<PAGE>

                       SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549

                                    FORM 10-Q

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

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

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

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

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

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

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

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

     27,092,040 shares of WatchGuard common stock were outstanding as of
November 1, 2001.

<PAGE>

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


                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
PART I.  FINANCIAL INFORMATION

<S>                                                                                                                     <C>
Item 1.   Financial Statements ........................................................................................  3

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

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

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

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

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

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

PART II.  OTHER INFORMATION

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

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


                                       Page 2

<PAGE>


                          PART I. FINANCIAL INFORMATION

Item 1.       Financial Statements

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

<TABLE>
<CAPTION>
                                                                                September 30,      December 31,
                                                                                    2001               2000
                                                                             ----------------   ----------------
<S>                                                                          <C>                <C>
                                       ASSETS

Current assets:
   Cash and cash equivalents ............................................... $      22,578      $       13,837
   Securities available for sale ...........................................        92,791             101,278
   Trade accounts receivable, net ..........................................        12,226              15,271
   Inventories, net ........................................................         5,704               7,026
   Prepaid expenses and other receivables ..................................         4,233               3,178
                                                                             ----------------   ----------------

     Total current assets ..................................................       137,532             140,590
Property and equipment, net ................................................         7,500               7,341
Goodwill, net ..............................................................        28,437              33,947
Other intangibles and other assets, net ....................................        11,483              14,052
                                                                             ----------------   ----------------

Total assets ............................................................... $     184,952      $      195,930
                                                                             ================   ================


                         LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
   Accounts payable ........................................................ $       5,056      $        7,256
   Accrued expenses ........................................................         5,138               4,395
   Deferred revenue ........................................................        16,910              11,874
                                                                             ----------------   ----------------

Total current liabilities ..................................................        27,104              23,525

Stockholders' equity:
   Preferred stock, $0.001 par value:
      Authorized shares:  10,000,000
      No shares issued and outstanding .....................................            --                  --
   Common stock, $0.001 par value:
      Authorized shares:  80,000,000
      Shares issued and outstanding:  27,075,110 at September 30, 2001 and
         26,287,072 at December 31, 2000 ...................................            27                  26
   Additional paid-in capital ..............................................       231,413             230,591
   Deferred stock-based compensation .......................................        (2,224)            (12,387)
   Accumulated other comprehensive income (loss) ...........................         1,010                (222)
   Accumulated deficit .....................................................       (72,378)            (45,603)
                                                                             ----------------   ----------------

Total stockholders' equity .................................................       157,848             172,405
                                                                             ----------------   ----------------

Total liabilities and stockholders' equity ................................. $     184,952      $      195,930
                                                                             ================   ================

</TABLE>

_______________________________

See accompanying notes.



                                       Page3

<PAGE>

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


<TABLE>
<CAPTION>
                                                                   Three Months Ended                Nine Months Ended
                                                                      September 30,                    September 30,
                                                             -------------------------------- --------------------------------
                                                                  2001             2000            2001             2000
                                                             ---------------  --------------- ---------------  ---------------

  Revenues:
  <S>                                                        <C>              <C>             <C>              <C>
    Product .............................................    $       12,806   $       14,782  $       39,345   $       35,276
    Service .............................................             4,462            2,453          12,533            5,501
                                                             ---------------  --------------- ---------------  ---------------
          Total revenues ................................            17,268           17,235          51,878           40,777

  Cost of revenues:
    Product .............................................             5,214            5,363          15,906           12,795
    Service .............................................             1,450              824           4,384            1,813
                                                             ---------------  ---------------  ---------------  ---------------

          Total cost of revenues ........................             6,664            6,187          20,290           14,608
                                                             ---------------  ---------------  ---------------  ---------------
  Gross margin ..........................................            10,604           11,048          31,588           26,169

  Operating expenses:
    Sales and marketing (1) .............................             7,380            5,849          23,241           17,375
    Research and development (2) ........................             4,129            3,413          14,140            9,195
    General and administrative (3) ......................             2,060            1,703           5,795            4,107
    Stock-based compensation ............................             1,468              193           8,534              657
    Amortization of  goodwill, purchased technology and
       other intangible assets acquired .................             2,724              368           8,172            1,104
    Restructuring charges ...............................                --               --           2,900               --
                                                             ---------------  --------------- ---------------  ---------------

          Total operating expenses ......................           17,761           11,526          62,782            32,438
                                                             ---------------  --------------- ---------------  ---------------

  Operating loss ........................................           (7,157)            (478)        (31,194)           (6,269)

  Interest income, net ..................................             1,292            1,812           4,615            4,529
                                                             ---------------  --------------- ---------------  ---------------

  Income (loss) before income taxes .....................            (5,865)           1,334         (26,579)          (1,740)

  Provision for income taxes ............................                28               --             196               --
                                                             ---------------  --------------- ---------------  ---------------

  Net income (loss) .....................................    $       (5,893)  $        1,334  $      (26,775)  $       (1,740)
                                                             ===============  =============== ===============  ===============

  Net income (loss) per share:

           Basic ........................................    $       (0.22)   $        0.06   $       (1.01)   $        (0.08)
                                                             ===============  =============== ===============  ===============

           Diluted ......................................    $       (0.22)   $        0.05   $       (1.01)   $        (0.08)
                                                             ===============  =============== ===============  ===============
  Shares used in computation of net income (loss) per
   share:

           Basic ........................................            26,839           24,147          26,594           22,882
                                                             ===============  =============== ===============  ===============

           Diluted.......................................            26,839           27,809          26,594           22,882
                                                             ===============  =============== ===============  ===============
</TABLE>

----------
(1)  Sales and marketing expenses exclude amortization of stock-based
     compensation of $30,000 and $36,000 for the three months ended September
     30, 2001 and 2000, respectively and $201,000 and $136,000 for the nine
     months ended September 30, 2001 and 2000, respectively.

(2)  Research and development expenses exclude amortization of stock-based
     compensation of $1,431,000 and $143,000 for the three months ended
     September 30, 2001 and 2000, respectively and $8,303,000 and $465,000 for
     the nine months ended September 30, 2001 and 2000, respectively.

(3)  General and administrative expenses exclude amortization of stock-based
     compensation of $7,000 and $14,000 for the three months ended September 30,
     2001 and 2000, respectively and $30,000 and $56,000 for the nine months
     ended September 30, 2001 and 2000, respectively.

See accompanying notes.

                                     Page 4

<PAGE>


                          WATCHGUARD TECHNOLOGIES, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                      --------------------------------------
                                 (In thousands)

<TABLE>
<CAPTION>
                                                                                               Nine Months Ended
                                                                                                  September 30,
                                                                                          -----------------------------
                                                                                              2001              2000
                                                                                          ------------      -----------

OPERATING ACTIVITIES:
<S>                                                                                         <C>               <C>
   Net loss ...........................................................................    $ (26,775)        $  (1,740)
   Adjustments to reconcile net loss to net cash used in operating activities:
       Depreciation and amortization of property and equipment ........................        1,634               945
       Loss on disposal of furniture ..................................................           --                39
       Amortization of goodwill and other intangible assets ...........................        8,172             1,104
       Amortization of stock-based compensation .......................................        9,113               657
       Provision for bad debt expense .................................................          696               351
       Changes in operating assets and liabilities:
         (Increase) decrease in trade accounts receivable .............................        2,349            (8,351)
         (Increase) decrease in inventories, net ......................................        1,322            (3,475)
         (Increase) in prepaid expenses and other receivables .........................       (1,055)           (1,334)
         (Increase) in other assets ...................................................          (93)             (401)
         Increase in accrued restructuring charges ....................................          863                --
         Increase (decrease) in accounts payable and accrued expenses .................       (2,320)            5,346
         Increase in deferred revenue .................................................        5,036             5,636
                                                                                           ---------         ---------

