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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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QUARTERLY REPORT PURSUANT TO SECTION
13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934



For the quarterly period ended September 30, 2005



Commission File Number: 000-26223



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TUMBLEWEED COMMUNICATIONS CORP.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|DELAWARE                                                       |  | 94-3336053                          
|(State of other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



700 SAGINAW DRIVE

REDWOOD CITY, CA 94063

(Address of principal executive offices, including zip code)



(650) 216-2000

(Registrants telephone number, including area code)



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



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



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



The number of shares of common
stock outstanding as of October 31, 2005 was 49,091,868.



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##### Table of Contents

SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS



This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are subject to the safe harbor created by those sections. The forward-looking statements are based on our
current expectations and projections about future events. Discussions containing such forward-looking statements may be found in Managements Discussion and Analysis of Financial Condition and Results of Operations. In some cases,
you can identify forward-looking statements by terminology such as may, will, should, could, predicts, projects, potential, continue,
expects, anticipates, future, intends, plans, believes, estimates, or the negative of these terms and other comparable terminology, including, but not limited to,
the following:



| |  |  | any projections of revenues, earnings, cash balances or cash flow, synergies or other financial items;
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | any statements of the plans, strategies and objectives of management for future operations;
| | - |  | -------------------------------------------------------------------------------------------



| |  |  | any statements regarding future economic conditions or performance;
| | - |  | -------------------------------------------------------------------



| |  |  | any statements regarding implementing our business strategy;
| | - |  | ------------------------------------------------------------



| |  |  | any statements regarding attracting and retaining customers;
| | - |  | ------------------------------------------------------------



| |  |  | any statements regarding obtaining and expanding market acceptance of the products and services we offer;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | any statements regarding competition in or size of our market; and
| | - |  | ------------------------------------------------------------------



| |  |  | any statements of assumptions underlying any of the foregoing.
| | - |  | --------------------------------------------------------------



These forward-looking statements are only predictions, not historical facts. These forward-looking statements involve certain risks and uncertainties, as
well as assumptions. Actual results, levels of activity, performance, achievements and events could differ materially from those stated, anticipated or implied by such forward-looking statements. The factors that could contribute to such differences
include those discussed under the caption Risks And Uncertainties That You Should Consider Before Investing In Tumbleweed in the section entitled Managements Discussion and Analysis of Financial Condition and Results of
Operations contained herein, as well as those discussed in our Form 10-K and other filings with the Securities and Exchange Commission. You should consider these risks carefully, among other things, in evaluating our prospects and future
financial performance. The occurrence of the events described in the risk factors could harm our business, results of operations and financial condition. These forward-looking statements are made as of the date of this Quarterly Report on Form 10-Q.
We disclaim any obligation to update or alter these forward-looking statements, whether as a result of new information, future events or otherwise, or any obligation to explain the reasons why actual results may differ.



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##### Table of Contents

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

INDEX



|               |  |                                                                                                                               |  |     
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------- |  | ----
|               |  |                                                                                                                               |  | Page
|               |  | Part I                                                                                                                        |  |     
|               |  |                                                                                                                              
|Item 1         |  | Financial Statements (unaudited)                                                                                              |  | 4   
|               |  | Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004                                          |  | 4   
|               |  | Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and September 30, 2004 |  | 5   
|               |  | Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and September 30, 2004           |  | 6   
|               |  | Notes to Condensed Consolidated Financial Statements                                                                          |  | 7   
|Item 2         |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                         |  | 15  
|Item 3         |  | Quantitative and Qualitative Disclosures About Market Risk                                                                    |  | 29  
|Item 4         |  | Controls and Procedures                                                                                                       |  | 29  
|               |  |                                                                                                                              
|               |  | Part II                                                                                                                       |  |     
|               |  |                                                                                                                              
|Item 1         |  | Legal Proceedings                                                                                                             |  | 30  
|Item 5         |  | Exhibits and Reports on Form 8-K                                                                                              |  | 31  
|Signatures     |  | 32                                                                                                                           
|Certifications |  |                                                                                                                              



TRADEMARKS



Our registered trademarks include Tumbleweed®, Tumbleweed Communications®, Secure Envelope®, Secure Inbox®, Tumbleweed IME Integrated Messaging Exchange®, WorldSecure®, Worldtalk®, MailGate® and Corvigo®.
Additional trademarks belonging to us include Tumbleweed Secure Guardian, Tumbleweed Secure Policy Gateway, Tumbleweed Secure Staging Server, Tumbleweed Staging Server, Tumbleweed Secure Mail, Tumbleweed Secure
Redirect, Tumbleweed Secure Public Network, Tumbleweed SPN, Tumbleweed Secure Archive, Tumbleweed Secure Web, Tumbleweed Secure CRM, Tumbleweed Secure Messenger, Tumbleweed Secure Statements,
Tumbleweed My Copy, Tumbleweed L2i, Tumbleweed IME Developer, Tumbleweed IME Personalize, WorldSecure/Mail and Tumbleweed IME Alert.



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##### Table of Contents

PART IFINANCIAL INFORMATION



ITEM 1FINANCIAL STATEMENTS(unaudited)



TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



Condensed Consolidated Balance Sheets

(in thousands)

(unaudited)



|                                                                  |  |                    |          |   |                   |   |          |  
|----------------------------------------------------------------- |  | ------------------ | -------- | - | ----------------- | - | -------- | -
|                                                                  |  | September 30, 2005 |          |   | December 31, 2004 |  
|Assets                                                            |  |                    |          |   |                   |   |          |  
|Current Assets:                                                   |  |                    |          |   |                   |   |          |  
|Cash and cash equivalents                                         |  | $                  | 25,684   |   |                   | $ | 21,435   |  
|Accounts receivable, net                                          |  |                    | 8,979    |   |                   |   | 7,459    |  
|Other current assets                                              |  |                    | 996      |   |                   |   | 1,544    |  
|                                                                  |  |                    |          |   |                   |   |          |  
|Total current assets                                              |  |                    | 35,659   |   |                   |   | 30,438   |  
|Goodwill                                                          |  |                    | 48,074   |   |                   |   | 48,074   |  
|Intangible assets, net                                            |  |                    | 4,808    |   |                   |   | 7,299    |  
|Property and equipment, net                                       |  |                    | 1,182    |   |                   |   | 1,316    |  
|Other assets                                                      |  |                    | 618      |   |                   |   | 589      |  
|                                                                  |  |                    |          |   |                   |   |          |  
|Total assets                                                      |  | $                  | 90,341   |   |                   | $ | 87,716   |  
|                                                                  |  |                    |          |   |                   |   |          |  
|Liabilities and Stockholders Equity                              |  |                    |          |   |                   |   |          |  
|Current liabilities:                                              |  |                    |          |   |                   |   |          |  
|Accounts payable                                                  |  | $                  | 242      |   |                   | $ | 324      |  
|Current installments of long-term debt                            |  |                    |         |   |                   |   | 267      |  
|Accrued liabilities                                               |  |                    | 5,732    |   |                   |   | 5,006    |  
|Accrued merger-related and other costs                            |  |                    | 197      |   |                   |   | 775      |  
|Deferred revenue                                                  |  |                    | 16,693   |   |                   |   | 13,915   |  
|                                                                  |  |                    |          |   |                   |   |          |  
|Total current liabilities                                         |  |                    | 22,864   |   |                   |   | 20,287   |  
|Long-term debt, excluding current installments                    |  |                    |         |   |                   |   | 200      |  
|Accrued merger-related and other costs, excluding current portion |  |                    | 96       |   |                   |   | 430      |  
|Deferred revenue, excluding current portion                       |  |                    | 5,183    |   |                   |   | 4,248    |  
|Other long-term liabilities                                       |  |                    | 136      |   |                   |   | 147      |  
|                                                                  |  |                    |          |   |                   |   |          |  
|Total long-term liabilities                                       |  |                    | 5,415    |   |                   |   | 5,025    |  
|                                                                  |  |                    |          |   |                   |   |          |  
|Total liabilities                                                 |  |                    | 28,279   |   |                   |   | 25,312   |  
|Stockholders equity:                                             |  |                    |          |   |                   |   |          |  
|Common stock                                                      |  |                    | 50       |   |                   |   | 48       |  
|Additional paid-in capital                                        |  |                    | 352,933  |   |                   |   | 351,122  |  
|Treasury stock                                                    |  |                    | (796     | ) |                   |   | (796     | )
|Deferred stock-based compensation                                 |  |                    | (291     | ) |                   |   | (525     | )
|Accumulated other comprehensive loss                              |  |                    | (573     | ) |                   |   | (651     | )
|Accumulated deficit                                               |  |                    | (289,261 | ) |                   |   | (286,794 | )
|                                                                  |  |                    |          |   |                   |   |          |  
|Total stockholders equity                                        |  |                    | 62,062   |   |                   |   | 62,404   |  
|                                                                  |  |                    |          |   |                   |   |          |  
|Total liabilities and stockholders equity                        |  | $                  | 90,341   |   |                   | $ | 87,716   |  
|                                                                  |  |                    |          |   |                   |   |          |  



See accompanying Notes
to Condensed Consolidated Financial Statements



4



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##### Table of Contents

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



Condensed Consolidated Statements of Operations

(in thousands, except per share data)

(unaudited)



|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|---------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                       |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                                       |  | 2005                            |        |   | 2004                           |   |        | 2005 |  |   | 2004   |  
|Revenue:                                                               |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Product revenue                                                        |  | $                               | 6,736  |   |                                | $ | 5,186  |      |  | $ | 16,449 |   |  | $ | 13,703 |  
|Service revenue                                                        |  |                                 | 6,593  |   |                                |   | 5,428  |      |  |   | 19,142 |   |  |   | 16,144 |  
|Intellectual property and other revenue                                |  |                                 | 351    |   |                                |   | 584    |      |  |   | 2,592  |   |  |   | 1,516  |  
|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total revenue                                                          |  |                                 | 13,680 |   |                                |   | 11,198 |      |  |   | 38,183 |   |  |   | 31,363 |  
|Cost of product revenue                                                |  |                                 | 906    |   |                                |   | 453    |      |  |   | 2,071  |   |  |   | 1,078  |  
|Cost of service revenue                                                |  |                                 | 1,393  |   |                                |   | 1,038  |      |  |   | 4,011  |   |  |   | 3,063  |  
|Amortization of intangible assets                                      |  |                                 | 510    |   |                                |   | 510    |      |  |   | 1,530  |   |  |   | 1,327  |  
|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total cost of revenue                                                  |  |                                 | 2,809  |   |                                |   | 2,001  |      |  |   | 7,612  |   |  |   | 5,468  |  
|Gross profit                                                           |  |                                 | 10,871 |   |                                |   | 9,197  |      |  |   | 30,571 |   |  |   | 25,895 |  
|Operating expenses:                                                    |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Research and development                                               |  |                                 | 3,141  |   |                                |   | 2,860  |      |  |   | 8,965  |   |  |   | 8,828  |  
|Sales and marketing                                                    |  |                                 | 6,493  |   |                                |   | 6,487  |      |  |   | 19,065 |   |  |   | 17,403 |  
|General and administrative                                             |  |                                 | 1,481  |   |                                |   | 1,345  |      |  |   | 4,325  |   |  |   | 3,689  |  
|Stock-based compensation expense(1)                                    |  |                                 | 219    |   |                                |   | 141    |      |  |   | 448    |   |  |   | 522    |  
|Amortization of intangible assets                                      |  |                                 | 321    |   |                                |   | 421    |      |  |   | 963    |   |  |   | 1,137  |  
|Merger-related and other costs                                         |  |                                 |       |   |                                |   | 533    |      |  |   | (96    | ) |  |   | 1,002  |  
|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total operating expenses                                               |  |                                 | 11,655 |   |                                |   | 11,787 |      |  |   | 33,670 |   |  |   | 32,581 |  
|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Operating loss                                                         |  |                                 | (784   | ) |                                |   | (2,590 | )    |  |   | (3,099 | ) |  |   | (6,686 | )
|Other income (loss), net                                               |  |                                 | 250    |   |                                |   | (113   | )    |  |   | 655    |   |  |   | 141    |  
|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Net loss before provision for income taxes                             |  |                                 | (534   | ) |                                |   | (2,703 | )    |  |   | (2,444 | ) |  |   | (6,545 | )
|Provision for income taxes                                             |  |                                 | 4      |   |                                |   | 28     |      |  |   | 23     |   |  |   | 29     |  
|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Net loss                                                               |  | $                               | (538   | ) |                                | $ | (2,731 | )    |  | $ | (2,467 | ) |  | $ | (6,574 | )
|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Net loss per sharebasic and diluted                                   |  | $                               | (0.01  | ) |                                | $ | (0.06  | )    |  | $ | (0.05  | ) |  | $ | (0.14  | )
|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Weighted average sharesbasic and diluted                              |  |                                 | 48,767 |   |                                |   | 47,955 |      |  |   | 48,419 |   |  |   | 46,339 |  
|                                                                       |  |                                 |        |  
|(1) Stock-based compensation expense is further classified as follows: |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Cost of service revenue                                                |  | $                               | (1     | ) |                                | $ |       |      |  | $ | 1      |   |  | $ | 11     |  
|Research and development                                               |  |                                 | 138    |   |                                |   | 45     |      |  |   | 221    |   |  |   | 164    |  
|Sales and marketing                                                    |  |                                 | 46     |   |                                |   | 90     |      |  |   | 114    |   |  |   | 329    |  
|General and administrative                                             |  |                                 | 36     |   |                                |   | 6      |      |  |   | 112    |   |  |   | 18     |  
|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total stock-based compensation expense                                 |  | $                               | 219    |   |                                | $ | 141    |      |  | $ | 448    |   |  | $ | 522    |  
|                                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  



