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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, 2004



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 Exchange
Act).    Yes ̈No  x



The number of shares of common stock outstanding as of October 31, 2004 was
47,986,355.



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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;
| | - | -------------------------------------------------------------------



| |  | implementing our business strategy;
| | - | -----------------------------------



| |  | attracting and retaining customers;
| | - | -----------------------------------



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



| |  | competition in our market;
| | - | --------------------------



| |  | any statements relating to integration or restructuring plans; 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 the risks factors and uncertainties under the caption Risks and Uncertainties
That You Should Consider Before Investing in Tumbleweed, among other things, in evaluating our prospects and future financial performance. The occurrence of the events described in the risk factors could harm the business, results of
operations and financial condition of Tumbleweed. 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.

INDEX



|               |  |                                                                                                                               |  |     
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------- |  | ----
|               |  |                                                                                                                               |  | Page
|               |  | Part I                                                                                                                        |  |     
|Item 1         |  | Financial Statements (unaudited)                                                                                              |  | 3   
|               |  | Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003                                          |  | 3   
|               |  | Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and September 30, 2003 |  | 4   
|               |  | Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and September 30, 2003           |  | 5   
|               |  | Notes to Condensed Consolidated Financial Statements                                                                          |  | 6   
|Item 2         |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                         |  | 13  
|Item 3         |  | Quantitative and Qualitative Disclosures About Market Risk                                                                    |  | 27  
|Item 4         |  | Controls and Procedures                                                                                                       |  | 28  
|               |  |                                                                                                                              
|               |  | Part II                                                                                                                       |  |     
|Item 1         |  | Legal Proceedings                                                                                                             |  | 28  
|Item 6         |  | Exhibits and Reports on Form 8-K                                                                                              |  | 30  
|Signatures     |  | 31                                                                                                                           
|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 30,2004 |          |   | December 31,2003 |  
|Assets                                                            |  |                   |          |   |                  |   |          |  
|Current Assets:                                                   |  |                   |          |   |                  |   |          |  
|Cash and cash equivalents                                         |  | $                 | 20,594   |   |                  | $ | 25,351   |  
|Accounts receivable, net                                          |  |                   | 8,002    |   |                  |   | 10,039   |  
|Other current assets                                              |  |                   | 1,774    |   |                  |   | 1,068    |  
|                                                                  |  |                   |          |   |                  |   |          |  
|Total current assets                                              |  |                   | 30,370   |   |                  |   | 36,458   |  
|Goodwill                                                          |  |                   | 49,471   |   |                  |   | 13,308   |  
|Intangible assets, net                                            |  |                   | 8,129    |   |                  |   | 4,392    |  
|Property and equipment, net                                       |  |                   | 1,304    |   |                  |   | 1,648    |  
|Other assets                                                      |  |                   | 671      |   |                  |   | 540      |  
|                                                                  |  |                   |          |   |                  |   |          |  
|Total assets                                                      |  | $                 | 89,945   |   |                  | $ | 56,346   |  
|                                                                  |  |                   |          |   |                  |   |          |  
|Liabilities and Stockholders Equity                              |  |                   |          |   |                  |   |          |  
|Current liabilities:                                              |  |                   |          |   |                  |   |          |  
|Accounts payable                                                  |  | $                 | 1,535    |   |                  | $ | 250      |  
|Current installments of long-term debt                            |  |                   | 267      |   |                  |   | 267      |  
|Accrued liabilities                                               |  |                   | 6,131    |   |                  |   | 6,791    |  
|Accrued merger-related and other costs                            |  |                   | 939      |   |                  |   | 485      |  
|Deferred revenue                                                  |  |                   | 12,757   |   |                  |   | 11,808   |  
|                                                                  |  |                   |          |   |                  |   |          |  
|Total current liabilities                                         |  |                   | 21,629   |   |                  |   | 19,601   |  
|Long-term debt, excluding current installments                    |  |                   | 267      |   |                  |   | 467      |  
|Accrued merger-related and other costs, excluding current portion |  |                   | 465      |   |                  |   | 540      |  
|Deferred revenue, excluding current portion                       |  |                   | 3,073    |   |                  |   | 2,984    |  
|Other long-term liabilities                                       |  |                   | 154      |   |                  |   | 159      |  
|Total long-term liabilities                                       |  |                   | 3,959    |   |                  |   | 4,150    |  
|                                                                  |  |                   |          |   |                  |   |          |  
|Total liabilities                                                 |  |                   | 25,588   |   |                  |   | 23,751   |  
|                                                                  |  |                   |          |   |                  |   |          |  
|Stockholders equity:                                             |  |                   |          |   |                  |   |          |  
|Common stock                                                      |  |                   | 49       |   |                  |   | 43       |  
|Additional paid-in capital                                        |  |                   | 352,488  |   |                  |   | 313,532  |  
|Treasury stock                                                    |  |                   | (796     | ) |                  |   | (796     | )
|Deferred stock-based compensation                                 |  |                   | (865     | ) |                  |   | (302     | )
|Accumulated other comprehensive loss                              |  |                   | (645     | ) |                  |   | (585     | )
|Accumulated deficit                                               |  |                   | (285,874 | ) |                  |   | (279,297 | )
|                                                                  |  |                   |          |   |                  |   |          |  
|Total stockholders equity                                        |  |                   | 64,357   |   |                  |   | 32,595   |  
|Total liabilities and stockholders equity                        |  | $                 | 89,945   |   |                  | $ | 56,346   |  
|                                                                  |  |                   |          |   |                  |   |          |  



