<PAGE>

                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION

                            WASHINGTON, D.C. 20549

                                   FORM 10-Q
(Mark One)

[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
    Act of 1934.

     For the quarterly period ended June 30, 1999.

                                      or

 [_] Transition report pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934.

                        Commission File Number: 0-24507

                         PILOT NETWORK SERVICES, INC.
            (Exact name of registrant as specified in its charter)

                 DELAWARE                                  94-3305774
     (State or other jurisdiction of                    (I.R.S. Employer
     incorporation or organization)                   Identification Number)

                          1080 MARINA VILLAGE PARKWAY
                               ALAMEDA, CA 94501
         (Address of principal executive offices, including zip code)

                                (510) 433-7800
             (Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                               Yes X  No ___
                                  ---

At June 30, 1999, there were 13,638,786 shares of the Registrant's Common Stock
outstanding.

                                 Page 1 of 17
<PAGE>

                         PILOT NETWORK SERVICES, INC.
                         QUARTERLY REPORT ON FORM 10-Q
                                     INDEX

<TABLE>
<CAPTION>
                                                                              Page Number
<S>                                                                           <C>
PART I.  FINANCIAL INFORMATION

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

         Condensed Consolidated Balance Sheets as of
         March 31, 1999 and June 30, 1999.................................         3

         Condensed Consolidated Statements of Operations for the
         three months ended June 30, 1998 and 1999........................         4

         Condensed Consolidated Statements of Cash Flows for the
         three months ended June 30, 1998 and 1999........................         5

         Notes to Financial Statements....................................         6

Item 2.  Management's Discussion and Analysis of Financial Condition and
         Results of Operations............................................         7

PART II. OTHER INFORMATION................................................        15

Item 2.  Changes in Securities and Use of Proceeds........................        15

Item 6.  Exhibits and Reports on Form 8-K.................................        15

SIGNATURES................................................................        16

INDEX TO EXHIBITS.........................................................        16
</TABLE>

                                 Page 2 of 17
<PAGE>

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

                         PILOT NETWORK SERVICES, INC.

                     CONDENSED CONSOLIDATED BALANCE SHEETS
                       (in thousands, except share data)
                                  (unaudited)

<TABLE>
<CAPTION>
                                                                                      March 31,          June 30,
                                                                                        1999               1999
                                                                                     -----------         --------
<S>                                                                                  <C>                 <C>
ASSETS
Current assets:
 Cash and cash equivalents..................................................         $    10,660         $  5,375
 Short-term investments.....................................................              12,352            9,488
 Trade receivables, less allowance for doubtful accounts of $157,000 and
  $222,000 as of March 31, 1999 and June 30, 1999, respectively                            3,438            2,729
 Prepaid and other current assets...........................................                 783              670
                                                                                     -----------         --------
  Total current assets......................................................              27,233           18,262
Property and equipment, net.................................................              14,184           17,918
Other assets................................................................                 698              522
                                                                                     -----------         --------
                                                                                     $    42,115         $ 36,702
                                                                                     -----------         --------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
 Accounts payable...........................................................         $     2,334         $  3,602
 Accrued expenses...........................................................               1,675            1,339
 Line of credit.............................................................               1,439              356
 Term loan..................................................................               3,000            3,000
 Current portion of capital lease obligations...............................               2,175            2,344
 Deferred revenue...........................................................               2,027            1,460
                                                                                     -----------         --------
  Total current liabilities.................................................              12,650           12,101
Capital lease obligations, net of current portion...........................               4,830            4,628
                                                                                     -----------         --------
  Total liabilities.........................................................              17,480           16,729
                                                                                     -----------         --------

Stockholders' equity:
 Common stock, $0.001 par value; 40,000,000 shares authorized; 13,913,024
  and 14,089,722 shares issued and outstanding as of March 31, 1999 and
  June 30, 1999, respectively...............................................                  14               14


 Additional paid-in capital.................................................              59,563           59,950
 Accumulated other comprehensive income.....................................                 127               82
 Deferred stock compensation................................................              (1,097)            (904)
 Accumulated deficit........................................................             (31,278)         (36,475)
 Treasury stock, 450,936 shares of common stock at cost
        as of March 31, 1999 and June 30, 1999, respectively................              (2,694)          (2,694)
                                                                                     -----------         --------
  Total stockholders' equity................................................              24,635           19,973
                                                                                     -----------         --------
                                                                                     $    42,115         $ 36,702
                                                                                     ===========         ========
</TABLE>

           See accompanying notes to condensed financial statements.

                                 Page 3 of 17
<PAGE>

                         PILOT NETWORK SERVICES, INC.