See accompanying Notes
to Condensed Consolidated Financial Statements



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##### Table of Contents

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)



|                                                                            |  |                                |        |   |      |   |        |  
|--------------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ---- | - | ------ | -
|                                                                            |  | Nine months endedSeptember 30, |       
|                                                                            |  | 2005                           |        |   | 2004 |  
|Cash flows from operating activities:                                       |  |                                |        |   |      |   |        |  
|Net loss                                                                    |  | $                              | (2,467 | ) |      | $ | (6,574 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                                |        |   |      |   |        |  
|Stock-based compensation expense                                            |  |                                | 448    |   |      |   | 522    |  
|Compensation for stock granted to former Incubator employees                |  |                                |       |   |      |   | 183    |  
|Depreciation and amortization expenses                                      |  |                                | 3,375  |   |      |   | 3,633  |  
|Loss on disposal of property and equipment                                  |  |                                | 24     |   |      |   | 194    |  
|Changes in operating assets and liabilities, net of effect of acquisitions: |  |                                |        |   |      |   |        |  
|Accounts receivable                                                         |  |                                | (1,520 | ) |      |   | 2,541  |  
|Other current assets and other assets                                       |  |                                | 519    |   |      |   | (144   | )
|Accounts payable, accrued liabilities, and other long-term liabilities      |  |                                | 633    |   |      |   | (938   | )
|Accrued merger-related and other costs                                      |  |                                | (912   | ) |      |   | (184   | )
|Deferred revenue                                                            |  |                                | 3,713  |   |      |   | 148    |  
|                                                                            |  |                                |        |   |      |   |        |  
|Net cash provided by (used in) operating activities                         |  |                                | 3,813  |   |      |   | (619   | )
|Cash flows from investing activities:                                       |  |                                |        |   |      |   |        |  
|Purchase of property and equipment                                          |  |                                | (774   | ) |      |   | (965   | )
|Acquisitions of Incubator Limited and Corvigo, Inc., net of cash acquired   |  |                                |       |   |      |   | (3,487 | )
|                                                                            |  |                                |        |   |      |   |        |  
|Net cash used in investing activities                                       |  |                                | (774   | ) |      |   | (4,452 | )
|Cash flows from financing activities:                                       |  |                                |        |   |      |   |        |  
|Repayments of borrowings                                                    |  |                                | (467   | ) |      |   | (200   | )
|Proceeds from issuance of common stock                                      |  |                                | 1,599  |   |      |   | 574    |  
|                                                                            |  |                                |        |   |      |   |        |  
|Net cash provided by financing activities                                   |  |                                | 1,132  |   |      |   | 374    |  
|Effect of exchange rate on cash and cash equivalents                        |  |                                | 78     |   |      |   | (60    | )
|                                                                            |  |                                |        |   |      |   |        |  
|Net increase (decrease) in cash and cash equivalents                        |  |                                | 4,249  |   |      |   | (4,757 | )
|Cash and cash equivalents, beginning of period                              |  |                                | 21,435 |   |      |   | 25,351 |  
|                                                                            |  |                                |        |   |      |   |        |  
|Cash and cash equivalents, end of period                                    |  | $                              | 25,684 |   |      | $ | 20,594 |  
|                                                                            |  |                                |        |   |      |   |        |  
|Supplemental disclosures of cash flow information:                          |  |                                |        |   |      |   |        |  
|Cash paid during the period for interest                                    |  | $                              | 20     |   |      | $ | 24     |  
|                                                                            |  |                                |        |   |      |   |        |  
|Cash paid during the period for taxes                                       |  | $                              | 10     |   |      | $ | 21     |  
|                                                                            |  |                                |        |   |      |   |        |  



See accompanying Notes
to Condensed Consolidated Financial Statements



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##### Table of Contents

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



(1) Organization



The condensed consolidated
financial statements included herein have been prepared by Tumbleweed Communications Corp. (Tumbleweed) without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information
and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial
statements should be read in conjunction with Tumbleweeds audited financial statements and notes thereto included in its Annual Report on Form 10-K for the fiscal year ended December 31, 2004, filed with the SEC on March 16, 2005.



The unaudited condensed consolidated financial statements
included herein reflect all adjustments (which include normal, recurring adjustments) which are, in the opinion of management, necessary to state fairly the financial position of Tumbleweed and its subsidiaries as of September 30, 2005, the
results of operations for the three and nine months ended September 30, 2005 and 2004, respectively, and cash flows for the nine months ended September 30, 2005 and 2004, respectively. The results for the three and nine months ended
September 30, 2005 are not necessarily indicative of the results expected for the full fiscal year ending December 31, 2005.



The accompanying condensed consolidated financial statements include the accounts of Tumbleweed and its subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation. The results of operations of Tumbleweeds wholly-owned subsidiaries, Incubator, Limited (Incubator) and Corvigo, Inc. (Corvigo), have been included
commencing March 15, 2004, and March 18, 2004, respectively, the effective dates of those acquisitions.



(2) Stock-Based Compensation



Tumbleweeds stock-based compensation program is a broad-based, long-term retention program that is intended to attract and retain employees and
align stockholder and employee interests. Tumbleweed accounts for its stock-based compensation arrangements for employees using the intrinsic-value method pursuant to Accounting Principles Board Opinion 25, Accounting for Stock Issued to
Employees (APB 25). As such, stock-based compensation expense is recorded for fixed plan stock options on the date of grant when the fair value of the underlying common stock exceeds the exercise price for stock options or the
purchase price for issuance or sales of common stock. Expense associated with stock-based compensation is amortized on an accelerated basis over the vesting period of the individual award consistent with the method described in Financial Accounting
Standards Board (FASB) Interpretation 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.



In the three months ended September 30, 2005, Tumbleweed recorded deferred stock-based compensation of $178,000 to recognize the fair value of stock
options granted to non-employees for professional services. The assumptions used to value the option grants were a contractual term of 10.0 years, volatility of 100%, risk-free interest rate of 4.15%, and dividend yield of 0%. The stock based
compensation expense recognized for the three months ended September 30, 2005 also included expense resulting from a separation agreement with a former employee. The separation agreement modified the former employees existing stock option
by extending the vesting period beyond the original terms of the stock option grants.



In the three months ended September 30, 2004, Tumbleweed recorded deferred stock-based compensation of $38,000 to recognize the fair value of stock options granted to a non-employee for professional services. The
assumptions used to value the option grant were a contractual term of 10.0 years, volatility of 100%, risk-free interest rate of 3.21%, and dividend yield of 0%. In the three months ended June 30, 2004, Tumbleweed recorded deferred stock-based
compensation of $183,000 to recognize the fair value of stock options granted to a non-employee for professional services. The assumptions used to value the option grant were a contractual term of 10.0 years, volatility of 100%, risk-free interest
rate of 2.58%, and dividend yield of 0%.



Tumbleweed recognized
stock-based compensation expense of approximately $219,000 and $141,000, in the three months ended September 30, 2005 and 2004, respectively, and approximately $448,000 and $522,000, in the nine months ended September 30, 2005 and 2004,
respectively.



Had stock-based compensation expense for its
stock-based compensation plan been determined consistent with the fair value approach set forth in Statement of Financial Accounting Standards (SFAS) 123, Accounting for Stock-Based Compensation (SFAS 123),
Tumbleweeds net losses for the three and nine months ended September 30, 2005 and 2004, respectively, would have been as follows (in thousands, except per share amounts):



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##### Table of Contents

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



|                                                                                                     |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  
|---------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                     |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                                                                     |  | 2005                            |        |   | 2004                           |   |        | 2005 |  |   | 2004    |  
|Net loss as reported                                                                                 |  | $                               | (538   | ) |                                | $ | (2,731 | )    |  | $ | (2,467  | ) |  | $ | (6,574  | )
|Add: Stock-based compensation expense included in net loss                                           |  |                                 | 219    |   |                                |   | 141    |      |  |   | 448     |   |  |   | 522     |  
|Less: Total stock-based compensation expense determined under fair value based method for all awards |  | $                               | (6,225 | ) |                                | $ | (3,218 | )    |  | $ | (9,609  | ) |  | $ | (6,754  | )
|                                                                                                     |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss pro forma                                                                                   |  | $                               | (6,544 | ) |                                | $ | (5,808 | )    |  | $ | (11,628 | ) |  | $ | (12,806 | )
|Basic and diluted net loss per share as reported                                                     |  | $                               | (0.01  | ) |                                | $ | (0.06  | )    |  | $ | (0.05   | ) |  | $ | (0.14   | )
|Basic and diluted net loss per share pro forma                                                       |  | $                               | (0.13  | ) |                                | $ | (0.12  | )    |  | $ | (0.24   | ) |  | $ | (0.28   | )
|                                                                                                     |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  



For purposes of
computing pro forma net loss, the fair value of each option grant was estimated on the date of grant using a Black-Scholes option pricing model. The assumptions used to value the option grants are stated as follows:



|                        |  |                                 |   |  |                                |   |  |           |   |  |           |  
|----------------------- |  | ------------------------------- | - |  | ------------------------------ | - |  | --------- | - |  | --------- | -
|                        |  | Three Months EndedSeptember 30, |   |  | Nine Months EndedSeptember 30, |  
|                        |  | 2005                            |   |  | 2004                           |   |  | 2005      |   |  | 2004      |  
|Stock options:          |  |                                 |   |  |                                |   |  |           |   |  |           |  
|Expected life           |  | 4.0 years                       |   |  | 4.0 years                      |   |  | 4.0 years |   |  | 4.0 years |  
|Volatility              |  | 92.32                           | % |  | 135                            | % |  | 92.32     | % |  | 135       | %
|Risk-free interest rate |  | 4.01                            | % |  | 3.21                           | % |  | 3.85      | % |  | 3.05      | %
|Dividend yield          |  | 0                               | % |  | 0                              | % |  | 0         | % |  | 0         | %
|                        |  |                                 |   |  |                                |   |  |           |   |  |           |  



In December 2004, the
FASB issued SFAS 123 (revised 2004), Share-Based Payment (SFAS 123R), which revises SFAS 123 and supersedes APB 25. SFAS 123R requires Tumbleweed to recognize in its financial statements the fair value of all share-based payments
to employees, including grants of employee stock options, effective at the beginning of the next fiscal year that starts after June 15, 2005. Tumbleweed will adopt SFAS 123R in the first quarter of 2006, beginning January 1, 2006 and will
continue to account for the stock compensation in accordance with APB 25 until then. The pro forma disclosures previously permitted under SFAS 123 will no longer be an alternative to financial statement recognition. Under SFAS 123R, Tumbleweed must
determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include modified prospective and
modified retroactive adoption options. Under the modified retroactive options, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The modified prospective method requires that compensation
expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R, while the retroactive methods would record compensation expense for all unvested stock options and restricted
stock beginning with the first period restated. Tumbleweed is evaluating the requirements of SFAS 123R and expects that the adoption of SFAS 123R will have a material impact on its consolidated results of operations and earnings per share.
Tumbleweed has not yet determined the method of adoption or the effect of adopting SFAS 123R, and has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123.



On July 19, 2005, Tumbleweeds Board of Directors approved the
acceleration of vesting of certain unvested stock options with exercise prices equal to or greater than $3.82 per share previously awarded to its employees (including its executive officers) and its directors under its stock option plans. The
acceleration of vesting was effective for stock options outstanding as of July 19, 2005. Options to purchase approximately 1.7 million shares of common stock were accelerated. All of the options accelerated had exercise prices greater than
Tumbleweeds common stock price of $3.24 on the date of acceleration. The weighted average exercise price of the options accelerated was $5.00. Since the exercise price of all of the accelerated options exceeded Tumbleweeds common stock
price on the date of acceleration, no stock-based compensation expense was recognized as a result of the acceleration. The purpose of the acceleration was to enable Tumbleweed to avoid recognizing compensation expense associated with these options
in future periods in its consolidated statement of operations upon adoption of SFAS 123R.



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(3) Net Loss Per Share



Tumbleweed excludes potentially dilutive securities from its diluted net loss per share computation when their effect would be antidilutive to net loss
per share amounts. The following potential common shares were excluded from the net loss per share computation (in thousands):



|                                                                                                                                                                                                              |  |                                 |  |                                |  |       |  |      
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- |  | ------------------------------ |  | ----- |  | -----
|                                                                                                                                                                                                              |  | Three Months EndedSeptember 30, |  | Nine Months EndedSeptember 30,
|                                                                                                                                                                                                              |  | 2005                            |  | 2004                           |  | 2005  |  | 2004 
|Warrants and options for which the exercise price was less than the average fair market value of Tumbleweeds common stock during the
period but were excluded as inclusion would decrease net loss per share |  | 3,450                           |  | 1,919                          |  | 2,265 |  | 5,026
|Warrants and options excluded due to the exercise price exceeding the average fair market value of common stock during the
period                                                                             |  | 5,444                           |  | 11,469                         |  | 7,461 |  | 2,480
|                                                                                                                                                                                                              |  |                                 |  |                                |  |       |  |      
|Total potential shares of common stock excluded from diluted net loss per share                                                                                                                               |  | 8,894                           |  | 13,388                         |  | 9,726 |  | 7,506



(4) Concentrations of Credit Risk



Financial instruments, which potentially subject
Tumbleweed to concentrations of credit risk, consist primarily of cash equivalents and accounts receivable. Tumbleweeds cash equivalents generally consist of money market mutual funds with qualified financial institutions. To reduce credit
risk with accounts receivable, Tumbleweed performs periodic evaluations of its customers financial conditions and, when necessary, records an allowance for credit losses. One customer comprised 16% of Tumbleweeds accounts receivable
balance, net of allowance for doubtful accounts, at September 30, 2005. One customer comprised 14% of Tumbleweeds accounts receivable balance, net of allowance for doubtful accounts, at December 31, 2004. This balance was collected
in full during the three months ended March 31, 2005. For the three and nine months ended September 30, 2005 and September 30, 2004, respectively, no single customer comprised 10% or more of Tumbleweeds revenue.



TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



(5) Business Combinations



On March 18, 2004, Tumbleweed completed the acquisition of Corvigo, an
anti-spam appliance vendor. The acquisition was entered into to strengthen Tumbleweeds position in the anti-spam and email security markets and to accelerate Tumbleweeds distribution plans through the addition of resellers already
selling the Corvigo appliance. The purchase price of $40.9 million consisted of an exchange of 4,732,284 shares of Tumbleweeds common stock with a fair value of $32.8 million based on the fair value of Tumbleweeds common stock on the
date of the acquisition, cash paid of $6.0 million, assumed stock options with a fair value of $1.3 million, severances for former Corvigo employees of $97,000, and other acquisition-related costs of $727,000, consisting primarily of legal fees,
banking fees, and accounting fees.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



The following is a summary of the allocation of the purchase price in the
acquisition of Corvigo (in thousands):



|                                      |  |   |       
|------------------------------------- |  | - | ------
|Net tangible assets                   |  | $ | 2,191 
|Core/developed technology             |  |   | 3,250 
|Maintenance agreements                |  |   | 150   
|Customer base and reseller agreements |  |   | 1,850 
|Trademarks and tradenames             |  |   | 150   
|Goodwill                              |  |   | 33,356
|                                      |  |   |       
|Total                                 |  | $ | 40,947
|                                      |  |   |       



On March 15,
2004, Tumbleweed completed the acquisition of Incubator, a reseller of Tumbleweeds products. The acquisition was entered into to expand Tumbleweeds sales in Europe. The purchase price of $1.7 million consisted of an exchange of 224,278
shares of Tumbleweeds common stock with a fair value of $1.6 million based on the fair value of Tumbleweeds common stock on the date of the acquisition and other acquisition-related costs of $119,000, consisting of legal and accounting
fees.



The following is a summary of the allocation of the
purchase price in the acquisition of Incubator (in thousands):



|                                      |  |   |       |  
|------------------------------------- |  | - | ----- | -
|Net tangible liabilities              |  | $ | (493  | )
|Maintenance agreements                |  |   | 350   |  
|Customer base and reseller agreements |  |   | 450   |  
|Goodwill                              |  |   | 1,410 |  
|                                      |  |   |       |  
|Total                                 |  | $ | 1,717 |  
|                                      |  |   |       |  



As part of the
acquisition of Incubator, Tumbleweed agreed that in the event that a specified sales goal was met in Tumbleweeds European sales region in the year ending December 31, 2004, Tumbleweeds purchase price for Incubator would increase by
the exchange of additional shares of Tumbleweeds common stock. During the three months ended September 30, 2004, the purchase agreement was amended to issue 62,509 shares to the former owners of Incubator worth $183,000 based on the fair
value of Tumbleweeds stock on the date of issuance as consideration for progress towards the European sales goal in the first six months of 2004. In addition, in the event that specified sales goals are met in Tumbleweeds European sales
region for the two-year period ending December 31, 2005, Tumbleweeds purchase price for Incubator would increase by the exchange of additional shares of Tumbleweeds common stock worth $1,000,000 plus 10% of the amount of
Tumbleweeds European sales in excess of the sales goal for the year ending December 31, 2005.



A summary of intangible assets as of September 30, 2005 follows (in thousands):



|                                      |  |                               |  |                     |        |                         |   |        |     |  |   |      
|------------------------------------- |  | ----------------------------- |  | ------------------- | ------ | ----------------------- | - | ------ | --- |  | - | -----
|                                      |  | Amortizationperiod (in years) |  | Grosscarryingamount |        | Accumulatedamortization |   |        | Net
|Core/ developed technology            |  | 3 to 4                        |  | $                   | 5,850  |                         | $ | (3,214 | )   |  | $ | 2,636
|Customer base and reseller agreements |  | 3                             |  |                     | 3,700  |                         |   | (2,179 | )   |  |   | 1,521
|Maintenance agreements                |  | 3 to 4                        |  |                     | 1,200  |                         |   | (722   | )   |  |   | 478  
|Trademarks and trade names            |  | 4                             |  |                     | 350    |                         |   | (177   | )   |  |   | 173  
|                                      |  |                               |  |                     |        |                         |   |        |     |  |   |      
|                                      |  |                               |  | $                   | 11,100 |                         | $ | (6,292 | )   |  | $ | 4,808
|                                      |  |                               |  |                     |        |                         |   |        |     |  |   |      



A summary of
intangible assets as of December 31, 2004 follows (in thousands):



|                                      |  |                               |  |                     |        |                         |   |        |     |  |   |      
|------------------------------------- |  | ----------------------------- |  | ------------------- | ------ | ----------------------- | - | ------ | --- |  | - | -----
|                                      |  | Amortizationperiod (in years) |  | Grosscarryingamount |        | Accumulatedamortization |   |        | Net
|Core/ developed technology            |  | 3 to 4                        |  | $                   | 5,850  |                         | $ | (1,955 | )   |  | $ | 3,895
|Customer base and reseller agreements |  | 3                             |  |                     | 3,700  |                         |   | (1,283 | )   |  |   | 2,417
|Maintenance agreements                |  | 3 to 4                        |  |                     | 1,200  |                         |   | (452   | )   |  |   | 748  
|Trademarks and trade names            |  | 4                             |  |                     | 350    |                         |   | (111   | )   |  |   | 239  
|                                      |  |                               |  |                     |        |                         |   |        |     |  |   |      
|                                      |  |                               |  | $                   | 11,100 |                         | $ | (3,801 | )   |  | $ | 7,299
|                                      |  |                               |  |                     |        |                         |   |        |     |  |   |      



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



The amounts above exclude an acquired workforce intangible asset of $476,000
resulting from the issuance by Tumbleweed in September 2003 of 86,538 shares of stock to a company to recruit certain of its contract engineers to Tumbleweed as employees in Tumbleweeds development center in Bulgaria. This intangible asset was
amortized in full as of September 30, 2004.



The estimated
amortization for each of the fiscal years subsequent to September 30, 2005, is as follows (in thousands):



|                         |  |   |      
|------------------------ |  | - | -----
|Year Ending December 31, |  |  
|2005                     |  | $ | 830  
|2006                     |  |   | 2,508
|2007                     |  |   | 1,238
|2008                     |  |   | 232  
|                         |  |   |      
|                         |  | $ | 4,808
|                         |  |   |      



Goodwill represents
the excess of the purchase price over the fair value of acquired net tangible and identified intangible assets. In accordance with the provisions of SFAS 142, Goodwill and Other Intangible Assets, the goodwill acquired in the Valicert, Inc.
(Valicert), Incubator, and Corvigo acquisitions will not be amortized, but instead, the goodwill balances will be tested for impairment at least annually and more frequently if certain impairment conditions exist. Any future impairment
loss related to the goodwill recorded in connection with the acquisitions of Valicert, Incubator, and Corvigo will not be deductible by Tumbleweed for federal income tax purposes.



Merger-related and other costs



There were no merger-related and other costs in the three months ended September 30, 2005. Merger-related and other
costs of a net credit of $96,000 for the nine months ended September 30, 2005 consist of a $296,000 credit related to the termination of an operating lease in Slough, United Kingdom partially offset by a $200,000 severance cost associated with
the resignation of our former Chief Executive Officer. The combined cost of the final lease settlement payments, commissions, brokerage fees, and legal fees related to the termination of the Slough lease was less than the existing accrual for the
loss on the lease, resulting in the expense credit. The Slough lease was assumed during the acquisition of Interface, Inc. in 2000 and covered approximately 13,000 square feet of office space. The lease was for a term ending in 2020 with quarterly
rent payments of approximately $65,000. The final lease settlement payment for the Slough lease of approximately $113,000 was made in July 2005.



Merger-related and other costs of $533,000 for the three months ended September 30, 2004 consist of $327,000 of severance costs for Tumbleweed
employees terminated in connection with the Corvigo acquisition, $183,000 related to anticipated losses on an operating lease assumed in the Corvigo acquisition, and $23,000 of other merger-related costs.



Merger-related and other costs of $1.0 million for the nine months ended
September 30, 2004 consist of $703,000 of severance costs for Tumbleweed employees terminated in connection with the Corvigo acquisition and the sale of Tumbleweeds offshore development subsidiary in India to a third party on June of
2004, $183,000 related to anticipated losses on an operating lease assumed in the Corvigo acquisition, $26,000 for a loss on the sale of Tumbleweeds offshore development center subsidiary in India, and $90,000 of other merger-related costs.
Tumbleweeds offshore development center subsidiary in India was acquired in the acquisition of Valicert and supported Tumbleweeds engineering, customer support, and consulting functions. This subsidiary was sold to consolidate
Tumbleweeds offshore development in its existing Bulgaria location.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



During the last three quarters of 2004, Tumbleweed recorded expenses for
Merger-related and other costs of $1.1 million consisting of $703,000 of severance costs for Tumbleweed employees terminated in connection with the Corvigo acquisition and the sale of Tumbleweeds development subsidiary in India to a third
party in June of 2004, $183,000 related to anticipated losses on an operating lease in Palo Alto, California, $168,000 related to anticipated losses on the operating lease in Slough, a credit of $44,000 for a gain on the sale of Tumbleweeds
development center subsidiary in India, and $68,000 of other merger-related costs. The Palo Alto lease was assumed during the acquisition of Corvigo and covers approximately 12,000 square feet of office space. The lease is for a term ending in 2007
with current monthly rent payments of approximately $22,000. Subsequent to the acquisition of Corvigo, Tumbleweed decided to vacate the Palo Alto facility. The $183,000 charge was recorded due to a revised estimate of the period required to locate
and contract with a sublessee and sublease rates. As a result of the new estimate, the existing accrual for the loss on the lease was found to be insufficient and the remaining balance for that liability was reclassified on the consolidated balance
sheet from Accrued liabilities to Accrued merger-related and other costs to be tracked along with the liability resulting from the revised estimate recorded in the three months ending September 30, 2004. This office space was subleased in
December 2004 for the remainder of the lease term with sublease rental income less than Tumbleweeds rent payments due to a weak office rental market in and around Palo Alto. The $168,000 charge was recorded due to a revised estimate of the
term of expected subleases on the building due to a weak office rental market in and around Slough.



The following table describes merger-related and other costs recorded in 2005, 2004 and 2003 (in thousands):



|                           |  |                |      |   |                                  |   |      |                                 |  |   |                                |   |  |                          |     |   |       |   |     |   |  |   |        |  
|-------------------------- |  | -------------- | ---- | - | -------------------------------- | - | ---- | ------------------------------- |  | - | ------------------------------ | - |  | ------------------------ | --- | - | ----- | - | --- | - |  | - | ------ | -
|                           |  | Severancecosts |      |   | Anticipatedoperatinglease losses |   |      | Merger-relatedmarketingprograms |  |   | Gain onsale ofIndiansubsidiary |   |  | Othermerger-relatedcosts |     |   | Total |  
|Balance December 31, 2003  |  | $              | 232  |   |                                  | $ | 793  |                                 |  | $ | 141                            |   |  | $                        |    |   |       | $ |    |   |  | $ | 1,166  |  
|2004 costs (credits)       |  |                | 703  |   |                                  |   | 351  |                                 |  |   |                               |   |  |                          | (44 | ) |       |   | 68  |   |  |   | 1,078  |  
|2004 reclassifications     |  |                |     |   |                                  |   | 116  |                                 |  |   |                               |   |  |                          |    |   |       |   |    |   |  |   | 116    |  
|2004 payments              |  |                | (598 | ) |                                  |   | (392 | )                               |  |   | (141                           | ) |  |                          | 44  |   |       |   | (68 | ) |  |   | (1,155 | )
|                           |  |                |      |   |                                  |   |      |                                 |  |   |                                |   |  |                          |     |   |       |   |     |   |  |   |        |  
|Balance December 31, 2004  |  | $              | 337  |   |                                  | $ | 868  |                                 |  | $ |                               |   |  | $                        |    |   |       | $ |    |   |  | $ | 1,205  |  
|2005 costs (credits)       |  |                | 200  |   |                                  |   | (296 | )                               |  |   |                               |   |  |                          |    |   |       |   |    |   |  |   | (96    | )
|2005 payments              |  |                | (362 | ) |                                  |   | (454 | )                               |  |   |                               |   |  |                          |    |   |       |   |    |   |  |   | (816   | )
|                           |  |                |      |   |                                  |   |      |                                 |  |   |                                |   |  |                          |     |   |       |   |     |   |  |   |        |  
|Balance September 30, 2005 |  | $              | 175  |   |                                  | $ | 118  |                                 |  | $ |                               |   |  | $                        |    |   |       | $ |    |   |  | $ | 293    |  
|                           |  |                |      |   |                                  |   |      |                                 |  |   |                                |   |  |                          |     |   |       |   |     |   |  |   |        |  



Severance costs are
scheduled to be paid until 2007. Payments for anticipated remaining losses on the operating lease are expected to occur over the life of the lease, which ends in 2007.



TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



(6) Comprehensive Loss



Comprehensive loss includes Tumbleweeds net loss as well as foreign currency translation adjustments. Comprehensive loss for the three months and
nine months ending September 30, 2005 and 2004, respectively, is as follows (in thousands):



|                                                          |  |                                 |      |   |                                |   |        |      |  |   |        |   |  |   |        |  
|--------------------------------------------------------- |  | ------------------------------- | ---- | - | ------------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                          |  | Three Months EndedSeptember 30, |      |   | Nine Months EndedSeptember 30, |  
|                                                          |  | 2005                            |      |   | 2004                           |   |        | 2005 |  |   | 2004   |  
|Net loss                                                  |  | $                               | (538 | ) |                                | $ | (2,731 | )    |  | $ | (2,467 | ) |  | $ | (6,574 | )
|Other comprehensive income (loss)translation adjustments |  |                                 | 7    |   |                                |   | (32    | )    |  |   | 92     |   |  |   | (60    | )
|                                                          |  |                                 |      |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Comprehensive loss                                        |  | $                               | (531 | ) |                                | $ | (2,763 | )    |  | $ | (2,375 | ) |  | $ | (6,634 | )
|                                                          |  |                                 |      |   |                                |   |        |      |  |   |        |   |  |   |        |  



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(7) Segment Information



As defined by SFAS 131, Disclosure About Segments of an Enterprise and Related Information, Tumbleweeds chief operating decision-maker is
its Chief Executive Officer. This officer reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenue by geographic region for purposes of making operating decisions and assessing financial
performance. The consolidated financial information reviewed is the information presented in the accompanying condensed consolidated statement of operations. Tumbleweed operates in a single segment.



Revenue information regarding operations in the different geographic regions
is as follows (in thousands):



|              |  |                                 |        |                                |   |        |  |      |        |  |   |       
|------------- |  | ------------------------------- | ------ | ------------------------------ | - | ------ |  | ---- | ------ |  | - | ------
|              |  | Three Months EndedSeptember 30, |        | Nine Months EndedSeptember 30,
|              |  | 2005                            |        | 2004                           |   | 2005   |  | 2004
|North America |  | $                               | 12,551 |                                | $ | 9,994  |  | $    | 34,508 |  | $ | 27,804
|Europe        |  |                                 | 295    |                                |   | 896    |  |      | 752    |  |   | 2,625 
|Asia          |  |                                 | 834    |                                |   | 308    |  |      | 2,923  |  |   | 933   
|              |  |                                 |        |                                |   |        |  |      |        |  |   |       
|Total         |  | $                               | 13,680 |                                | $ | 11,198 |  | $    | 38,183 |  | $ | 31,363
|              |  |                                 |        |                                |   |        |  |      |        |  |   |       



Substantially all of
Tumbleweeds long-lived assets are located in the United States.



(8)
Contingencies



In December 2001, certain plaintiffs filed
a class action lawsuit in the United States District Court for the Southern District of New York on behalf of purchasers of the common stock of Valicert, alleging violations of federal securities laws. In re Valicert, Inc. Initial Public Offering
Securities Litigation, No. 01-CV-10889 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, No. 21 MC 92 (SAS). The operative amended complaint is brought on purported behalf of all persons who
purchased Valicert common stock from the date of its July 27, 2000 initial public offering (IPO) through December 6, 2000. It names as defendants Valicert, its former Chief Executive Officer, its Chief Financial Officer (the
Valicert Defendants), as well as an investment banking firm that served as an underwriter for the IPO. The complaint alleges liability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934, on the grounds that the registration statement for the IPO did not disclose that: (1) the underwriter agreed to allow certain customers to purchase shares in the IPO in exchange for excess commissions to be paid to the
underwriter; and (2) the underwriter arranged for certain customers to purchase additional shares in the aftermarket at predetermined prices. The complaint also appears to allege that false or misleading analyst reports were issued. The
complaint does not claim any specific amount of damages. Similar allegations have been made in lawsuits relating to more than 300 other initial public offerings conducted in 1999 and 2000, all of which have been consolidated for pretrial purposes.
In February 2003, the Court issued a ruling on all defendants motions to dismiss, denying Valicerts motion to dismiss the claims under the Securities Act of 1933, but granting Valicerts motion to dismiss the claims under the
Securities Exchange Act of 1934.



In June 2003, Valicert
accepted a settlement proposal presented to all issuer defendants in this case. Under the proposed settlement, the plaintiffs will dismiss and release all claims against the Valicert Defendants in exchange for a contingent payment guaranty by the
insurance companies collectively responsible for insuring the issuers in all the consolidated cases, and the assignment or surrender of control to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Under the
guaranty, the insurers will be required to pay the amount, if any, by which $1 billion exceeds the aggregate amount ultimately collected by the plaintiffs from the underwriter defendants in all of the cases. If the plaintiffs fail to recover $1
billion and payment is required under the guaranty, Valicert would be responsible to pay its pro rata portion of the shortfall, up to the amount of the deductible retention under its insurance policy, which is $500,000. The timing and amount of
payments that Valicert could be required to make under the proposed settlement will depend on several factors, principally the timing and amount of any payment required by the insurers pursuant to the $1 billion guaranty. The proposed settlement is
subject to approval of the Court, which cannot be assured. The accompanying condensed consolidated financial statements do not include a reserve for any potential loss, as Tumbleweed does not consider a loss to be probable at this time.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



In June 2003, Tumbleweed was served with a summons and first amended
complaint, captioned Liu v. Credit Suisse First Boston, et alia, alleging the violation of federal and state securities laws, purportedly on behalf of persons who acquired the common stock of Tumbleweed (other than purchasers of
Tumbleweeds IPO) from August 6, 1999 to October 18, 2000. The case was transferred to the United States District Court for the Southern District of New York, where in March 2005, the Court dismissed the case with prejudice. In June
2005 plaintiffs filed an appeal of the dismissal with the United States Court of Appeals for the Second Circuit, which remains pending. An adverse outcome in this case could harm Tumbleweeds business and operating results. Moreover, the costs
in defending this lawsuit could harm future operating results. The accompanying condensed consolidated financial statements do not include a reserve for any potential loss, as Tumbleweed does not consider a loss to be probable at this time.



All costs incurred as a result of these legal proceedings and
claims are charged to expense as incurred. Tumbleweed indemnifies its customers from third party claims of intellectual property infringement relating to the use of its products. Historically, costs related to these guarantees have not been
significant. Tumbleweed is unable to estimate the potential impact of these guarantees on its future results of operations.



(9) Recent Accounting Pronouncements



In May 2005, the FASB issued SFAS 154, Accounting Changes and Error Corrections  a replacement of APB Opinion No. 20 and FASB Statement
No. 3 (SFAS 154). SFAS 154 requires retrospective application to prior periods financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the
cumulative effect of the change. SFAS 154 also requires that retrospective application of a change in accounting principle be limited to the direct effects of the change. Indirect effects of a change in accounting principle, such as a change in
nondiscretionary profit-sharing payments resulting from an accounting change, should be recognized in the period of the accounting change. SFAS 154 also requires that a change in depreciation, amortization, or depletion method for long-lived,
nonfinancial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date this Statement is issued. Tumbleweed will adopt the provisions of SFAS 154 in the first quarter of 2006, beginning
January 1, 2006.



In March 2005, the SEC issued Staff
Accounting Bulletin 107, Share-Based Payment (SAB 107) regarding the SECs interpretation of SFAS 123R. This interpretation expresses the views of the SEC regarding the interaction between SFAS 123R and certain SEC rules and
regulations and provides the SECs views regarding the valuation of share-based payment arrangements for public companies. In particular, SAB 107 provides guidance related to share-based payment transactions with non-employees, the transition
from nonpublic to public entity status, valuation methods, the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, non generally accepted accounting
principles financial measures, first-time adoption of SFAS 123R in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon
adoption of SFAS 123R, the modification of employee share options prior to adoption of Statement 123R and disclosures in Managements Discussion and Analysis subsequent to adoption of SFAS 123R. Tumbleweed will adopt SAB 107 in connection with
its adoption of SFAS 123R in the first quarter of 2006, beginning January 1, 2006, which is expected to have a material impact on its consolidated results of operations and earnings per share.



FASB Staff Position 109-2, Accounting and Disclosure Guidance for the
Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP 109-2), provides guidance under SFAS 109, Accounting for Income Taxes, with respect to recording the potential impact of the
repatriation provisions of the American Jobs Creation Act of 2004 (the Jobs Act) on enterprises income tax expense and deferred tax liability. The Jobs Act was enacted in October 2004. FSP 109-2 states that an enterprise is allowed
time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS 109. Tumbleweed has adopted FSP 109-2 and the adoption did
not have a material impact on its financial position or results of operations.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



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



The following discussion should be read in conjunction with the consolidated condensed financial statements and the accompanying notes to this
Quarterly Report on Form 10-Q and Tumbleweeds Annual Report on Form 10-K for 2004 filed with the Securities and Exchange Commission (SEC), as well as Managements Discussion and Analysis of Financial Condition and Results of
Operations included therein. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that
could cause or contribute to these differences include, but are not limited to, those discussed below and those listed under Risks and Uncertainties That You Should Consider Before Investing In Tumbleweed.



General



Tumbleweed Communications Corp. (Tumbleweed or we) is a recognized leader in providing secure
Internet communication solutions for enterprises and government customers of all sizes. With our products, organizations can block security threats, protect information, safely conduct business online, and reduce their cost of doing business. Our
industry-leading product suitesMailGate, SecureTransport and Valicert Validation Authority - offer solutions for anti-spam, content filtering, email encryption, multi-protocol file transfer and comprehensive identity validation.



We are trusted by over 1,400 enterprise customers who use our products to
connect with over ten thousand corporations and millions of end-users. Our market focus is in the financial services, healthcare, and government segments. Our security software and appliances provide comprehensive, modular solutions for email, file
transfer and identity validation applications. Using products from our extensive portfolio, organizations can more safely and reliably conduct business over the internet.



Overview of the Three and Nine Month Periods Ended September 30, 2005



Our operating results during the three and nine months ended
September 30, 2005 improved relative to the same three and nine months in 2004 in revenue, net loss, and cash flow. Our growth in revenue of 22% in the three and nine month periods ended September 30, 2005 from the same three and nine
months in 2004, was driven by a number of factors including increased revenue from our Mailgate and Validation Authority products, an increase in patent license revenue during nine month period ended September 30, 2005, and revenue growth in
our targeted customer sectors in the health care and government industries. Our reduction in net loss of 80% and 62% in the three and nine month periods ended September 30, 2005, respectively, from the same three and nine months in 2004, was
due to our growth in revenues and our continuing focus on generating cost efficiencies including our development center in Bulgaria which has allowed us to augment our research and development and services offerings at a relatively lower cost
structure. In addition, we were cash flow positive from operations and overall in the nine months ended September 30, 2005 due to our reduction in net loss.



Backlog



Our backlog consists of deferred revenue as well as contractual commitments that are not due and payable as of the balance sheet date, or for which
collectibility is in doubt, and/or for which the product or service has not yet been delivered. Our backlog excludes all items relating to consulting and training services. Backlog was $23.2 million and $20.4 million at September 30, 2005 and
December 31, 2004, respectively. We believe that approximately $17.0 million of the backlog at September 30, 2005 will be recognized as revenue in the next twelve months.



Outlook



We believe that our success in the remainder of 2005 will depend on our ability to increase customer adoption of our MailGate, SecureTransport, and
Valicert Validation Authority products; the ability to successfully expand our sales internationally and through distribution by third party resellers; our ability to further implement the processes related to selling hardware appliance products,
such as supply chain effectiveness; and our ability to maintain control over expenses and cash. We believe that key risks include overall economic conditions and the overall level of information technology spending; economic and business conditions
within our target customer sectors in the financial services, health care, and government industries; timing of the closure of customer contracts; growing our sales internationally; and competitive factors in our rapidly changing industry. Our
prospects must be considered in light of the risks, expenses and difficulties encountered by companies at an early stage of development, particularly given that we operate in rapidly evolving markets, have completed several acquisitions and face an
uncertain economic environment. We may not be successful in addressing such risks and difficulties.



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CRITICAL ACCOUNTING POLICIES AND ESTIMATES



Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial
statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments in determining the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We regularly evaluate our estimates, including those related to revenue recognition, customer arrangements, collectibility of accounts
receivable, valuation of assets, and contingencies and litigation. When making estimates, we consider our historical experience, our knowledge of economic and market factors and various other assumptions that we believe to be reasonable under the
circumstances. Actual results may differ from these estimates under different assumptions or conditions.



We believe that the following critical accounting policies represent areas where significant judgments and estimates have been used in the preparation of
our consolidated financial statements.



Revenue Recognition



We derive our revenue from three sources: (i) product revenue, which
includes license fees for products sold as software or on appliances, subscription-based license fees, and transaction-based license fees; (ii) service revenue, which includes support and maintenance fees, consulting fees, and training fees;
and (iii) intellectual property and other revenue, which includes patent license fees and the sale of distribution rights. As described below, significant management judgments and estimates must be made and used in connection with the revenue
recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period based on the judgments and estimates made by our management.



We recognize revenue in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition,
as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions.