See accompanying Notes
to Condensed Consolidated Financial Statements



3



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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, |  
|                                                                          |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003   |  
|Revenue:                                                                  |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Product revenue                                                           |  | $                               | 5,186  |   |                                | $ | 5,067  |      |  | $ | 13,703 |   |  | $ | 10,973 |  
|Service revenue                                                           |  |                                 | 5,428  |   |                                |   | 3,154  |      |  |   | 16,144 |   |  |   | 8,640  |  
|Intellectual property and other revenue                                   |  |                                 | 584    |   |                                |   | 404    |      |  |   | 1,516  |   |  |   | 935    |  
|                                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total revenue                                                             |  |                                 | 11,198 |   |                                |   | 8,625  |      |  |   | 31,363 |   |  |   | 20,548 |  
|Cost of product revenue                                                   |  |                                 | 453    |   |                                |   | 255    |      |  |   | 1,078  |   |  |   | 748    |  
|Cost of service revenue                                                   |  |                                 | 1,038  |   |                                |   | 1,079  |      |  |   | 3,063  |   |  |   | 3,228  |  
|Amortization of intangible assets                                         |  |                                 | 510    |   |                                |   | 217    |      |  |   | 1,327  |   |  |   | 534    |  
|                                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total cost of revenue                                                     |  |                                 | 2,001  |   |                                |   | 1,551  |      |  |   | 5,468  |   |  |   | 4,510  |  
|Gross profit                                                              |  |                                 | 9,197  |   |                                |   | 7,074  |      |  |   | 25,895 |   |  |   | 16,038 |  
|Operating expenses:                                                       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Research and development                                                  |  |                                 | 2,860  |   |                                |   | 2,560  |      |  |   | 8,828  |   |  |   | 6,573  |  
|Sales and marketing                                                       |  |                                 | 6,487  |   |                                |   | 4,425  |      |  |   | 17,403 |   |  |   | 11,127 |  
|General and administrative                                                |  |                                 | 1,345  |   |                                |   | 1,551  |      |  |   | 3,689  |   |  |   | 4,489  |  
|Stock-based compensation expense (1)                                      |  |                                 | 141    |   |                                |   | 75     |      |  |   | 522    |   |  |   | 124    |  
|Amortization of intangible assets                                         |  |                                 | 421    |   |                                |   | 206    |      |  |   | 1,137  |   |  |   | 226    |  
|Write-off of in-process research and development                          |  |                                 |       |   |                                |   |       |      |  |   |       |   |  |   | 100    |  
|Merger-related and other costs                                            |  |                                 | 533    |   |                                |   | 549    |      |  |   | 1,002  |   |  |   | 2,436  |  
|                                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total operating expenses                                                  |  |                                 | 11,787 |   |                                |   | 9,366  |      |  |   | 32,581 |   |  |   | 25,075 |  
|                                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Operating loss                                                            |  |                                 | (2,590 | ) |                                |   | (2,292 | )    |  |   | (6,686 | ) |  |   | (9,037 | )
|Other income (expense), net                                               |  |                                 | (113   | ) |                                |   | 512    |      |  |   | 141    |   |  |   | 577    |  
|Net loss before provision for income taxes                                |  |                                 | (2,703 | ) |                                |   | (1,780 | )    |  |   | (6,545 | ) |  |   | (8,460 | )
|Provision for income taxes                                                |  |                                 | 28     |   |                                |   | 17     |      |  |   | 29     |   |  |   | 24     |  
|                                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Net loss                                                                  |  | $                               | (2,731 | ) |                                | $ | (1,797 | )    |  | $ | (6,574 | ) |  | $ | (8,484 | )
|                                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Net loss per sharebasic and diluted                                      |  | $                               | (0.06  | ) |                                | $ | (0.04  | )    |  | $ | (0.14  | ) |  | $ | (0.25  | )
|                                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Weighted average sharesbasic and diluted                                 |  |                                 | 47,955 |   |                                |   | 40,541 |      |  |   | 46,339 |   |  |   | 34,104 |  
|(1)    Stock-based
compensation expense is further classified as follows: |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Cost of service revenue                                                   |  | $                               |       |   |                                | $ | 8      |      |  | $ | 11     |   |  | $ | 21     |  
|Research and development                                                  |  |                                 | 45     |   |                                |   | 20     |      |  |   | 164    |   |  |   | 26     |  
|Sales and marketing                                                       |  |                                 | 90     |   |                                |   | 41     |      |  |   | 329    |   |  |   | 56     |  
|General and administrative                                                |  |                                 | 6      |   |                                |   | 6      |      |  |   | 18     |   |  |   | 21     |  
|                                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total stock-based compensation expense                                    |  | $                               | 141    |   |                                | $ | 75     |      |  | $ | 522    |   |  | $ | 124    |  
|                                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  