                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                     (in thousands, except per share data)
                                  (unaudited)

<TABLE>
<CAPTION>
                                                                           Three months ended
                                                                                June 30,
                                                                           1998          1999
                                                                           ----          ----
<S>                                                                        <C>           <C>
Service revenues...................................................        $ 3,720       $ 5,816
Cost of service revenues...........................................          4,023         6,430
                                                                           -------       -------
Gross margin.......................................................           (303)         (614)
                                                                           -------       -------
Operating costs and expenses:
 Sales and marketing...............................................          2,134         2,938
 Engineering and development.......................................            299           635
 General and administrative........................................            688           760
                                                                           -------       -------
 Operating expenses................................................          3,121         4,333
                                                                           -------       -------
Operating loss.....................................................         (3,424)       (4,947)

Interest expense, net..............................................           (208)         (250)
                                                                           -------       -------
Net loss...........................................................        $(3,632)      $(5,197)

Accretion on redeemable convertible preferred stock................           (337)            -
                                                                           -------       -------

Net loss attributable to common stockholders.......................        $(3,969)      $(5,197)
                                                                           =======       =======

Basic and diluted net loss per share...............................         $(1.81)       $(0.38)
                                                                           =======       =======

Shares used in computing net loss per share........................          2,198        13,557
                                                                           =======       =======
</TABLE>

           See accompanying notes to condensed financial statements.

                                 Page 4 of 17
<PAGE>

                         PILOT NETWORK SERVICES, INC.

                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                           (in thousands, unaudited)

<TABLE>
<CAPTION>
                                                                          Three months ended
                                                                               June 30,
                                                                           1998         1999
                                                                           ----         ----
<S>                                                                      <C>            <C>
Cash flows from operating activities:
 Net loss........................................................        $(3,632)        $(5,197)
 Adjustments to reconcile net loss to net cash used in operating
  activities:
  Foreign currency translation loss..............................              -              (8)
  Depreciation and amortization..................................            852           1,599
  Amortization of deferred compensation..........................            294             193
  Amortization of loan fees......................................              -             150
  Changes in operating assets and liabilities:
   Trade receivables.............................................         (1,174)            709
   Prepaid and other assets......................................           (281)            139
   Accounts payable..............................................          1,652           1,268
   Accrued expenses..............................................            606            (336)
   Deferred revenue..............................................            476            (567)
                                                                         -------         -------
   Net cash used in operating activities.........................         (1,207)         (2,050)
                                                                         -------         -------
Cash flows used in investing activities:
 Purchases of property and equipment.............................           (768)         (4,840)
 Proceeds from sale of short-term investments....................              -           2,827
                                                                         -------         -------
   Net cash used in investing activities.........................           (768)         (2,013)
                                                                         -------         -------
Cash flows from financing activities:
 Net proceeds from issuance of common stock......................            143             387
 Proceeds from working capital line of credit....................          1,056               -
 Payments of working capital line of credit......................              -          (1,083)
 Proceeds from term loan.........................................          6,000               -
 Principal payments of obligations under capital leases..........           (495)           (526)
                                                                         -------         -------
   Net cash provided by (used in) financing activities...........          6,704          (1,222)
                                                                         -------         -------

Net increase (decrease) in cash and cash equivalents.............          4,729          (5,285)

Cash and cash equivalents, beginning of period...................          1,447          10,660
                                                                         -------         -------
Cash and cash equivalents, end of period.........................        $ 6,176         $ 5,375
                                                                         =======         =======

Supplemental disclosure of cash flow information:
 Cash paid during the period for interest........................        $   220         $   385
                                                                         =======         =======
 Noncash financing activities:
  Assets acquired under capital lease obligations................        $ 1,629         $   493
                                                                         =======         =======
  Accretion of preferred stock...................................        $   337         $     -
                                                                         =======         =======
</TABLE>

           See accompanying notes to condensed financial statements.

                                 Page 5 of 17
<PAGE>

NOTES TO FINANCIAL STATEMENTS

1.   Basis of presentation

     The interim financial statements included herein for Pilot Network
Services, Inc. (the "Company" or "Pilot") have been prepared by the Company,
without audit, pursuant to the rules and regulations for Form 10-Q of the
Securities and Exchange Commission. In management's opinion, the interim
financial statements include all adjustments (which include only normal and
recurring adjustments) necessary for a fair presentation of the information set
forth therein. Certain information and footnote disclosures normally included in
the financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to such rules and
regulations. The results of operations for the three months ended June 30, 1999
are not necessarily indicative of the operating results expected for the entire
year. The financial statements included herein should be read in conjunction
with the Company's March 31, 1999, financial statements and notes thereto
included in the Company's Form 10-K filed with the Securities and Exchange
Commission and dated June 29, 1999.

2.   Basic and diluted net loss per share

     Basic and diluted net loss per share has been computed using the weighted
average number of common shares outstanding during the period. Inclusion of
common share equivalents would be anti-dilutive and have been excluded from
diluted per share calculations. Pro forma net loss per share includes the
Company's preferred stock on an as-converted basis.