NET CASH USED IN OPERATING ACTIVITIES .................................................       (1,058)           (1,223)

INVESTING ACTIVITIES:
   Purchases of equipment and furniture and other .....................................       (1,793)           (4,497)
   Cash received on disposal of furniture .............................................           --                95
   Proceeds from sales and maturities of marketable securities ........................      157,457            55,129
   Purchases of marketable securities .................................................     (147,738)         (120,454)
                                                                                           ---------         ---------

NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES ...................................        7,926           (69,727)

FINANCING ACTIVITIES:
   Principal repayments on line of credit and notes payable ...........................           --              (383)
   Proceeds from the sale of common stock, net of expenses ............................           --            90,427
   Proceeds from the exercise of common stock options and warrants, and the sale
       of common stock through the employee stock purchase plan .......................        1,873             5,615
                                                                                           ---------         ---------

NET CASH PROVIDED BY FINANCING ACTIVITIES .............................................        1,873            95,659
                                                                                           ---------         ---------

NET INCREASE IN CASH AND CASH EQUIVALENTS .............................................        8,741            24,709

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD ......................................       13,837             1,903
                                                                                           ---------         ---------

CASH AND CASH EQUIVALENTS AT END OF PERIOD ............................................    $  22,578         $  26,612
                                                                                           =========         =========

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
   Adjustment to deferred stock based compensation for options cancelled upon
     employee terminations ............................................................    $   1,392         $      --
</TABLE>

_____________________________

See accompanying notes.

                                     Page 5

<PAGE>

                          WATCHGUARD TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

      Description of Business

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

      Interim Financial Information

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

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      Revenue Recognition

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

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

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

      Principles of Consolidation

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

                                     Page 6

<PAGE>

      Comprehensive Income (Loss)

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

<TABLE>
<CAPTION>
                                         Three Months Ended       Nine Months Ended
                                            September 30,           September 30,
                                       ---------------------  -----------------------
                                          2001       2000         2001        2000
                                       ---------  ----------  ----------- -----------
      <S>                              <C>        <C>         <C>         <C>
Net income (loss) ...................  $ (5,893)   $  1,334    $(26,775)   $ (1,740)

Unrealized gain on investments ......       731         229       1,232          33
                                       --------    --------    --------    --------


Comprehensive income (loss) .........  $ (5,162)   $  1,563    $(25,543)   $ (1,707)
                                       ========    ========    ========    ========
</TABLE>

      Recent Accounting Pronouncements

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

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

      Reclassifications

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

NOTE 3 - BALANCE SHEET ACCOUNT DETAIL (in thousands)

      Trade Accounts Receivable, Net

      Trade accounts receivable, net consisted of the following:

<TABLE>
<CAPTION>
                                                                         September 30,     December 31,
                                                                             2001             2000
                                                                         -------------    -------------
<S>                                                                      <C>              <C>
      Trade accounts receivable .....................................      $ 14,860          $ 16,869
      Reserve for returns and allowances ............................        (1,824)             (965)
      Allowance for uncollectible accounts...........................          (810)             (633)
                                                                           --------          --------
                                                                           $ 12,226          $ 15,271
                                                                           ========          ========
</TABLE>

                                          Page 7

<PAGE>

      Inventories, net

<TABLE>
<CAPTION>
       Inventories, net consisted of the following:              September 30,          December 31,
                                                                     2001                  2000
                                                               ---------------        ---------------
       <S>                                                     <C>                    <C>
       Finished goods ....................................     $         4,684        $         4,077
       Components ........................................               1,772                  3,394
                                                               ---------------        ---------------
                                                                         6,456                  7,471
       Inventory reserves ................................                (752)                  (445)
                                                               ---------------        ---------------
                                                               $         5,704        $         7,026
                                                               ===============        ===============
</TABLE>

NOTE 4 - INTERNATIONAL REVENUES

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

<TABLE>
<CAPTION>
                                                           Three Months Ended September 30,   Nine Months Ended September 30,
                                                           ---------------------------------  --------------------------------
                                                                2001             2000              2001             2000
                                                           ---------------  ----------------  ---------------  ---------------
      <S>                                                  <C>              <C>               <C>              <C>
      United States ..................................     $        8,114   $        8,058    $       22,924   $       18,555
      Rest of World ..................................              9,154            9,177            28,954           22,222
                                                           --------------   --------------    --------------   --------------
      Total ..........................................     $       17,268   $       17,235    $       51,878   $       40,777
                                                           ==============   ==============    ==============   ==============
</TABLE>


NOTE 5 - BUSINESS RESTRUCTURING

      In April 2001, WatchGuard announced a restructuring plan designed to
streamline operations and reduce operating costs. This restructuring plan
included a reduction in workforce and a consolidation of excess facilities, in
addition to other cost-saving strategies. As part of the restructuring plan,
WatchGuard has exited the consumer security market, and terminated various
original equipment manufacturer (OEM) agreements to develop product and services
for that market and is streamlining operations in support of new products and
services aimed at business customers. As a result of this restructuring,
WatchGuard recorded a $2.9 million restructuring charge during the second
quarter of 2001. The restructuring charge for the nine months ended September
30, 2001 included the following (in thousands):

<TABLE>
<CAPTION>

                                                                          Restructuring     Amounts paid or        Accrued
                                                                             charges            charged            balance
                                                                         -----------------  ----------------- -----------------
       <S>                                                               <C>                <C>               <C>
       Severance and termination benefits ...........................    $        1,015     $          998    $           17
       Stock-based compensation .....................................               579                579                --
       Abandoned facilities and other ...............................             1,306                460               846
                                                                         --------------     --------------    --------------
       Total ........................................................    $        2,900     $        2,037    $          863
                                                                         ==============     ==============    ==============
</TABLE>

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

                                     Page 8

<PAGE>

NOTE 6 - STOCK OPTION EXCHANGE PROGRAM

      In July 2001, WatchGuard offered a voluntary stock option exchange program
to its employees. The plan allowed employees, at their option, to exchange
before August 1, 2001 unexercised stock options with an exercise price equal to
or greater than $15 that were granted to eligible optionees under the 1996 Stock
Option Incentive Plan and the 2000 Stock Option Plan. In addition, if an
employee chose to participate, any option granted to that employee within the
six months preceding August 1, 2001 that had a lower exercise price than any
option tendered was automatically tendered for exchange. In exchange, WatchGuard
expects to grant on February 2, 2002 a new option to purchase a number of shares
equal to the number of shares underlying the cancelled option. The exercise
price of the replacement option would then be equal to the average of the high
and low sales prices of a share of WatchGuard's common stock as reported on the
NASDAQ National Market on February 1, 2002, the last date preceding February 2,
2002 for which such a price exists. Except for relatively minor differences each
replacement option will be vested and exercisable to the same degree as the
original option. Pursuant to the offer, WatchGuard has accepted for cancellation
and exchange options to purchase 2,101,347 shares of WatchGuard common stock.
For financial reporting purposes the option exchange program is not considered
compensatory. WatchGuard, therefore, does not anticipate recording stock
compensation charges as a result of the implementation of the program.

                                     Page 9

<PAGE>

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

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

Forward-Looking Statements

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

Overview

      WatchGuard is a leading provider of Internet security solutions designed
to protect enterprises that use the Internet for electronic commerce and secure
communications. Our award-winning products and services include firewalls for
access control, virtual private networks, or VPNs, for secure communications and
our new ServerLock products for server content and application security. Our
core market includes small- to medium-sized enterprises, or SMEs, large
Internet-distributed enterprises, or IDEs, with ultra-high-speed connections
supporting VPNs between the IDEs and their geographically dispersed branch
offices and telecommuters, small and home offices, or SOHOs, with broadband
connections, and telecommuters. Our acquisition of Qiave Technologies
Corporation in October 2000 allowed us to expand our product line with a
software-based solution designed to protect server content and applications from
unauthorized and unintentional access and manipulation. Our innovative
subscription-based LiveSecurity Service delivers threat responses, software
updates, expert editorials, support flashes and virus alerts over the Internet,
which enables enterprises to protect their data and communications in a
continuously changing environment, with minimal effort.