We make significant judgments related to revenue recognition. Specifically, in connection with each transaction involving our products, we must evaluate
whether: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) our fee is fixed or determinable, and (iv) collectibility is probable. We apply these criteria as discussed below.



| |  | Persuasive evidence of an arrangement exists. We require a written contract, signed by both the customer and us, or a purchase order from those customers that have previously
negotiated a standard license arrangement or volume purchase agreement with us prior to recognizing revenue on an arrangement.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Delivery has occurred. We deliver software to our customers physically or electronically. For physical deliveries, our standard transfer terms are typically free on board
shipping point. For electronic deliveries, delivery occurs when we provide the customer access codes or keys that allow the customer to take immediate possession of the software on its hardware.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The fee is fixed or determinable. Our determination that an arrangement fee is fixed or determinable depends principally on the arrangements payment terms. Our standard
payment terms require the arrangement fee to be due within 90 days. Where these terms apply, we regard the fee as fixed or determinable, and we recognize revenue upon delivery, assuming other revenue recognition criteria are met. If the payment
terms do not meet this standard, which we refer to as extended payment terms, we do not consider the fee to be fixed or determinable and generally recognize revenue when customer installments are due and payable.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Collectibility is probable. To recognize revenue, we must judge collectibility of the arrangement fees, which we do on a customer-by-customer basis pursuant to our credit
review policy. We typically sell to customers with whom we have a history of successful collection. For new customers, we evaluate the customers financial position and ability to pay. If we determine that collectibility is not probable based
upon our credit review process or the customers payment history, we recognize revenue when cash is collected.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We allocate revenue on software transactions (referred to as an arrangement in the accounting literature) involving multiple elements to each
undelivered element based on their respective fair values. The residual is allocated to the product license. Our determination of fair value of each element in multiple element arrangements is based on vendor-specific objective evidence
(VSOE). We limit our assessment of VSOE for each element to the price charged when the same element is sold separately.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



Valuation of Allowance for Doubtful Accounts



We maintain allowances for doubtful accounts for estimated losses resulting
from the inability of our customers to make required payments. A considerable amount of judgment is required when we assess the realization of receivables, including assessing the probability of collection and the current credit-worthiness of each
customer. We must make estimates of the collectibility of our accounts receivable. We specifically analyze accounts receivable, including review of historical bad debts, customer credit-worthiness, current economic trends, aging of the balance and
estimated collectibility percentages for different aging ranges, and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. If the financial condition of our customers were to deteriorate,
resulting in an impairment of their ability to make payments, additional allowances may be required which would result in an additional general and administrative expense in the period such determination is made.



Valuation of Long-Lived Assets and Goodwill



We assess the impairment of identifiable intangibles, long-lived assets and
goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important, which could trigger an impairment review, include the following:



| |  |  | significant underperformance relative to expected historical or projected future operating results;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | significant changes in the manner or our use of the acquired assets or the strategy for our overall business;
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | significant negative industry or economic trends;
| | - |  | -------------------------------------------------



| |  |  | significant decline in our stock price for a sustained period; and
| | - |  | ------------------------------------------------------------------



| |  |  | our market capitalization relative to our net book value.
| | - |  | ---------------------------------------------------------



We evaluate goodwill on an annual basis during the second quarter of our fiscal year for indications of impairment based on our fair value as determined
by our market capitalization in accordance with in Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other Intangible Assets(SFAS 142). If this evaluation indicates that the value of the goodwill
may be impaired, we make an assessment of the impairment of the goodwill using the two-step method prescribed by SFAS 142. Any such impairment charge could be significant and have a material adverse effect on our reported financial statements. We
did not record any impairment charges on our goodwill during 2005 or 2004, respectively. As of September 30, 2005, we had goodwill of $48.1 million.



Accrual for Anticipated Operating Lease Losses



During 2003 we recognized a charge of $996,000 related to potential losses on an operating lease in Slough, United Kingdom that was included in our
consolidated statement of operations as Merger-related and other costs. The charge was estimated to include required repairs, remaining lease liabilities, and brokerage fees, offset by estimated sublease income. During the three months ended
December 31, 2004 we recognized an additional charge of $168,000 on this same lease that was included in our consolidated statement of operations as Merger-related and other costs due to a revised estimate of the term of expected subleases on
the building. During the three months ended June 30, 2005, we recognized a $296,000 credit related to this same lease that was included in our consolidated statement of operations as Merger-related and other costs due to the combined cost of
the final lease settlement payments, commissions, brokerage fees, and legal fees related to the termination of this lease being less than the existing accrual for the loss on the lease. During the three months ended September 30, 2004, we
recognized a charge of $183,000 related to potential losses on an operating lease in Palo Alto, California that was included in our consolidated statement of operations as Merger-related and other costs. The charge was estimated to include remaining
lease liabilities and brokerage fees, offset by estimated sublease income. This office space was subleased in December 2004 for the remainder of the lease term with sublease rental income less than Tumbleweeds rent payments due to a weak
office rental market in and around Palo Alto. Estimates related to sublease costs and income are based on assumptions regarding the period required to locate and contract with a sublessee, sublease rates, and brokerage fees. Each reporting period we
review these estimates, and to the extent that our assumptions change and/or actual charges are incurred, the ultimate charge for the loss on this operating lease could vary from our current estimates.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



RESULTS OF OPERATIONS



Three and Nine Months Ended September 30, 2005 and 2004



Revenue. Revenue, which consists of product revenue, service revenue and intellectual property and other revenue,
results from new contracts and backlog. Product revenue consists of license fees, subscription-based license fees, and transaction-based license fees. Service revenue includes support and maintenance fees, consulting fees, and training fees.
Intellectual property and other revenue consists of patent license fees and the sale of distribution rights. Total revenue for the three months ended September 30, 2005 increased to $13.7 million from $11.2 million for the same three months in
2004. The increase in total revenue was primarily due to a $1.8 million increase in license revenue and a $788,000 increase in support and maintenance revenue. Total revenue for the nine months ended September 30, 2005 increased to $38.2
million from $31.4 million for the same nine months in 2004. The increase in total revenue was primarily due to a $3.1 million increase in license revenue, a $2.6 million increase in support and maintenance revenue, and a $1.1 million increase in
patent license revenue.



Product revenue increased to $6.7
million for the three months ended September 30, 2005 from $5.2 million for the same three months in 2004. The increase in product revenue was due to an increase in license revenue of $1.8 million, partially offset by decreases in
subscription-based license revenue and transaction-based license revenue of $119,000 and $81,000, respectively. Product revenue increased to $16.4 million for the nine months ended September 30, 2005 from $13.7 million for the same nine months
in 2004. The increase in product revenue was primarily due to an increase in license revenue of $3.1 million, partially offset by decreases in transaction-based license revenue and subscription-based license revenue of $187,000 and $161,000,
respectively. The increases in license revenue for the three and nine month periods were primarily due to an increased volume of license contracts. The decreases in subscription-based license revenue and transaction-based license revenue for the
three and nine month periods were due to our continued transition away from those selling models and towards selling perpetual licenses with associated support and maintenance contracts.



Service revenue increased to $6.6 million for the three months ended September 30, 2005 from $5.4 million for the same
three months in 2004. The increase in service revenue was primarily due to an increase in support and maintenance revenue of $788,000 and an increase in consulting revenue of $300,000. Service revenue increased to $19.1 million for the nine months
ended September 30, 2005 from $16.1 million for the same nine months in 2004. The increase in service revenue was primarily due to an increase in support and maintenance revenue of $3.1 million. The increase in support and maintenance revenue
was due to revenue growth in our installed customer base, an increase in sales of our dynamic anti-spam service which is sold on a subscription fee basis, and an expansion of our customer base. The increase in consulting revenue for the three month
period was due to increased consulting opportunities due to the expansion of our customer base and repeat business with existing customers for development projects.



Intellectual property and other revenue decreased to $351,000 for the three months ended September 30, 2005 from
$584,000 for the same three months in 2004. The decrease in intellectual property for the three months ended September 30, 2005 was due to a decrease in patent license revenue. Intellectual property and other revenue increased to $2.6 million
for the nine months ended September 30, 2005 from $1.5 million for the same nine months in 2004. The increase in intellectual property and other revenue for the nine months ended September 30, 2005 was due to an increase in patent license
revenue.



Cost of revenue. Cost of revenue is comprised
of product costs, service costs, and the amortization of intangible assets for core/developed technology and maintenance agreements relating to the acquisitions of Valicert, Inc. (Valicert), Incubator, Limited (Incubator) and
Corvigo, Inc. (Corvigo). Product costs are primarily comprised of royalties paid to third parties for software licensed by us for inclusion in our products, the cost of our appliance products, and employee and employee-related costs for
hardware operations. Service costs are comprised primarily of employee and employee-related costs for customer support, consulting, and contract development projects with third parties. Total cost of revenue increased to $2.8 million for the three
months ended September 30, 2005 from $2.0 million for the same three months in 2004. The increase in total cost of revenue was due to a $453,000 increase in product costs and a $355,000 increase in service costs. Total cost of revenue increased
to $7.6 million for the nine months ended September 30, 2005 from $5.5 million for the same nine months in 2004. The increase in total cost of revenue was due to a $993,000 increase in product costs, a $948,000 increase in service costs, and a
$203,000 increase in the amortization of intangible assets.



Product costs increased to $906,000 for the three months ended September 30, 2005 from $453,000 for the same three months in 2004. Product costs increased to $2.1 million for the nine months ended September 30, 2005 from $1.1
million for the same nine months in 2004. The increases in product costs were primarily due to increases in appliance costs, royalty costs, and employee and employee-related costs for hardware operations. Appliance costs increased by $257,000 and
$438,000 for the three and nine months ended September 30, 2005, respectively, due to an increase in sales of our appliance



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products and an expense in the three months ended September 30, 2005 for obsolete inventory associated with our transition to a new appliance
manufacturer. Royalty costs increased by $148,000 and $415,000 for the three and nine months ended September 30, 2005, respectively, primarily due to the addition of new software licenses from third parties included in our products. Employee
and employee-related costs increased by $32,000 and $100,000 due to the addition of headcount to support supply chain efforts related to our appliance products.



Service costs increased to $1.4 million for the three months ended September 30, 2005 from $1.0 million for the same three months in 2004. Service
costs increased to $4.0 million for the nine months ended September 30, 2005 from $3.1 million for the same nine months in 2004. The increases in service costs for the three and nine month periods ended September 30, 2005 were due to
increases in employee and employee-related costs, partially offset by decreases in allocated overhead charges over the nine month period. Employee and employee-related costs increased by $259,000 and $915,000, respectively, for the three and nine
months ended September 30, 2005 due to an increase in average services headcount. The increase in average services headcount was primarily due to the need for greater personnel resources to fulfill the requirements for our increased service
revenues. Allocated overhead charges decreased by $163,000 for the nine months ended September 30, 2005, due to a decrease in our allocable cost base caused by lower information technology and facility costs.



Amortization of intangible assets included in cost of revenue was $510,000
for both the three months ended September 30, 2005 and September 30, 2004, respectively. Amortization of intangible assets included in cost of revenue increased to $1.5 million in the nine months ended September 30, 2005 from $1.3
million for the same nine months in 2004. The increase in the amortization of intangible assets included in cost of revenue for the nine month period was due to the acquisitions of Incubator and Corvigo in March of 2004 since there was a full nine
months of amortization during the nine months ended September 30, 2005 compared to less than seven months of amortization recognized during the same nine months in 2004.



Research and development expenses. Research and development expenses are primarily comprised of employee and
employee-related costs and other costs required for the development and quality assurance of our products. Research and development expenses for the three months ended September 30, 2005 increased to $3.1 million from $2.9 million for the same
three months in 2004. Research and development expenses for the nine months ended September 30, 2005 increased to $9.0 million from $8.8 million for the same nine months in 2004. The increases in research and development expenses were primarily
due to increases in employee and employee-related costs, partially offset by allocated overhead charges. Employee and employee-related costs increased by $349,000 and $693,000, respectively, for the three and nine months ended September 30,
2005 primarily due to salary increases and growth in engineering headcount driven by our efforts to broaden and upgrade our products. Allocated overhead charges decreased by $197,000 and $636,000, respectively, for the three and nine months ended
September 30, 2005 due to a decrease in our allocable cost base caused by lower information technology and facility costs.



Sales and marketing expenses. Sales and marketing expenses are primarily comprised of employee and employee-related costs, travel expenses, and
costs associated with marketing programs. Sales and marketing expenses were $6.5 million each for the three months ended September 30, 2005 and 2004, respectively. Sales and marketing expenses for the nine months ended September 30, 2005
increased to $19.1 million from $17.4 million for the same nine months in 2004. The increase in sales and marketing expenses for the nine months ended September 30, 2005 was primarily due to a $632,000 increase in employee and employee-related
costs, a $613,000 increase in consulting costs, a $414,000 increase in marketing programs, and a $123,000 increase in travel expenses. Employee and employee-related costs increased primarily due to increased commissions as a result of increased
sales. Consulting costs increased due to the increased usage of third parties to augment the capabilities of our sales and marketing employees. Travel expenses also increased as a function of our increased sales.



General and administrative expenses. General and administrative
expenses consist primarily of employee and employee-related and support costs for our administrative, finance, legal, and human resources departments as well as public reporting costs, bad debt expense, and professional fees including intellectual
property enforcement and protection costs. General and administrative expenses for the three months ended September 30, 2005 increased to $1.5 million from $1.3 million for the same three months in 2004. General and administrative expenses for
the nine months ended September 30, 2005 increased to $4.3 million from $3.7 million for the same nine months in 2004. The increases in general and administrative expenses were primarily due to increases in commissions, travel, and recruiting
expenses. Commissions increased by $52,000 and $248,000 in the three and nine months ended September 30, 2005, respectively, due to an overall increase in patent license revenue for the nine month period. Recruiting expenses increased by
$39,000 and $253,000 in the three and nine months ended September 30, 2005, respectively, due to the utilization of third-parties to assist in our hiring processes, including the recruitment of our new Chief Executive Officer, with little
comparable expenses for the three and nine months ended September 30, 2004. Travel expenses increased by $56,000 and $37,000 during the three and nine months ended September 30, 2005 primarily due to an increased volume of travel activity.



