %
|Weighted-average risk-free interest rate  |  | 3.8                         | % |  | 5.0                       | % |  | 3.8  | % |  | 4.8  | %

ESPP



|                                          |  |                                   |   |  |      |  
|----------------------------------------- |  | --------------------------------- | - |  | ---- | -
|                                          |  | Three andSix Months EndedJune 30, |  
|                                          |  | 2005                              |   |  | 2006 |  
|Weighted-average expected volatility      |  | 95.0                              | % |  | 32.4 | %
|Weighted-average expected life (in years) |  | 1.3                               |   |  | 1.3  |  
|Weighted-average dividend rate            |  | 0.0                               | % |  | 0.0  | %
|Weighted-average risk-free interest rate  |  | 3.8                               | % |  | 4.7  | %

Expected volatilities are based on historical volatilities of WatchGuards common stock which
WatchGuard believes is representative of future stock price trends; the expected life represents the weighted-average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and historical
exercise patterns; the dividend rate is based on WatchGuards history of not paying dividends and the resultant future expectation of dividend payments; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of
grant for periods corresponding with the expected life of the option.



9



---

##### Table of Contents

Stock-based compensation expense recognized for the three and six months ended June 30, 2006 is
based on awards ultimately expected to vest, and accordingly, has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures
differ from those estimates. The estimated forfeiture rate was determined based on the WatchGuards historical experience. Prior to the adoption of SFAS 123(R) on January 1, 2006, estimates included in WatchGuards pro forma
disclosures accounted for forfeitures on an as-incurred basis which is consistent with the requirements of SFAS 123.

Description of
Plans

WatchGuards 1996 Stock Incentive Compensation Plan (the 1996 Plan) provides for the grant of stock awards, incentive stock
options and nonqualified stock options to employees, officers, directors, agents, consultants and independent contractors. WatchGuards 2000 Stock Option Plan (the 2000 Plan) provides for the grant of nonqualified stock options to non-officer
employees, agents, consultants, advisors and independent contractors.

Stock options under both the 1996 Plan and the 2000 Plan generally
are granted at fair market value on the date of grant. The shares of common stock covered by options granted on the date of hire generally vest at the rate of 25% on the first anniversary of the date of grant, and an additional 2.08% every month
thereafter, with all shares becoming fully vested on the fourth anniversary of the date of grant. Options granted other than on the date of hire generally vest at the rate of 2.08% every month, commencing one month from the date of grant. Stock
options granted under both the 1996 Plan and the 2000 Plan have a term of ten years. Shares issued upon exercise of stock options under the 1996 Plan and the 2000 Plan are drawn from authorized and unissued shares of WatchGuards common stock.

Restricted stock awards under the 1996 Plan generally are granted at fair market value on the date of grant. To date, stock awards under
the 1996 Plan consist of restricted stock grants under WatchGuards Director and Section 16 Officer Stock Ownership Program (the Program) and restricted stock grants to non-employee directors in the form of annual board compensation. Under
the Program, voluntary purchases of WatchGuards capital stock by its directors or officers will be matched by WatchGuard in the form of a restricted stock grant equal to 50% of the number of shares purchased in the open market, up to a maximum
of 5,000 matching restricted shares per participant per year. The matching restricted shares granted by WatchGuard vest annually over three years, and any unvested matching restricted stock shares will be forfeited if the shares that were matched
are sold. Non-employee directors also receive an annual grant of 2,500 shares of restricted stock, which vests over a one year period, as part of their annual board compensation.

The 1999 ESPP permits eligible employees of WatchGuard to purchase common stock through payroll deductions of up to 15% of their compensation. The price
of the common stock purchased under the ESPP is the lesser of 85% of the fair market value on the first day of an offering period and 85% of the fair market value on the last day of an offering period.

Stock Option Activity and Stock-Based Compensation Expense

The following table summarizes WatchGuards stock option activity under all share-based compensation plans during the six months ended June 30, 2006:



|                               |  |           |   |  |                               |      |                                                   |      |                           |   |          
|------------------------------ |  | --------- | - |  | ----------------------------- | ---- | ------------------------------------------------- | ---- | ------------------------- | - | ---------
|                               |  | Options   |   |  | Weighted-AverageExercisePrice |      | Weighted-AverageRemaining ContractualTerm (Years) |      | Aggregate Intrinsic Value
|Balance at beginning of period |  | 5,427,364 |   |  | $                             | 4.05 |                                                   |      |                           |   |          
|Granted                        |  | 323,850   |   |  | $                             | 4.54 |                                                   |      |                           |   |          
|Exercised                      |  | (387,519  | ) |  | $                             | 3.74 |                                                   |      |                           |   |          
|Forfeited                      |  | (233,871  | ) |  | $                             | 4.06 |                                                   |      |                           |   |          
|Cancelled                      |  | (104,015  | ) |  | $                             | 4.51 |                                                   |      |                           |   |          
|                               |  |           |   |  |                               |      |                                                   |      |                           |   |          
|Balance at end of period       |  | 5,025,809 |   |  | $                             | 4.09 |                                                   | 7.32 |                           | $ | 2,422,979
|                               |  |           |   |  |                               |      |                                                   |      |                           |   |          
|Exercisable at end of period   |  | 3,157,092 |   |  | $                             | 4.26 |                                                   | 6.49 |                           | $ | 1,559,218

The weighted-average grant date fair value of options granted during the three and six months
ended June 30, 2006 was $2.75 and $2.64 per option, respectively. The aggregate intrinsic value of options outstanding at June 30, 2006 is calculated as the difference between the exercise price of the underlying options and the market
price of WatchGuards common stock at June 30, 2006. 3.6 million shares had exercise prices that were lower than the $4.15 market price of WatchGuards common stock as of that date. The total intrinsic value of options exercised
during the three months and six months ended June 30, 2006 was $240,500 and $357,500, respectively, determined as of the exercise date. The total fair value of shares vested during the three and six months ended June 30, 2006 was $538,000
and $973,500, respectively.



10



---

##### Table of Contents

Fair Value Disclosures Prior to the Adoption of SFAS 123(R)

Stock-based compensation for the three and six months ended June 30, 2005 was determined using the intrinsic value method. The following table
provides supplemental information for the three and six months ended June 30, 2005 as if stock-based compensation had been computed under SFAS 123 (in thousands, except per share amounts):



|                                                                          |  |                                 |        |   |                               |   |         |  
|------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ----------------------------- | - | ------- | -
|                                                                          |  | Three Months EndedJune 30, 2005 |        |   | Six Months EndedJune 30, 2005 |  
|Net loss  as reported                                                    |  | $                               | (1,979 | ) |                               | $ | (5,897  | )
|Add: stock-based compensation, as reported                                |  |                                 | 967    |   |                               |   | 967     |  
|Deduct: stock-based compensation determined under fair-value-based method |  |                                 | (3,770 | ) |                               |   | (5,504  | )
|                                                                          |  |                                 |        |   |                               |   |         |  
|Net loss  pro forma                                                      |  | $                               | (4,782 | ) |                               | $ | (10,434 | )
|                                                                          |  |                                 |        |   |                               |   |         |  
|Net loss per share, basic and diluted  as reported                       |  | $                               | (0.06  | ) |                               | $ | (0.17   | )
|Net loss per share, basic and diluted  pro forma                         |  | $                               | (0.14  | ) |                               | $ | (0.31   | )

Net Loss Per Share

Basic and diluted net loss per share is calculated using the weighted-average number of shares of unrestricted common stock outstanding. Other common
stock equivalents, including stock options, are excluded from the computation because their effect is antidilutive. Shares used in the calculation of basic and diluted net loss per share for the three and six months ended June 30, 2006, also
exclude 33,667 shares of unvested restricted stock. Shares used in the calculation of basic and diluted net loss per share for the three and six months ended June 30, 2005, exclude 46,000 shares of unvested restricted stock.

Comprehensive Loss

WatchGuards investments consist primarily of corporate and municipal bonds and U.S. government securities. WatchGuards investment securities are considered available-for-sale, as defined by SFAS No. 115,
Accounting for Certain Investments in Debt and Equity Securities, and are stated at fair value, with unrealized gains and losses included as a component of stockholders equity. During the three and six months ended June 30,
2005 and 2006, there were no realized gains or losses on available-for-sale securities.

The following table sets forth the components of
comprehensive loss (in thousands):



|                                      |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                      |  | Three Months Ended June 30, |        |   | Six Months Ended June 30, |  
|                                      |  | 2005                        |        |   | 2006                      |   |        | 2005 |  |   | 2006   |  
|Net loss                              |  | $                           | (1,979 | ) |                           | $ | (3,352 | )    |  | $ | (5,897 | ) |  | $ | (7,436 | )
|Unrealized gain (loss) on investments |  |                             | 124    |   |                           |   | 38     |      |  |   | (39    | ) |  |   | 112    |  
|                                      |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Comprehensive loss                    |  | $                           | (1,855 | ) |                           | $ | (3,314 | )    |  | $ | (5,936 | ) |  | $ | (7,324 | )
|                                      |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  

Recent Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes
 an Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 establishes threshold and measurement attributes for financial statement measurement and recognition of tax positions taken or expected to be taken in a tax return. FIN
48 also provides guidance on derecognition and classification of related tax balances, associated interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after
December 15, 2006. WatchGuard is currently evaluating the impact that the adoption of FIN 48 will have on its financial position, results of operations or cash flows.



11



---

##### Table of Contents

NOTE 3  BALANCE SHEET ACCOUNT DETAIL

Trade Accounts Receivable, Net

Trade accounts receivable, net consisted of the following (in thousands):



|                                            |  |                   |        |   |               |   |        |  
|------------------------------------------- |  | ----------------- | ------ | - | ------------- | - | ------ | -
|                                            |  | December 31, 2005 |        |   | June 30, 2006 |  
|Trade accounts receivable                   |  | $                 | 7,628  |   |               | $ | 4,770  |  
|Reserve for returns, rebates and allowances |  |                   | (2,331 | ) |               |   | (1,169 | )
|Allowance for doubtful accounts             |  |                   | (414   | ) |               |   | (428   | )
|                                            |  |                   |        |   |               |   |        |  
|                                            |  | $                 | 4,883  |   |               | $ | 3,173  |  
|                                            |  |                   |        |   |               |   |        |  

Inventories, Net

Inventories, net consisted of the following (in thousands):



|                    |  |                  |       |   |              |   |       |  
|------------------- |  | ---------------- | ----- | - | ------------ | - | ----- | -
|                    |  | December 31,2005 |       |   | June 30,2006 |  
|Finished goods      |  | $                | 2,784 |   |              | $ | 2,764 |  
|Components          |  |                  | 1,834 |   |              |   | 2,443 |  
|                    |  |                  |       |   |              |   |       |  
|                    |  |                  | 4,618 |   |              |   | 5,206 |  
|Inventory allowance |  |                  | (525  | ) |              |   | (674  | )
|                    |  |                  |       |   |              |   |       |  
|                    |  | $                | 4,093 |   |              | $ | 4,532 |  
|                    |  |                  |       |   |              |   |       |  

Inventories held by sell through customers, included as a component of finished goods, were
$470,000 and $735,000 at December 31, 2005 and June 30, 2006, respectively.

Accrued Expenses and Other Liabilities

Accrued expenses and other liabilities consisted of the following (in thousands):



|                                     |  |                  |       |              |   |      
|------------------------------------ |  | ---------------- | ----- | ------------ | - | -----
|                                     |  | December 31,2005 |       | June 30,2006
|Accrued payroll-related liabilities  |  | $                | 1,765 |              | $ | 2,028
|Deposits from sell through customers |  |                  | 1,180 |              |   | 1,255
|Other accrued liabilities            |  |                  | 4,040 |              |   | 3,752
|                                     |  |                  |       |              |   |      
|                                     |  | $                | 6,985 |              | $ | 7,035
|                                     |  |                  |       |              |   |      

NOTE 4  GUARANTEES

WatchGuards operating lease for its corporate headquarters includes a collateral restriction that requires WatchGuard to maintain an irrevocable standby letter of credit issued to WatchGuards landlord
secured by restricted cash. At December 31, 2005 and June 30, 2006, WatchGuards restricted cash balance, including both the short-term and long-term portions, was $3.0 million and $2.4 million, respectively, in conjunction with the
facilities lease.