     Excluded from the computation of diluted earnings per share for the period
ending June 30, 1998, are options to acquire 1,556,940 shares of common stock
and 7,763,030 common share equivalents resulting from the assumed conversion of
the Series A, B, C, D, E and F preferred stock and related warrants because
their effects would be anti-dilutive. Excluded from the computation of diluted
earnings per share for the period ending June 30, 1999, are options to acquire
2,357,645 shares of common stock and 255,374 common share equivalents from the
assumed exercise of common stock warrants because their effects would be anti-
dilutive.

     Had the outstanding shares of redeemable convertible preferred stock and
the Series A Preferred Stock converted to common stock as of April 1, 1998, or
the date of issuance if later, pro-forma basic and diluted loss per share for
June 30, 1998, would have been $0.36 on an approximate share count of 9,961,000.

3.   Recent accounting pronouncements

     In June 1998, the Financial Accounting Standards Board issued SFAS 133,
"Accounting for Derivative Instruments and Hedging Activities." This statement
establishes standards for derivative instruments and hedging activities. The
Company is required to adopt SFAS 133 as amended by SFAS 137 in the first
quarter of fiscal year 2001. The Company does not anticipate that SFAS 133 as
amended by SFAS 137 will have a material impact on its financial statements.

4.   Comprehensive Loss

     Total comprehensive loss for the quarter ended June 30, 1999, was
$5,242,000.

                                 Page 6 of 17
<PAGE>

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


     In addition to historical information, this Quarterly Report contains
forward-looking statements. The forward-looking statements are subject to
certain risks and uncertainties that could cause actual results to differ
materially from those reflected in such forward-looking statements. Factors that
might cause such a difference include, but are not limited to, those discussed
in the section entitled "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors That May Affect Future Results and
Market Price of Stock." Readers are cautioned not to place undue reliance on
these forward-looking statements, which reflect management's opinions only as of
the date hereof. The Company undertakes no obligation to revise or publicly
release the results of any revision to these forward-looking statements. Readers
should carefully review the risk factors that may be described in other
documents the Company files from time to time with the Securities and Exchange
Commission, including its Annual Report on Form 10-K filed by the Company on
June 29, 1999, and any Quarterly Reports on Form 10-Q filed by the Company in
the future.

OVERVIEW

     Pilot provides a wide range of secure Internet services that incorporate
high-bandwidth connectivity and enable secure electronic business over the
Internet. The services are offered for a fixed monthly fee on an annual
subscription-basis. The Company's services include secure hosting and Internet
connectivity services that enable secure connectivity between a corporate
network and the Internet and secure virtual private networking services that
enable remote users and wide-area networks to securely communicate enterprise-
wide and over the Internet. The Company offers a scalable solution that allows
customers to quickly deploy and expand electronic business capabilities by
subscribing to Pilot's secure Internet services.

RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 1998 AND 1999

     SERVICE REVENUES. In the three months ended June 30, 1999, service revenues
increased 56% to $5.8 million from $3.7 million in the three months ended June
30, 1998. This growth was due primarily to increases in the number of new
customers and to additional services sold to existing customers. To a lesser
extent, annual price increases for various offered services also contributed to
this growth. Additionally, the Company was able to shorten the implementation
time for certain new services, allowing for earlier recognition of
implementation fees and billing of fees for recurring services.

     COST OF SERVICE REVENUES. Cost of service revenues increased to $6.4
million, or 111% of service revenues, in the three months ended June 30, 1999,
compared to $4.0 million, or 108% of service revenues, in the three months ended
June 30, 1998. The increase in cost of service revenue was a result of an
increase in security implementation, customer service and operations personnel
to 77 at June 30, 1999, as well as increases in recruiting, consulting,
telecommunications and depreciation directly related to the Company's revenue
growth. Additionally, incremental costs associated with the opening of a new
Network Security Center in Alameda, California contributed to the increase in
cost of service revenues. The Company expects the cost of service revenues to
increase on an absolute basis as a result of expected customer expansion in the
Company's Network Security Centers.

     SALES AND MARKETING. Sales and marketing expenses increased 38% to $2.9
million in the three months ended June 30, 1999, from $2.1 million in the three
months ended June 30, 1998, but decreased as a percentage of service revenues to
51% for the three months ended June 30, 1999, from 57% for the three months
ended June 30, 1998. The increase in sales and marketing expense was a result of
an increase in sales and marketing personnel to 42 at June 30, 1999, as well as
increases in recruiting, commissions and sales promotion directly related to the
expanded sales activity. The Company expects that

                                 Page 7 of 17
<PAGE>

its sales and marketing expenses will continue to increase in absolute dollars
for at least the next twelve months as the Company makes additional investments
in expanding its sales and marketing activities.