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Stock-based compensation expense. Stock-based compensation expense consists of the amortization of
deferred stock-based compensation recorded as a result of stock option grants to non-employees, unvested options assumed in the Valicert and Corvigo acquisitions, options granted to employees at exercise prices less than the fair value of the
underlying stock on the grant date, continued vesting of stock options for a former employee after the end of their service period, and the vesting acceleration of certain employees stock options, net of credits related to stock options
granted to employees who were later terminated before the options vested. Stock-based compensation expense for the three months ended September 30, 2005 increased to $219,000 from $141,000 for the same three months in 2004. Stock-based
compensation expense for the nine months ended September 30, 2005 decreased to $448,000 from $522,000 for the same nine months in 2004. The increase in stock-based compensation expense for the three months ended September 30, 2005 is
primarily due to an expense of $144,000 for the intrinsic value of stock options for a former employee that will continue to vest for a period after the employees service period ended during the three months ended September 30, 2005. This
was partially offset by reductions in the amortization of deferred stock-based compensation resulting from unvested options assumed in the Valicert and Corvigo acquisitions as expense associated with stock-based compensation is amortized on an
accelerated basis over the vesting period of the individual award consistent with the method described in Financial Accounting Standards Board (FASB) Interpretation 28, Accounting for Stock Appreciation Rights and Other Variable Stock
Option or Award Plans. The decrease in stock-based compensation expense for the nine months ended September 30, 2005 was due to reductions in the amortization of deferred stock-based compensation resulting from unvested options assumed in
the Valicert and Corvigo acquisitions.



In December 2004, the
FASB issued SFAS 123 (revised 2004), Share-Based Payment (SFAS 123R), which revises SFAS 123, Accounting for Stock-Based Compensation (SFAS 123) and supercedes Accounting Principles Board Opinion 25,
Accounting for Stock Issued to Employees. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values, effective at the
beginning of the next fiscal year that starts after June 15, 2005. We will adopt SFAS 123R in the first quarter of 2006, beginning January 1, 2006. The pro forma disclosures previously permitted under SFAS 123 will no longer be an
alternative to financial statement recognition. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at
date of adoption. The transition methods include prospective and retroactive adoption options. Under the retroactive options, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The
prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R, while the retroactive methods would record compensation expense for
all unvested stock options and restricted stock beginning with the first period restated. We are evaluating the requirements of SFAS 123R and we expect that the adoption of SFAS 123R will have a material impact on our consolidated results of
operations and earnings per share. We have not yet determined the method of adoption or the effect of adopting SFAS 123R, and we have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures
under SFAS 123 included in the Notes to Condensed Consolidated Financial Statements.



On July 19, 2005, our Board of Directors approved the acceleration of vesting of certain unvested stock options with exercise prices equal to or greater than $3.82 per share previously awarded to our employees
(including our executive officers) and our directors under the our stock option plans. The acceleration of vesting was effective for stock options outstanding as of July 19, 2005. Options to purchase approximately 1.7 million shares of
common stock were accelerated. All of the options accelerated had exercise prices greater than our common stock price of $3.24 on the date of acceleration. The weighted average exercise price of the options accelerated was $5.00. The purpose of the
acceleration was to enable us to avoid recognizing compensation expense associated with these options in future periods in our consolidated statement of operations, upon adoption of SFAS 123R.



Amortization of intangible assets. Amortization of intangible assets
included in operating expenses consists of the amortization of intangible assets for customer base and reseller agreements and trademarks and tradenames recorded as a result of the Valicert, Incubator, and Corvigo acquisitions, and the amortization
of an acquired workforce intangible asset related to the conversion of certain former contract engineers to employees in our offshore development center in Bulgaria. Amortization of intangible assets included in operating expenses for the three
months ended September 30, 2005 decreased to $321,000 from $421,000 for the same three months in 2004. Amortization of intangible assets included in operating expenses for the nine months ended September 30, 2005 decreased to $963,000 from
$1.1 million for the same nine months in 2004. The decreases in the amortization of intangible assets included in operating expenses was due to the amortization in full during 2004 of the acquired workforce asset, partially offset by a full nine
months of amortization of the intangible assets acquired in the acquisitions of Incubator and Corvigo, during the nine months ended September 30, 2005, compared to less than seven months of amortization recognized during the same nine months in
2004.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



Merger-related and other costs. There were no merger-related and other
costs in the three months ended September 30, 2005. Merger-related and other costs of a net credit of $96,000 for the nine months ended September 30, 2005 consist of a $296,000 credit related to the termination of an operating lease in
Slough, United Kingdom and a $200,000 severance cost associated with the resignation of our former Chief Executive Officer. The combined cost of the final lease settlement payments, commissions, brokerage fees, and legal fees related to the
termination of the Slough lease was less than the existing accrual for the loss on the lease, resulting in the expense credit.



Merger-related and other costs of $533,000 for the three months ended September 30, 2004 consist of $327,000 of severance costs for Tumbleweed
employees terminated in connection with the Corvigo acquisition, $183,000 related to anticipated losses on an operating lease assumed in the Corvigo acquisition, and $23,000 of other merger-related costs. The operating lease covers approximately
12,000 square feet of office space in Palo Alto, California. The lease is for a term ending in 2007 with current monthly rent payments of approximately $22,000. Anticipated future sublease rental income is expected to be less than the rent expense
due to a weak office rental market in and around Palo Alto. The $183,000 charge was recorded due to a revised estimate of the period required to locate and contract with a sublessee and sublease rates. Merger-related and other costs of $1.0 million
for the nine months ended September 30, 2004 consist of $703,000 of severance costs for Tumbleweed employees terminated in connection with the Corvigo acquisition and the sale of our offshore development center subsidiary in India to a third
party in June of 2004, $183,000 related to anticipated losses on an operating lease assumed in the Corvigo acquisition, $26,000 for a loss on the sale of our offshore development center subsidiary in India, and $90,000 of other merger-related costs.



Other income (loss), net. Other income (loss), net, is
generally comprised of interest income earned on investment securities and interest expense incurred on outstanding debt. Other income, net for the three months ended September 30, 2005 increased to $250,000 compared to a loss of $113,000 for
the same three months in 2004. Other income, net for the nine months ended September 30, 2005 increased to $655,000 from $141,000 for the same nine months in 2004. The increases in other income, net were partially due to increases in interest
income of $109,000 and $246,000, respectively, in the three and nine months ended September 30, 2005 due to an increase in interest rates. In addition, other income increased by $118,000 and $53,000, respectively, in the three and nine months
ended September 30, 2005 due to increases in amounts collected from current and former employees of acquired companies that were previously deemed uncollectible. In addition, during the three and nine months ended September 30, 2004, a
loss of $113,000 was recorded primarily resulting from the sale of certain computer equipment and a gain of approximately $100,000 was recorded from the sale of a product line. No comparable gains or losses occurred during 2005. Finally, during the
nine months ended September 30, 2005, income of $204,000 was recorded for the refund of previously paid value added tax related to a Valicert subsidiary. No comparable income occurred during 2004



LIQUIDITY AND CAPITAL RESOURCES



Since inception, we have financed our operations primarily through the
issuance of equity securities. As of September 30, 2005, we had approximately $25.7 million in cash and cash equivalents.



Net cash provided by operating activities for the nine months ended September 30, 2005 was $3.8 million. Net cash used in operating activities for
the nine months ended September 30, 2004 was $619,000. Net cash provided by operating activities for the nine months ended September 30, 2005 was primarily the result of our net loss of $2.5 million and adjustments to reconcile net loss to
net cash provided by operating activities including an increase in deferred revenue of $3.7 million, non-cash charges for depreciation and amortization expenses of $3.4 million and stock-based compensation expense of $447,000, and an increase in
accounts receivable of $1.5 million. The change to net cash provided by operating activities for the nine months ended September 30, 2005 of $3.8 million from net cash used in operating activities for the nine months ended September 30,
2004 of $619,000 was primarily due to a decrease in our net loss of $4.1 million.



Net cash used in investing activities for the nine months ended September 30, 2005 decreased to $774,000 from $4.5 million for the same nine months in 2004. Net cash used in investing activities for the nine
months ended September 30, 2005 was comprised of $774,000 of purchases of property and equipment. The decrease in net cash used in investing activities was due to a $3.5 million outflow for the acquisitions of Incubator and Corvigo in the nine
months ended September 30, 2004. The $3.5 million outflow for the acquisitions of Incubator and Corvigo includes the impact of a $6.0 million cash payment to Corvigo shareholders as part of the purchase price for Corvigo.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



Net cash provided by financing activities for the nine months ended
September 30, 2005 increased to $1.1 million from $374,000 for the same nine months in 2004. Net cash provided by financing activities for the nine months ended September 30, 2005 was comprised of an inflow of $1.6 million for the proceeds
from the issuance of common stock as a result of the exercises of stock options, partially offset by an outflow of $467,000 related to the full repayment of outstanding debt originally assumed in the acquisition of Valicert. The increase in net cash
provided by financing activities was due to a $1.0 million increase in proceeds from the issuance of common stock in the nine months ended September 30, 2005 as compared to the same nine months in 2004 due to an increase in stock option
exercises.



As of September 30, 2005, our principal
commitments consisted of obligations related to outstanding operating leases and unconditional purchase obligations. We do not anticipate a substantial increase in operating lease obligations in the immediate future.



In June 1999, we entered into an operating lease covering approximately
40,000 square feet of office space in Redwood City, California that was scheduled to expire in November 2004. During the three months ended September 30, 2003, we renewed this lease in advance of the scheduled termination date at a lower
monthly rent cost in exchange for an extension of the lease term. The renewed lease expires in July 2008 with current monthly rent payments of approximately $73,000. This lease obligation is included in the table below.



As a result of the Corvigo acquisition, we assumed an operating lease in Palo
Alto, California. The lease is for a term ending in 2007 with current monthly rent payments of approximately $22,000. Subsequent to the acquisition of Corvigo, we decided to vacate the Palo Alto facility. This office space was subleased in December
2004 for the remainder of the lease term with sublease rental income less than our rent payments due to a weak office rental market in and around Palo Alto. This lease obligation is included in the table below.



In the acquisition of Valicert, we assumed debt of $855,000 resulting from
equipment leases with two financing companies. During 2003, this debt was refinanced with an $800,000 loan with a bank. This debt was repaid in full during the three months ended September 30, 2005.



Our capital requirements depend on numerous factors, including revenue
generated from operations and market acceptance of our products and services, the resources devoted to the development of our products and services and to sales and marketing and other operating activities. We believe that our existing capital
resources should enable us to maintain our current and planned operations for at least the next twelve months. Our current cash reserves, however, may be insufficient if we experience either lower than expected revenues or extraordinary or
unexpected cash expenses, or for other reasons. Funding, if pursued, may not be available on acceptable terms or at all. If adequate funds are not available, we may be required to curtail significantly or defer one or more of our operating goals or
programs, or take other steps that could harm our business or future operating results. We will continue to consider future financing alternatives, which may include the incurrence of debt, additional public or private equity offerings or an equity
investment by a strategic partner; however, we have no present commitments or arrangements assuring us of any future equity or debt financing.



At September 30, 2005, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to
as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing,
liquidity, market or credit risk that could arise if we had engaged in such relationships.



Contractual Obligations and Commercial Commitments



Future cash payments for contractual obligations and commercial commitments as of September 30, 2005, are as follows (in thousands):



|                                   |  |      |     |      |   |       |  |      |       |      |   |            |  |       |   |  |   |   |  |   |      
|---------------------------------- |  | ---- | --- | ---- | - | ----- |  | ---- | ----- | ---- | - | ---------- |  | ----- | - |  | - | - |  | - | -----
|                                   |  | 2005 |     | 2006 |   | 2007  |  | 2008 |       | 2009 |   | After 2009 |  | Total
|Operating leases                   |  | $    | 413 |      | $ | 1,316 |  | $    | 934   |      | $ | 391        |  | $     |  |  | $ |  |  | $ | 3,054
|Unconditional purchase obligations |  |      | 163 |      |   | 492   |  |      | 320   |      |   | 70         |  |       |  |  |   |  |  |   | 1,045
|                                   |  |      |     |      |   |       |  |      |       |      |   |            |  |       |   |  |   |   |  |   |      
|Total                              |  | $    | 576 |      | $ | 1,808 |  | $    | 1,254 |      | $ | 461        |  | $     |  |  | $ |  |  | $ | 4,099
|                                   |  |      |     |      |   |       |  |      |       |      |   |            |  |       |   |  |   |   |  |   |      



The amounts above will
be offset by sublease payments of $34,000, $244,000, and $20,000 in 2005, 2006, and 2007, respectively.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



RISKS AND UNCERTAINTIES THAT YOU SHOULD CONSIDER BEFORE INVESTING IN TUMBLEWEED



We have a history of losses and may experience losses in the future.



Our prospects must be considered in light of the risks,
expenses, delays and difficulties frequently encountered by companies engaged in rapidly evolving technology markets like ours. We incurred net losses of $7.5 million, $9.2 million, and $20.9 million in 2004, 2003, and 2002, respectively. As of
September 30, 2005, we had incurred cumulative net losses of $289.2 million.



Our success may depend in large part upon the adoption and utilization of our products and technology, as well as our ability to effectively maintain existing relationships and develop new relationships with customers
and strategic partners. If we do not succeed in doing so, we may not achieve or maintain profitability on a timely basis or at all. In particular, we intend to expend significant financial and management resources on product development, sales and
marketing, strategic relationships, technology and operating infrastructure. As a result, we may incur additional losses and continued negative cash flow from operations for the foreseeable future and may not achieve or maintain profitability.