WatchGuards hardware products carry a one-year warranty from the delivery date that includes factory repair
services or replacement products as needed. WatchGuard accrues estimated expenses for warranty obligations at the time that products are shipped based on historical product repair and replacement information. WatchGuards liability is affected
by the warranty terms provided to WatchGuard by the original equipment manufacturers ranging from 16 to 24 months from the manufacture date. Other factors that affect WatchGuards warranty liability include the number of installed units,
historical rates of warranty claims and cost per claim. WatchGuard periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. WatchGuards estimated product warranty liability, included as a
component of accrued expenses and other liabilities, was $426,000 and $144,000 at June 30, 2005 and 2006, respectively. Changes to WatchGuards estimated product warranty liability during the six months ended June 30, 2005 and
June 30, 2006 were as follows (in thousands):



|                                                        |  |                                |      |   |                                |   |      |  
|------------------------------------------------------- |  | ------------------------------ | ---- | - | ------------------------------ | - | ---- | -
|                                                        |  | Six Months Ended June 30, 2005 |      |   | Six Months Ended June 30, 2006 |  
|Beginning balance                                       |  | $                              | 530  |   |                                | $ | 216  |  
|Additions charged to cost of revenues during the period |  |                                | 136  |   |                                |   | 85   |  
|Settlements made during the period                      |  |                                | (240 | ) |                                |   | (157 | )
|                                                        |  |                                |      |   |                                |   |      |  
|Ending balance                                          |  | $                              | 426  |   |                                | $ | 144  |  
|                                                        |  |                                |      |   |                                |   |      |  



12



---

##### Table of Contents

NOTE 5  BUSINESS RESTRUCTURINGS

At December 31, 2005 and June 30, 2006, WatchGuards accrued restructuring charges, including both the short-term and long-term portions,
were $3.9 million and $3.4 million, respectively. Additional charges of $110,000 related to the 2001 restructuring were recorded during the three months ended June 30, 2006, due to the revision of the cost of excess facilities resulting from a
change in the commencement date of a subleasing arrangement. These charges were offset by an $18,000 reduction in the 2002 restructuring liability during the second quarter of 2006, due to the revision of estimated proceeds from the rate
renegotiation on a subleasing arrangement.

2001 Restructuring

In the second quarter of 2001, WatchGuard announced a restructuring plan designed to streamline operations and reduce operating costs. All costs related
to this restructuring have been paid or settled, except for accrued amounts related to losses for the lease commitments, net of estimated proceeds from subleases of abandoned facilities, which are expected to be paid through 2010. The accrued
liabilities relating to this restructuring at December 31, 2005 and June 30, 2006, and activity recorded through June 30, 2006, are as follows (in thousands):



|                               |  |                   |       |                               |   |      |               |  |   |      
|------------------------------ |  | ----------------- | ----- | ----------------------------- | - | ---- | ------------- |  | - | -----
|                               |  | December 31, 2005 |       | Amounts(Paid) or Charged, Net |   |      | June 30, 2006
|Abandoned facilities and other |  | $                 | 1,427 |                               | $ | (204 | )             |  | $ | 1,223
|                               |  |                   |       |                               |   |      |               |  |   |      

2002 Restructuring

In the second quarter of 2002, WatchGuard implemented a restructuring plan primarily designed to eliminate redundancies and excess headcount resulting
from the acquisition of RapidStream, Inc., which included a reduction in workforce, consolidation of excess facilities and elimination of technology-related contracts that were no longer required or part of WatchGuards strategy. All costs
related to this restructuring have been paid or settled, except for accrued amounts related to losses for the lease commitments, net of estimated proceeds from subleases of abandoned facilities, which are expected to be paid through 2010. The
accrued liabilities relating to this restructuring at December 31, 2005 and June 30, 2006, and activity recorded through June 30, 2006, are as follows (in thousands):



|                               |  |                   |       |                               |   |      |               |  |   |      
|------------------------------ |  | ----------------- | ----- | ----------------------------- | - | ---- | ------------- |  | - | -----
|                               |  | December 31, 2005 |       | Amounts(Paid) or Charged, Net |   |      | June 30, 2006
|Abandoned facilities and other |  | $                 | 2,448 |                               | $ | (252 | )             |  | $ | 2,196
|                               |  |                   |       |                               |   |      |               |  |   |      

NOTE 6  LEGAL PROCEEDINGS

WatchGuard, SonicWALL, Inc., and Michael N. Valentine, a former WatchGuard and current SonicWALL employee, have conclusively resolved the lawsuit filed by
WatchGuard in the United States District Court for the Northern District of Texas, Dallas Division, as well as the counterclaim filed in the same action by Mr. Valentine against WatchGuard. The action has been resolved to the parties
mutual satisfaction and has accordingly been dismissed with prejudice to its refiling.

On April 8, 2005, a holder of WatchGuard
common stock, on behalf of himself and purportedly on behalf of a class of WatchGuard stockholders, filed an action in the United States District Court for the Western District of Washington (the Washington Court) against WatchGuard and some of its
current and former officers, alleging violations of the federal securities laws arising out of, among other things, its announcement on March 15, 2005 that it was restating some of its financial results for interim periods of 2004.
Subsequently, a number of other related purported class action suits also alleging violations of the federal securities laws were filed by holders of WatchGuards common stock. The various actions have been consolidated by the Washington Court,
and are referred to herein as the Action. On October 3, 2005, a consolidated amended complaint was filed in the Action and WatchGuard filed a motion to dismiss the consolidated complaint. On April 21, 2006, the Washington Court granted
WatchGuards motion and dismissed the consolidated amended complaint. The Court granted plaintiffs leave to amend their complaint and on May 8, 2006, the plaintiffs filed their second consolidated amended complaint. Watchguard has filed a
motion to dismiss the second consolidated amended complaint. The Court has yet to schedule a hearing on this motion. In addition, two related stockholder derivative suits were subsequently filed against some of WatchGuards current and former
directors and officers in the Superior Court of the State of Washington, King County and in the Washington Court, respectively, which are referred to as the Derivative Actions. Plaintiffs in the Action and the Derivative Actions seek unspecified
compensatory damages. WatchGuard has obtained a stay of both of the Derivative Actions until after the resolution of the motion to dismiss the Action. WatchGuard intends to vigorously defend against the Action, but is unable, however, to predict the
ultimate outcome of the Action. There can be no assurance that WatchGuard will be successful in defending against the Action and, if WatchGuard is unsuccessful, it may be subject to significant



13



---

##### Table of Contents

damages, which could have a material adverse effect on its operating results and financial position. Even if WatchGuard is successful, defending against the
Action is likely to be expensive, time consuming and may divert managements attention from other business concerns and harm WatchGuards business, which could have a material adverse effect on WatchGuards operating results.

NOTE 7  SUBSEQUENT EVENT

On
July 25, 2006, WatchGuard, Gladiator Corporation (Gladiator), which is wholly owned by Francisco Partners, and Warrior Merger Sub, Inc., a wholly owned subsidiary of Gladiator Corporation, entered into an Agreement and Plan of Merger
(Agreement) under which Warrior Merger Sub, Inc. will be merged with and into WatchGuard, with WatchGuard surviving the merger as a wholly owned subsidiary of Gladiator Corporation; provided, however, the Agreement permits Gladiator to elect to
change the structure or method of effecting the combination of Warrior with WatchGuard so long as certain conditions under the Agreement are satisfied. A copy of the Agreement was included as an exhibit to Form 8-K that WatchGuard filed with the
Securities and Exchange Commission on July 25, 2006. Under the terms of the Agreement, each outstanding share of WatchGuard common stock will be converted into the right to receive $4.25 in cash. In addition, each outstanding option to purchase
shares of WatchGuard common stock will be cancelled at the time of the merger, with holders of options (whether or not vested) with an exercise price less than $4.25 per share entitled to receive for each such option a cash payment equal to
(i) the amount by which $4.25 exceeds the per share exercise price for the option multiplied by (ii) the number of shares subject to such option. Total cash consideration for this transaction is estimated at approximately $151 million of
which $60 million will be contributed by WatchGuard. In connection with this transaction, Francisco Partners has provided WatchGuard with an equity commitment letter, pursuant to which it has pledged to invest cash in Gladiator sufficient to
complete the transaction. The transaction, which is subject to stockholder and regulatory approvals, is targeted to be completed in the fourth quarter of 2006.



|ITEM2. | 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 our financial condition and operating results. The discussion should be read in conjunction with the unaudited consolidated
financial statements and the notes thereto. References to we, our and us in this quarterly report refer to WatchGuard Technologies, Inc. and our wholly owned subsidiaries.

Forward-Looking Statements

Our disclosure and
analysis in this quarterly report contain forward-looking statements, which provide our current expectations or forecasts of future events. Forward-looking statements in this quarterly report include, without limitation:



| |  |  | information concerning possible or assumed future operating results, trends in financial results and business plans, including those relating to earnings growth and revenue growth;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | statements about our costs and operating expenses relative to our revenues and about the expected composition of our revenues;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | statements about our future capital requirements and the sufficiency of our cash, cash equivalents, investments and available bank borrowings to meet these requirements;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | information about the anticipated timing of new product releases;
| | - |  | -----------------------------------------------------------------



| |  |  | other statements about our plans, objectives, expectations and intentions; and
| | - |  | ------------------------------------------------------------------------------



| |  |  | other statements that are not historical facts.
| | - |  | -----------------------------------------------

Words
such as expects, believes, anticipates, intends and will and similar words may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement
is not forward-looking. Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause 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 factors described in the section entitled Risk Factors in this quarterly
report. Other factors besides those described in this quarterly report could also affect actual results. You should carefully consider the factors described in the section entitled Risk Factors in evaluating our forward-looking
statements.

You should not unduly rely on these forward-looking statements, which speak only as of the date of this quarterly report. We
undertake no obligation to publicly revise any forward-looking statement to reflect circumstances or events after the date of this quarterly report, or to reflect the occurrence of unanticipated events. You should, however, review the factors and
risks we describe in the reports we file from time to time with the Securities and Exchange Commission, or SEC.



14



---

##### Table of Contents

Overview

We are a leading provider of network security solutions designed to protect small- to medium-sized enterprises, or SMEs, that use the Internet for e-commerce and secure communications. We provide SMEs worldwide with integrated and
expandable network security solutions employing multi-layered defenses designed to protect not only against existing threats, but against future threats, in an intelligent way backed by an intuitive user interface and the expert guidance and support
of our LiveSecurity Service. With the risk that threats and attacks will compromise multiple access points in a corporate network, an effective security solution requires more layers of defense than just firewalls for access control and virtual
private networks, or VPNs, for secure communications. A security solution that integrates multiple layers of defense, however, must do so efficiently to preserve performance and remain flexible enough to adapt to future threats and attacks in the
evolving security landscape.

Thousands of enterprises worldwide use our award-winning products and services to meet these requirements.
The core of our products and services is our family of integrated, expandable Firebox X security solutions. We offer firewall protection and intrusion prevention technology for access control, virtual private networking for secure communications,
content and spam filtering, gateway and desktop anti-virus protection and vulnerability assessment services. Our Firebox X security solutions allow users to upgrade to any higher model in the particular line simply by applying a software license
key. We also offer our customers a unified management interface designed to allow even the non-security professional to effectively install, configure and monitor our security products as well as manage multiple security products from a central
console and the networking features required for more complex network installations. We also offer our customers a Secure Socket Layer, or SSL, VPN Gateway appliance for secure, always-on connectivity to applications and corporate resources. In
addition, our innovative subscription-based LiveSecurity Service provides our customers with access to expert guidance and support so they can protect their data and communications in a continuously changing environment.

Our market spans the SME market, from smaller-sized companies for which ease-of-use is a primary requirement, to medium-sized companies, including those
with high-speed connections supporting VPNs between the corporate headquarters and geographically dispersed branch offices for which performance, scalability and networking features are key requirements. Our security solutions also give enterprises
a security management choice. An enterprise can manage its own Internet security with our product offerings or outsource its security management to an Internet service provider, or ISP, or other managed service provider implementing our managed
security solutions. For the service provider, our technology improves the economics of managed security services through a scalable delivery platform that enables the service provider to remotely configure and manage thousands of customer sites
quickly and easily.