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 Cash Flows

(in thousands)

(unaudited)



|                                                                            |  |                                |        |   |      |   |        |  
|--------------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ---- | - | ------ | -
|                                                                            |  | Nine months endedSeptember 30, |       
|                                                                            |  | 2004                           |        |   | 2003 |  
|Cash flows from operating activities:                                       |  |                                |        |   |      |   |        |  
|Net loss                                                                    |  | $                              | (6,574 | ) |      | $ | (8,484 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                                |        |   |      |   |        |  
|Stock-based compensation expense                                            |  |                                | 522    |   |      |   | 124    |  
|Compensation for stock granted to former Incubator employees                |  |                                | 183    |   |      |   |       |  
|Compensation for stock options granted below fair market value              |  |                                |       |   |      |   | 29     |  
|Depreciation and amortization expenses                                      |  |                                | 3,633  |   |      |   | 1,789  |  
|Write-off of in-process research and development                            |  |                                |       |   |      |   | 100    |  
|Bad debt expense                                                            |  |                                |       |   |      |   | 236    |  
|Loss on disposal of property and equipment                                  |  |                                | 194    |   |      |   | 44     |  
|Changes in operating assets and liabilities, net of effect of acquisitions: |  |                                |        |   |      |   |        |  
|Accounts receivable                                                         |  |                                | 2,541  |   |      |   | (2,043 | )
|Other current assets and other assets                                       |  |                                | (144   | ) |      |   | 904    |  
|Accounts payable, accrued liabilities, and other long-term liabilities      |  |                                | (938   | ) |      |   | (4,508 | )
|Accrued merger-related and other costs                                      |  |                                | (184   | ) |      |   | 1,473  |  
|Deferred revenue                                                            |  |                                | 148    |   |      |   | 2,166  |  
|                                                                            |  |                                |        |   |      |   |        |  
|Net cash used in operating activities                                       |  |                                | (619   | ) |      |   | (8,170 | )
|Cash flows from investing activities:                                       |  |                                |        |   |      |   |        |  
|Purchase of property and equipment                                          |  |                                | (965   | ) |      |   | (529   | )
|Acquisitions of Incubator Limited and Corvigo, Inc., net of cash acquired   |  |                                | (3,487 | ) |      |   |       |  
|Acquisition of Valicert, net of cash acquired                               |  |                                |       |   |      |   | 818    |  
|                                                                            |  |                                |        |   |      |   |        |  
|Net cash provided by (used in) investing activities                         |  |                                | (4,452 | ) |      |   | 289    |  
|Cash flows from financing activities:                                       |  |                                |        |   |      |   |        |  
|Repayments of borrowings                                                    |  |                                | (200   | ) |      |   | (831   | )
|Proceeds from borrowings                                                    |  |                                |       |   |      |   | 800    |  
|Proceeds from issuance of common stock                                      |  |                                | 574    |   |      |   | 1,655  |  
|                                                                            |  |                                |        |   |      |   |        |  
|Net cash provided by financing activities                                   |  |                                | 374    |   |      |   | 1,624  |  
|Effect of exchange rate on cash and cash equivalents                        |  |                                | (60    | ) |      |   | 80     |  
|                                                                            |  |                                |        |   |      |   |        |  
|Net decrease in cash and cash equivalents                                   |  |                                | (4,757 | ) |      |   | (6,177 | )
|Cash and cash equivalents, beginning of period                              |  |                                | 25,351 |   |      |   | 29,210 |  
|                                                                            |  |                                |        |   |      |   |        |  
|Cash and cash equivalents, end of period                                    |  | $                              | 20,594 |   |      | $ | 23,033 |  
|                                                                            |  |                                |        |   |      |   |        |  
|Supplemental disclosures of cash flow information:                          |  |                                |        |   |      |   |        |  
|Cash paid during the period for interest                                    |  | $                              | 24     |   |      | $ | 45     |  
|                                                                            |  |                                |        |   |      |   |        |  
|Cash paid during the period for taxes                                       |  | $                              | 21     |   |      | $ | 37     |  
|                                                                            |  |                                |        |   |      |   |        |  



See accompanying Notes
to Condensed Consolidated Financial Statements



5



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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, 2003, filed with
the SEC on March 15, 2004.



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, 2004, the results of operations for the three and nine months ended September 30, 2004 and 2003, respectively, and cash flows for the nine months ended September 30, 2004 and 2003, respectively. The results for the three and nine
months ended September 30, 2004 and 2003, respectively, are not necessarily indicative of the results expected for the full fiscal year.



The accompanying consolidated condensed 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, Valicert, Inc. (Valicert), Incubator, Limited (Incubator), and Corvigo, Inc.
(Corvigo), have been included commencing June 23, 2003, March 15, 2004, and March 18, 2004, the effective dates of those acquisitions, respectively.



(2) Stock-Based Compensation



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. As such, deferred stock-based compensation is recorded for fixed plan stock options when the fair value of the underlying common stock on the date of grant exceeds the stock option
exercise price or the purchase price for issuance or sales of common stock. Deferred stock-based compensation is being 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.



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%.