If we do not develop our products, marketing and distribution channels more
successfully than our competitors, our business could be harmed.



If we do not optimize our methods of producing, marketing and selling our products, it could significantly limit our ability to compete successfully against current and future competitors. The markets in which we compete are intensely
competitive and rapidly changing, in part because third parties (such as hackers and spammers) whose timing and methods are somewhat unpredictable can have a significant impact on customer demand. Vendors in our markets use different methods of
marketing and distribution in order to meet expected customer demand. For example, our competitors in the anti-spam market include multiple software-only vendors, appliance-only vendors, and service providers, as well as vendors that offer a
combination of some or all of the foregoing. Moreover, vendors offerings range from single-function point products and services to more sophisticated and scalable multi-functional offerings. In addition, pricing and other terms and conditions
of sales contracts also vary considerably among our competition. Because it is difficult to predict demand in our rapidly changing markets, we may not be able to manage our marketing and sales efforts in an optimal way, which may disadvantage our
business in comparison to competitors.



Additional competitive
factors in our industry include customer-driven requirements such as additional functionality, improved product performance, ease of use, integration capacity, platform coverage, and the quality of each vendors global technical support. Some
of our competitors have greater financial, technical, sales, marketing and other resources than we do, as well as greater name recognition and a larger installed customer base. Additionally, some of these competitors have research and development
capabilities that may allow them to develop new or improved products that may compete with product lines we market and distribute.



We expect that the market for email and data security products will become more consolidated with larger companies being better positioned to compete in
such an environment in the long term. As this market continues to develop, a number of companies with greater resources than ours could attempt to increase their presence in this market by acquiring or forming strategic alliances with our
competitors or business partners.



Our success will depend on
our ability to adapt to these competing forces, to develop more effective products more rapidly and less expensively than our competitors, and to educate potential customers as to the benefits of licensing our products rather than developing their
own products. Competitors could introduce products with superior features, scalability and functionality at lower prices than our products and could also bundle existing or new products with other more established products in order to compete with
us. In addition, because there are relatively low barriers to entry for the software market, we expect additional competition from other established and emerging companies. Increased competition is likely to result in price reductions, reduced gross
margins and loss of market share, any of which could harm our business.



In addition, our success depends on our ability to grow and develop our indirect distribution channels and the inability to do so could adversely affect future operating results. Our failure to increase revenue through our indirect
distribution channels could have a material adverse effect on our business, operating results, and financial condition. We must increase the number of strategic and other third-party relationships with vendors of Internet-related systems and
application software, resellers and systems integrators. Our existing or future channel partners may choose to devote greater resources to marketing and supporting the products of other companies.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



The volume of spam may not continue to grow rapidly, which may adversely affect the market
for anti-spam solutions.



Although the volume of spam has
grown rapidly during the last several years, it may not continue to do so because of recently enacted anti-spam legislation, enforcement efforts under that legislation, and collaborative efforts by leaders of the email provider industry, as well as
the potential development of new and successful anti-spam technologies. Accordingly, the market for anti-spam solutions may not continue to grow rapidly and may in fact decline, which may adversely affect our business.



Contractual issues may arise during the negotiation of license agreements that may delay
the anticipated closure of a transaction and our ability to recognize revenue as anticipated.



Because we focus on selling enterprise-wide software products to enterprises and government entities, the process of contractual negotiation is critical
and may be lengthy. Additionally, many factors may require us to defer recognition of license revenue for a significant period of time after entering into a license agreement.



Many customers negotiate software licenses near the end of each quarter. In part, this is because customers are able, or
believe that they are able, to negotiate lower prices and more favorable terms at that time. Our reliance on a large portion of software license revenue occurring at the end of the quarter and the increase in the dollar value of transactions that
occur at the end of a quarter can result in increased uncertainty relating to quarterly revenues. Due to end-of-period variances, forecasts may not be achieved, either because expected sales do not occur or because they occur at lower prices or on
terms that are less favorable to us.



A limited number of customers account
for a high percentage of our revenue, and the failure to maintain or expand these relationships could adversely affect our future revenue.



The loss of one or more of our major customers, the failure to attract new customers on a timely basis or a reduction in revenue associated with existing
or proposed customers would harm our future revenue and prospects. During the three months ended September 30, 2005 and 2004, five customers comprised approximately 22% and 25% of our revenue, respectively. During the nine months ended
September 30, 2005 and 2004, five customers comprised approximately 14% and 11% of our revenue, respectively.



Fluctuations in our quarterly operating results may not be predictable and may result in significant volatility in our stock price.



Our product revenue has fluctuated and our quarterly operating results may
continue to fluctuate based on, among other things, the timing of the execution and termination of customer agreements in a given quarter. We have experienced, and expect to continue to experience, fluctuations in revenue and operating results from
quarter to quarter for other reasons, including the timing of our target customers election to adopt and implement our technology, election of our customers to delay their purchase commitments or purchase in smaller amounts, and timing and
ability to continue to license our patents. Further, we have experienced and may continue to experience difficulty in managing the amount and timing of operating costs and capital expenditures relating to our business, operations and infrastructure
as well as collecting fees owed by customers. Finally, any acquisitions or divestitures we complete as well as the announcement or introduction of new or enhanced products and services in the secure content management, content security, secure
online communications, or document delivery markets may create additional volatility in our results.



As a result of these factors, we believe that quarter-to-quarter comparisons of our revenue and operating results are not necessarily meaningful, and that
these comparisons may not be accurate indicators of future performance. We may not be able to accurately forecast our revenue or expenses. Because our staffing and operating expenses are based on anticipated revenue levels, and because a high
percentage of our costs are fixed, small variations in the timing of the recognition of specific revenue could cause significant variations in operating results from quarter to quarter. In addition, many of our customers delay purchases of our
products until the end of each quarter. If we are unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall, any significant revenue shortfall would likely have an immediate negative effect on our operating
results. Moreover, we believe the challenges and difficulties that we face, as outlined above with respect to financial forecasts, also apply to securities analysts that may publish estimates of our financial results. Our operating results in the
past have, and in future quarters may, fail to meet our expectations or those of securities analysts or our investors due to any of a wide variety of factors, including fluctuations in financial ratios or other metrics used to measure our
performance. If this occurs, we would expect to experience an immediate and significant decline in the trading price of our stock.



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Economic conditions that result in a decrease in information technology spending could adversely affect our ability to
maintain and increase revenue.



Our revenue and
profitability or loss depends on the overall demand for our products, our intellectual property, and our services, particularly within the industries in which we offer specific versions of our products. Because our sales are primarily to customers
in the financial services, health care, and government industries, our business depends on the overall economic conditions and the economic and business conditions within these industries. Any weakening of the global economy, the information
technology industry in particular, and the weakening of the business conditions within the above industries could cause a decrease in our license revenues. A softening of demand for information technology spending caused by a continued weakening of
the economy, domestically or internationally, may result in a decrease in revenues and continued losses.



We expect to continue making strategic investments and acquisitions and potentially divest assets, which may involve substantial costs, may substantially dilute our existing investors, and may fail to yield
anticipated benefits.



We are continuously evaluating
investments in complementary technologies and businesses as well as strategic divestments. Acquisitions of companies, divisions of companies, or products, including our acquisitions of Incubator, and Corvigo, as well as divestitures entail numerous
risks, including:



| |  | potential inability to successfully integrate acquired operations, technologies, people in dispersed geographic areas and products or to realize cost savings or other anticipated
benefits from integration as well as the existence of potential unknown liabilities associated with acquired business;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the inability to recognize revenue from target acquisitions or assess the relative percentages of in-process research and development expense that can be immediately written off as
compared to the amount which must be amortized over the appropriate life of the asset in accordance with our expectations;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | diversion of managements attention, disruption of ongoing business and impairment of relationships with employees and customers of either an acquired company or our business;
and
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | coordinating sales and pricing efforts to effectively communicate the value and capabilities of the combined company.
|- |  | ---------------------------------------------------------------------------------------------------------------------



As a result of acquisitions, we may acquire significant assets that include
goodwill and other purchased intangibles. The testing of these intangibles under established accounting guidelines for impairment requires significant use of judgment and assumptions. Changes in business conditions could require adjustments to the
valuation of these assets.



Our stock price could be adversely affected if
we are unable to continue to favorably assess the effectiveness of our internal control over financial reporting or if our auditors are unable to provide an unqualified attestation report on our assessment.



In the future, we may encounter problems or delays in completing the
implementation of any changes necessary to make a favorable assessment of our internal controls over financial reporting. In addition, in connection with the attestation process by our independent registered public accounting firm, we may encounter
future problems or delays in completing the implementation of any requested improvements and receiving a favorable attestation. If we cannot favorably assess the effectiveness of our internal controls over financial reporting, investor confidence
and our stock price could be adversely affected.



The terms of any financing
we may obtain could result in substantial dilution of existing stockholders.



In the future, we may be required or elect to seek additional financing to fund our operations. Factors such as the commercial success of our existing products and services, the timing and success of any new products
and services, the progress of our research and development efforts, our results of operations, the status of competitive products and services, and the timing and success of potential strategic alliances or potential opportunities to acquire or sell
technologies or assets may require us to seek additional funding sooner than we expect. In the event that we require additional cash, we may not be able to secure additional financing on terms that are acceptable to us, especially in light of
uncertainty in the current market environment, and we may not be successful in implementing or negotiating such other arrangements to improve our cash position. If we raise additional funds through the issuance of equity or convertible debt
securities, the percentage ownership of our stockholders would be reduced and the securities we issue might have rights, preferences and privileges senior to those of our current stockholders. If adequate funds were not available on acceptable terms
or at all, our ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion, take advantage of new opportunities, develop or enhance products or services, or otherwise respond to competitive pressures
could be significantly limited.



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Our certificate of incorporation and bylaws contain provisions that could discourage or prevent an acquisition of us,
which could depress our stock price.



Certain provisions
of our certificate of incorporation and bylaws, as well as provisions of Delaware law, may discourage or prevent an acquisition or disposition of our business. Our certificate of incorporation and bylaws may inhibit changes of control that are not
approved by our Board of Directors. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. In particular, our certificate of incorporation includes provisions for a classified
Board of Directors and prohibits stockholder action by written consent. Further, our bylaws contain provisions requiring advance notice for nomination of directors and stockholders proposals. In addition, as a Delaware corporation, we are
subject to Section 203 of the Delaware General Corporation Law. In general, this law prevents a person who becomes the owner of 15% or more of the corporations outstanding voting stock from engaging in specified business combinations for
three years unless specified conditions are satisfied. In addition, our certificate of incorporation allows our Board of Directors to issue preferred stock without further stockholder approval. The issuance of preferred stock also could effectively
limit the voting power of the holders of our common stock. This could have the effect of delaying, deferring or preventing a change in control.



We may be unable to adequately protect our intellectual property rights or may be subject to claims of patent infringement, either of which could result in substantial
costs to us.



We currently rely on a combination of
patents, trade secrets, copyrights, trademarks and licenses, together with non-disclosure and confidentiality agreements, to establish and protect our proprietary rights in our products. We hold certain patent rights with respect to some of our
products. Our existing patents or trademarks, as well as any future patents or trademarks obtained by us, may be challenged, invalidated or circumvented, or our competitors may independently develop or patent technologies that are substantially
equivalent or superior to our technology. We also rely on unpatented trade secrets and other unpatented proprietary information. Although we take precautionary measures to maintain our unpatented proprietary information, others may acquire
equivalent information or otherwise gain access to or disclose our proprietary information, and we may be unable to meaningfully protect our rights to our proprietary information. As a result, our operating results could suffer.



Third parties could assert patent or other intellectual property infringement
claims against us and the cost of responding to such assertions, regardless of their validity, could be significant. We may increasingly be subject to claims of intellectual property infringement as the number of our competitors grows and the
functionality of their products and services increasingly overlap with ours. In addition, we may infringe upon patents that may be issued to third parties in the future. It may be time consuming and costly to defend ourselves against any of these
claims and we may not prevail. Furthermore, parties making such claims may be able to obtain injunctive or other equitable relief that could block our ability to further develop or commercialize some or all of our products in the United States and
abroad. In the event of a claim of infringement, we may be required to obtain one or more licenses from or pay royalties to third parties. We may be unable to obtain any such licenses at a reasonable cost, if at all. Defense of any lawsuit or
failure to obtain such license could harm our business.



The enforcement of
our intellectual property rights, especially through patent infringement lawsuits we may initiate, could result in substantial litigation costs and ultimately may not result in additional revenue to us or a favorable judicial determination.



Since 1999 we have aggressively pursued cases of
potential infringement by third parties of our patents and other intellectual property rights. The enforcement process is costly and requires significant management attention. These costs are expensed during the period incurred, and the costs of
pursuing the litigation may not be directly matched with the related patent license agreement revenue, if any. In addition, our enforcement of our rights may increase the risk of adverse claims, with or without merit, which could be time consuming
to defend, result in costly litigation, divert managements attention and resources, limit the use of our services, or require us to enter into royalty or license agreements. In addition, such counter-claims asserted by these third parties may
be found to be valid and could result in an injunction or damages against us. Our ability to prevail in this litigation is inherently uncertain, and if we were subject to an adverse judicial determination, our ability to protect our products and to
secure related licensing or settlement revenue could be lost.



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Failure to license necessary third party software incorporated in our products could cause
delays or reductions in our sales.