     ENGINEERING AND DEVELOPMENT. Engineering and development expenses increased
113% to $635,000 in the three months ended June 30, 1999, from $299,000 in the
three months ended June 30, 1998, and increased as a percentage of service
revenues to 11% for the three months ended June 30, 1999, from 8% for the three
months ended June 30, 1998. The increase in engineering and development expense
was a result of an increase in personnel to 18 at June 30, 1999, as well as
increases in recruiting and consulting. The Company expects that its engineering
and development expenses will continue to increase in absolute dollars for at
least the next twelve months as the Company makes additional investments in
developing its secure electronic commerce services.

     GENERAL AND ADMINISTRATIVE. General and administrative expenses increased
11% to $761,000 in the three months ended June 30, 1999 from $688,000 in the
three months ended June 30, 1998, but decreased as a percentage of service
revenues to 13% for the three months ended June 30, 1999, from 19% for the three
months ended June 30, 1998. The increase in general and administrative expenses
was a result of an increase in personnel to 17 at June 30, 1999, as well as
increases in professional fees, business taxes and amortization of deferred
compensation as well as other costs associated with being a public company. The
Company expects that its general and administrative expenses will continue to
increase in absolute dollars for at least the next twelve months as the Company
continues to expand its operations and incurs additional costs associated with
being a public company.

LIQUIDITY AND CAPITAL RESOURCES

     At June 30, 1999, the Company's cash, cash equivalents and short-term
investments totaled $14.9 million compared to cash, cash equivalents and short-
term investments of $23.0 million at March 31, 1999.

     As of June 30, 1999, the Company had an $8.0 million equipment line of
credit and lease facility for financing of equipment purchases at interest rates
of approximately 15%. Borrowings under the facilities are repayable in monthly
installments of principal and interest over 48 months and are secured by a lien
on the financed equipment. As of June 30, 1999, the Company had borrowed an
aggregate of $7.3 million under these lines of credit and lease facilities. The
Company is currently negotiating for additional operating and equipment lease
lines of credit with several financial institutions.

     On May 11, 1998, the Company negotiated a line of credit with a financial
institution for an aggregate amount of $1.5 million. The line of credit
currently bears interest of 10.0% per annum and is secured by assets of the
Company. At June 30, 1999, $1.1 million of this debt facility was available.

     On June 30, 1998, the Company completed a borrowing arrangement with two
lenders providing $6.0 million of short term financing. The loans expired in
June 1999 and incurred interest at 13.5% per annum. The loans contained various
pre-payment options available after the Company's initial public offering date
of August 10, 1998. As additional consideration, the Company issued 150,000
warrants to purchase common stock at $11.20 per share. The Company calculated
the fair value of the warrants of $1.2 million and recorded such amount as a
discount on the loans which has been amortized over the expected terms of the
loans. One of the lenders exercised its option for repayment of $3.0 million
which was repaid in October 1998. On July 1, 1999, the Company repaid the
remaining $3.0 million liability to the other lender.

     On October 19, 1998, the Company announced an open-market common stock
repurchase program under which the Company would repurchase up to 1.5 million
shares of its Common Stock. As of June 30, 1999, 450,936 shares had been
repurchased, at an aggregate cost to the Company of approximately $2.7 million.
The Company does not anticipate making any additional repurchases under this
program.

     The Company believes that its existing capital resources, available
equipment lease financing and additional operating and lease lines of credit
currently under negotiation will be adequate to fund its current

                                 Page 8 of 17
<PAGE>

operations through fiscal 2000. The Company believes that it will be necessary
for the Company to sell equity securities for the purpose of financing the
Company's operations after March 31, 2000. There can be no assurance that the
Company will be successful in generating anticipated levels of cash from
operations or completing any anticipated borrowings or equity financings,
including successful completion of its current line of credit negotiations. If,
prior to March 31, 2000, the Company is unable to generate sufficient cash flow
from operations or additional borrowings, it may be required to sell assets,
scale down its operations and expansion plans, refinance all or a portion of its
existing indebtedness or obtain other sources of financing earlier than planned,
any of which could have a material adverse impact on the Company's business,
results of operations and financial condition. There can be no assurance that
any such refinancing would be available on commercially reasonable terms, or at
all, or that any other financing could be obtained.

YEAR 2000 RISKS

     The Company has established procedures for evaluating and managing the
risks and costs associated with the Year 2000 problem and believes that the
internal computer systems that the Company has developed are currently Year 2000
compliant. To date, the Company has not incurred significant incremental costs
in order to comply with Year 2000 requirements and does not believe it will
incur significant incremental costs in order to comply with Year 2000
requirements in the foreseeable future. In the quarter ended December 31, 1998,
the Company formed a group of its technical staff on a project to upgrade and
standardize hardware, operating systems and application software versions on
most of the Company's production equipment. The Company believes that this
project is required for general consistency and operating efficiencies. However,
a by-product of this effort will be a greater level of assurance that the
Company is Year 2000 compliant. The project is currently estimated to last at
least through September 1999.