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

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

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

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

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

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

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

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

                                     Page 10

<PAGE>

      . During the second and third quarters of 2001, we introduced higher
        performance third-generation security appliances, our Firebox III
        product line, including products targeted at the larger enterprise, the
        large IDE markets, as well as to small businesses and branch offices.

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

Sources of Revenues and Revenue Recognition Policy

      We generate revenues through

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

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

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

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

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

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

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

                                     Page 11

<PAGE>

Results of Operations

The following table provides financial data for the periods indicated as a
percentage of total revenues:
<TABLE>
<CAPTION>
                                                                       Three Months Ended                 Nine Months Ended
                                                                          September 30,                      September 30,
                                                                   ---------------------------        -------------------------
                                                                     2001              2000             2001             2000
                                                                   -------            --------        --------         --------
<S>                                                                <C>                <C>             <C>              <C>
Revenues:
  Product ......................................................     74.2%               85.8%          75.8%            86.5%
  Service ......................................................     25.8                14.2           24.2             13.5
                                                                    -----               -----          -----            -----
        Total revenues .........................................    100.0               100.0          100.0            100.0
Cost of revenues:
  Product ......................................................     30.2                31.1           30.7             31.4
  Service ......................................................      8.4                 4.8            8.5              4.4
                                                                    -----               -----          -----            -----
        Total cost of revenues .................................     38.6                35.9           39.1             35.8
                                                                    -----               -----          -----            -----
Gross margin ...................................................     61.4                64.1           60.9             64.2
Operating expenses:
  Sales and marketing ..........................................     42.7                33.9           44.8             42.6
  Research and development .....................................     23.9                19.8           27.3             22.5
  General and administrative ...................................     11.9                 9.9           11.2             10.1
  Stock-based compensation .....................................      8.5                 1.1           16.5              1.6
  Amortization of  goodwill, purchased technology and
     other intangible assets acquired ..........................     15.8                 2.1           15.8              2.7
  Restructuring charges ........................................      0.0                 0.0            5.6              0.0
                                                                    -----               -----          -----            -----
        Total operating expenses ...............................    102.9                66.9          121.0             79.5
                                                                    -----               -----          -----            -----
Operating loss .................................................    (41.4)               (2.8)         (60.1)           (15.4)
Interest income, net ...........................................      7.5                10.5            8.9             11.1
                                                                    -----               -----          -----            -----
Income (loss) before income taxes ..............................    (34.0)                7.7          (51.2)            (4.3)
Provision for income taxes .....................................      0.2                 0.0            0.4              0.0
                                                                    -----               -----          -----            -----
Net income (loss) ..............................................    (34.1)%               7.7%         (51.6)%           (4.3)%
                                                                    =====               =====          =====            =====
</TABLE>

     Beginning late in the fourth quarter of 2000 and continuing through the
third quarter of 2001 we saw a general global downturn in spending by businesses
on information technology, and the events of September 11, 2001 and their
aftermath have exacerbated this downturn. These factors have affected the demand
for our products and services. We generated revenues of $17.3 million in the
three months ended September 30, 2001, a slight increase from revenues of $17.2
million the three months ended September 30, 2000 and a slight decrease of 1.4%
from $17.5 million in revenues for the three months ended June 30, 2001. Our net
loss for the three months ended September 30, 2001 was ($5.9 million), or
($0.22) per share, compared to a net income of $1.3 million or $0.06 per share,
for the three months ended September 30, 2000 and a net loss of ($10.4 million),
or ($0.39) per share in the three months ended June 30, 2001. Our net loss
improved in the three months ended September 30, 2001 as compared to the three
months ended June 30, 2001 due mainly to a one time restructuring charge
recorded in the three months ended June 30, 2001 and to reduced operating costs.
The net loss included $4.2 million of non-cash charges related to stock-based
compensation and amortization of goodwill, purchased technology and other
intangible assets acquired for the three months ended September 30, 2001 and
$8.2 million of non-cash charges related to stock-based compensation and
amortization of goodwill, purchased technology and other intangible assets
acquired and restructuring charges for the three months ended June 30, 2001.

     In April 2001, we implemented a restructuring plan designed to streamline
operations and reduce costs. We have streamlined operations to focus on our core
business of firewalls, VPNs and server security for business customers. As part
of this reorganization we have exited the consumer security market, and
terminated various OEM agreements to develop products and services for that
market and reduced our staff by approximately 50 people, or 16% of our workforce
at that time. We have also consolidated our development and product marketing
activities into product-specific areas to better focus on our business
customers. We believe that the staff reduction, which impacted all functional
areas of the company, will allow us to reduce our break-even point to better
drive towards profitability. We will continue to invest in the research and
development efforts we believe are necessary to ensure we maintain our
leadership position in providing enterprises with Internet security and VPN
solutions that are easy to install and manage. As a result of this
restructuring, we recorded a $2.9 million restructuring charge during the three
months ended June 30, 2001.

                                     Page 12

<PAGE>

Three Months Ended September 30, 2001 and 2000

Revenues

     Total revenues, which consist of product revenues and service revenues
remained relatively flat increasing only slightly from $17.2 million in the
three months ended September 30, 2000 to $17.3 million in the three months ended
September 30, 2001. Revenues remained relatively flat primarily due to a
decrease in product revenues attributable to the general global downturn in
spending by businesses on information technology mentioned above as well as the
events of September 11, 2001 and their aftermath which were partially offset by
an increase in service revenues. The increase in service revenues was derived
dually from the deferral attributable to bundled product revenues and the
renewals of LiveSecurity from the existing customer base. Total international
revenues represented approximately 53% of total revenues in the three months
ended September 30, 2000 and 53% in the three months ended September 30, 2001.
In the three months ended September 30, 2000, global revenues from one of our
distributors Ingram Micro, Inc., accounted for $2.5 million in revenues or
approximately 14% of revenues and in the three months ended September 30, 2001,
global revenues from Ingram Micro, Inc., were $1.8 million, or approximately 11%
of revenues and revenues from another distributor, Tech Data, were $2.1 million,
or approximately 12% of revenues.

     Product revenues include: (1) perpetual software license fees for our
Firebox System and the sale of our security appliance as part of our security
solutions; (2) sales of software options, such as user expansion and VPN
software management modules; (3) sales of our NOC, security suite software
license as part of LiveSecurity for MSS; and (4) sales from our new ServerLock
product line, which is based on technology acquired in conjunction with our
purchase of Qiave. Product revenues decreased from $14.8 million in the three
months ended September 30, 2000 to $12.8 million in the three months ended
September 30, 2001, a decrease of 13%. Product revenues as a percentage of total
revenues decreased from 86% in the three months ended September 30, 2000 to 74%
in the three months ended September 30, 2001 due to a lower growth rate
associated with slowing economic conditions as well as the events of September
11, 2001 and their aftermath and due to an increase in service revenues from an
increased base of customers renewing their LiveSecurity subscriptions . Given
the current economic uncertainty and slowdown in capital spending, it is
difficult to predict revenue levels in future quarters, which may be more
variable than historically.

     Service revenues include the annual fee for our LiveSecurity broadcast
service, which is sold as part of the Firebox System and LiveSecurity for MSS.
Service revenues increased from $2.5 million in the three months ended September
30, 2000 to $4.5 million in the three months ended September 30, 2001, an
increase of 82%. As a percentage of total revenues, service revenues increased
from 14% in the three months ended September 30, 2000 to 26% in the three months
ended September 30, 2001, which reflects an increased base of customers renewing
their LiveSecurity service subscriptions, and a reduced growth rate for product
sales.