Since January 2004, we have continued to substantially invest in the development of our products as follows:



| |  |  | In February 2004, we introduced our Firebox X line of integrated, expandable security appliances for SMEs, combining firewall, VPN, application layer security, intrusion prevention
functionality, spam blocking, Web filtering and authentication in a single appliance designed to enable customers to upgrade the appliance to any higher model in the same line or to add ports just by applying a software license key.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In August 2004, we extended the Firebox X family of integrated, upgradeable security appliances to address the needs of remote offices, telecommuters and small businesses with the
launch of the Firebox X Edge line, designed to provide commercial-class security at the furthest points of the network at an affordable price point.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In December 2004, we made available our Gateway AntiVirus for email for our Firebox X line of integrated, upgradeable security appliances. This robust signature-based solution,
combined with our existing deep application inspection capability, is designed to provide comprehensive security against email borne threats at an affordable cost.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In December 2004, we extended the Firebox X Edge line with a wireless version offering secure 802.11g wireless connection, and enhanced the Edge software for wired and wireless to
include WAN / WAN failover and WAN / Modem failover for greater reliability.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In April 2005, we introduced the Firebox X Peak line, our highest-performance line of integrated security appliances, with up to 1 gigabyte per second firewall throughput, high port
density and advanced networking features. In connection with this product introduction, we also launched Fireware Pro, our advanced security and network operating system designed for more complex network environments. Fireware Pro comes bundled with
all Firebox X Peak appliances and is available as an upgrade to Firebox X Core appliances (formerly referred to as the Firebox X line).
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In August 2005, we introduced the Firebox SSL Core VPN Gateway with Citrix Secure Access. The Firebox SSL Core VPN Gateway combines Citrix SSL VPN secure access technology, the
Citrix Access Gateway, with our Firebox hardware platform to provide a professional-grade access solution for increasingly mobile SME workforces.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



15



---

##### Table of Contents

| |  |  | In October 2005, we introduced new enhancements for our security appliance, the Firebox X Edge. These new enhancements allow businesses to provide controlled network access to
visitors, added lightweight directory access protocol (LDAP) support which provides centralized control of Edge user privileges, and expanded its WebBlocker categories to 40 providing greater granularity in managing web access.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In May 2006, we introduced the new e-Series Unified Threat Management, or UTM, hardware platform that enhances performance, increases port density and adds security functions to our
Firebox X Core and Peak products lines. We also released Fireware Pro 8.3, the latest version of our advanced appliance software. As a result of this upgrade, Fireware Pro is now designed to enable anti-virus scanning on HTTP traffic, extending AV
protection to Web servers and clients. The new appliance software also supports networking functionality that provides greater security and flexibility to small and mid-sized businesses.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In June 2006, we introduced the new e-Series hardware and software solution for our Firebox X Edge product line. Designed for remote or branch offices and small businesses, the new
wired and wireless Firebox X Edge e-Series platforms extend ease of use and strong security by adding advanced networking and dynamic quality of service (QoS) support. These new hardware platforms have also been redesigned to meet the European Union
RoHS and WEEE environmental requirements required to sell new electronic hardware in the EU.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our financial statements, including those related to:



| |  |  | revenue recognition, including sales returns and allowances and promotional rebates;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | provision for doubtful accounts;
| | - |  | --------------------------------



| |  |  | inventory reserves;
| | - |  | -------------------



| |  |  | restructuring reserves;
| | - |  | -----------------------



| |  |  | analysis for impairment of goodwill and other long-lived intangible assets; and
| | - |  | -------------------------------------------------------------------------------



| |  |  | stock-based compensation.
| | - |  | -------------------------

We base our estimates on
historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from these estimates if our assumptions change or if actual circumstances differ from those in our assumptions.

We believe the following critical accounting policies affect the more significant judgments and estimates used in preparing our consolidated financial statements.

Revenue Recognition

Revenue recognition rules
for software companies are complex. Although we follow specific and detailed guidelines in measuring revenue, certain judgments affect the application of our revenue policy. The complexity of the revenue recognition rules and estimates inherent in
the revenue recognition process makes revenue results difficult to predict, and any shortfall in revenues or delay in recognizing revenues could cause our operating results to vary significantly from quarter to quarter and could result in future
operating losses.

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 to our service provider customers at volume pricing rates; and
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | sales of service subscription renewals directly to end-users, generally at the manufacturers suggested retail price.
| | - |  | ---------------------------------------------------------------------------------------------------------------------

Product revenues, net of sales returns, allowances and promotions, include:



| |  |  | sales of our Firebox products, bundling our security appliances and perpetual software licenses as part of our security solution;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



16



---

##### Table of Contents

| |  |  | revenues from license sales of software options, such as user expansion, software management modules and the license portion of subscriptions; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | revenues from sales of our network operations center security suite software license as part of our managed security solution.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------

Most of our Firebox products and certain software products include an initial period of service subscription (generally 3 to 12 months) bundled in the
product price. Because there is a timing difference between when products and service subscriptions are delivered, the related revenues must be allocated to each element using the residual method, as defined in Statement of Position, or SOP 98-9, an
amendment to SOP 97-2, Software Revenue Recognition, if vendor-specific objective evidence of fair value for undelivered elements of the arrangement (typically services) has been established. Under the residual method, the amounts
allocated to the undelivered elements (typically services) are equal to their fair value as established by vendor-specific objective evidence. The residual revenues in the arrangement are then allocated to the delivered elements (typically
products). Vendor-specific objective evidence of fair value is based on the price charged when an element is sold separately or, if an element is not yet sold separately, on the price established by authorized management if it is probable that the
price, once established, will not change before the element is separately introduced into the marketplace. Prior to recognizing any revenues, we ensure that there is persuasive evidence of the arrangement, delivery has occurred, collection is
probable, and the fee is fixed or determinable. For software that is delivered electronically in conjunction with a product sale, the delivery criterion discussed in the preceding paragraph is considered to have been met when the product has been
delivered, and additionally, the customer has been provided with access codes that allow the customer to take immediate possession of the software on its product pursuant to an agreement or purchase order for the product.

We are required to exercise judgment in deciding how to interpret the evidence of vendor-specific objective evidence of fair value to determine the
allocation of arrangement consideration with respect to a given element, and in determining whether an established price is likely to change prior to separate market introduction. These judgments may materially affect the timing of our revenue
recognition and operating results

We recognize revenues allocated to products, including software license fees, using either the sell
through or sell in method of revenue recognition as determined both by the sales support provided to customers within a market and by the contractual arrangement with each channel customer. When the channel customer is a distributor with unlimited
stock returns and rotation rights, or when we actively engage in activities to assist in selling distributor inventory to channel customers, product revenues are not recognized until the distributors sell the products to their channel customers (the
sell through method). Otherwise, revenue is recognized upon delivery of the products to the channel customer (the sell in method). Revenues from LiveSecurity Service subscriptions and other services are recognized ratably
over the term of the subscription, ranging from 3 to 30 months. Our standard payment terms range from 30 to 60 days. We offer term discounts to certain of our larger customers.

Service revenues primarily include the allocated fees for the initial LiveSecurity Service and other services subscriptions and for LiveSecurity Service
and other services subscription renewals. These service fees provide our customers access to our LiveSecurity Service and other services for product updates, security threat responses, general security information and technical support. These
service fees also give our service provider customers access to the LiveSecurity Service along with the ability to manage and update a specific number of their customers security appliances. Service subscription revenues are recognized ratably
on a monthly basis over the subscription period.

We have established allowances for estimated returns and pricing protection rights. We
have also established an allowance for promotional rebates that may be earned by our customers. We estimate these allowances and adjust them periodically based on historical rates of returns and allowances, as well as the expected effect of current
promotional programs and new product introductions. We estimate the allowance for promotional rebates based on the maximum amounts potentially available to the customers, unless we have accumulated sufficient historic evidence for individual
customers with respect to their realization of rebates. If new or expanded promotional programs are introduced, or new products are announced, additional allowances will be required. Alternatively, if actual promotional rebates fall below maximum
exposure levels, we will reduce the allowances and recognize additional revenue.

Provision for Doubtful Accounts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Judgment is
required when we assess the ultimate realization of receivables, including the probability of collection and the creditworthiness of each customer. If the financial condition of our customers were to deteriorate, resulting in an impairment of their
ability to make payments, additional allowances might be required, which could have an adverse effect on our financial condition and operating results.



17



---

##### Table of Contents

Inventory Valuation

Our inventories are stated at the lower of cost or market, with cost being determined on a first-in, first-out basis. When the inventories cost is in excess of their market value, we write our inventories down to
estimated market value based on assumptions about future demand and market conditions. The introduction of new products that replace existing products, technological advances, and variation in market trends or customer preferences could, however,
significantly affect these estimates and result in additional inventory write-downs, which could have an adverse effect on our financial condition and operating results.

Restructuring

During 2001 and 2002 we implemented two restructuring plans and recorded
significant accruals related to those restructuring plans. These accruals included estimates related to the abandonment of excess facilities. We later adjusted, as required, the restructuring accruals due to continued poor real estate market
conditions in the areas where these excess facilities are located. The actual costs related to the restructuring may differ from our estimate if it takes us longer than expected to find suitable tenants for excess facilities or if there are further
changes in the real estate market in those areas where excess facilities are located. Any additional adjustments resulting from these factors could have a material effect on our financial condition and operating results.

Accounting for Goodwill and Other Long-Lived Intangible Assets

Our business acquisitions have resulted in, and future acquisitions typically will result in, the recording of goodwill, which represents the excess of the purchase price over the fair value of identifiable assets
acquired and liabilities assumed, including capitalized technology and other definite-lived intangible assets.

Pursuant to Statement of
Financial Accounting Standards, or SFAS 142, Goodwill and Other Intangible Assets, we test goodwill for impairment at least annually. We have selected October 1 as the date for our annual impairment test. Application of the goodwill
impairment test may require judgments, including those inherent in the determination of fair value of the reporting unit in which the goodwill resides and the resulting determination of the implicit value of the goodwill. Significant judgments
required to estimate the fair value include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value.

Separable intangible assets that do not have indefinite lives are amortized over their useful lives typically ranging between three and five years. In
accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, these assets are also periodically reviewed for the existence of facts and circumstances, both internal and external, which may suggest potential
impairment. The determination of whether these intangible assets are impaired involves significant judgments based on short- and long-term projections of future performance. Certain of these forecasts reflect assumptions regarding our ability to
continue to develop and ultimately to commercialize the products based on these intangible assets, as well as our projections of future cash flows from these products. Changes in strategy and/or market conditions may result in an impairment charge
to our operating expenses, which could have an adverse effect on our financial condition and operating results

Stock-Based Compensation

As of January 1, 2006, we adopted SFAS 123R, Share-Based Payment (SFAS 123(R)). In accordance with SFAS 123(R), we
are required to measure compensation cost for stock awards at fair value and recognize compensation expense over the service period for awards expected to vest. The estimation of stock awards that will ultimately vest requires judgment, and to the
extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We use historical data to estimate pre-vesting forfeitures. Actual results,
and future changes in estimates, may differ substantially from our current estimates. Changes in these estimates could have a material impact on our reported results of operations.

We estimate the fair value of our stock options using the Black-Scholes valuation model. We estimate the expected term of options granted based on
historical exercise patterns, which we believe are representative of future behavior. We estimate the volatility of our common stock at the date of grant based on historical volatility. We base the risk-free interest rate that we use in the
Black-Scholes option valuation model on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with equivalent remaining terms. We use an expected dividend yield of zero in the Black-Scholes option valuation
model, as we have never paid any cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future. We may elect to use different assumptions under the Black-Scholes valuation model in the future, and
changes in these assumptions could materially affect the determination of fair value, and have a material impact on our reported results of operations.



18



---

##### Table of Contents

Results of Operations

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



|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   
|--------------------------------------- |  | -------------------------- | -- |  | ------------------------ | -- |  | ----- | -- |  | ----- | --
|                                        |  | Three Months EndedJune 30, |    |  | Six Months EndedJune 30, |   
|                                        |  | 2005                       |    |  | 2006                     |    |  | 2005  |    |  | 2006  |   
|Revenues:                               |  |                            |    |  |                          |    |  |       |    |  |       |   
|Product                                 |  | 63.4                       | %  |  | 50.9                     | %  |  | 59.6  | %  |  | 54.9  | % 
|Service                                 |  | 36.6                       |    |  | 49.1                     |    |  | 40.4  |    |  | 45.1  |   
|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   
|Total revenues                          |  | 100.0                      |    |  | 100.0                    |    |  | 100.0 |    |  | 100.0 |   
|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   
|Cost of revenues:                       |  |                            |    |  |                          |    |  |       |    |  |       |   
|Product                                 |  | 25.9                       |    |  | 22.0                     |    |  | 25.3  |    |  | 23.4  |   
|Service                                 |  | 7.2                        |    |  | 11.2                     |    |  | 7.9   |    |  | 10.1  |   
|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   
|Total cost of revenues                  |  | 33.1                       |    |  | 33.2                     |    |  | 33.2  |    |  | 33.5  |   
|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   
|Gross margin                            |  | 66.9                       |    |  | 66.8                     |    |  | 66.8  |    |  | 66.5  |   
|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   
|Operating expenses:                     |  |                            |    |  |                          |    |  |       |    |  |       |   
|Sales and marketing                     |  | 37.4                       |    |  | 40.3                     |    |  | 42.1  |    |  | 39.2  |   
|Research and development                |  | 23.7                       |    |  | 28.7                     |    |  | 25.1  |    |  | 29.0  |   
|General and administrative              |  | 16.6                       |    |  | 20.9                     |    |  | 16.6  |    |  | 22.2  |   
|Amortization of other intangible assets |  | 1.2                        |    |  | 1.5                      |    |  | 1.3   |    |  | 1.4   |   
|Restructuring charges                   |  | 0.0                        |    |  | 0.5                      |    |  | 0.0   |    |  | 0.3   |   
|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   
|Total operating expenses                |  | 78.9                       |    |  | 91.9                     |    |  | 85.1  |    |  | 92.1  |   
|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   
|Operating loss                          |  | (12.0                      | )  |  | (25.1                    | )  |  | (18.3 | )  |  | (25.6 | ) 
|Interest and other income, net          |  | 2.4                        |    |  | 4.9                      |    |  | 2.5   |    |  | 4.4   |   
|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   
|Loss before income taxes                |  | (9.6                       | )  |  | (20.2                    | )  |  | (15.8 | )  |  | (21.2 | ) 
|Provision for income taxes              |  | 0.1                        |    |  | 0.2                      |    |  | 0.2   |    |  | 0.1   |   
|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   
|Net loss                                |  | (9.7                       | )% |  | (20.4                    | )% |  | (16.0 | )% |  | (21.3 | )%
|                                        |  |                            |    |  |                          |    |  |       |    |  |       |   