     Despite the Company's belief that its internal computer systems are
currently Year 2000 compliant, many of the Company's customers maintain their
Internet operations on commercially available operating systems, which may be
impacted by Year 2000 complications. In addition, the Company relies on third
party vendors for certain equipment, which may contain embedded instructions,
and software included within the Company's services, which may not be Year 2000
compliant. The Company is conducting an audit of its third-party suppliers as to
the Year 2000 compliance of their systems. However, the failure to correct or
discover a material Year 2000 problem could result in an interruption in, or a
failure of, certain normal business activities or operations. Such failures
could materially and adversely affect the Company's results of operations,
liquidity and financial condition. Due to the general uncertainty inherent in
the Year 2000 problem resulting in part from the uncertainty of the Year 2000
readiness of third-party suppliers and customers, the Company is unable to
determine at this time whether the consequences of Year 2000 failures will have
a material impact on the Company's results of operations, liquidity or financial
condition. The Company does not have a contingency plan if it is unable to reach
Year 2000 readiness prior to December 31, 1999. However, the Company intends to
develop such a plan as it completes the remainder of its readiness efforts. The
Company believes this plan will be in place prior to December 1999.

     The dates on which the Company believes its audit of third party suppliers
and its overall Year 2000 readiness will be completed is based on the Company's
management's best estimates, which were derived utilizing numerous assumptions
of future events, including the continued availability of certain resources,
third-party cooperation and modification plans, and other factors. However,
there can be no guarantee that these estimates will be achieved, or that there
will not be a delay in, or increased costs associated with, the implementation
of Year 2000 compliant solutions. Specific factors that might cause differences
between the estimates and actual results include, but are not limited to, the
availability and cost of personnel trained in these areas, the ability to locate
and correct all relevant computer code, timely responses to and corrections by
third-parties and suppliers, the ability to implement interfaces between the new
systems and the systems not being replaced, and similar uncertainties. Due to
the general uncertainty inherent in the Year 2000 problem, resulting in part
from the uncertainty of the Year 2000 readiness of third-parties and the
interconnection of global businesses, the Company cannot ensure its ability to
timely and cost-effectively resolve problems associated with the Year 2000 issue
and is unable to determine at this time whether the consequences of Year 2000
failures will have a material impact on the Company's results of

                                 Page 9 of 17
<PAGE>

operations, liquidity or financial condition. The Company operates a number of
servers on behalf of its customers. The Company has limited control over most of
the software and applications that are running on such servers and believes that
it bears no responsibility for the Year 2000 compliance of such servers. The
Company is unable to determine what costs, if any, it may have to incur to the
extent that such customers are unable to complete their own Year 2000 compliance
on such servers. Although the Company believes that it is not obligated to make
such upgrades and believes that any costs incurred should be billable to its
customers, Year 2000 problems on such customer servers may force the Company to
make significant, unplanned allocations of limited technical and financial
resources. Any significant unplanned allocations could have a material and
adverse impact on the Company's results of operations, liquidity and financial
condition.


FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK

   The Company operates in a rapidly changing environment that involves numerous
risks, some of which are beyond the Company's control. The following discussion
highlights some of these risks.

   LIMITED OPERATING HISTORY; HISTORY OF LOSSES. The Company began operations in
1993, and has experienced operating losses and negative cash flows from
operations in each quarterly and annual period. As of June 30, 1999, the Company
had an accumulated deficit of approximately $36.5 million. The revenue and
income potential of the Company's business and market is unproven, and the
Company's limited operating history makes an evaluation of the Company and its
prospects difficult. The Company has recently made and expects to continue
making significant investments in security technologies, new and existing
Network Security Centers, sales and marketing activities, and the development of
new services. As a result, the Company experienced a decline in gross margin and
an increase in net loss in fiscal 1998 and fiscal 1999 and expects to continue
experiencing significant net losses on a quarterly and annual basis for the
foreseeable future, including a negative gross margin at least for the next nine
months. Failure of the Company's services to achieve market acceptance would
have a material adverse effect on the Company's business, results of operations
and financial condition. There can be no assurance that the Company will ever
achieve profitability on a quarterly or an annual basis or will sustain
profitability if achieved.