     We have established a returns and allowances reserve to address the return
rights, pricing protection rights, and promotional rebates that may be earned by
some of our customers. The provision for sales returns and allowances was
$362,000, or 2% of total revenues before returns and allowances, in the three
months ended September 30, 2000 and $2.4 million, or 12% of total revenues,
before returns and allowances, in the three months ended September 30, 2001. The
increase in the provision as a percent of revenue reflects an increase during
2001 in the actual returns and the future expected returns of current products
originating from new products introduced during 2001. The increase in the
provision as a percent of revenue also reflects promotional rebates that were
introduced during 2001 and restocking and price protection rights. We expect to
continue to introduce new products each year, which may impact our reserve for
sales returns and allowances.

Cost of Revenues and Gross Margin

     Total cost of revenues, which includes product and service costs, increased
from $6.2 million in the three months ended September 30, 2000 to $6.7 million
in the three months ended September 30, 2001, an increase of 8%. As a percentage
of total revenues, cost of revenues increased from 36% in the three months ended
September 30, 2000 to 39% in the three months ended September 30, 2001. Gross
margins are impacted by various factors, including the volume discount levels
contained in our channel customer agreements, the cost of our Firebox
appliances, the mix of product and service sales, which may include hardware and
software products and service subscriptions or both, the cost of royalties
associated with our products, and the costs of our technical support
organization and LiveSecurity Service.

                                     Page 13

<PAGE>

     Cost of product revenues, which includes the cost of manufacturing our
security appliance, product packaging and third-party product licensing fees,
decreased from $5.4 million in the three months ended September 30, 2000 to $5.2
million in the three months ended September 30, 2001, a decrease of 3%. The
decrease was primarily due to lower product sales volume. Cost of product
revenues as a percentage of total product revenues increased from 36% in the
three months ended September 30, 2000 to 41% in the three months ended September
30, 2001. The increase in cost of product revenues as a percentage of product
revenues reflects promotional programs on certain existing Firebox products
established to facilitate the introduction of several new products during the
quarter ended September 30, 2001. The increase also reflects a change in product
mix, in which the sales volume of some of our lower-margin products increased on
a relative basis from the third quarter of 2000 to the third quarter of 2001. We
expect product mix changes, which would result from increased sales of
relatively higher margin software products such as ServerLock, to have a
positive impact on gross margins. Cost savings and product mix changes that
improve gross margins, however, may be offset in the short term by heightened
price competition and by the promotional programs on existing products mentioned
above. We therefore expect that gross margins, in dollars and as a percentage of
revenues, will be negatively impacted in the short term by price competition and
by promotional programs but will gradually improve during the balance of 2001
and into 2002, primarily, as a result of reductions in manufacturing costs.

     Cost of service revenues, which includes the costs of our technical support
organization and costs associated with our LiveSecurity Service, increased from
$824,000 in the three months ended September 30, 2000 to $1.5 million in the
three months ended September 30, 2001, an increase of 76%. As a percentage of
total service revenues, cost of service revenues decreased from 34% in the three
months ended September 30, 2000 to 33% in the three months ended September 30,
2001. Cost of service revenues as a percentage of total service revenues has
decreased slightly reflecting an increase in the investment in our customer
support organization which coincides with a increasingly growing number of
customers who are implementing VPNs in a more complex environment, as well as a
broader customer base. We expect service costs to continue to increase in total
dollar amount as our user base expands. In the longer term, as revenues from
LiveSecurity subscriptions increase and account for a greater percentage of
total revenues, we expect our service margins to increase.

Operating Expenses

     Sales and Marketing. Sales and marketing expenses include salaries,
commissions and employee-related expenses and certain variable marketing
expenses, including distributor promotional costs, public relations costs,
marketing collateral and trade show expenses. Total sales and marketing expenses
increased from $5.8 million in the three months ended September 30, 2000 to $7.4
million in the three months ended September 30, 2001, an increase of 26%. As a
percentage of total revenues, sales and marketing expenses increased from 34% in
the three months ended September 30, 2000 to 43% in the three months ended
September 30, 2001. The dollar increase in sales and marketing expenses was
primarily due to recruiting and supporting a greater number of current and
prospective resellers and distributors and to increased efforts to establish
brand recognition of our products and services. Specifically, the increase was
due to an increase in variable marketing costs from $1.6 million in the three
months ended September 30, 2000 to $2.8 million in the three months ended
September 30, 2001 related to specific marketing activities designed to increase
brand awareness.

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

     Research and Development. Research and development expenses include
salaries, non-capitalized equipment and software tools, depreciation from
capital equipment and software, nonrecurring costs associated with our security
appliance prototypes and payments to designers and contractors. Research and
development expenses increased from $3.4 million in the three months ended
September 30, 2000 to $4.1 million in the three months ended September 30, 2001,
an increase of 21%. As a percentage of total revenues, research and development
expenses increased from 20% in the three months ended September 30, 2000 to 24%
in the three months ended September 30, 2001. The increase in research and
development expenses reflects the growth of our research and development
organization to expand and enhance our Firebox System and LiveSecurity for MSS
product lines and ServerLock products, and our efforts to respond to new and
emerging worldwide Internet security threats through our LiveSecurity Service.
Specifically, the increase was due to payroll and related expenses which
increased from $2.1 million in the three months ended September 30, 2000 to $2.8
million in the three months ended September 30, 2001, a portion of which is
related to the research and development costs of our ServerLock products
originating from our acquisition of Qiave.

     We expect to continue to increase our research and development expenses in
total dollar amounts to enhance and expand our current product offerings,
develop new products and enhance our rapid response team, which analyzes and
addresses internet security threats, and our advisory council, which provides
continuing education and editorials on internet security. We also expect
research and development expenses to increase at a slower rate than revenues
and, therefore, expect to see a gradual reduction over time of these expenses as
a percentage of total revenues.

                                     Page 14

<PAGE>

     General and Administrative. General and administrative expenses include
costs of executive, human resource, finance and administrative support
functions, provision for uncollectible accounts and legal and accounting
professional services. General and administrative expenses increased from $1.7
million in the three months ended September 30, 2000 to $2.1 million in the
three months ended September 30, 2001, an increase of 21%. As a percentage of
total revenues, general and administrative expenses increased from 10% in the
three months ended September 30, 2000 to 12% in the three months ended September
30, 2001. The dollar increase in general and administrative expenses reflects
the expansion of our infrastructure to manage the growth of our operations and
costs associated with being a public company, an increase in payroll and related
expenses and increases in other general and administrative areas such as bad
debt.

     Stock-based Compensation. Stock-based compensation expenses arise from
amortization of previously deferred stock-based compensation over the vesting
periods of the common stock subject to repurchase and stock options. Stock-based
compensation expense was $193,000 in the three months ended September 30, 2000
and $1.5 million in the three months ended September 30, 2001. The allocation of
the stock-based compensation expense associated with the functional operating
expense categories of sales and marketing, research and development, and general
and administrative was $36,000, $143,000 and $14,000 in the three months ended
September 30, 2000 and $30,000, $1.4 million, and $7,000 in the three months
ended September 30, 2001.

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

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

Interest Income

     Interest income is generated from the investment of proceeds from the sale
of common stock in our initial public offering in 1999 and our public offering
in February 2000. Interest income decreased from $1.8 million in the three
months ended September 30, 2000 to $1.3 million in the three months ended
September 30, 2001. This decrease resulted from both a decrease in the average
balance of invested funds and a decrease in the average rates of return.