In the three months
ended March 31, 2004, Tumbleweed recorded deferred stock-based compensation of $1,397,000 for the difference at the effective date of acquisition of Corvigo between the exercise price and the fair value of the common stock underlying the unvested
options assumed upon the acquisition, multiplied by the ratio representing the remaining vesting period of the options assumed. In the three months ended June 30, 2003, Tumbleweed recorded deferred stock-based compensation of $528,000 for the
difference at the effective date of acquisition of Valicert between the exercise price and the fair value of the common stock underlying the unvested options assumed upon the acquisition.



Tumbleweed recognized stock-based compensation expense of approximately $141,000 and $75,000, in the three months ended
September 30, 2004 and 2003, respectively, and approximately $522,000 and $124,000, in the nine months ended September 30, 2004 and 2003, 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, Tumbleweeds net losses for the three and nine months ended September 30,
2004 and 2003, respectively, would have been as follows (in thousands, except per share amounts):



|                                                                                                     |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  
|---------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                     |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                                                                     |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003    |  
|Net loss as reported                                                                                 |  | $                               | (2,731 | ) |                                | $ | (1,797 | )    |  | $ | (6,574  | ) |  | $ | (8,484  | )
|Add: Stock-based compensation expense included in net loss                                           |  |                                 | 141    |   |                                |   | 75     |      |  |   | 522     |   |  |   | 124     |  
|Less: Total stock-based compensation expense determined under fair value based method for all awards |  | $                               | (3,218 | ) |                                | $ | (1,668 | )    |  | $ | (6,754  | ) |  | $ | (4,704  | )
|                                                                                                     |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss pro forma                                                                                   |  | $                               | (5,808 | ) |                                | $ | (3,390 | )    |  | $ | (12,806 | ) |  | $ | (13,064 | )
|Basic and diluted net loss per share as reported                                                     |  | $                               | (0.06  | ) |                                | $ | (0.04  | )    |  | $ | (0.14   | ) |  | $ | (0.25   | )
|Basic and diluted net loss per share pro forma                                                       |  | $                               | (0.12  | ) |                                | $ | (0.08  | )    |  | $ | (0.28   | ) |  | $ | (0.38   | )
|                                                                                                     |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |         |  



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements(Continued)



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, |  
|                        |  | 2004                            |   |  | 2003                           |   |  | 2004      |   |  | 2003      |  
|Stock options:          |  |                                 |   |  |                                |   |  |           |   |  |           |  
|Expected life           |  | 4.0 years                       |   |  | 4.0 years                      |   |  | 4.0 years |   |  | 4.0 years |  
|Volatility              |  | 135                             | % |  | 139                            | % |  | 135       | % |  | 141       | %
|Risk-free interest rate |  | 3.21                            | % |  | 2.67                           | % |  | 3.05      | % |  | 2.44      | %
|Dividend yield          |  | 0                               | % |  | 0                              | % |  | 0         | % |  | 0         | %



(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,
|                                                                                                                                                                                                              |  | 2004                            |  | 2003                           |  | 2004  |  | 2003 
|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 |  | 1,919                           |  | 5,051                          |  | 5,026 |  | 2,194
|Warrants and options excluded due to the exercise price exceeding the average fair market value of common stock during the
period                                                                             |  | 11,469                          |  | 2,966                          |  | 2,480 |  | 5,875
|                                                                                                                                                                                                              |  |                                 |  |                                |  |       |  |      
|Total potential shares of common stock excluded from diluted net loss per share                                                                                                                               |  | 13,388                          |  | 8,017                          |  | 7,506 |  | 8,069



(4) 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 e-mail security markets and to accelerate Tumbleweeds distribution plans through the addition of
resellers already selling the Corvigo appliance. Since March 18, 2004, Corvigos results of operations have been included in Tumbleweeds consolidated condensed financial statements. The acquisition was accounted for using the purchase
method of accounting and accordingly, the purchase price was allocated to the assets acquired and liabilities assumed based on their estimated fair values on the acquisition date. The purchase price of $42.3 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, an exchange of 386,000 options to purchase
Tumbleweeds common stock with a fair value of $2.7 million, including the intrinsic value of unvested options of $1.4 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.



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                              |  |   | 34,753
|                                      |  |   |       
|Total                                 |  | $ | 42,334
|                                      |  |   |       



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. Since March 15, 2004, Incubators results of operations have been
included in Tumbleweeds consolidated condensed financial statements. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the assets acquired and liabilities assumed
based on their estimated fair values on the acquisition date. 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 stock on the date of the acquisition and other acquisition-related costs of $119,000 consisting of legal fees.



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Notes to Condensed Consolidated Financial Statements(Continued)



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 certain sales goal is 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 worth $770,000 plus 10% of the amount of Tumbleweeds European sales in excess of the sales goal for the year ending December 31, 2004. In addition, in the event that certain sales
goals are met in Tumbleweeds European sales region for both the year and the two year period, respectively, 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. During the three months ended September 30, 2004, Tumbleweeds Board
of Directors approved a non-recoverable grant of stock to the former owners of Incubator worth $183,000 based on the fair value of Tumbleweeds stock on the date of the stock grant as consideration for progress towards the European sales goal
in the first six months of 2004. The value of the grant is included in Tumbleweeds Sales and marketing expenses for the three months ended September 30, 2004. As a result of this stock grant, Tumbleweeds contingent purchase price for
Incubator decreased by the $183,000 paid.