   FUTURE CAPITAL NEEDS. The Company believes that its existing capital
resources, available equipment lease financing and additional operating and
lease lines of credit currently under negotiation will be adequate to fund its
current operations through fiscal 2000. The Company believes that it will be
necessary for the Company to sell equity securities for the purpose of financing
the Company's operations after March 31, 2000. There can be no assurance that
the Company will be successful in generating anticipated levels of cash from
operations or completing any anticipated borrowings or equity financings,
including successful completion of its current line of credit negotiations. If,
prior to March 31, 2000, the Company is unable to generate sufficient cash flow
from operations or additional borrowings, it may be required to sell assets,
scale down its operations and expansion plans, refinance all or a portion of its
existing indebtedness or obtain other sources of financing earlier than planned,
any of which could have a material adverse impact on the Company's business,
results of operations and financial condition. There can be no assurance that
any such refinancing would be available on commercially reasonable terms, or at
all, or that any other financing could be obtained.


   POTENTIAL FLUCTUATIONS IN RESULTS OF OPERATIONS. The Company derives revenue
from its customers primarily through initial setup fees and ongoing monthly
service charges. For each new customer, the Company must incur costs in
anticipation of the customer's decision to use the Company's services and in
advance of the receipt of sufficient revenues to repay these costs and provide a
return on the Company's investment. As a result, a relatively large portion of
the Company's expenditures are fixed in the short-term, and the Company's
success is substantially dependent on the continued growth in its customer base
and the retention of its customers for sufficient periods to provide returns on
the Company's investment. There can be no assurance that the Company's customers
will maintain or renew their commitments to use the Company's services. The
Company typically experiences a lengthy sales cycle for

                                 Page 10 of 17
<PAGE>

its services, particularly given the importance to customers of adequately
securing Internet connectivity for electronic commerce and the need to educate
them regarding the requirements for effective network security. Changes in the
rate of growth in the Company's customer base, customer renewal rates and the
sales cycle for the Company's services, have caused, or are expected in the
future to cause, significant fluctuations in the Company's results of operations
on a quarterly and an annual basis.

   For these and other reasons, in some future quarters, the Company's results
of operations may fall below the expectations of securities analysts or
investors, which could have a material adverse effect on the market price of the
Company's Common Stock.

   RISKS ASSOCIATED WITH SECURITY BREACHES. The Company's success is
substantially dependent on the continued confidence of its current and future
customers that the Company provides superior network security protection.
Despite the Company's focus on Internet security, there can be no assurance that
the Company will be able to stop unauthorized attempts, whether made
unintentionally or by computer "attackers," to gain access to or disrupt the
network operations of the Company's customers. The Company's Heuristic Defense
Infrastrucure delivered through its Network Security Centers is designed to
prevent unauthorized access to customers' networks from the Internet. Any
failure by the Company to stop unauthorized access from the Internet or
disruptions to related Internet operations of its customers could materially
adversely affect such customers and the Company. Although the Company generally
limits warranties and liabilities relating to security in its customer
contracts, the Company's customers may seek to hold the Company responsible for
any losses suffered by the customer as a result of unauthorized access to
customers' network systems from the Internet. This could result in liability to
the Company, which could have a material adverse effect upon its business,
operating results and financial condition. Moreover, computer attackers from the
Internet could infiltrate the Company's network and seek to sabotage its network
or services by creating bugs or viruses or through other means. In addition, any
adverse publicity resulting from any such unauthorized access could deter future
customers from using the Company's services and could cause current customers to
cease using the Company's services, which could have a material adverse effect
upon the Company's business, operating results and financial condition.

   RISKS ASSOCIATED WITH THE EMERGING MARKET FOR OUTSOURCED NETWORK SECURITY
SERVICES. The market for Internet security monitoring, detection and defense
services in general is new and rapidly evolving. If the market for such services
fails to grow or grows more slowly than the Company currently anticipates, the
Company's business, operating results and financial condition would be
materially and adversely affected.

   RISKS OF BUSINESS EXPANSION AND MANAGEMENT OF GROWTH. The Company intends to
expand domestically and internationally by adding Network Security Centers in
new locations and expanding Network Security Centers in existing locations. The
Company's inability to manage effectively its expansion, including any
disruption of service to current customers, would have a material adverse effect
upon the Company's business, results of operations and financial condition.

   In addition, the Company will be required to expend substantial resources for
leases and improvements of facilities, purchases of equipment, implementation of
multiple telecommunications connections and hiring of network, administrative,
customer support, and sales and marketing personnel. Furthermore, any problems
encountered in connection with the expansion of existing Network Security
Centers may cause the interruption of service to current customers.

   The Company has recently hired large numbers of new employees. This growth
has placed and may continue to place a significant strain on the Company's
financial, management, operational and other resources. If the Company's
executives were unable to manage growth effectively, the Company's business,
results of operations and financial condition would be materially adversely
affected.

   COMPETITION. The market served by the Company is new, rapidly evolving,
highly competitive and largely undefined. There are few general barriers to
entry, and the Company expects that it will face additional competition from
existing competitors and new market entrants in the future. There can be no
assurance that the Company will have the resources or expertise to compete
successfully in the future.