Income Taxes

     Income tax expense of $28,000 for the three months ended September 30, 2001
primarily relates to our provision for foreign income taxes associated with our
international operations. We have experienced losses since inception, resulting
in a net operating loss carryforward position for federal income tax purposes of
approximately $132.2 million as of September 30, 2001. These carryforwards, if
not utilized, will begin to expire in 2011, and may be subject to limitations
under Section 382 of the Internal Revenue Code.

Nine Months Ended September 30, 2001 and 2000

Revenues

     Total revenues increased from $40.8 million in the nine months ended
September 30, 2000 to $51.9 million in the nine months ended September 30, 2001,
an increase of 27%. In the nine months ended September 30, 2000, revenues from
one of our distributors, Ingram Micro, Inc., were $5.1 million, or approximately
12% of total revenues, while revenues from another distributor, Tech Data, were
$4.2 million, or approximately 10% of total revenues. In the nine months ended
September 30, 2001, revenues from one of our distributors, Ingram Micro, Inc.,
were $6.7 million, or approximately 13% of total revenues and revenues from
another distributor, Tech Data, were $5.5 million, or approximately 11% of total
revenues . The increase in total revenues was primarily due to distribution
sales volume increases in the our major geographical markets. Total
international revenues represented approximately 54% of total revenues in the
nine months ended September 30, 2000 and 56% in the nine months ended September
30, 2001.

                                     Page 15

<PAGE>

     Product revenues increased from $35.3 million in the nine months ended
September 30, 2000 to $39.3 million in the nine months ended September 30, 2001,
an increase of 12%. As a percentage of total revenues, product revenues
decreased from 87% in the nine months ended September 30, 2000 to 76% in the
nine months ended September 30, 2001 reflecting a lower growth rate associated
with slowing economic conditions and the events of September 11, 2001 and their
aftermath.

     Service revenues increased from $5.5 million in the nine months ended
September 30, 2000 to $12.5 million in the nine months ended September 30, 2001,
an increase of 128%. As a percentage of total revenues, service revenues
increased from 14% in the nine months ended September 30, 2000 to 24% in the
nine months ended September 30, 2001 reflecting a growing customer base,
increased renewals of LiveSecurity subscription, as well as slower growth rate
of product revenues discussed above.

     The provision for sales returns and allowances was $1.2 million, or 3% of
total revenues, in the nine months ended September 30, 2000 and $4.5 million, or
9% of total revenues, in the nine months ended September 30, 2001. The increase
in the provision as a percentage of total revenue reflects an increase during
2001 in actual returns and the future expected return rates of current products
that may originate from the introduction of the products during the nine months
ended September 30, 2001. The increase in the provision as a percentage of total
revenues also reflects promotional rebates that were introduced during 2001 and
restocking and price protection rights. We expect to continue to introduce new
products each year, which may impact our reserve for sales returns and
allowances.

Cost of Revenues

     Cost of revenues increased from $14.6 million in the nine months ended
September 30, 2000 to $20.3 million in the nine months ended September 30, 2001,
an increase of 39%. As a percentage of total revenues, cost of revenues
increased from 36% in the nine months ended September 30, 2000 to 39% in the
nine months ended September 30, 2001. The dollar increases in cost of revenues
were primarily due to increases in sales volume.

     Cost of product revenues increased from $12.8 million in the nine months
ended September 30, 2000 to $15.9 million in the nine months ended September 30,
2001, an increase of 24%. The increase was primarily due to greater sales
volume. Cost of product revenues as a percentage of total product revenues
increased from 36% in the nine months ended September 30, 2000 to 40% in the
nine months ended September 30, 2001. The increase in cost of product revenues
as a percentage of product revenues reflects promotional programs on certain
existing Firebox products established to facilitate the introduction of several
new products during the nine months ended September 30, 2001. The increase also
reflects a change in product mix, in which the sales volume of some of our
lower-margin products increased on a relative basis from the nine months ended
September 30, 2000 as compared to the nine months ended September 30, 2001.

     Cost of service revenues increased from $1.8 million in the nine months
ended September 30, 2000 to $4.4 million in the nine months ended September 30,
2001, an increase of 142%. As a percentage of total service revenues, cost of
service revenues increased from 33% in the nine months ended September 30, 2000
to 35% in the nine months ended September 30, 2001. This increase reflects an
investment in our customer support organization to assist the growing number of
customers who are implementing VPNs in a more complex environment, as well as a
broader customer base. We expect service costs to continue to increase in total
dollar amount as our user base expands. In the longer term, as revenues from
LiveSecurity subscriptions increase and account for a greater percentage of
total revenues, we expect our service margins to increase.

Operating Expenses

     Sales and Marketing. Sales and marketing expenses increased from $17.4
million in the nine months ended September 30, 2000 to $23.2 million in the nine
months ended September 30, 2001, an increase of 34%. As a percentage of total
revenues, sales and marketing expenses increased from 43% in the nine months
ended September 30, 2000 to 45% in the nine months ended September 30, 2001. The
dollar increase and percentage increase in sales and marketing expenses was
primarily due to recruiting, training and supporting our domestic and
international resellers and distributors and, to a lesser extent, to
establishing brand recognition of our products and services. Specifically, major
components of the increase included:

      . an increase in payroll and related expenses from $7.5 million to $8.7
        million;

      . an increase in variable marketing costs from $5.8 million to $8.7
        million; and

      . an increase in travel and related expenses from $2.4 million to $2.8
        million.

                                     Page 16

<PAGE>

     Research and Development. Research and development expenses increased from
$9.2 million in the nine months ended September 30, 2000 to $14.1 million in the
nine months ended September 30, 2001, an increase of 54%. As a percentage of
total revenues, research and development expenses increased from 23% in the nine
months ended September 30, 2000 to 27% in the nine months ended September 30,
2001. The dollar increase in research and development expenses reflects the
growth of our research and development organization to expand our enterprise
product line and our efforts in researching and evaluating new and emerging
security threats for our LiveSecurity broadcast service. Specifically, major
components of the increase included:

     .  an increase in payroll and related expenses from $5.9 million to $8.8
        million, the majority of which is related to the research and
        development costs of our ServerLock products originating from our
        acquisition of Qiave; and

     .  an increase in facilities expenses from $319,000 to $1.4 million, a
        combination of the costs associated with the new corporate headquarters
        and the costs of facilities originating from our acquisition of Qiave.

     General and Administrative. General and administrative expenses increased
from $4.1 million in the nine months ended September 30, 2000 to $5.8 million in
the nine months ended September 30, 2001, an increase of 41%. As a percentage of
total revenues, general and administrative expenses increased from 10% in the
nine months ended September 30, 2000 to 11% in the nine months ended September
30, 2001. The dollar increase in general and administrative expenses reflects
the expansion of our infrastructure to manage the growth of our operations, and
primarily relates to an increase in payroll and related expenses. Specifically,
major components of the increase included:

     .  an increase in payroll and related expenses from $1.8 million to $2.5
        million; and

     .  an increase in professional fees, public company expenses and bad debt
        expenses from $1.0 million to $1.8 million, the major component of
        which, bad debt expenses, increased from $300,000 in the nine months
        ended September 30, 2000 to $700,000 in the nine months ended September
        30, 2001, reflecting both an increase in risk associated with a broader
        customer base and the uncertain economy.

     Stock-based Compensation. Amortization of deferred compensation expense was
$657,000 in the nine months ended September 30, 2000 and $8.5 million in the
nine months ended September 30, 2001. The allocation of the stock-based
compensation expense associated with the functional operating expense categories
of sales and marketing, research and development, and general and administrative
for the nine months ended September 30, 2000 was $136,000, $465,000 and $56,000,
respectively, and was $201,000, $8.3 million, and $30,000, respectively, for the
nine months ended September 30, 2001.