On June 23, 2003,
Tumbleweed acquired Valicert, which develops and licenses secure Internet communications and identity validation software for file transfer, financial messaging, and business process integration. The acquisition was entered into to combine the two
companies into a single, more competitive industry participant. Since June 23, 2003, Valicerts results of operations have been included in Tumbleweeds consolidated condensed financial statements. The acquisition was accounted for using
the purchase method of accounting and accordingly, the purchase price was allocated to the assets acquired and liabilities assumed based on their estimated fair values on the acquisition date. The purchase price of $17.0 million consisted of an
exchange of 9,713,634 shares of Tumbleweeds common stock with a fair value of $13.0 million based on the average fair value of Tumbleweeds stock two days before and two days after the announcement date of February 18, 2003, assumed stock
options with a fair value of $1.7 million, severances for former Valicert employees of $276,000, and other acquisition-related costs of $2.0 million, consisting primarily of legal fees, investment banking fees, financial printing fees, accounting
fees, and proxy mailing fees.



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



|                                      |  |   |        |  
|------------------------------------- |  | - | ------ | -
|Net tangible liabilities              |  | $ | (1,647 | )
|Core/developed technology             |  |   | 2,600  |  
|Maintenance agreements                |  |   | 700    |  
|Customer base and reseller agreements |  |   | 1,400  |  
|Trademarks and tradenames             |  |   | 200    |  
|In-process research and development   |  |   | 100    |  
|Purchases orders (license)            |  |   | 300    |  
|Goodwill                              |  |   | 13,308 |  
|                                      |  |   |        |  
|Total                                 |  | $ | 16,961 |  
|                                      |  |   |        |  



A summary of
intangible assets as of September 30, 2004 follows (in thousands):



|                                      |  |                               |  |                     |        |                         |   |        |     |  |   |      
|------------------------------------- |  | ----------------------------- |  | ------------------- | ------ | ----------------------- | - | ------ | --- |  | - | -----
|                                      |  | Amortizationperiod (in years) |  | Grosscarryingamount |        | Accumulatedamortization |   |        | Net
|Core/ developed technology            |  | 3 to 4                        |  | $                   | 5,850  |                         | $ | (1,534 | )   |  | $ | 4,316
|Customer base and reseller agreements |  | 3                             |  |                     | 3,700  |                         |   | (983   | )   |  |   | 2,717
|Maintenance agreements                |  | 3 to 4                        |  |                     | 1,200  |                         |   | (364   | )   |  |   | 836  
|Trademarks and trade names            |  | 4                             |  |                     | 350    |                         |   | (90    | )   |  |   | 260  
|                                      |  |                               |  |                     |        |                         |   |        |     |  |   |      
|                                      |  |                               |  | $                   | 11,100 |                         | $ | (2,971 | )   |  | $ | 8,129
|                                      |  |                               |  |                     |        |                         |   |        |     |  |   |      



The amounts above
exclude intangible assets related to the acquisition of Valicert for purchase orders (license) and in-process research and development in the amount of $300,000 and $100,000, respectively, as these amounts were written off in full in 2003. The
amounts above also 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 research and development center in Bulgaria. This intangible asset was amortized in full as of September 30, 2004.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements(Continued)



The estimated amortization for each of the fiscal years subsequent to September 30, 2004, is as
follows (in thousands):



|                         |  |   |      
|------------------------ |  | - | -----
|Year Ending December 31, |  |  
|2004                     |  | $ | 830  
|2005                     |  |   | 3,321
|2006                     |  |   | 2,508
|2007                     |  |   | 1,238
|2008                     |  |   | 232  
|                         |  |   |      
|                         |  | $ | 8,129
|                         |  |   |      



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,
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. During the three months ended September 30, 2004 and June 30, 2004, respectively,
Tumbleweed increased its goodwill balance by $83,000 and $11,000, respectively, due to actual expenditures for acquisition-related costs related to the Corvigo acquisition being higher than previously estimated. During the three months ended June
30, 2004, Tumbleweed increased its goodwill balance by $15,000 due to actual expenditures for acquisition-related costs related to the Incubator acquisition being higher than previously estimated.



Pro Forma Results



The following pro forma summary presents Tumbleweeds consolidated
results of operations for the three and nine months ended September 30, 2004 and 2003, as if the acquisitions of Valicert, Incubator, and Corvigo had been consummated at the beginning of the earliest period presented. The pro forma consolidated
results of operations include certain pro forma adjustments, including amortization of intangible assets, amortization of deferred compensation and the elimination of certain merger-related charges incurred by Valicert, prior to the merger with
Tumbleweed, in the three months ended March 31, 2003. The pro forma results do not give effect to the deferred revenue adjustments on revenue as the adjustments are directly related to the mergers and the effects are non-recurring. Under the
purchase method of accounting, the deferred revenue balances of Valicert, Incubator, and Corvigo were reduced by $1.0 million, $390,000, and $793,000, respectively, to the fair value of the related obligations as of the acquisition dates of June 23,
2003; March 15, 2004; and March 18, 2004, respectively. These adjustments have had the effect of reducing the amount of revenue the combined company recognized in the three and nine months ended September 30, 2004 and 2003, respectively, and will
also affect the amount of revenue the combined company will recognize in future periods compared to the amount of revenue Valicert, Incubator, and Corvigo would have recognized in the same periods absent the mergers.