Revenues



|                                   |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|---------------------------------- |  | --------------------------- | ------ | - | -------------------------- | - | ------ | ------------------------- | ---- | ----- | -------------------------- | ---- | - | ------ | - |  | - | ------ | - |  | ----- | --
|                                   |  | Three Months Ended June 30, |        |   | Percent Increase(Decrease) |   |        | Six Months Ended June 30, |      |       | Percent Increase(Decrease) |     
|                                   |  | 2005                        |        |   | 2006                       |   |        |                           | 2005 |       |                            | 2006 |   |       
|Revenues (in thousands):           |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Product                            |  | $                           | 12,878 |   |                            | $ | 8,390  |                           |      | (34.9 | )%                         |      | $ | 22,009 |   |  | $ | 19,263 |   |  | (12.5 | )%
|Service                            |  |                             | 7,445  |   |                            |   | 8,078  |                           |      | 8.5   | %                          |      |   | 14,929 |   |  |   | 15,795 |   |  | 5.8   | % 
|                                   |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Total                              |  | $                           | 20,323 |   |                            | $ | 16,468 |                           |      | (19.0 | )%                         |      | $ | 36,938 |   |  | $ | 35,058 |   |  | (5.1  | )%
|                                   |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Revenues (as % of total revenues): |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Product                            |  |                             | 63.4   | % |                            |   | 50.9   | %                         |      |       |                            |      |   | 59.6   | % |  |   | 54.9   | % |  |       |   
|Service                            |  |                             | 36.6   |   |                            |   | 49.1   |                           |      |       |                            |      |   | 40.4   |   |  |   | 45.1   |   |  |       |   
|                                   |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Total                              |  |                             | 100.0  | % |                            |   | 100.0  | %                         |      |       |                            |      |   | 100.0  | % |  |   | 100.0  | % |  |       |   
|                                   |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   



19



---

##### Table of Contents

We categorize our revenues into three geographic regions: the Americas, Europe/Middle East/Africa, or
EMEA, and Asia Pacific, or APAC. Revenue information by geographic region, in dollars and as a percentage of total revenues, was as follows:



|                                   |  |                             |        |   |                 |   |        |                           |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|---------------------------------- |  | --------------------------- | ------ | - | --------------- | - | ------ | ------------------------- | ---- | ----- | ------------------------- | ---- | - | ------ | - |  | - | ------ | - |  | ----- | --
|                                   |  | Three Months Ended June 30, |        |   | PercentDecrease |   |        | Six Months Ended June 30, |      |       | PercentIncrease(Decrease) |     
|                                   |  | 2005                        |        |   | 2006            |   |        |                           | 2005 |       |                           | 2006 |   |       
|Revenues (in thousands):           |  |                             |        |   |                 |   |        |                           |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|Americas                           |  | $                           | 9,141  |   |                 | $ | 8,828  |                           |      | (3.4  | )%                        |      | $ | 16,589 |   |  | $ | 17,938 |   |  | 8.1   | % 
|EMEA                               |  |                             | 7,959  |   |                 |   | 5,284  |                           |      | (33.6 | )%                        |      |   | 14,744 |   |  |   | 11,901 |   |  | (19.3 | )%
|APAC                               |  |                             | 3,223  |   |                 |   | 2,356  |                           |      | (26.9 | )%                        |      |   | 5,605  |   |  |   | 5,219  |   |  | (6.9  | )%
|                                   |  |                             |        |   |                 |   |        |                           |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|Total                              |  | $                           | 20,323 |   |                 | $ | 16,468 |                           |      | (19.0 | )%                        |      | $ | 36,938 |   |  | $ | 35,058 |   |  | (5.1  | )%
|                                   |  |                             |        |   |                 |   |        |                           |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|Revenues (as % of total revenues): |  |                             |        |   |                 |   |        |                           |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|Americas                           |  |                             | 45.0   | % |                 |   | 53.6   | %                         |      |       |                           |      |   | 44.9   | % |  |   | 51.2   | % |  |       |   
|EMEA                               |  |                             | 39.2   |   |                 |   | 32.1   |                           |      |       |                           |      |   | 39.9   |   |  |   | 33.9   |   |  |       |   
|APAC                               |  |                             | 15.8   |   |                 |   | 14.3   |                           |      |       |                           |      |   | 15.2   |   |  |   | 14.9   |   |  |       |   
|                                   |  |                             |        |   |                 |   |        |                           |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|Total                              |  |                             | 100.0  | % |                 |   | 100.0  | %                         |      |       |                           |      |   | 100.0  | % |  |   | 100.0  | % |  |       |   
|                                   |  |                             |        |   |                 |   |        |                           |      |       |                           |      |   |        |   |  |   |        |   |  |       |   

The dollar and percentage decrease in product revenues, for the three months ended June 30,
2006, as compared to the three months ended June 30, 2005, was primarily attributable to certain channel customers in the United Kingdom, or U.K., and Germany-Austria-Switzerland, or DACH, that converted to the sell through method of revenue
recognition beginning in the second quarter of 2006, a reduction in shipments, and increased promotional rebates associated with expanded programs.

The dollar and percentage decrease in product revenues, for the six months ended June 30, 2006, as compared to the six months ended June 30, 2005, was primarily due to a reduction in shipments and increased promotional rebates
associated with expanded programs.

We recognize revenue from certain of our channel customers when we sell product to them (the sell
in method). Where the customer is a distributor with unlimited stock returns and rotation rights, or when we actively engage in activities to assist in selling distributor inventory to channel customers, product revenues are not recognized
until the distributors sell the products to their customers (the sell through method). During the first quarter of 2005, we negotiated changes in contractual obligations with certain channel customers in North America, Australia and New
Zealand, which provided such customers with unlimited return rights. The changes were triggered by the need to offer promotional programs to give us the flexibility in the respective markets to be more competitive, responsive and effective. As a
result of these contract changes, we converted these customers to a sell through method beginning in the first quarter of 2005. When a channel customer is converted from the sell in method to the sell through method of revenue recognition, revenue
can no longer be recognized when product is sold to the channel customer, because revenue from products in that channel customers inventory was already recognized in prior periods. Therefore, revenue on individual inventory items sold
subsequent to the conversion can only be recognized after the converted channel customer has disposed of its inventory predating the conversion. As of December 31, 2004, the converted customers held inventory for which we had already recognized
revenues in the amount of $2.3 million. Substantially all of these inventories were sold through by the converted customers during the first quarter of 2005.

During the second quarter of 2006, we converted certain channel customers in the U.K. and DACH to a sell through method of revenue recognition. As of March 31, 2006, the converted customers held inventory for
which WatchGuard had already recognized revenues in the amount of $2.2 million. During the second quarter of 2006, these customers sold through approximately $1.9 million of these inventories with approximately $300,000 carried over to later
quarters.

While the conversion of customers from a sell in method to a sell through method of revenue recognition resulted in a reduction
of revenues during the quarter of conversion, the total effect of this reduction cannot be measured reliably due to a change in customer buying patterns upon conversion to the sell through method.

We plan on taking similar measures with the remaining customers in Europe in the third quarter of 2006, and are evaluating taking similar measures with
our customers in our remaining geographic locations. To the extent that sales support activities and conversions of additional channel customers require us to record revenue on the sell through method, there will be a material adverse effect on
revenues and results of operations for the quarter in which those conversions take place, with the magnitude depending on the inventory levels with those channel customers at the time of conversion. To recognize revenue on a sell through method from
a channel customer, we will need to obtain adequate reporting on inventory levels from that channel customer to determine how much of our product has been sold to the end customers. If we are unable to obtain such reporting, our ability to recognize
revenue from such channel customers could be materially adversely affected and our financial results would be harmed.



20



---

##### Table of Contents

From a regional standpoint, the dollar decrease in revenues in the Americas and the international markets
for the three months ended June 30, 2006, as compared to the three months ended June 30, 2005, was primarily attributed to fewer shipments and the conversion of certain channel customers in the U.K. and DACH to the sell through method of
revenue recognition during the second quarter of 2006. Revenues from the Americas market increased in the six month period ended June 30, 2006, as compared to the six months period ended June 30, 2005 primarily due to the effects of
converting certain channel customers in North America to the sell through method of revenue recognition in the first quarter of 2005. Revenues from the international markets decreased primarily due to fewer shipments, the conversion of certain
international customers in Europe to the sell through method of revenue recognition during the second quarter of 2006 and increased promotional rebates associated with expanded programs.

Given the continuing economic and geopolitical uncertainty, it is difficult to predict product revenue levels in future quarters, which may decline or
fluctuate more than they have historically.

Service revenues consist of revenues recognized from initial fees for our LiveSecurity Service
and other service subscriptions bundled with a hardware or software product sale, and revenues recognized for subscription renewals sold to our existing customer base. The dollar and percentage increase in service revenues for the three and six
months ended June 30, 2006, compared to the three and six months ended June 30 2005, was primarily due to growth of our installed customer base, resulting in a greater number of LiveSecurity Service renewals, as well as initial purchases
of existing and new subscription-based services.

Service revenues recognized from initial LiveSecurity Service and other service
subscription fees are generally related to product and software shipments in preceding quarters, while revenues recognized from service renewals depend on the existing customer base and the percentage of those customers eligible for renewal that
elect to renew their subscriptions. A decline in product shipments will result in lower initial LiveSecurity Service subscriptions bundled with the products, while an increase in our installed customer base, even from declining product shipments,
will increase the number of customers with the opportunity to renew their LiveSecurity Service subscriptions. Due to these factors, it is difficult to predict future service revenue levels.

Cost of Revenues and Gross Margin



|                                                      |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|----------------------------------------------------- |  | --------------------------- | ------ | - | -------------------------- | - | ------ | ------------------------- | ---- | ----- | -------------------------- | ---- | - | ------ | - |  | - | ------ | - |  | ----- | --
|                                                      |  | Three Months Ended June 30, |        |   | Percent Increase(Decrease) |   |        | Six Months Ended June 30, |      |       | Percent Increase(Decrease) |     
|                                                      |  | 2005                        |        |   | 2006                       |   |        |                           | 2005 |       |                            | 2006 |   |       
|Cost of revenues (in thousands):                      |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Product                                               |  | $                           | 5,265  |   |                            | $ | 3,626  |                           |      | (31.1 | )%                         |      | $ | 9,348  |   |  | $ | 8,194  |   |  | (12.3 | )%
|Service                                               |  |                             | 1,457  |   |                            |   | 1,835  |                           |      | 25.9  | %                          |      |   | 2,928  |   |  |   | 3,539  |   |  | 20.9  | % 
|                                                      |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Total                                                 |  | $                           | 6,722  |   |                            | $ | 5,461  |                           |      | (18.8 | )%                         |      | $ | 12,276 |   |  | $ | 11,733 |   |  | (4.4  | )%
|                                                      |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Cost of revenues (as % of total revenues):            |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Product                                               |  |                             | 25.9   | % |                            |   | 22.0   | %                         |      |       |                            |      |   | 25.3   | % |  |   | 23.4   | % |  |       |   
|Service                                               |  |                             | 7.2    |   |                            |   | 11.2   |                           |      |       |                            |      |   | 7.9    |   |  |   | 10.1   |   |  |       |   
|                                                      |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Total                                                 |  |                             | 33.1   | % |                            |   | 33.2   | %                         |      |       |                            |      |   | 33.2   | % |  |   | 33.5   | % |  |       |   
|                                                      |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Cost of revenues (as % of related revenue component): |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Product (as % of product revenues)                    |  |                             | 40.9   | % |                            |   | 43.2   | %                         |      |       |                            |      |   | 42.5   | % |  |   | 42.5   | % |  |       |   
|Service (as % of service revenues)                    |  |                             | 19.6   | % |                            |   | 22.7   | %                         |      |       |                            |      |   | 19.6   | % |  |   | 22.4   | % |  |       |   
|Gross margin (in thousands):                          |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Product                                               |  | $                           | 7,613  |   |                            | $ | 4,764  |                           |      | (37.4 | )%                         |      | $ | 12,661 |   |  | $ | 11,069 |   |  | (12.6 | )%
|Service                                               |  |                             | 5,988  |   |                            |   | 6,243  |                           |      | 4.3   | %                          |      |   | 12,001 |   |  |   | 12,256 |   |  | 2.1   | % 
|                                                      |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Total                                                 |  | $                           | 13,601 |   |                            | $ | 11,007 |                           |      | (19.1 | )%                         |      | $ | 24,662 |   |  | $ | 23,325 |   |  | (5.4  | )%
|                                                      |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Gross margin (as % of related revenue component):     |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   
|Product (as % of product revenues)                    |  |                             | 59.1   | % |                            |   | 56.8   | %                         |      |       |                            |      |   | 57.5   | % |  |   | 57.5   | % |  |       |   
|Service (as % of service revenues)                    |  |                             | 80.4   | % |                            |   | 77.3   | %                         |      |       |                            |      |   | 80.4   | % |  |   | 77.6   | % |  |       |   
|Total (as % of total revenues)                        |  |                             | 66.9   | % |                            |   | 66.8   | %                         |      |       |                            |      |   | 66.8   | % |  |   | 66.5   | % |  |       |   
|                                                      |  |                             |        |   |                            |   |        |                           |      |       |                            |      |   |        |   |  |   |        |   |  |       |   



21



---

##### Table of Contents

Gross margins are affected by various factors, including the mix of product and service sales (which
include hardware and software products and LiveSecurity Service and other service subscriptions), discount levels offered to our customers, the cost of our hardware appliances (including components and labor), costs of excess and obsolete inventory,
lower of cost or market assessment of inventory carrying value, fixed manufacturing overhead, the cost of royalties associated with our products, promotional programs, and the cost of our technical support organization and LiveSecurity Service.