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

Interest Income

     Interest income is generated from the investment of proceeds from the sale
of common stock in our initial public offering in 1999 and our public offering
in February 2000. Interest income increased from $4.5 million in the nine months
ended September 30, 2000 to $4.6 million in the nine months ended September 30,
2001. The increase resulted primarily from the full nine month period's
investment in 2001 of the proceeds of our public offering that occurred in 2000,
in addition to the investment of the proceeds from our initial public offering
in 1999.

                                     Page 17

<PAGE>
Quarterly Results of Operations

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

<TABLE>
<CAPTION>
                                                                              Three Months Ended
                                                      -------------------------------------------------------------------
                                                        Sept. 30,     June 30,     Mar. 31,     Dec. 31,     Sept. 30,
                                                          2001          2001         2001         2000          2000
                                                      ------------- ------------ ------------ ------------- -------------
                                                                               (In thousands)

Consolidated Statement of Operations Data:
<S>                                                   <C>           <C>          <C>          <C>             <C>
Revenues:
   Product ........................................     $ 12,806      $ 13,255     $ 13,284     $ 16,734      $ 14,782
   Service ........................................        4,462         4,253        3,818        3,192         2,453
                                                      ------------- ------------ ------------ ------------- -------------
     Total revenues ...............................       17,268        17,508       17,102       19,926        17,235
Cost of revenues:
   Product ........................................        5,214         5,425        5,267        6,137         5,363
   Service ........................................        1,450         1,558        1,376        1,174           824
                                                      ------------- ------------ ------------ ------------- -------------
     Total cost of revenues .......................        6,664         6,983        6,643        7,311         6,187
                                                      ------------- ------------ ------------ ------------- -------------
Gross margin ......................................       10,604        10,525       10,459       12,615        11,048

Operating expenses:
   Sales and marketing ............................        7,380         7,690        8,171        6,838         5,849
   Research and development .......................        4,129         4,740        5,271        4,704         3,413
   General and administrative .....................        2,060         1,865        1,870        1,895         1,703
   Stock-based compensation .......................        1,468         2,546        4,520        7,750           193
   Amortization of goodwill, purchased technology
     and other intangible assets acquired .........        2,724         2,724        2,724        7,123           368
   Restructuring charges ..........................          --          2,900          --           --            --
                                                      ------------- ------------ ------------ ------------- -------------
     Total operating expenses .....................       17,761        22,465       22,556       28,310        11,526

                                                      ------------- ------------ ------------ ------------- -------------
Operating loss ....................................       (7,157)      (11,940)     (12,097)     (15,695)         (478)
Interest income, net ..............................        1,292         1,622        1,701        1,986         1,812
                                                      ------------- ------------ ------------ ------------- -------------
Income (loss) before income taxes .................       (5,865)      (10,318)     (10,396)     (13,709)        1,334
Provision for income taxes ........................           28            84           84          215            --
                                                      ------------- ------------ ------------ ------------- -------------
Net income (loss) .................................     $ (5,893)     $(10,402)    $(10,480)    $(13,924)     $  1,334
                                                      ============= ============ ============ ============= =============
</TABLE>

                                       Page 18

<PAGE>

<TABLE>
<CAPTION>
                                                                                   Three Months Ended
                                                     -----------------------------------------------------------------------------
                                                       Sept. 30,      June 31,        Mar. 31,        Dec. 31,        Sept. 30,
                                                         2001           2001            2001            2000             2000
                                                     ------------   ------------   --------------   -------------   --------------

Consolidated Statement of Operations Data:
<S>                                                  <C>            <C>            <C>              <C>             <C>
Revenues:
   Product ......................................         74.2 %         75.7 %          77.7 %           84.0 %           85.8 %
   Service ......................................         25.8           24.3            22.3             16.0             14.2
                                                     ------------   ------------   --------------   -------------   --------------
     Total revenues .............................        100.0          100.0           100.0            100.0            100.0
Cost of revenues:
   Product ......................................         30.2           31.0            30.8             30.8             31.1
   Service ......................................          8.4            8.9             8.0              5.9              4.8
                                                     ------------   ------------   --------------   -------------   --------------
     Total cost of revenues .....................         38.6           39.9            38.8             36.7             35.9
                                                     ------------   ------------   --------------   -------------   --------------
Gross margin ....................................         61.4           60.1            61.2             63.3             64.1

Operating expenses: .............................
   Sales and marketing ..........................         42.7           43.9            47.8             34.3             33.9
   Research and development .....................         23.9           27.1            30.8             23.6             19.8
   General and administrative ...................         11.9           10.7            10.9              9.5              9.9
   Stock-based compensation .....................          8.5           14.5            26.5             38.9              1.1
   Amortization of goodwill, purchased technology
     and other intangible assets acquired .......         15.8           15.6            15.9             35.7              2.1
   Restructuring charges ........................          0.0           16.6             0.0              0.0              0.0
                                                     ------------   ------------   --------------   -------------   --------------
     Total operating expenses ...................        102.9          128.3           131.9            142.1             66.9
                                                     ------------   ------------   --------------   -------------   --------------
Operating loss ..................................        (41.4)         (68.2)          (70.7)           (78.8)            (2.8)
Interest income, net ............................          7.5            9.3             9.9             10.0             10.5
                                                     ------------   ------------   --------------   -------------   --------------
Income (loss) before income taxes ...............        (34.0)         (58.9)          (60.8)           (68.8)             7.7
Provision for income taxes ......................          0.2            0.5             0.5              1.1              0.0
                                                     ------------   ------------   --------------   -------------   --------------
Net income (loss) ...............................        (34.1)%        (59.4)%         (61.3)%          (69.9)%            7.7 %
                                                     ============   ============   ==============   =============   ==============
</TABLE>

      As discussed above, we believe that global economic, political and other
uncertainties as well as constrained corporate information technology spending
have slowed the demand for our products and services. Like most companies in the
technology sector, we experienced a downturn in revenues from the fourth quarter
of 2000 to the third quarter of 2001. Revenues for the first, second and third
quarters of 2001 were $17.1 million, $17.5 million, and $17.3 million
respectively, and were significantly lower than revenues of $19.9 million which
were recorded for the fourth quarter of 2000. Both revenues and our quarterly
operating results for 2001 were negatively impacted by the economic slowdown
worldwide and an overall reduction in capital spending. Revenue levels in future
quarters are difficult to predict given the current business climate, including
the aftermath of the events of September 11, 2001, however, and may be more
variable than usual.

      Our gross margins as a percentage of revenues have decreased slightly over
the past year until a slight increase in the three months ended September 30,
2001. Gross margins as a percentage of revenues in the three months ended
September 30, 2001 increased due to lower costs associated with our new Firebox
III product line and due to leverage in our service revenue model. We have
continued to make significant investments in our customer support organization
to meet the needs of our expanding customer base. However, while these
investments had a negative impact on our gross margins during recent quarters,
our service margins have improved in the three months ended September 30, 2001
as our LiveSecurity subscription base has expanded. Gross margins in the second
and third quarters of 2001 were negatively impacted by promotional programs on
certain existing Firebox products established to facilitate the introduction of
the new Firebox III product line during the nine months ended September 30,
2001. Gross margins during 2001 were also negatively impacted by our sales
product mix, in which lower-margin products comprised a greater percentage of
overall revenues. Competitive selling pressures in future quarters could
adversely impact on our gross margins.