Pro forma results for the three and nine months ended September 30, 2004 and
2003, respectively, are as follows (in thousands, except per share amounts):



|                                     |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |         |  
|------------------------------------ |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                     |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                     |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003   |  
|Revenues                             |  | $                               | 11,198 |   |                                | $ | 9,280  |      |  | $ | 31,946 |   |  | $ | 27,716  |  
|Net loss                             |  | $                               | (2,619 | ) |                                | $ | (2,893 | )    |  | $ | (9,425 | ) |  | $ | (13,403 | )
|Net loss per sharebasic and diluted |  | $                               | (0.05  | ) |                                | $ | (0.06  | )    |  | $ | (0.20  | ) |  | $ | (0.30   | )
|                                     |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |         |  



The pro forma results
are not necessarily indicative of those that would have actually occurred had the acquisition taken place at the beginning of the periods presented. Pro forma results include merger-related and other costs of $533,000 and $549,000 for the three
months ended September 30, 2004 and 2003, respectively, and $1.0 million and $2.4 million for the nine months ended September 30, 2004 and 2003, respectively.



Merger-related and Other Costs



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



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Notes to Condensed Consolidated Financial Statements(Continued)



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. 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 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.



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 2, 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.



During the last three quarters of 2003, Tumbleweed
recorded merger-related and other costs of $2.9 million consisting of $1.1 million of severance costs for Tumbleweed employees terminated in connection with the Valicert acquisition, $596,000 of merger-related marketing programs, $174,000 of other
merger-related costs, and a $996,000 charge related to anticipated losses on an operating lease. The operating lease was assumed during the acquisition of Interface, Inc. in 2000 and covers approximately 13,000 square feet of office space in Slough,
United Kingdom. The lease is for a term ending in 2020 with quarterly rent payments of approximately $65,000. This office space had been subleased to a tenant who was providing Tumbleweed with quarterly rent payments of approximately $65,000 until
the sublease was terminated effective July 2003. Anticipated future sublease rental income is expected to be less than the rent expense due to a weak office rental market in and around Slough. The following table describes merger-related and other
costs recorded in 2004 and 2003 (in thousands):



|                           |  |                |       |   |                                  |   |      |                                  |  |   |                                |   |  |                            |     |   |       |   |      |   |  |   |        |  
|-------------------------- |  | -------------- | ----- | - | -------------------------------- | - | ---- | -------------------------------- |  | - | ------------------------------ | - |  | -------------------------- | --- | - | ----- | - | ---- | - |  | - | ------ | -
|                           |  | Severancecosts |       |   | Anticipatedoperatinglease losses |   |      | Merger- relatedmarketingprograms |  |   | Loss onsale ofIndiansubsidiary |   |  | Other merger- relatedcosts |     |   | Total |  
|2003 costs                 |  | $              | 1,143 |   |                                  | $ | 996  |                                  |  | $ | 596                            |   |  | $                          |    |   |       | $ | 174  |   |  | $ | 2,909  |  
|2003 payments              |  |                | (911  | ) |                                  |   | (203 | )                                |  |   | (455                           | ) |  |                            |    |   |       |   | (174 | ) |  |   | (1,743 | )
|Balance December 31, 2003  |  | $              | 232   |   |                                  | $ | 793  |                                  |  | $ | 141                            |   |  | $                          |    |   |       | $ |     |   |  | $ | 1,166  |  
|Costs                      |  |                |      |   |                                  |   |     |                                  |  |   |                               |   |  |                            |    |   |       |   |     |   |  |   |       |  
|Payments                   |  |                | (135  | ) |                                  |   | (76  | )                                |  |   | (141                           | ) |  |                            |    |   |       |   |     |   |  |   | (352   | )
|Balance March 31, 2004     |  | $              | 97    |   |                                  | $ | 717  |                                  |  | $ |                               |   |  | $                          |    |   |       | $ |     |   |  | $ | 814    |  
|Costs                      |  |                | 376   |   |                                  |   |     |                                  |  |   |                               |   |  |                            | 26  |   |       |   | 67   |   |  |   | 469    |  
|Payments                   |  |                | (88   | ) |                                  |   | (31  | )                                |  |   |                               |   |  |                            | (26 | ) |       |   | (67  | ) |  |   | (212   | )
|Balance June 30, 2004      |  | $              | 385   |   |                                  | $ | 686  |                                  |  | $ |                               |   |  | $                          |    |   |       | $ |     |   |  | $ | 1,071  |  
|Costs                      |  |                | 327   |   |                                  |   | 183  |                                  |  |   |                               |   |  |                            |    |   |       |   | 23   |   |  |   | 533    |  
|Reclassifications          |  |                |      |   |                                  |   | 116  |                                  |  |   |                               |   |  |                            |    |   |       |   |     |   |  |   | 116    |  
|Payments                   |  |                | (210  | ) |                                  |   | (83  | )                                |  |   |                               |   |  |                            |    |   |       |   | (23  | ) |  |   | (316   | )
|Balance September 30, 2004 |  | $              | 502   |   |                                  | $ | 902  |                                  |  | $ |                               |   |  | $                          |    |   |       | $ |     |   |  | $ | 1,404  |  



Severance costs will
be paid in 2004 and 2005. Payments for other merger-related costs will be paid in 2004. Payments for anticipated remaining losses on the operating leases are expected to occur over the life of the leases, the longer of which ends in 2020.