Cost of product revenues includes the cost of manufacturing our security appliances, distribution operations, product packaging,
third-party product licensing fees and provisions for inventory reserves and product warranty costs.

The decrease in cost of product
revenues, in terms of absolute dollars, for the three months ended June 30, 2006, as compared to the three months ended June 30, 2005, was primarily due to lower shipments, a decrease in the costs of excess and obsolete inventory caused by
product life cycle considerations, and reduced freight costs, which includes a refund resulting from overpayment of freight paid in prior periods.

The decrease in cost of product revenues, in terms of absolute dollars, for the six months ended June 30, 2006, as compared to the six months ended June 30, 2005, was primarily due to lower shipments and reduced freight costs,
partially offset by an increase in royalties for third-party intellectual property.

The dollar decrease in product gross margins for the
three and six months ended June 30, 2006, compared to the three and six months ended June 30, 2005, was primarily due to increased promotional rebates associated with expanded programs and increased royalties for third-party intellectual
property.

Cost of service revenues includes the costs of our technical support organization and direct costs associated with our
LiveSecurity Service. Cost of service revenue increased, in terms of absolute dollars, for the three and six months ended June 30, 2006, as compared to the three and six months ended June 30, 2005, primarily due to increased headcount and
a higher proportion of information technology costs incurred in support of our technical support organization during the first and second quarters of 2006.

The dollar increase in service gross margins for the three and six months ended June 30, 2006, compared to the three and six months ended June 30, 2005 is primarily due to growth of our installed customer
base. The percentage decrease in service gross margins for the three and six months ended June 30, 2006, compared to the three and six months ended June 30, 2005 is primarily due to higher costs incurred in support of our technical support
organization and LiveSecurity Service as discussed above.

Forecasting future gross margins is difficult, as our gross margins could be
adversely affected in the future by heightened sales price competition, increased material costs, key component shortages and excess and obsolete inventory charges. Our margins could also be negatively affected by continued economic uncertainty,
which could result in downward pressure on the prices of technology-based products.



22



---

##### Table of Contents

Operating Expenses

Sales and Marketing



|                                                      |  |                             |       |   |                  |   |       |                           |      |       |                  |      |   |        |   |  |   |        |   |  |       |   
|----------------------------------------------------- |  | --------------------------- | ----- | - | ---------------- | - | ----- | ------------------------- | ---- | ----- | ---------------- | ---- | - | ------ | - |  | - | ------ | - |  | ----- | --
|                                                      |  | Three Months Ended June 30, |       |   | Percent Decrease |   |       | Six Months Ended June 30, |      |       | Percent Decrease |     
|                                                      |  | 2005                        |       |   | 2006             |   |       |                           | 2005 |       |                  | 2006 |   |       
|Sales and marketing expenses (in thousands)           |  | $                           | 7,607 |   |                  | $ | 6,630 |                           |      | (12.8 | )%               |      | $ | 15,553 |   |  | $ | 13,731 |   |  | (11.7 | )%
|Sales and marketing expenses (as % of total revenues) |  |                             | 37.4  | % |                  |   | 40.3  | %                         |      |       |                  |      |   | 42.1   | % |  |   | 39.2   | % |  |       |   

Sales and marketing expenses include salaries, commissions and employee-related expenses,
stock-based compensation and certain discretionary marketing expenses, including distributor promotional costs, public relations costs, marketing collateral, trade shows, advertising expenses, direct marketing and costs of demonstration units.

Sales and marketing expenses decreased, in terms of absolute dollars, for the three and six months ended June 30, 2006, as compared
to the three and six months ended June 30, 2005. The decrease in sales and marketing expenses is primarily due to:



| |  |  | A decrease in cash-based compensation and benefit expenses, primarily due to a reduction in sales commission directly related to the achievement of corporate objectives, and the
departure of certain individuals in senior management; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Lower discretionary spending on marketing-related activities in 2006, primarily due to planned reductions in marketing costs for trade shows and product marketing. The decrease was
partially offset by increases in our marketing development fund expenditures, reflecting increased activities associated with our new e-Series UTM hardware platform.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We expect our sales and marketing expenses, in terms of absolute dollars, for the third quarter of 2006 will remain comparable to levels incurred in the
second quarter of 2006. Our actual sales and marketing expenses could differ materially from those anticipated, which could have an adverse effect on our operating results.

Research and Development



|                                                           |  |                             |       |   |                  |   |       |                           |      |      |                  |      |   |       |   |  |   |        |   |  |     |  
|---------------------------------------------------------- |  | --------------------------- | ----- | - | ---------------- | - | ----- | ------------------------- | ---- | ---- | ---------------- | ---- | - | ----- | - |  | - | ------ | - |  | --- | -
|                                                           |  | Three Months Ended June 30, |       |   | Percent Decrease |   |       | Six Months Ended June 30, |      |      | Percent Increase |     
|                                                           |  | 2005                        |       |   | 2006             |   |       |                           | 2005 |      |                  | 2006 |   |      
|Research and development expenses (in thousands)           |  | $                           | 4,821 |   |                  | $ | 4,734 |                           |      | (1.8 | )%               |      | $ | 9,264 |   |  | $ | 10,167 |   |  | 9.7 | %
|Research and development expenses (as % of total revenues) |  |                             | 23.7  | % |                  |   | 28.7  | %                         |      |      |                  |      |   | 25.1  | % |  |   | 29.0   | % |  |     |  

Research and development expenses include costs associated with the development of new products,
enhancements of existing products, product integration efforts, product certifications and quality assurance activities. These costs consist primarily of employee salaries and benefits, including stock-based compensation, costs of noncapitalized
equipment, software tools, our security appliance prototypes and certification procedures, payments to designers and contractors and depreciation of capital equipment and software.

Research and development expenses decreased, in terms of absolute dollars, for the three months ended June 30, 2006, as compared to the three months
ended June 30, 2005. The decrease in research development expenses is primarily due to a reduction in stock-based compensation costs resulting from the adoption of SFAS 123(R).

Research and development expenses increased, in terms of absolute dollars, for the six months ended June 30, 2006, as compared to the six months
ended June 30, 2005, primarily due to:



| |  |  | An increase in compensation and benefit expenses, reflecting a significant planned increase in headcount; and
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | Higher spending on contract labor, consulting and outsourced development and certification costs, primarily costs incurred in support of anticipated future product launches.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We anticipate our research and development expenses, in terms of absolute dollars, in the third quarter of 2006 to be
comparable to levels incurred in the second quarter of 2006. Research and development expenses may vary significantly from quarter to quarter due to inherent uncertainties in the timing of certain development costs. Our actual research and



23



---

##### Table of Contents

development expenses could differ materially from those anticipated which could have an adverse effect on our operating results.

General and Administrative



|                                                             |  |                             |       |   |                  |   |       |                           |      |     |                  |      |   |       |   |  |   |       |   |  |      |  
|------------------------------------------------------------ |  | --------------------------- | ----- | - | ---------------- | - | ----- | ------------------------- | ---- | --- | ---------------- | ---- | - | ----- | - |  | - | ----- | - |  | ---- | -
|                                                             |  | Three Months Ended June 30, |       |   | Percent Increase |   |       | Six Months Ended June 30, |      |     | Percent Increase |     
|                                                             |  | 2005                        |       |   | 2006             |   |       |                           | 2005 |     |                  | 2006 |   |      
|General and administrative expenses (in thousands)           |  | $                           | 3,368 |   |                  | $ | 3,444 |                           |      | 2.3 | %                |      | $ | 6,124 |   |  | $ | 7,771 |   |  | 26.9 | %
|General and administrative expenses (as % of total revenues) |  |                             | 16.6  | % |                  |   | 20.9  | %                         |      |     |                  |      |   | 16.6  | % |  |   | 22.2  | % |  |      |  

General and administrative expenses include costs of executive, human resource, finance and
administrative support functions, stock-based compensation, provisions for doubtful accounts, costs of legal and accounting professional services, and director and officer insurance.

General and administrative expenses increased, in terms of absolute dollars, for the three and six months ended June 30, 2006, as compared to the
three and six months ended June 30, 2005. The increase in general and administrative expenses is primarily due to:



| |  |  | An increase in compensation and benefit expenses, reflecting stock-based compensation costs resulting from the adoption of SFAS 123(R), and a significant planned increase in
headcount; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Higher legal and professional expenses, reflecting costs associated with ongoing litigation and various other legal matters, including our proposed acquisition by Gladiator
Corporation.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The increase in general and administrative expenses is partially offset by a reduction in audit fees and costs
incurred in connection with corporate governance requirements pursuant to the Sarbanes-Oxley Act of 2002 and a refund resulting from overpayment of business and occupation taxes in prior periods.

Supplemental Information about Stock-Based Compensation

On January 1, 2006, we adopted the provisions of SFAS 123(R) using the modified prospective method, which requires measurement of compensation cost for all stock-based awards at fair value on the date of grant
and recognition of compensation cost over the service period for awards expected to vest. The fair value of our stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation technique previously utilized
for stock options in footnote disclosures required under SFAS 123. The fair value of our restricted stock is determined based on the number of shares granted and the quoted price of our common stock. Under SFAS 123(R), our expenses associated with
restricted stock and stock option awards are recognized over the respective service period, which generally equals the vesting period, net of estimated forfeitures, using the straight-line method. The estimation of stock awards that will ultimately
vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised.

Prior to the adoption of SFAS 123(R), we followed the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees to account for our employee stock option and restricted stock awards. Accordingly, compensation cost for stock option and restricted stock awards was measured as the excess, if any, of the quoted
market price of our common stock at the measurement date (or the balance sheet date, if the measurement date had not yet occurred) over the amount, if any, required to be paid by the employee. Compensation cost was charged to expense over the
vesting period of each respective award using the accelerated method of expense recognition. To the extent stock awards were forfeited prior to vesting, the corresponding previously recognized expense was reversed as an offset to operating expenses.
Also, to the extent stock options awards were subject to a repricing, exchange offer, other modifications or performance criteria, such awards were subject to variable accounting treatment. Measurement date was defined as the grant date for all
stock awards other than variable stock options and variable restricted stock awards. Measurement date for variable stock options and variable restricted stock awards was the date both the number of shares and purchase (exercise) price, if any, were
known. Accordingly, changes in the quoted market price of our common stock were reflected as an adjustment to stock-based compensation expense for variable awards in the periods in which the changes occurred until the date both the number of shares
and purchase price, if any, were known.



24



---

##### Table of Contents

The following table summarizes stock-based compensation expense for stock awards and purchases under our
Employee Stock Purchase Plan, or ESPP, for the three and six months ended June 30, 2005 and 2006 (in thousands):



|                           |  |                             |     |                           |   |      |  |      |     |  |   |      
|-------------------------- |  | --------------------------- | --- | ------------------------- | - | ---- |  | ---- | --- |  | - | -----
|                           |  | Three Months Ended June 30, |     | Six Months Ended June 30,
|                           |  | 2005                        |     | 2006                      |   | 2005 |  | 2006
|Cost of revenues:          |  |                             |     |                           |   |      |  |      |     |  |   |      
|Product                    |  | $                           | 10  |                           | $ | 5    |  | $    | 10  |  | $ | 13   
|Service                    |  |                             | 52  |                           |   | 28   |  |      | 52  |  |   | 63   
|Sales and marketing        |  |                             | 252 |                           |   | 158  |  |      | 252 |  |   | 393  
|Research and development   |  |                             | 415 |                           |   | 151  |  |      | 415 |  |   | 403  
|General and administrative |  |                             | 238 |                           |   | 416  |  |      | 238 |  |   | 957  
|                           |  |                             |     |                           |   |      |  |      |     |  |   |      
|Total                      |  | $                           | 967 |                           | $ | 758  |  | $    | 967 |  | $ | 1,829
|                           |  |                             |     |                           |   |      |  |      |     |  |   |      

At June 30, 2006, we had $2.8 million of unrecognized compensation expense related to our
unvested stock options and restricted stock awards. The weighted average period over which we expect to recognize this expense is approximately 1.3 years.

Amortization of Other Intangible Assets

Amortization of other intangible assets consists primarily
of amortization of capitalized technology obtained in our acquisition of RapidStream in 2002. This technology is expected to be fully amortized by March 31, 2007. We amortize our intangible assets acquired on a straight-line basis over an
expected useful life of five years.