                                     Page 19

<PAGE>

      We also have continued to make investments in our sales and marketing
organization, as reflected in the increased expenditure levels during the first
nine months of 2001. In addition, our second quarter 2001 operating expenses
included significant restructuring charges associated with our restructuring
plan. Other significant increases in operating expenses during the first nine
months of 2001, including research and development, stock-based compensation,
and the amortization of intangibles, were primarily related to our acquisition
of Qiave in October 2000. While our operating expenses, excluding amortization
of goodwill, intangibles and stock-based compensation, and restructuring charges
continued to increase in dollar amounts through the first quarter of 2001, we
did reduce these expenses by approximately $1.0 million in the second quarter of
2001 and $700,000 in the third quarter of 2001 as compared to the prior quarter.
Increased operating expenses as a percentage of total revenues during the first,
second and third quarters of 2001, as compared to previous quarters, resulted
from the lower revenues discussed above.

      In light of the current economic slowdown and the uncertainty of market
conditions, we implemented programs during the nine months ended September 30,
2001 to increase efficiencies and reduce costs within all areas of our
organization, in an effort to better align our expenses with near-term revenue
projections. These programs include the reduction in workforce discussed
earlier, as well as a consolidation of excess facilities and related fixed asset
charges. Our quarterly operating results have fluctuated significantly in the
past and will probably continue to fluctuate.

Liquidity and Capital Resources

     As of September 30, 2001, we had $115.4 million in cash, cash equivalents
and securities available for sale, invested primarily in high-quality money
market accounts and marketable securities. We believe that the market risk
arising from our holdings of these financial instruments is not material. We
currently have outstanding a $3.0 million unconditional letter of credit we
issued in September 2000 to our landlord in conjunction with our building lease
for our corporate headquarters. Currently, our letter of credit is
collateralized by investments with our bank. Our working capital as of September
30, 2001 was $110.4 million.

     Operating activities

     Our operating activities resulted in net cash outflows of $1.2 million in
the nine months ended September 30, 2000 and $1.1 million in the nine months
ended September 30, 2001. The operating cash outflows during these periods
resulted primarily from significant investments in sales and marketing and
research and development, all of which led to operating losses. Cash used in
operating activities was net of non-cash charges totaling $3.1 million for the
nine months ended September 30, 2000 and $19.6 million for the nine months ended
September 30, 2001. These non-cash charges were primarily associated with the
amortization of goodwill and other intangibles, depreciation and amortization of
capital assets, provisions for bad debts, and compensation charges resulting
from the issuance of stock options and common stock subject to repurchase by
WatchGuard. Cash utilized by working capital components for operating activities
was $2.6 million for the nine months ended September 30, 2000 and cash provided
by working capital components for operating activities was $6.1 million for the
nine months ended September 30, 2001. In the nine-month period ended September
30, 2001, there were large fluctuations within some major working capital
components, as described below:

     (a) Net receivables decreased from $15.3 million at December 31, 2000 to
         $12.2 million at September 30, 2001, reflecting the decrease in
         revenues from $19.9 million for the three months ended December 31,
         2000 to $17.3 million for the three months ended September 30, 2001.
         Days sales outstanding, or DSOs, were 69 days at December 31, 2000 and
         64 days at September 30, 2001, calculated on a quarterly basis. DSOs
         are impacted by the payment terms contained in our customer contracts,
         risks associated with the uncertain economy, linearity in revenues in
         any particular quarter and the amount of deferred revenue contained in
         the receivable balance that has not been recognized as revenue. Based
         on the current sales mix, the resulting timing differences arising from
         varying payment terms in our customer agreements, the linearity of
         revenues in any particular quarter and the growth of deferred revenue,
         we expect our DSOs to generally range from 55 days to 70 days. However,
         any change in these factors could negatively impact expected DSO
         results.

     (b) Sales reserves for returns and allowances were $965,000 at December 31,
         2000 and $1.8 million at September 30, 2001, reflecting our estimate of
         returns and allowances associated with the return rights, price
         protection rights, and promotional rebates of some of our customers. We
         increased the sales reserve during the nine months ended September 30,
         2001 to reflect the potential for increased returns and pricing
         adjustments associated with new products introduced during the nine
         months ended September 30, 2001, promotional rebates introduced during
         2001, restocking and price protection rights. The reserve will continue
         to fluctuate from time to time depending on the timing of product
         introductions and pricing program changes.

                                     Page 20

<PAGE>

     (c) Net inventories decreased from $7.0 million at December 31, 2000 to
         $5.7 million at September 30, 2001. The overall decrease reflects
         consumption of Firebox component inventory in the manufacture of
         finished goods inventory. We maintain a reserve for inventory
         obsolescence and will continue to analyze the adequacy of our reserves
         on a periodic basis.

     (d) Prepaid expenses and other receivables increased from $3.2 million at
         December 31, 2000 to $4.2 million at September 30, 2001, primarily due
         to an increase in prepaid product royalty costs, prepaid insurance and
         prepaid rents.

     (e) Accounts payable and accrued expenses decreased from $11.7 million at
         December 31, 2000 to $10.2 million at September 30, 2001. This decrease
         resulted primarily from the timing of inventory purchases and other
         expenditures during the fourth quarter of 2000 as compared to the
         period ended September 30, 2001.

     (f) Deferred revenue increased from $11.9 million at December 31, 2000 to
         $16.9 million at September 30, 2001, an increase of 42%. This increase
         reflects the deferral of revenue from bundled LiveSecurity
         subscriptions included in new product revenues and renewals of
         LiveSecurity subscriptions from a growing customer base.

     Investing activities

     Cash used in investing activities was $69.7 million in the nine months
ended September 30, 2000 and cash provided by investing activities was $7.9
million in the nine months ended September 30, 2001. These activities primarily
relate to short-term investing activity of the proceeds received from our public
offerings, and capital expenditures for equipment and furniture.

     Financing activities

     Cash provided by financing activities totaled $95.7 million in the nine
months ended September 30, 2000 and $1.9 million in the nine months ended
September 30, 2001. We received $90.4 million in proceeds from a public offering
in the first quarter of 2000. We received cash in both periods from the exercise
of employee stock options and the purchase of common stock through our employee
stock purchase plan.

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

                                     Page 21

<PAGE>

Unaudited Pro Forma Operating Results

      Our management reviews our operating results on a pro forma basis in
making operating decisions, and we believe pro forma results provide additional
meaningful information. The following table provides our pro forma results for
the three and nine month periods ended September 30, 2000 and 2001 (in
thousands, except per share data):

<TABLE>
<CAPTION>
                                                                                 Three Months Ended      Nine Months Ended
                                                                                     September 30,         September 30,
                                                                                --------------------   --------------------
                                                                                  2001        2000       2001        2000
                                                                                --------    --------   --------    --------
<S>                                                                             <C>         <C>        <C>         <C>
Net income (loss) ...........................................................   $ (5,893)   $  1,334   $(26,775)   $ (1,740)

Adjustments to reconcile net income (loss) in the financial statements to pro
   forma net income (loss):

       Stock-based compensation .............................................      1,468         193      8,534         657
       Amortization of goodwill, purchased technology and
       other intangible assets acquired .....................................      2,724         368      8,172       1,104
       Restructuring charges ................................................         --          --      2,900          --
                                                                                --------    --------   --------    --------
Pro forma net income (loss) .................................................   $ (1,701)   $  1,895   $ (7,169)   $     21
                                                                                ========    ========   ========    ========
   Pro forma net income (loss) per share:
         Basic ..............................................................   $  (0.06)   $   0.08   $  (0.27)   $     --
                                                                                ========    ========   ========    ========
         Diluted ............................................................   $  (0.06)   $   0.07   $  (0.27)   $     --
                                                                                ========    ========   ========    ========
   Shares used in computation of pro forma net income (loss) per share:
         Basic ..............................................................     26,839      24,147     26,594      22,882
                                                                                ========    ========   ========    ========
         Diluted ............................................................     26,839      27,809     26,594      27,432
                                                                                ========    ========   ========    ========
</TABLE>

----------

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

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

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

     .   restructuring charges.