                                 Page 11 of 17
<PAGE>

   The Company competes with a broad range of products and services. Many of the
Company's competitors have substantially greater financial, technical and
marketing resources, larger customer bases, longer operating histories, greater
name recognition and more established relationships in the industry than the
Company. As a result, certain of these competitors may be able to develop and
expand their network infrastructures and service offerings more quickly, adapt
to new or emerging technologies and changes in customer requirements more
quickly, take advantage of acquisition and other opportunities more readily,
devote greater resources to the marketing and sale of their products and adopt
more aggressive pricing policies than the Company. In addition, the Company
believes that the businesses in which the Company competes are likely to
encounter consolidation in the near future, which could result in increased
price and other competition that could have a material adverse effect on the
Company's business, results of operations and financial condition.

   RISK OF SYSTEM FAILURE. The Company's success depends on the excellence of
security protection and uninterrupted operation of its network infrastructure.
Despite existing and planned precautions by the Company, the occurrence of a
natural disaster or other unanticipated problems at one or more of the Company's
Network Security Centers could result in interruptions in the services provided
by the Company. Any damage to or failure of the Company's systems or those of
its service providers could result in reductions in, or terminations of,
services supplied to the Company's customers. Such reductions or terminations in
service could materially and adversely impact the Company's customers, which
could have a material adverse effect on the Company's business, results of
operations and financial condition.

   RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS. A key component of the
Company's long-term strategy is to expand into international markets. If revenue
generated by any international Network Security Center is not adequate to offset
the expense of establishing and maintaining any such international operation,
the Company's business, results of operations and financial condition could be
materially adversely affected. In addition, the Company faces certain risks
inherent in conducting business internationally, any of which could adversely
affect the Company's international operations.

   DEPENDENCE UPON SCALABILITY OF THE COMPANY'S NETWORK. The Company must
continue to expand and adapt its network infrastructure as the number of
customers and the amount of information they wish to transmit increases, and as
customer requirements change. The expansion and adaptation of the Company's
telecommunications infrastructure will require substantial financial,
operational and management resources. Due to the limited deployment of the
Company's services to date, the ability of the Company's network to connect and
manage a substantially larger number of customers at high transmission speeds is
as yet unknown, and the Company faces risks related to the network's ability to
operate with higher customer levels while maintaining superior performance. The
Company's failure to achieve or maintain high capacity data transmission could
significantly reduce customer demand for its services and have a material
adverse effect on its business, results of operations and financial condition.
There can be no assurance that the Company will be able to expand or adapt its
telecommunications infrastructure to meet additional demand or its customers'
changing requirements.

   DEPENDENCE UPON THIRD PARTY NETWORK INFRASTRUCTURE PROVIDERS. The Company's
success will depend upon third party network infrastructure providers. In
addition, the Company relies on a number of public and private peering
interconnections (i.e., arrangements among access providers to carry traffic of
each other) to deliver its services. If the carriers that operate the Internet
exchange points ("IXPs") were to discontinue their support of the peering points
or to refuse to offer services to the Company and no alternative providers were
to emerge, or such alternative providers were to increase the cost of utilizing
the IXPs, the transmission of network traffic by the Company would be
significantly constrained. If the Company were unable to access on a cost-
effective basis alternative networks to distribute its customers' content or
pass through any additional costs of utilizing these networks to its customers,
the Company's business, results of operations and financial condition could be
materially adversely affected.

   DEPENDENCE ON OTHER THIRD-PARTY RELATIONSHIPS. The Company is dependent on
other companies to supply certain key components of its telecommunications
infrastructure and system and

                                 Page 12 of 17
<PAGE>

network management solutions that, in the quantities and quality demanded by the
Company, are available only from sole or limited sources. Any failure to obtain
required components or software on a timely basis and at an acceptable cost
would have a material adverse effect on the Company's business, results of
operations and financial condition. The Company also intends to develop
alternative distribution and lead generation channel partners for the Company's
services, such as systems integration firms and bandwidth providers. Any failure
by the Company to develop these channel partners could materially and adversely
impact the ability of the Company to generate increased revenues, which could
have a material adverse effect on the Company's business, results of operations
and financial condition.

   RAPID TECHNOLOGICAL CHANGE; EVOLVING INDUSTRY STANDARDS. The Company's future
success will depend, in part, on its ability to offer services that incorporate
leading technology, address the increasingly sophisticated and varied needs of
its current and prospective customers and respond to technological advances and
emerging industry standards and practices on a timely and cost-effective basis.
The market for the Company's services is characterized by rapidly changing and
unproven technology, evolving industry standards, changes in customer needs,
emerging competition and frequent new service introductions. There can be no
assurance that future advances in technology will be beneficial to, or
compatible with, the Company's business or that the Company will be able to
incorporate such advances on a cost-effective and timely basis into its
business. The Company believes that its ability to compete successfully is also
dependent upon the continued compatibility and interoperability of its services
with products, services and architectures offered by various vendors as part of
the Company's services. There can be no assurance that such products will be
compatible with the Company's infrastructure or that such products will
adequately address changing customer needs. In addition, there can be no
assurance that products, services or technologies developed by others will not
render the Company's services uncompetitive or obsolete.