Amortization of other intangible assets was $243,000 for the three months ended June 30, 2005 and
2006, and was $487,000 and $486,000 for the six months ended June 30, 2005 and 2006, respectively.

Restructuring Charges

Restructuring charges for the three months ended June 30, 2006 are associated with the restructuring plans initiated in 2001 and
2002. Costs incurred in 2006 related to the revision of our estimates for future costs associated with the sublease of excess facilities in our corporate headquarters in Seattle, Washington.

During the second quarter of 2006, we incurred an additional $110,000 of restructuring charges associated with our 2001 restructuring plan. The
additional charge was due to a revision in the cost of excess facilities resulting from a change in the commencement date of a subleasing arrangement. These charges were offset by an $18,000 reduction in the 2002 restructuring liability during the
second quarter of 2006, due to the revision of estimated proceeds from the rate renegotiation on a subleasing arrangement.

Interest and Other
Income, Net

Interest and other income, net, is primarily comprised of interest income generated from our available-for-sale
investments. Interest income was $488,000 and $814,000 for the three months ended June 30, 2005 and 2006, respectively, and $940,000 and $1.5 million for the six months ended June 30, 2005 and 2006, respectively. The increase in
interest and other income, net is primarily due to higher interest rates on invested balances in 2006.

Income Tax Provision

Income tax expense was $29,000 and $30,000 for the three months ended June 30, 2005 and 2006, respectively. Income tax expense was $71,000 and
$48,000 for the six months ended June 30, 2005 and 2006, respectively. Income tax expense, in all periods, primarily relates to our provision for foreign income taxes associated with our international operations.

Liquidity and Capital Resources

At June 30,
2006, we had $75.4 million in cash, cash equivalents, available-for-sale investments and restricted cash, which were invested primarily in high-quality money market accounts and marketable securities, as compared to $77.8 million at
December 31, 2005. We believe that the market risk arising from our holdings of these financial instruments is not material. Our working capital at June 30, 2006 was $51.3 million, as compared to $56.4 million at December 31, 2005.



25



---

##### Table of Contents

Operating Activities

Our operating activities resulted in net cash outflows of $4.0 million for the six months ended June 30, 2005 and $3.1 million for the six months
ended June 30, 2006. Operating cash outflows during each of these periods reflects net losses adjusted for non-cash expenses and changes in operating assets and liabilities.

The difference between our net loss and our operating cash outflow is attributable to noncash expenses included in net loss, and changes in the operating
assets and liabilities, as presented below (in thousands):



|                                            |  |                          |        |   |      |   |        |  
|------------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ------ | -
|                                            |  | Six Months EndedJune 30, |       
|                                            |  | 2005                     |        |   | 2006 |  
|Net loss                                    |  | $                        | (5,897 | ) |      | $ | (7,436 | )
|Noncash expenses                            |  |                          | 2,757  |   |      |   | 3,712  |  
|Changes in operating assets and liabilities |  |                          | (897   | ) |      |   | 613    |  
|                                            |  |                          |        |   |      |   |        |  
|Net cash used in operating activities       |  | $                        | (4,037 | ) |      | $ | (3,111 | )
|                                            |  |                          |        |   |      |   |        |  

Noncash expenses are associated with the amortization of other intangible assets, depreciation and
amortization of property and equipment, and stock-based compensation charges resulting from the issuance of stock options and restricted stock to employees, directors and consultants and stock purchases under our ESPP.

Changes in operating assets and liabilities primarily reflect changes in working capital components of the balance sheet, apart from cash and short-term
available-for-sale investments, and changes in long-term deferred rent, long-term deferred revenues and long-term restructuring liabilities. Significant fluctuations within each of these categories are described below.

Trade Accounts Receivable, Net decreased from $4.9 million at December 31, 2005 to $3.2 million at June 30, 2006. Days sales
outstanding, or DSOs, calculated on a quarterly basis, was 23 days at December 31, 2005 and 20 days at June 30, 2006. DSOs are affected by:



| |  |  | the payment terms contained in our customer contracts (which may vary geographically);
| | - |  | --------------------------------------------------------------------------------------



| |  |  | term discounts taken by our customers;
| | - |  | --------------------------------------



| |  |  | revenues on product sales for some of our major distributors that are recorded when these distributors have sold the product to their customers;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the conversion of customers from sell-in to the sell through method;
| | - |  | --------------------------------------------------------------------



| |  |  | risks associated with the uncertain economy; and
| | - |  | ------------------------------------------------



| |  |  | whether revenues in a particular quarter are linear (that is, whether revenues are evenly distributed throughout the quarter or weighted more toward the end of the quarter).
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Accounts Payable decreased from $4.7 million at December 31, 2005 to $2.3 million at June 30, 2006,
primarily due to timing of payment of accounts payable.

Total Accrued Restructuring Costs decreased from $3.9 million at
December 31, 2005 to $3.4 million at June 30, 2006, reflecting the ongoing payment of rents on abandoned facilities, net of sublease income.

Total Deferred Revenuesincreased from $20.4 million at December 31, 2005 to $22.9 million at June 30, 2006. The increase in deferred revenues is primarily due to LiveSecurity Service subscription
renewals on a growing installed customer base, partially offset by expirations and non-renewals of existing subscriptions and sales returns and allowances.

Investing Activities

Cash provided by investing activities was $8.3 million and $2.7 million
for the six months ended June 30, 2005 and 2006, respectively. In both periods, these amounts primarily reflect changes in our investment portfolio and capital expenditures for property and equipment.

Financing Activities

Cash
provided by financing activities totaled $356,000 and $2.4 million for the six months ended June 30, 2005 and 2006, respectively. Cash provided by financing activities in both periods reflects the exercise of employee stock options and the
purchase of common stock through our ESPP. Cash provided by financing activities for the six months ended June 30, 2006 also reflects a $600,000 reduction in restricted cash.



26



---

##### Table of Contents

We believe that our existing available cash, cash equivalents and available-for-sale investments will be
sufficient to meet our operating expenses, working capital needs and capital expenditure requirements for at least the next 12 months. However, if the underlying assumed levels of spending prove to be inaccurate, or if we choose to pursue
acquisitions or investments in complementary business technology, we may seek additional funding before that time through public or private financings or other arrangements.



|ITEM3. | 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 short-term investments 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 at the time of purchase, with the exception of U.S. treasury and agency
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, with the average maturity of our investments equal to one year or less. The 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 affected by either a 100 basis point increase or decrease in interest rates,
due primarily to the short-term nature of the major portion 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 incurred some expenses in foreign currencies during the three and six months ended June 30, 2006 and expect to continue to do so in the future, we do not anticipate that foreign exchange gains or losses will
be material to us. Although we have not engaged in foreign currency hedging to date, we may do so in the future. In addition, we may be required to denominate our sales in foreign currencies at some point in the future to remain competitive.



|ITEM4. | CONTROLS AND PROCEDURES
|------ | -----------------------

Evaluation of disclosure controls and procedures. As of the end of the period covered by this quarterly report, we carried out an evaluation, under the supervision and with the participation of our
management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) of the Securities
Exchange Act of 1934, as amended, or the Exchange Act). You should note that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed
in achieving its stated goals under all potential future conditions. Based on our evaluation as of that date, including an evaluation of changes in internal controls over financial reporting described in the paragraph below, our Chief Executive
Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act
is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and is accumulated and communicated to management, including our Chief Executive Officer and our Chief Financial Officer, as
appropriate to allow timely decisions regarding required disclosure.

Changes in internal controls over financial
reporting. There were no significant changes in our internal controls over financial reporting during the second quarter of 2006 that have materially affected, or are reasonably likely to materially affect, our internal controls over
financial reporting.

PART II. OTHER INFORMATION



|ITEM1. | LEGAL PROCEEDINGS
|------ | -----------------

We
are subject to legal claims and litigation arising in the ordinary course of business, such as employment or intellectual property claims. The outcome of any such matters is currently undeterminable and an adverse result in one or more matters could
negatively affect our operating results in the period in which it occurs.

WatchGuard, SonicWALL, Inc., and Michael N. Valentine, a former
WatchGuard and current SonicWALL employee, have conclusively resolved the lawsuit filed by WatchGuard in the United States District Court for the Northern District of Texas, Dallas Division, as well as the counterclaim filed in the same action by
Mr. Valentine against WatchGuard. The action has been resolved to the parties mutual satisfaction and has accordingly been dismissed with prejudice to its refiling.



27



---

##### Table of Contents

On April 8, 2005, a holder of our common stock, on behalf of himself and purportedly on behalf of a
class of our stockholders, filed an action in the United States District Court for the Western District of Washington, or the Washington Court, against us and some of our current and former officers, alleging violations of the federal securities
laws arising out of, among other things, our announcement on March 15, 2005 that we were restating some of our financial results for interim periods of 2004. Subsequently, a number of other related purported class action suits also alleging
violations of the federal securities laws were filed by holders of our common stock. The various actions have been consolidated by the Washington Court, and are referred to herein as the Action. On October 3, 2005, a consolidated amended
complaint was filed in the Action and we filed a motion to dismiss the consolidated amended complaint. On April 21, 2006, the Washington Court granted our motion and dismissed the consolidated amended complaint. The Court granted plaintiffs
leave to amend their complaint and on May 8, 2006, the plaintiffs filed their second consolidated amended complaint. We have filed a motion to dismiss the second consolidated amended complaint. The Court has yet to schedule a hearing on this
motion. In addition, two related stockholder derivative suits were subsequently filed against some of our current and former directors and officers in the Superior Court of the State of Washington, King County and in the Washington Court,
respectively, which are referred to as the Derivative Actions. Plaintiffs in the Action and the Derivative Actions seek unspecified compensatory damages. We have obtained a stay of both of the Derivative Actions until after the resolution of the
motion to dismiss the Action.



|ITEM1A. | RISK FACTORS
|------- | ------------

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 materially
adversely affected and the trading price of our common stock could decline.

Our business and results of operations are likely to be affected by our
proposed merger with Gladiator Corporation.

On July 25, 2006, we agreed to be acquired by Gladiator Corporation, or Gladiator,
which is wholly owned by Francisco Partners, pursuant to an Agreement and Plan of Merger by and among us, Gladiator and Warrior Merger Sub, Inc., or Warrior, a wholly owned subsidiary of Gladiator, under which Warrior will be merged into us, and we
will survive the merger as a wholly owned subsidiary of Gladiator; provided, however, the merger agreement permits Gladiator to elect to change the structure or method of effecting the combination of Warrior with us so long as certain conditions
under the merger agreement are satisfied. The announcement of the merger could have an adverse effect on our business in the near term if current partners curtail their relationships with us pending consummation of the proposed merger. Activities
relating to the proposed merger and related uncertainties could divert our managements and our employees attention from our day-to-day business, cause disruptions among our relationships with customers and business partners, and cause
employees to seek alternative employment, all of which could detract from our ability to grow revenue and minimize costs. In addition, we may be disadvantaged in our attempts to attract and retain personnel by our announcement of the proposed
merger. The success of our business depends on our continued ability to attract and retain highly qualified management and other personnel. Competition for personnel among companies in the internet security industry is intense.

If the conditions to the proposed merger set forth in the merger agreement are not met, the merger may not occur.

Several conditions must be satisfied to complete the proposed merger with Gladiator. These conditions are set forth in detail in the merger agreement,
which was attached as an exhibit to our current report on Form 8-K filed with the SEC on July 25, 2006. We cannot assure you that each of the conditions will be satisfied. If the conditions are not satisfied or waived, the proposed merger will
not occur or will be delayed, and we may lose some or all of the benefits of the proposed merger. For example, if either our or Gladiators representations and warranties are not true and correct and, with some exceptions, the failure to be
true and correct has a material adverse effect at the closing, the other party may not be required to close.

Failure to complete the proposed merger
with Gladiator would negatively affect our future business and operations.

If the proposed merger with Gladiator is not completed,
we could suffer a number of consequences that may adversely affect our business, operating results of operations and stock price, including the following:



| |  |  | activities relating to the proposed merger and related uncertainties may lead to a loss of revenue and progress with existing and potential corporate partners that we may not be
able to regain if the proposed merger does not occur;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the market price of our common stock could significantly decline following an announcement that the proposed merger has been abandoned;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | we may be required in specific circumstances to pay a termination fee and expenses of up to $6 million to Gladiator;
| | - |  | --------------------------------------------------------------------------------------------------------------------



28



---

##### Table of Contents

| |  |  | we would remain liable for our costs related to the proposed merger;
| | - |  | --------------------------------------------------------------------



| |  |  | we may not be able to continue our present level of operations and therefore would have to scale back our present level of business and consider additional reductions in force;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | we may not be able to take advantage of alternative business opportunities or effectively respond to competitive pressures; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



| |  |  | our board of directors may not be able to find another partner willing to pay an equivalent or more attractive price for another merger or business combination than that which would
have been paid by Gladiator.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

In connection with the proposed merger, we will file a preliminary proxy statement with the SEC
in connection with the special meeting of stockholders that we will hold for the stockholders to vote on and adopt the merger agreement. We urge all of our stockholders to read this preliminary proxy statement and the definitive proxy statement,
when they become available, and any other relevant documents filed with the SEC because they contain important information about us, Gladiator and the proposed merger, risks relating to the proposed merger and related matters.