We license third party
software that we incorporate into our products. These licenses may not continue to be available on commercially reasonable terms, or at all. Some of this technology would be difficult to replace. The loss of any such license could result in delays
or reductions of our applications until we identify, license and integrate or develop equivalent software. If we are required to enter into license agreements with third parties for replacement technology, we could face higher royalty payments and
our products may lose certain attributes or features. In the future, we might need to license other software to enhance our products and meet evolving customer needs. If we are unable to do this, we could experience reduced demand for our products.



Our appliance products may not be adopted in the market and may expose us
to hardware supply chain issues.



As a result of the
product and technology acquired in the Corvigo acquisition, we have seen an increase in sales of our products sold as hardware appliances, which are manufactured by a third-party. The inclusion of these hardware appliances in our product portfolio
subjects us to additional risks, including, but not limited to:



| |  |  | the inability of the manufacturer to perform in accordance with our expectations;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | the inability to deliver appliance products to customers in a timely manner, harming our ability to win time-sensitive customer contracts and/or recognize revenue;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | product shortages that could result in increased product costs;
| | - |  | ---------------------------------------------------------------



| |  |  | price increases from suppliers that may not be able to be passed on to customers;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | oversupply or obsolescence of inventory, which may result in the need to reduce our prices and/or write down inventory; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | product quality issues.
| | - |  | -----------------------



The occurrence of any of these events could adversely affect our business and operating results.



We are a defendant in two purported securities class action lawsuits that could divert
management attention and resources or eventually expose us to liability.



In June 2003, we were served with a summons and first amended complaint, captioned Liu v. Credit Suisse First Boston, et alia, alleging the violation of federal and state securities laws, purportedly on behalf
of persons who acquired our common stock of (other than purchasers of our initial public offering) from August 6, 1999 to October 18, 2000. The case was transferred to the United States District Court for the Southern District of New York,
where in March 2005, the Court dismissed the case with prejudice. In June 2005 plaintiffs filed an appeal of the dismissal with the United States Court of Appeals for the Second Circuit, which remains pending. An adverse outcome in this case could
harm our business and operating results. Moreover, the costs in defending this lawsuit could harm future operating results. The accompanying condensed consolidated financial statements do not include a reserve for any potential loss, as we do not
consider a loss to be probable at this time.



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In December 2001, certain plaintiffs filed a class action lawsuit in the United States District Court for
the Southern District of New York on behalf of purchasers of the common stock of Valicert, alleging violations of federal securities laws. In re Valicert, Inc. Initial Public Offering Securities Litigation, No. 01-CV-10889 (SAS) (S.D.N.Y.),
related to In re Initial Public Offering Securities Litigation, No. 21 MC 92 (SAS). In June 2003, Valicert accepted a settlement proposal presented to all issuer defendants in this case. Under the proposed settlement, the plaintiffs will
dismiss and release all claims against the Valicert Defendants in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuers in all the consolidated cases, and the assignment or surrender
of control to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Under the guaranty, the insurers will be required to pay the amount, if any, by which $1 billion exceeds the aggregate amount ultimately
collected by the plaintiffs from the underwriter defendants in all of the cases. If the plaintiffs fail to recover $1 billion and payment is required under the guaranty, Valicert would be responsible to pay its pro rata portion of the shortfall, up
to the amount of the deductible retention under its insurance policy, which is $500,000. The timing and amount of payments that Valicert could be required to make under the proposed settlement will depend on several factors, principally the timing
and amount of any payment required by the insurers pursuant to the $1 billion guaranty. The proposed settlement is subject to approval of the Court, which cannot be assured. Failure of the Court to approve the settlement followed by an adverse
outcome could harm our business and operating results. Moreover, the costs in defending this lawsuit could harm future operating results. The accompanying condensed consolidated financial statements do not include a reserve for any potential loss,
as we do not consider a loss to be probable at this time.



If we lose the
services of executive officers or other key employees, our ability to develop our business and secure customer relationships will suffer.



We are substantially dependent on the continued services and performance of our executive officers and other key personnel and do not have long-term employment agreements
with any of our key personnel. In this regard, we recently appointed a new Chief Executive Officer, which subjects us to heightened risks related to this transition as he assumes this role and makes changes to our business and operations. The loss
of the services of any of our executive officers or other key employees could significantly delay or prevent the achievement of our development and strategic objectives.



Our international business exposes us to additional risks that may result in future additional costs or limit the market for product
sales.



Products and services provided to our
international customers accounted for 8% and 11% of our revenues for the three months ended September 30, 2005 and 2004, respectively and 10% and 11% of our revenues for the nine months ended September 30, 2005 and 2004, respectively.
Conducting business outside of the United States subjects us to additional risks, including:



| |  |  | changes in regulatory requirements;
| | - |  | -----------------------------------



| |  |  | reduced protection of intellectual property rights; evolving privacy laws; tariffs and other trade barriers;
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | difficulties in staffing and managing foreign operations;
| | - |  | ---------------------------------------------------------



| |  |  | problems in collecting accounts receivable; and
| | - |  | -----------------------------------------------



| |  |  | difficulties in authenticating customer information.
| | - |  | ----------------------------------------------------



Managing these risks may subject us to additional costs that may not be justified in light of the market opportunity, and the inability to comply with or
manage foreign laws and related risks may preclude or limit sales in foreign jurisdictions.



We rely on public key cryptography and other security techniques that could be breached, resulting in reduced demand for our products and services.



A requirement for the continued growth of electronic commerce is the secure transmission of confidential information over
public networks. We rely on public key cryptography, an encryption method that utilizes two keys, a public and private key, for encoding and decoding data, and on digital certificate technology, to provide the security and authentication necessary
for secure transmission of confidential information. Regulatory and export restrictions may prohibit us from using the strongest and most secure cryptographic protection available, and thereby may expose us or our customers to a risk of data
interception. A party who is able to circumvent our security measures could misappropriate proprietary information or interrupt our or our customers operations. Any compromise or elimination of our security could result in risk of loss or
litigation and possible liability and reduce demand for our products and services.



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ITEM 3QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



We currently do not use financial instruments to hedge operating expenses in Bulgaria, Japan, the Netherlands, Switzerland, or the United Kingdom
denominated in the respective local currency. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.



We do not use derivative financial instruments for speculative trading purposes, nor do we hedge our foreign currency exposure in a manner that entirely
offsets the effects of changes in foreign exchange rates. We regularly review our hedging program and may as part of this review determine at any time to change our hedging program.



Interest Rate Sensitivity



The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the fair value of the investment to fluctuate. For example, if we
hold a security that was issued with a fixed rate equal to the then-prevailing interest rate and the prevailing interest rate later rises, the fair value of our investment will decline. To minimize this risk, we maintain our portfolio of cash
equivalents in commercial paper and money market funds. In general, our investments are not subject to market risk because the interest paid on these funds fluctuates with the prevailing interest rate. As of September 30, 2005, none of our cash
equivalents were subject to market risk.



ITEM 4CONTROLS AND PROCEDURES



(a) Evaluation of disclosure controls and procedures.



Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended (the Exchange Act)) as of September 30, 2005. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2005, our
disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act and are effective in
ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as
appropriate to allow timely decisions regarding required disclosure.



(b)
Changes in internal controls over financial reporting.



During
the three months ended September 30, 2005, we transitioned to a new financial system to be used for our general ledger accounting. This system is designed to enhance our financial reporting by providing more timely and accurate financial and
accounting information, and by eliminating the need to transfer financial data from one financial system to another.



Other than the change mentioned above, no other changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act) occurred during the thee months ended September 30, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



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PART IIOTHER INFORMATION



ITEM 1LEGAL PROCEEDINGS



In December 2001, certain plaintiffs filed a class action lawsuit in the United States District Court for the Southern District of New York on behalf of purchasers of the common stock of Valicert, alleging violations
of federal securities laws. In re Valicert, Inc. Initial Public Offering Securities Litigation, No. 01-CV-10889 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, No. 21 MC 92 (SAS). The operative amended
complaint is brought on purported behalf of all persons who purchased Valicert common stock from the date of its July 27, 2000 initial public offering (IPO) through December 6, 2000. It names as defendants Valicert, its former
Chief Executive Officer, its Chief Financial Officer (the Valicert Defendants), as well as an investment banking firm that served as an underwriter for the IPO. The complaint alleges liability under Sections 11 and 15 of the Securities
Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that the registration statement for the IPO did not disclose that: (1) the underwriter agreed to allow certain customers to purchase shares in the
IPO in exchange for excess commissions to the paid to the underwriter; and (2) the underwriter arranged for certain customers to purchase additional shares in the aftermarket at predetermined prices. The complaint also appears to allege that
false or misleading analyst reports were issued. The complaint does not claim any specific amount of damages. Similar allegations have been made in lawsuits relating to more than 300 other initial public offerings conducted in 1999 and 2000, all of
which have been consolidated for pretrial purposes. In February 2003, the Court issued a ruling on all defendants motions to dismiss, denying Valicerts motion to dismiss the claims under the Securities Act of 1933, but granting
Valicerts motion to dismiss the claims under the Securities Exchange Act of 1934.



In June 2003, Valicert accepted a settlement proposal presented to all issuer defendants in this case. Under the proposed settlement, the plaintiffs will dismiss and release all claims against the Valicert Defendants
in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuers in all the consolidated cases, and the assignment or surrender of control to the plaintiffs of certain claims the issuer
defendants may have against the underwriters. Under the guaranty, the insurers will be required to pay the amount, if any, by which $1 billion exceeds the aggregate amount ultimately collected by the plaintiffs from the underwriter defendants in all
of the cases. If the plaintiffs fail to recover $1 billion and payment is required under the guaranty, Valicert would be responsible to pay its pro rata portion of the shortfall, up to the amount of the deductible retention under its insurance
policy, which is $500,000. The timing and amount of payments that Valicert could be required to make under the proposed settlement will depend on several factors, principally the timing and amount of any payment required by the insurers pursuant to
the $1 billion guaranty. The proposed settlement is subject to approval of the Court, which cannot be assured. The accompanying consolidated financial statements do not include a reserve for any potential loss, as we do not consider a loss to be
probable at this time.



In June 2003, we were served with a
summons and first amended complaint, captioned Liu v. Credit Suisse First Boston, et alia, alleging the violation of federal and state securities laws, purportedly on behalf of persons who acquired our common stock of (other than purchasers
of our IPO) from August 6, 1999 to October 18, 2000. The case was transferred to the United States District Court for the Southern District of New York, where in March 2005, the Court dismissed the case with prejudice. In June 2005
plaintiffs filed an appeal of the dismissal with the United States Court of Appeals for the Second Circuit, which remains pending. An adverse outcome in this case could harm our business and operating results. Moreover, the costs in defending this
lawsuit could harm future operating results. The accompanying condensed consolidated financial statements do not include a reserve for any potential loss, as we do not consider a loss to be probable at this time.



All costs incurred as a result of these legal proceedings and claims are
charged to expense as incurred.



We indemnify our customers
from third party claims of intellectual property infringement relating to the use of our products. Historically, costs related to these guarantees have not been significant and we are unable to estimate the potential impact of these guarantees on
our future results of operations.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



|ITEM 5EXHIBITS | 
|--------------- | 



a. Exhibits are incorporated herein by reference or are filed with this report as indicated below (numbered in accordance with Item 601 of Regulation S-K):



|              |  |                                                                                                                                                                      
|------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                          
|3.1(1)        |  | Amended and Restated Certificate of Incorporation of Registrant                                                                                                      
|              | 
|3.2(1)        |  | Amended and Restated Bylaws of Registrant                                                                                                                            
|              | 
|10.4(2)       |  | Employment agreement between James W. Guthrie and Tumbleweed, dated August 24, 2005                                                                                  
|              | 
|31.1          |  | Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|              | 
|31.2          |  | Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|              | 
|32.1          |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                    
|              | 
|32.2          |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                    

---

|(1) | Incorporated by reference to our Registration Statement on Form S-1/A (File No. 333-79687), filed June 29, 1999.
|--- | ----------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to our Current Report on Form 8-K, filed September 15, 2005.
|--- | --------------------------------------------------------------------------------------



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



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, hereunto duly authorized:



|                       |  |                                 |  |                                                                                                                                              
|---------------------- |  | ------------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------
|                       |  | TUMBLEWEED COMMUNICATIONS CORP.
|                       |  |                                
|Date: November 2, 2005 |  | By:                             |  | /S/ CRAIG D. BRENNAN                                                                                                                         
|                       |  |                                 |  | Craig D. Brennan Chairman of the Board and Chief Executive Officer (Principal Executive Officer)                                             
|                       |  |                                
|Date: November 2, 2005 |  | By:                             |  | /S/ TIMOTHY G. CONLEY                                                                                                                        
|                       |  |                                 |  | Timothy G. Conley Senior Vice President of Finance and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



INDEX TO EXHIBITS



|              |  |                                                                                                                                                                      
|------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                          
|3.1(1)        |  | Amended and Restated Certificate of Incorporation of Registrant                                                                                                      
|              | 
|3.2(1)        |  | Amended and Restated Bylaws of Registrant                                                                                                                            
|              | 
|10.4(2)       |  | Employment agreement between James W. Guthrie and Tumbleweed, dated August 24, 2005                                                                                  
|              | 
|31.1          |  | Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|              | 
|31.2          |  | Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|              | 
|32.1          |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                    
|              | 
|32.2          |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                    

---

|(1) | Incorporated by reference to our Registration Statement on Form S-1/A (File No. 333-79687), filed June 29, 1999.
|--- | ----------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to our Current Report on Form 8-K, filed September 15, 2005.
|--- | --------------------------------------------------------------------------------------



33