(5) Comprehensive Loss



Comprehensive loss includes Tumbleweeds net loss as well as foreign
currency translation adjustments, recorded net of tax. Comprehensive loss for the three months and nine months ending September 30, 2004 and 2003, respectively, is as follows (in thousands):



|                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|--------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                          |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                          |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003   |  
|Net loss                                                  |  | $                               | (2,731 | ) |                                | $ | (1,797 | )    |  | $ | (6,574 | ) |  | $ | (8,484 | )
|Other comprehensive income (loss)translation adjustments |  |                                 | (32    | ) |                                |   | 19     |      |  |   | (60    | ) |  |   | 80     |  
|                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Comprehensive loss                                        |  | $                               | (2,763 | ) |                                | $ | (1,778 | )    |  | $ | (6,634 | ) |  | $ | (8,404 | )
|                                                          |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  



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Notes to Condensed Consolidated Financial Statements(Continued)



(6) 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 consolidated statement of operations. Tumbleweed operates in a single reporting segment.



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



|              |  |                                 |        |                                |   |       |  |      |        |  |   |       
|------------- |  | ------------------------------- | ------ | ------------------------------ | - | ----- |  | ---- | ------ |  | - | ------
|              |  | Three Months EndedSeptember 30, |        | Nine Months EndedSeptember 30,
|              |  | 2004                            |        | 2003                           |   | 2004  |  | 2003
|North America |  | $                               | 9,994  |                                | $ | 8,475 |  | $    | 27,804 |  | $ | 19,567
|Europe        |  |                                 | 896    |                                |   | 125   |  |      | 2,625  |  |   | 432   
|Asia          |  |                                 | 308    |                                |   | 25    |  |      | 933    |  |   | 549   
|              |  |                                 |        |                                |   |       |  |      |        |  |   |       
|Total         |  | $                               | 11,198 |                                | $ | 8,625 |  | $    | 31,363 |  | $ | 20,548
|              |  |                                 |        |                                |   |       |  |      |        |  |   |       



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



(7)
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 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 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.



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 initial public offering) from August 6, 1999
to October 18, 2000. The case is now pending in the United States District Court for the Southern District of New York. In September 2004, the Court granted plaintiffs motion for leave to file a third amended complaint, and Tumbleweed filed a
motion to dismiss this case pursuant to Fed. R. Civ. P. 12(b). 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.



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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements(Continued)



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 and Tumbleweed is unable to
estimate the potential impact of these guarantees on its future results of operations.



(8) Recent Accounting Pronouncements



In March
2004, the FASB issued No. 03-1 (EITF 03-01), The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments which provides new guidance for assessing impairment losses on investments. Additionally,
EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-01; Tumbleweed will evaluate the impact of EITF 03-01 once final
guidance is issued.



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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 2003 filed with the SEC, including any amendments to our Annual Report filed with the 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.



Overview



Tumbleweed Communications Corp. (Tumbleweed or we)
is a leading provider of email and data security products for enterprises and government agencies. Our solutions are used by these organizations when email, file transfer or Web communications are mission-critical. By making Internet communications
secure, reliable and automated, our products help customers significantly reduce their cost of doing business.



We have more than 1,000 enterprise customers who use our products to connect with over ten thousand corporations and millions of end-users.
Tumbleweeds market focus is in the financial services, healthcare and insurance, government and enterprise markets. Our customers include ABN Amro Bank, Bank of America Securities, Catholic Healthcare West, JP Morgan Chase & Co., The
Regence Group (Blue Cross/Blue Shield), St. Lukes Episcopal Healthcare System, the US Food and Drug Administration, the US Navy and Marine Corps, and Wells Fargo Bank.