                                     Page 22

<PAGE>

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

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

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

      Since inception through the third quarter of 2001, we have incurred net
losses and experienced negative cash flows from operations in each quarter,
except for the third quarter of 2000. As of September 30, 2001, we had an
accumulated deficit of approximately $72.4 million. Although our revenues have
increased each year since we began operations, we do not believe that the
historical percentage growth rate of our revenues will be sustainable as our
revenue base increases and we may not achieve or sustain profitability in future
periods. While we introduced certain cost-saving measures in the second quarter
of 2001 in response to the current economic downturn we expect that over time we
will have to increase our operating expenses in connection with

     .  expanding into new product markets;

     .  continuing to develop our technology;

     .  expanding into new geographic markets;

     .  hiring additional personnel;

     .  upgrading our information and internal control systems; and

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

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

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

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

      Beginning late in the fourth quarter of 2000 and continuing through the
third quarter of 2001, we saw a general economic downturn in the U.S. economy,
and more recently, the worldwide economy. The events of September 11, 2001 and
their aftermath have exacerbated this downturn. These factors have affected the
demand for our products and services. We do not know how long this economic
downturn will last or how severe it will become. We also cannot predict the
extent of the impact of the economic downturn in the United States on economies
in other countries and geographic regions in which we conduct business. To the
extent that this downturn continues or spreads to other geographic regions, the
Internet security industry and demand for our products and services are likely
to be adversely affected and could result in a decline in our stock price.

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

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

      We believe that many potential customers, particularly SMEs, do not fully
understand or are not aware of the need for Internet security products and
services, particularily those products designed for server content and
application security. Historically, only enterprises having substantial
resources have developed or purchased Internet security solutions. Also, there
is a perception that Internet security is costly and difficult to implement. We
will therefore not succeed unless the market understands the need for Internet
security and we can convince our potential customers of our ability to provide
this security

                                     Page 23

<PAGE>

in a cost-effective and administratively feasible manner. Although we have
spent, and will continue to spend, considerable resources educating potential
customers about the need for Internet security and the benefits of our products
and services, our efforts may be unsuccessful.

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

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

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

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

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

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

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

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

      . loss of key personnel;

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

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

                                     Page 24

<PAGE>

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

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

      . potentially dilutive issuances of equity securities; and

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

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

      We sell most of our products and services through our distribution
network, and we expect our success to continue to depend in large part on their
performance. Our channel customers have the ability to sell products and
services that are competitive with ours, to devote more resources to those
competitive products or to cease selling our products and services altogether.
Two channel customers, Ingram Micro and Tech Data, together accounted for 23% of
our revenues for the third quarter of 2001 and 24% of our revenues for the nine
months ended September 30, 2001. The loss of one of these distributors, a
reduction in their sales, a reduction in our share of their sales of internet
security products, or a loss or reduction in sales involving one or more other
channel customers, particularly if the reduction results in increased sales of
competitive products, could harm our business.

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

      We provide some of our channel customers with product return rights for
stock rotation, 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. The short life cycles of our products and the
difficulty of predicting future sales increase the risk that new product
introductions or price reductions by us or our competitors could result in
significant product returns or price adjustments. In September 1998, for
example, when we introduced the Firebox II security appliance, we experienced an
increase in returns of previous products and product versions. Provisions for
returns and allowances for the years ended December 31, 1998, 1999, and 2000,
were $1.7 million, $1.1 million and $1.9 million, or 13%, 5% and 3% of total
revenues before returns and allowances. The provision for returns and allowances
was $1.2 million or 3% of total revenues before returns and allowances for the
nine month period ended September 30, 2000 and $4.5 million, or 8% of total
revenues before returns and allowances for the nine month period ended September
30, 2001. This increase in the provision for the nine month period ended
September 30, 2001 reflects promotional rebates that were introduced during
2001,the actual returns of current products, and the future expected returns of
current products that may originate from the introduction of our new Firebox III
family of products during the nine months ended September 30, 2001. While we
increased our provision for returns and allowances during the nine month period
ended September 30, 2001 to reflect the potential for promotional rebate costs,
for increased returns and for pricing adjustments associated with new products
introduced during the nine months ended September 30, 2001 and products we
expect to introduce in subsequent months, the provision may still be inadequate.

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

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

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

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

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<PAGE>

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

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

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

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

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

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

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

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

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

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

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

      Our success will depend in part on our continued ability to license
technology that is important for the functionality of our products. A
significant interruption in the supply of a third-party technology could delay
our development and sales until we can find, license and integrate equivalent
technology. This could damage our brand and result in loss of current and

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<PAGE>

potential customers. Although we believe that we could find other sources for
the technology we license, alternative technologies may be unavailable on
acceptable terms, if at all. We depend on our third-party licensors to deliver
reliable, high-quality products, develop new products on a timely and cost-
effective basis and respond to evolving technology and changes in industry
standards. We also depend on the continued compatibility of our third-party
software with future versions of our products.

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

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

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

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

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

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

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

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

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

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

      . pay damages;

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

      . redesign products or services that incorporate infringing technology.

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

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<PAGE>

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.

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

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

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

      Our ability to grow will depend in part on the expansion of our
international sales and operations, which are expected to continue to account
for a significant portion of our revenues. Sales to customers outside of the
United States accounted for approximately 35% of our revenues in 1998, 50% in
1999, 55% in 2000, and 56% for the nine months ended September 30, 2001. The
failure of our channel customers to sell our products internationally would
limit our ability to increase our revenues. In addition, our international sales
are subject to the risks inherent in international business activities,
including

      . cost of customizing products for foreign countries;

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

      . difficulties in acquiring and authenticating customer information;

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

      . regional economic and political conditions.

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

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

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

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

      . public or private debt financings; and

      . capital lease transactions.

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

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

      . our ability to expand our customer base;

      . the growth of our sales and marketing capabilities; and

      . the cost of any acquisitions we may complete.

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

Our stock price is volatile.

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

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

      . changes in analysts' earnings projections or recommendations;

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<PAGE>

      . failure to meet analysts' revenue or earnings projections;

      . our inability to successfully implement our business strategy;

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

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

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

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

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

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

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

      . accounting for goodwill. In July 2001 The Financial Accounting Standards
        Board (FASB) issued SFAS No. 142, "Goodwill and Other Intangible
        Assets." SFAS No. 142 requires that goodwill and other indefinite lived
        intangibles no longer be amortized to earnings, but instead be reviewed
        for impairment and written down and charged to earnings only in the
        periods in which the recorded value of goodwill is more than its fair
        value. Separatable intangible assets that do not have indefinite lives
        will continue to be amortized over their useful lives. WatchGuard will
        adopt the provisions of SFAS No. 141 and SFAS No. 142 on January 1,
        2002, except for the provisions of SFAS No. 141 as it relates to
        business combinations which are effective June 30, 2001. We expect the
        adoption of SFAS No. 142 to have the impact of reducing our amortization
        of goodwill commencing January 1, 2002, however, impairment reviews may
        result in future periodic write-downs of goodwill.

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

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

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Item 3.  Quantitative and Qualitative Disclosures About Market Risk

      Interest Rate Risk

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

      Foreign Currency Risk

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

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                           PART II. OTHER INFORMATION

Item 2.   Changes in Securities and Use of Proceeds

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

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

Item 6.   Exhibits and Reports on Form 8-K

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

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

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

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

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

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                                   SIGNATURES

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

November 9, 2001
                                      WATCHGUARD TECHNOLOGIES, INC





                                      By: /s/ Michael E. McConnell
                                          --------------------------------------
                                          Michael E. McConnell
                                          Senior Vice President, Chief Financial
                                          Officer and Treasurer
                                          (Principal Financial and Accounting
                                           Officer)

                                 Page 32