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, we have incurred net losses and experienced negative cash flows from operations in each quarter, except that we
had net income and a positive cash flow from operations in the third quarter of 2000 and a positive cash flow from operations in the third quarter of 2001 and the fourth quarter of 2004 and third quarter of 2005. As of June 30, 2006, we had an
accumulated deficit of approximately $153.6 million. We may not be able to continue to grow our revenue in the future, and even if we do, the historical percentage growth rate of our revenues may not be sustainable as our revenue base increases. In
addition, irrespective of our revenue, we may not achieve or sustain profitability in future periods as a result of our operating expenses. We expect that over time we will have to increase our operating expenses in connection with:



| |  |  | continuing to develop our technology;
| | - |  | -------------------------------------



| |  |  | expanding into new product markets;
| | - |  | -----------------------------------



| |  |  | expanding into new geographic markets;
| | - |  | --------------------------------------



| |  |  | continuing to drive demand of our products;
| | - |  | -------------------------------------------



| |  |  | hiring additional personnel;
| | - |  | ----------------------------



| |  |  | upgrading our information and internal control systems;
| | - |  | -------------------------------------------------------



| |  |  | meeting enhanced regulatory and corporate governance requirements;
| | - |  | ------------------------------------------------------------------



| |  |  | litigation; 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. If our operating results for a future quarter or year fail to meet market expectations, this shortfall 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 reduce our spending in time to compensate for any unexpected quarterly or annual shortfall in revenues. If this occurs our operating results could fall below the
expectations of securities analysts and investors, which could result in a decline in our stock price.



29



---

##### Table of Contents

If our estimates or judgments relating to our critical accounting policies are based on assumptions that change or
prove to be incorrect, our operating results could fall below expectations of securities analysts and investors, resulting in a decline in our stock price.

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as provided in our managements discussion and analysis of financial
condition and results of operations in this quarterly report, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our operating results may be
adversely affected if our assumptions change or if actual circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of securities analysts and investors, resulting in a decline in our
stock price.

Significant assumptions and estimates used in preparing our consolidated financial statements include those related to:



| |  |  | revenue recognition, including sales returns and allowances and promotional rebates;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | provision for doubtful accounts;
| | - |  | --------------------------------



| |  |  | inventory reserves;
| | - |  | -------------------



| |  |  | restructuring reserves;
| | - |  | -----------------------



| |  |  | analysis of impairment of goodwill and other long-lived intangible assets; and
| | - |  | ------------------------------------------------------------------------------



| |  |  | stock-based compensation.
| | - |  | -------------------------

Examples of estimates we have
made include, but are not limited to, those associated with the costs of excess and obsolete inventory, costs of our 2001 and 2002 restructuring, impairment analysis of the intangible assets obtained in our 2002 acquisition of RapidStream Inc., as
well as goodwill relating to the acquisitions of BeadleNet LLC, Qiave Technologies Corporation and RapidStream. The estimates may prove to be inaccurate. For example, the costs of excess and obsolete inventory may increase above current estimates if
our revenues fall below our sales forecasts. Although we do not anticipate further significant adjustments to our 2001 and 2002 restructuring, the actual costs related to the restructuring may differ from our estimate.

If potential customers do not accept our Firebox products and related optional products and services, including the LiveSecurity Service, our business will not
succeed.

We currently expect that future revenues will be primarily generated through sales of our Firebox products and related
optional products and services, including the LiveSecurity Service, and we cannot succeed if the market does not accept these products and services. Some of our Firebox products, particularly our key Firebox X e-Series family of products and our
relatively new Fireware operating system, however, are relatively new and unproven. The Firebox X Edge e-Series line of products has only been available since June 2006, the Firebox X Peak and Core e-Series lines of products have only been available
since May 2006, and the Fireware operating system has only been available since April 2005. In addition, we have only recently begun to focus on marketing and selling the related optional products and services, and we may be unsuccessful in
marketing, selling and delivering these types of options. The Firebox X family of products, which replaced a product line that represented a majority of our revenues, also represents a relatively new approach to providing security to the SME market
in that the products are designed to be expandable both to incorporate additional features and to provide increased performance, and we may be unsuccessful in marketing and selling this type of product or the upgrades necessary for customers to take
advantage of the expandability. If customers purchase less expensive models than they otherwise would because of the ability to later upgrade the product, but then fail to purchase upgrades, our revenues from those products would be negatively
affected. In addition, we may have to increase discounts on the older Firebox X product lines to maintain an acceptable level of sales, which could also have a material adverse affect on our revenues and results of operations. If sales of our
Firebox products do not meet expectations, we may have excess inventory of products or components, and such excess inventory would have a negative effect on our operating results.

To receive our LiveSecurity Service and other optional services, enterprises are required to pay an annual subscription fee, either to us or, if they
obtain the service through one of our channel customers, to the channel customer. SMEs may be unwilling to pay a subscription fee to keep their Internet security up to date and to receive Internet security-related information or to obtain additional
security-related features and services. Because our LiveSecurity Service is an innovative service, and our other subscription services are new and unproven, we may not be able to 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 Network security rather than using the services of third-party service providers. As a result, our products and services and the
outsourcing of Network security to third parties may not achieve significant market acceptance.



30



---

##### Table of Contents

If we are unable to compete successfully in the highly competitive market for Internet security products and
services for any reason, including because current or potential competitors gain competitive advantage through partnering or acquisition, our business will fail.

The market for Network 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 Check Point Systems, Inc., Cisco Systems, Inc., Fortinet Inc., Juniper Networks, Inc., Nokia Corporation,
SonicWALL, Inc. and Symantec Corporation. Other competitors offering security products include hardware and software vendors such as 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,
many of our smaller competitors that specialize in providing protection from a single type of Network security threat are often able to deliver these specialized Network security products to the market more quickly than us. Our current and potential
competitors may also establish cooperative relationships among themselves or with third parties that may further enhance their resources. In addition, current or potential competitors may be acquired by third parties with greater available
resources, as has happened as a result of Junipers acquisition of Netscreen Technologies, Inc. As a result of such acquisitions, our current or potential competitors might 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.

While some of our competitors have traditionally targeted either large-enterprise security needs or consumer
security needs, these vendors could adapt their existing products to make them more attractive to our markets. If these or other of our competitors were to focus their greater financial, technical and marketing resources on our markets, our business
could be harmed. In addition, as our security solutions are adopted by larger enterprises, we expect to see increased competition from our competitors that traditionally target large-enterprise security needs. Increased competition in any of our
markets could result in price reductions, fewer customer orders, reduced gross margins and loss of market share.

We rely on third-party channel
customers to generate most of our revenues, and if they 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 the performance of this network. To the extent our channel customers are unsuccessful selling our
products, or we are unable to partner with and retain a sufficient number of channel customers in each of the regions in which we sell products, our ability to sell our products and services will be limited. Our channel customers also 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. The loss of one or more of these channel customers, a reduction in
their sales or a reduction in our share of their sales of Network security products, particularly if any such changes result in increased sales of competitive products, could harm our business. In addition, we are still in the process of
reorganizing our channel in the Asia Pacific region and, particularly, Japan. If this reorganization causes disruption, we could experience a loss or reduction in sales involving one or more of our channel customers.

Channel customers often specialize in selling certain types of products or in selling to specific segments of the market. To be successful, we must
therefore have the right channel customers selling our products in the appropriate market segments as well as have a sufficient number of channel partners selling our products. To the extent that we are unable to partner with and retain the right
channel customers to sell our products, or we introduce new products that our channel customers are unable to sell effectively, our ability to sell our products and services will be limited. For example, our Firebox X Peak e-Series product line
recently introduced in May 2006 is targeted at SME customers that are typically larger or more sophisticated in their use of the Internet than those buying our other Firebox X products. If our current channel customers are unable to sell this
product line effectively, of if we are unable to join with and retain channel customers that can sell this product line effectively, our ability to sell this product line and related services may be limited.

The requirement to recognize revenue on a sell through basis for certain third-party channel customers could negatively affect our future revenues.

We recognize revenue from certain of our channel customers when we sell product to them (the sell in method). Where the
customer is a distributor with unlimited stock returns and rotation rights, or when we actively engage in sales activities to sell distributor inventory to channel customers, product revenues are not recognized until the distributors sell the
products to their customers (the sell through method). During the first quarter of 2005, we negotiated changes in



31



---

##### Table of Contents

contractual obligations with certain channel customers in North America, Australia and New Zealand which provided such customers with unlimited return
rights. The changes were triggered by the need to offer promotional programs to give us the flexibility in the respective markets to be more competitive, responsive and effective. As a result of these contract changes, we converted these customers
to a sell through method beginning in the first quarter of 2005. When a channel customer is converted from the sell in method to the sell through method of revenue recognition, revenue can no longer be recognized when product is sold to the channel
customer, but instead is recognized when the channel customer sells it through to its own customers. In addition, because revenue from products in that channel customers inventory was already recognized in prior periods, revenue on individual
inventory items sold subsequent to the conversion can only be recognized after the converted channel customer has disposed of its inventories predating the conversion.

During the second quarter of 2006, we converted certain channel customers in the U.K. and DACH to a sell through method of revenue recognition and we plan on taking similar measures with remaining customers in Europe
in the third quarter of 2006. We are also evaluating taking similar measures with our customers in our remaining geographic locations. To the extent additional channel customers are converted, there will be a material adverse effect on revenues and
results of operations for the quarter in which those conversions take place, with the magnitude depending on the inventory levels with those channel customers at the time of conversion. To recognize revenue on a sell through method from a channel
customer, we will need to obtain adequate reporting on inventory levels from that channel customer to determine how much of our product has been sold to the end customers. If we are unable to obtain such reporting, our ability to recognize revenue
from such channel customers could be materially adversely affected and our financial results would be harmed.

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

We provide most of our
channel customers with product return rights for stock rotation and price protection rights for their inventories, which they may exercise if we lower our prices for those products. We also provide promotional rebates to some of our channel
customers. We may experience significant returns, price adjustments and rebate costs for which we may not have adequate allowances, particularly with the introduction of any new products, as we did with the introduction of our Firebox X product
line, which replaced our Firebox III product line. 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, and we expect to introduce new products in 2006. When we introduced the Firebox II, the Firebox III and then later the Firebox X Core and Firebox X Edge security appliances, we experienced an
increase in returns of previous products and product versions. While we review and adjust our provision for returns and allowances in order to properly reflect the potential for promotional rebate costs, increased returns and pricing adjustments
associated with the introduction of new products, such as the Firebox X e-Series product lines introduced in May and June 2006, the provision may still be inadequate. An increase in the provision for returns and allowances will result in the
reduction of revenues.

Customer demand, competitive pressure and rapid changes in technology and industry standards could render our products and
services unmarketable or obsolete, and we may be unable to introduce new or improved products and services, or update existing products or services, timely and successfully.

To succeed, we must continually change and improve our products, add new products and services, provide updates to products and services and replace
existing products and services in response to changes in customer demand, competitive pressure, 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 computer hacker techniques. We may be unable to successfully and timely develop and introduce these new, improved or updated products and services or achieve and maintain
market acceptance for new, improved or updated products and services we develop and introduce.

The development and introduction of new,
technologically advanced Internet security products and services, or providing updates to existing products or services, is a complex and uncertain process that requires great innovation, the ability to anticipate technological and market trends,
the ability to deliver updates to a large customer base efficiently and in a timely fashion and the ability to obtain required domestic and foreign governmental and regulatory certifications. Because Internet security technology is complex and often
contains encryption technology, it can require long development, testing and certification periods.

Releasing new or improved products and
services, or updates to products or 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 experienced delays in the scheduled or expected
introduction of new, improved and updated products and services, and in the future we may experience delays, or be unable to introduce an expected new, improved or updated product or service at all. When we do introduce new or enhanced products and
services, we may be unable to successfully manage the transition from



32



---

##### Table of Contents

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. In the past, when we have introduced new or improved products or services, we have experienced issues with the transition, which had an adverse effect on our operating results, and we have recently
introduced new products across all of our product lines and expect to introduce additional new products and services in the second half of 2006. These have included, but were not limited to, issues such as excess inventories of products that were
replaced that we had difficulty selling as customer demand for those product decreased, shortages of new product due to manufacturing and delivery issues that prevented us from delivering enough new product to meet demand and lower-than-expected
initial sales of new or improved products as our sales personnel and channels adapted to selling the new or improved products or services.

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 in the future 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 the quarters last month and 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.

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. Companies in the electronics industry regularly experience lower-than-required component allocations, and the industry is subject to frequent component shortfalls. We have experienced such component
shortfalls recently, with memory and flash component manufacturers providing these components on a limited allocation basis only. Although we have found additional or replacement sources for hardware components in the past, it is possible that we
might not be able to find additional or replacement sources for our hardware components to address future shortfalls. Even if we find replacement sources, our operations could be disrupted or negatively affected if we have to add or switch to a
replacement vendor, if our component supply is interrupted for an extended period or if the costs of the components increase due to shortages, which could result in loss of customer orders and revenue.