   DEPENDENCE ON KEY PERSONNEL. The Company's success depends in significant
part upon the continued services of its key technical, sales and senior
management personnel, including the Company's President and Chief Executive
Officer, Marketta Silvera, and the Company's Vice President, Engineering and
Development, Thomas Wadlow. Any officer or employee of the Company can terminate
his or her relationship with the Company at any time. The loss of the services
of one or more of the Company's key employees or the Company's failure to
attract additional qualified personnel could have a material adverse effect on
the Company's business, results of operations and financial condition.

   RISKS ASSOCIATED WITH INFORMATION DISSEMINATED THROUGH THE COMPANY'S NETWORK.
The law relating to the liability of on-line services companies and Internet
access providers for information carried on or disseminated through their
networks is currently unsettled. It is possible that claims could be made
against on-line services companies and Internet access providers under both
United States and foreign law for defamation, negligence, copyright or trademark
infringement, or other theories based on the nature and content of the materials
disseminated through their networks. The imposition upon the Company and other
Internet network providers of potential liability for information carried on or
disseminated through their systems could require the Company to implement
measures to reduce its exposure to such liability, which may require the
expenditure of substantial resources, or to discontinue certain service or
product offerings.

   PROTECTION AND ENFORCEMENT OF INTELLECTUAL PROPERTY RIGHTS. The Company
relies on a combination of copyright, trademark, patent, service mark and trade
secret laws and contractual restrictions to establish and protect certain
proprietary rights in technology underlying its services. There can be no
assurance that patents or trademarks will be issued or granted from currently
pending or any future applications, or that any patents or trademarks that may
be issued or granted will be sufficient in scope or strength to provide
meaningful protection or any commercial advantage to the Company. The laws of
certain foreign countries may not protect the Company's products, services or
intellectual property rights to the same extent as do the laws of the United
States.

   There can be no assurance that contractual arrangements or other steps taken
by the Company to protect its intellectual property will prove sufficient to
prevent infringement of or misappropriation of the Company's technology or to
deter independent third-party development of similar technologies. Any such

                                 Page 13 of 17
<PAGE>

infringement or misappropriation, should it occur, could have a material adverse
effect on the Company's business, results of operation and financial condition.

   To date, the Company has not been notified that the Company's products
infringe the proprietary rights of third parties, but there can be no assurance
that third parties will not claim infringement or indemnification by the Company
with respect to current or future products. Any such claim, whether meritorious
or not, could be time-consuming, result in costly litigation, cause product
installation delays, prevent the Company from using important technologies or
methods, subject the Company to substantial damages, or require the Company to
enter into royalty or licensing agreements. As a result, any such claim could
have a material adverse effect upon the Company's business, results of
operations and financial condition.

                                 Page 14 of 17
<PAGE>

PART II.  OTHER INFORMATION.

ITEM 2.   CHANGES IN SECURITIES AND USE OF PROCEEDS.

The Company filed a registration statement on Form S-1, File No. 333-57453, for
an initial public offering of Common Stock which was declared effective by the
Securities and Exchange Commission on August 10, 1998. In that offering, the
Company sold an aggregate of 3,110,000 shares of its Common Stock with net
offering proceeds of $39.4 million. As of June 30, 1999, the Company had used
approximately $28.1 million of those proceeds as follows:

  Construction of plant, building and facilities:         $4.3 million
  Purchase and installation of machinery and equipment:   $7.4 million
  Purchases of real estate:                              None
  Acquisition of other businesses:                       None
  Repayment of indebtedness:                              $4.6 million
  Working capital:                                       None
  Repurchase of Common Stock:                             $2.7 million
  Cash loss from operations:                              $9.1 million

The foregoing amounts represent the Company's best estimate of its use of
proceeds for the period indicated. No payments were made to directors or
officers of the Company or their associates, holders of 10% or more of any class
of equity securities of the Company or to affiliates of the Company.


ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K


A. Exhibits

Exhibit Number      Description of Exhibit

27.1                Financial Data Schedule


B. Reports on Form 8-K

None

                                 Page 15 of 17
<PAGE>

SIGNATURES

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


August 16, 1999         /s/ William C. Leetham
---------------         ----------------------
                        William C. Leetham
                        Senior Vice President, Finance and Administration
                        Chief Financial Officer, Treasurer and Secretary
                        (Principal Financial and Accounting Officer)


EXHIBIT INDEX


Exhibit Number      Description of Exhibit

27.1                Financial Data Schedule

                                 Page 16 of 17