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

We rely on third-party contract manufacturers for the assembly of all of our security appliance hardware platforms and for the
design of certain of our security appliance hardware platforms. If a third-party manufacturer fails to or inadequately performs its obligations, we may be required to find a replacement, possibly on relatively short notice. Moreover, our contract
manufacturers may not be able to react quickly if our forecasts exceed or fall short of our predictions. Even if we are able to find a replacement source for these finished products on a timely basis, our operations could be disrupted if we have to
add or switch to a replacement manufacturer, particularly if we were required to replace or redesign a hardware platform, or if our finished goods supply is interrupted for an extended period, which could result in loss of customer orders and
revenue.

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 or for delivering new products.

Our success will depend in part on our continued ability to license
technology that is important for the functionality of our products and for the delivery of new products based on third-party technology. A significant interruption in the supply of a third-party technology, including open source software, could
delay our development and sales of existing, updated or new products 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.



33



---

##### Table of Contents

If we do not retain our key employees, if changes to the management team cause disruption or if new management team
members fail to perform, our ability to formulate and 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, finance and accounting, 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. In addition, there have been changes to our management and development teams recently, including the addition of a new vice president of worldwide
sales and the departure of our vice president of marketing and local heads of Asia Pacific and Europe/Middle East/Africa Sales in 2006, and a new chief financial officer in 2005. If these changes have a negative effect on our operations, our
business and operating results could be adversely affected.

Because many potential customers do not fully understand or remain unaware of the need
for comprehensive and up-to-date Network security, may perceive it as costly and difficult to implement, or may not understand the components of comprehensive Internet security well enough to effectively compare competitive offerings, our products
and services may not achieve market acceptance.

We believe that many potential customers, particularly SMEs, do not fully
understand or are not aware of the need for comprehensive and up-to-date Network security products and services, and also may not fully understand the components of comprehensive Network security well enough to effectively compare competitive
offerings. Any inability to effectively compare competitive offerings may give companies with greater resources or more recognizable brands a competitive advantage over us. We will therefore not succeed unless the market understands the need for
comprehensive and up-to-date Internet security and we can convince our potential customers of our ability to provide this security in an integrated, cost-effective and administratively feasible manner. Although we have spent, and will continue to
spend, considerable resources educating potential customers about the need for comprehensive and up-to-date Network security and the benefits of our products and services, our efforts may be unsuccessful.

We may be unable to adequately expand and adapt our operational systems to accommodate growth or recent changes in how we deliver our products and services to
customers, 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. In addition, our operational systems required for the delivery of products and services through license-key activation were not originally designed for the combination of the number of product and
service offerings and customer volumes that may be required in the future, and we will have to update and expand our operational systems to accommodate this activity. We may be unable to update and expand our operational systems in a timely fashion
or without disruption to our business, and we may encounter performance difficulties when operating with a substantially greater number of customers or a substantially greater number of products and services offered through license-key activation or
a combination of the two. These difficulties 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 or
increased number of products and services offered through license-key activation may cause unanticipated system disruptions, slower response times and poor customer service, including problems filling customer orders.

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.

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 Network 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 the license. 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.



34



---

##### Table of Contents

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 Network 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 Network 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.

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 our LiveSecurity Service and other optional services.

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 in a timely
fashion, if at all, could adversely affect our international and domestic sales and operating results. 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.

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 patents, trade secrets, copyrights,
trademarks, service marks and similar proprietary rights We may, however, be unsuccessful in protecting our trade secrets or, even if successful, any required litigation may be costly and time consuming, which could harm our business. Moreover, 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 14 issued patents and 13 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.



35



---

##### Table of Contents

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
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | redesign products or services that incorporate infringing technology, which may not be technologically or economically feasible.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------

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.

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 56% of our revenues in 2004 and 61%
of our revenues in 2005. 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:



| |  |  | export and import restrictions, such as those affecting encryption commodities and software, those requiring local content or those regulating the materials or chemicals used in
manufacturing our products as well as their disposal, such as the European Union Waste Electrical and Electronic Equipment, or WEEE, and Restriction of Use of Certain Hazardous Substances, or RoHS, directives;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | cost of customizing products for foreign countries;
| | - |  | ---------------------------------------------------



| |  |  | 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, any increase in the value of the U.S. dollar relative to foreign currencies makes our products less competitive in international markets. Because of this, we may be required to
denominate our sales in foreign currencies at some point in the future to remain competitive.

In attempting to integrate the business and technology
of any future acquisition, we could incur significant costs that may not be outweighed by any benefits of the acquisition.

As part
of our business strategy, we may acquire other companies, products or technologies, and these acquisitions may result in substantial costs. The costs of any future acquisitions may include costs for:



| |  |  | integration of operations, including combining teams and processes in various functional areas;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | reorganization or closure of operations and facilities;
| | - |  | -------------------------------------------------------



| |  |  | integration of new technology into our products;
| | - |  | ------------------------------------------------



| |  |  | fees and expenses of professionals involved in completing the integration process; and
| | - |  | --------------------------------------------------------------------------------------



| |  |  | potential existing liabilities of any future acquisition target.
| | - |  | ----------------------------------------------------------------

Successful integration of the operations, technology, products, customers, suppliers and personnel of any future acquisition could place a significant burden on our management and internal resources. The diversion of the attention of our
management and any difficulties encountered in the transition and integration process could disrupt our business and have an adverse effect on our business and operating results.



36



---

##### Table of Contents

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

We believe that our existing available cash, cash equivalents and investments will be sufficient to meet our operating expenses, working capital needs and
capital expenditure requirements 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.
| | - |  | ---------------------------------------------

Our
existing capital and future revenues may therefore 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;
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | public or private debt financings; and
| | - |  | --------------------------------------



| |  |  | capital lease transactions.
| | - |  | ---------------------------

Financing, however, 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;
| | - |  | ----------------------------------------------------------



| |  |  | 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.

We are the subject of litigation, which may be expensive and may be time consuming for our management team.

On
April 8, 2005, a holder of our common stock, on behalf of himself and purportedly on behalf of a class of our stockholders, filed an action in the United States District Court for the Western District of Washington, or the Washington Court,
against us and some of our current and former officers, alleging violations of the federal securities laws arising out of, among other things, our announcement on March 15, 2005 that we were restating some of our financial results for interim
periods of 2004. Subsequently, a number of other related purported class action suits also alleging violations of the federal securities laws were filed by holders of our common stock. The various actions have been consolidated by the Washington
Court, and are referred to herein as the Action. On October 3, 2005, a consolidated amended complaint was filed in the Action, and we filed a motion to dismiss the consolidated amended complaint. On April 21, 2006, the Washington Court
granted our motion and dismissed the consolidated amended complaint. The Washington Court granted plaintiffs leave to amend their complaint and on May 8, 2006, the plaintiffs filed their second consolidated amended complaint. We have filed a
motion to dismiss the second consolidated amended complaint. The Court has yet to schedule a hearing on this motion. In addition, two related stockholder derivative suits were subsequently filed against some of our current and former directors and
officers in the Superior Court of the State of Washington, King County and in the Washington Court, respectively, which are referred to as the Derivative Actions. Plaintiffs in the Action and the Derivative Actions seek unspecified compensatory
damages. We have obtained a stay of both of the Derivative Actions until after the resolution of our motion to dismiss the Action. We are obligated to indemnify our officers and directors to the extent permitted by applicable law in connection with
the Action, and have insurance for such individuals, to the extent of the limits of the applicable insurance policies and subject to potential reservations of rights. We intend to vigorously defend against the Action and Derivative Actions. We are
unable, however, to predict the ultimate outcome of the Action and Derivative Actions. We cannot assure you that we will be successful in defending against the Action and Derivative Actions and, if we are unsuccessful, we may be subject to



37



---

##### Table of Contents

significant damages that could have a material adverse effect on our business, financial condition and operating results. Even if we are successful,
defending against the Action and Derivative Actions is likely to be expensive, time consuming and may divert managements attention from other business concerns and harm our business.



|ITEM4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS
|------ | ---------------------------------------------------

We held an annual meeting of our stockholders on May 4, 2006. Of the 34,541,521 shares of
common stock outstanding as of the record date for the annual meeting, 30,358,861 shares, or 92.0% of the total shares eligible to vote at the annual meeting, were represented in person or by proxy.



| | 1) | At the annual meeting, Steven N. Moore was elected to serve as a Class 3 member of our board of directors, to hold office until the third annual meeting of stockholders following
his election or until his successor is elected and qualified. The Board members whose terms in office continued after the annual meeting of stockholders were Edward J. Borey, Michael R. Hallman, Michael R. Kourey, Richard A. LeFaivre, Ph.D. and
William J. Schroeder. Mr. Moore was elected with the following voting results:
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|           |  |               
|---------- |  | --------------
|Votes For  |  | Votes Withheld
|26,386,399 |  | 3,972,462     



| | 2) | A proposal to approve the ratification of Ernst &Young LLP as the Companys independent registered public accounting firm for the year ending December 31, 2006 passed
with the following results:
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|           |  |               |  |        
|---------- |  | ------------- |  | -------
|Votes For  |  | Votes Against |  | Abstain
|29,696,967 |  | 592,213       |  | 69,681 



| | 3) | A proposal to ratify and approve our Rights Agreement dated May 5, 2005 with Mellon Investor Services LLC (as Rights Agent) was not approved by stockholders who are not
affiliated with management or any member of the board, or the Independent Stockholders, with the following results:
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                                   |  |                                        |  |                                      |  |                                           
|---------------------------------- |  | -------------------------------------- |  | ------------------------------------ |  | ------------------------------------------
|Votes ofIndependentStockholdersFor |  | Votes ofIndependentStockholdersAgainst |  | IndependentStockholders WhoAbstained |  | Broker Non-Votes ofIndependentStockholders
|6,045,059                          |  | 16,338,699                             |  | 267,559                              |  | 9,125,218                                 



|ITEM6. | EXHIBITS
|------ | --------



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



|       |  |                                                                                                                                            
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------------
|Number |  | Description                                                                                                                                
|3.1    |  | Restated Certificate of Incorporation of the registrant (Exhibit 3.1)(a)                                                                   
|       | 
|3.2    |  | Amended and Restated Bylaws of the registrant (Exhibit 3.2)(b)                                                                             
|       | 
|3.3    |  | Certificate of Designations of Series A Participating Cumulative Preferred Stock of the registrant (Exhibit 3.1)(c)                        
|       | 
|31.1   |  | Section 302 Certification of Edward J. Borey                                                                                               
|       | 
|31.2   |  | Section 302 Certification of Bradley E. Sparks                                                                                             
|       | 
|32.1   |  | Certification of Edward J. Borey pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  
|       | 
|32.2   |  | Certification of Bradley E. Sparks pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

---

|(a) | Incorporated by reference to the specified exhibit to the registrants Registration Statement on Form S-1 (File No. 333-76587), filed with the SEC on April 20, 1999,
as amended.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



38



---

##### Table of Contents

|(b) | Incorporated by reference to the specified exhibit to the registrants Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 (File No. 000-26819), filed with
the SEC on August 9, 2004.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(c) | Incorporated by reference to the specified exhibit to the registrants Form 8-A12G (File No. 000-26819), filed with the SEC on May 9, 2005.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------



39



---

##### Table of Contents

SIGNATURES

Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.

Date: August 9, 2006



WATCHGUARD TECHNOLOGIES, INC.By:

/s/ Bradley E. SparksBradley E. SparksChief Financial Officer(Authorized Officer)(Principal Financial and Accounting Officer)




40



---

##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

INDEX TO EXHIBITS



|       |  |                                                                                                                                            
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------------
|Number |  | Description                                                                                                                                
|3.1    |  | Restated Certificate of Incorporation of the registrant (Exhibit 3.1)(a)                                                                   
|       | 
|3.2    |  | Amended and Restated Bylaws of the registrant (Exhibit 3.2)(b)                                                                             
|       | 
|3.3    |  | Certificate of Designations of Series A Participating Cumulative Preferred Stock of the registrant (Exhibit 3.1)(c)                        
|       | 
|31.1   |  | Section 302 Certification of Edward J. Borey                                                                                               
|       | 
|31.2   |  | Section 302 Certification of Bradley E. Sparks                                                                                             
|       | 
|32.1   |  | Certification of Edward J. Borey pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  
|       | 
|32.2   |  | Certification of Bradley E. Sparks pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

---

|(a) | Incorporated by reference to the specified exhibit to the registrants Registration Statement on Form S-1 (File No. 333-76587), filed with the SEC on April 20, 1999,
as amended.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(b) | Incorporated by reference to the specified exhibit to the registrants Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 (File No. 000-26819), filed with
the SEC on August 9, 2004.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(c) | Incorporated by reference to the specified exhibit to the registrants Form 8-A12G (File No. 000-26819), filed with the SEC on May 9, 2005.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------



41