Our software solutions are:



| | Email Firewall and Dynamic Anti-Spam Service to protect companies from spam junk email, viruses, and to implement content filtering for regulatory compliance;
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Secure File Transfer for automating the transfer of payments files, Electronic Data Interchange (EDI) files, check images and other business-critical information
between corporations, banks and processors;
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Secure Email and Document Delivery for protecting confidential information such as patient records and financial statements;
|- | ----------------------------------------------------------------------------------------------------------------------------



| | Identity Validation to authorize users to access secure computing systems and to digitally sign files and transactions; and
|- | ---------------------------------------------------------------------------------------------------------------------------



| | MailGate Appliance for protection from spam and other email threats at the gateway.
|- | -------------------------------------------------------------------------------------



Overview of the Three and Nine Month Periods Ended September 30, 2004



Our operating results during the three and nine months ended September 30, 2004 showed improvement relative to the same
three and nine months in 2003 in both revenue and operating cash flow. Our growth in revenue of 30% and 53% in the three and nine months ended September 30, 2004, respectively, from the same three and nine months in 2003, was driven by a number of
factors including increased customer adoption of our email firewall products, revenues from the secure file transfer and identity validation products we acquired in the Valicert acquisition, revenue from the MailGate product acquired in the Corvigo
acquisition, and growth



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in our targeted customer sectors in the financial services, health care, and government industries. Our increase in net
loss of 52% in the three month period ended September 30, 2004, from the same three months in 2003 was due to an increase in intangible asset amortization and stock-based compensation expense, both primarily related to the Corvigo acquisition, as
well as an increase in sales and marketing expenses which have helped drive our increase in revenue. Our reduction in net loss of 23% in the nine months ended September 30, 2004, from the same nine months in 2003, 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. Operating cash flow
improved by 92% in the nine months ended September 30, 2004 due to our reduction in net loss and lower accounts receivable balance due to an increase in collections from our customers.



Key Performance Indicators



Our key performance indicators are customer orders received (bookings), recognized revenue, and deferred revenue. We measure bookings as the dollar value
of contractual agreements entered into with customers in the period that result in either revenue recognized in the period, deferred revenue at the end of the period, or expected billings in future periods. Generally, an increase in our bookings
will result in an increase in our revenue and/or deferred revenue. The timing of bookings is uncertain as we sell to enterprises and government entities and the process of contractual negotiation is critical and may be lengthy.



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 services. Backlog was $19.0 million and $15.3 million at September 30,
2004 and December 31, 2003, respectively. We believe that $14.1 million of the backlog at September 30, 2004 will be recognized as revenue in the next twelve months.



Outlook



We believe that our near-term success will depend particularly on our ability to increase customer adoption of our email firewall, secure file transfer,
anti-spam, and identity validation products, our ability to successfully integrate the Valicert, Incubator, and Corvigo acquisitions, our ability to improve supply chain effectiveness associated with our appliance products, 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; expanding our reseller channel; 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 new and rapidly evolving markets, have completed several acquisitions and face an uncertain
economic environment. We may not be successful in addressing such risks and difficulties. Please refer to the Risks and Uncertainties section for additional information.



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, 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 agreement 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.



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



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 end-user 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 FOB 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 paid 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.



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;
|- | -------------------------------------------------



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



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



We evaluate goodwill on an annual basis for indications of impairment based on our fair value as determined by our market capitalization in accordance
with SFAS 142, Goodwill and Other Intangible Assets.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 the three and nine months ended September 30, 2004 or 2003,
respectively. As of September 30, 2004, we had goodwill of $49.5 million.



Accrual for Anticipated Operating Lease Losses



In the three months ended June 30, 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 dilapidations, remaining lease liabilities, and brokerage fees, offset by estimated sublease income. In 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. Estimates related to sublease costs and income are based on assumptions regarding the period required to locate and contract with a sublessee and sublease rates. Each reporting period we review these estimates,
and to the extent that our assumptions change, the ultimate charge for the loss on these operating leases could vary from our current estimates.



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RESULTS OF OPERATIONS



Three and Nine Month Periods Ended September 30, 2004 and 2003



Revenue. Revenue, which consists of product revenue, service revenue and intellectual property and other revenue, results from new contracts and backlog. We define
backlog as deferred revenue, 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. 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
agreement fees and the sale of distribution rights. Total revenue for the three months ended September 30, 2004 increased to $11.2 million from $8.6 million for the same three months in 2003. The increase in total revenue was primarily due to a $2.2
million increase in support and maintenance revenue and a $180,000 increase in patent license agreement revenue. Total revenue for the nine months ended September 30, 2004 increased to $31.4 million from $20.5 million for the same nine months in
2003. The increase in total revenue was primarily due to a $7.0 million increase in support and maintenance revenue, a $2.7 million increase in license revenue, and a $862,000 increase in patent license agreement revenue.



Product revenue increased to $5.2 million for the three months ended
September 30, 2004 from $5.1 million for the same three months in 2003. Product revenue increased to $13.7 million for the nine months ended September 30, 2004 from $11.0 million for the same nine months in 2003. While product revenue was largely
unchanged in the three months ended September 30, 2004, relative to the same three months in 2003, the increase in product revenue for the nine months ended September 30, 2004 relative to the same nine months in 2003 was primarily due to an increase
in license revenue of $2.7 million. The increase in license revenue for the nine month period was driven by increased sales of the secure file transfer and identity validation products that we acquired in the Valicert acquisition and the MailGate
product that we acquired in the Corvigo acquisition, with less comparable revenue in 2003 since the Valicert acquisition occurred late in the second quarter of 2003 and the Corvigo acquisition occurred in 2004. In addition, license revenue increased
as a result of increased sales of our email firewall products.



Service revenue increased to $5.4 million for the three months ended September 30, 2004 from $3.2 million for the same three months in 2003. Service revenue increased to $16.1 million for the nine months ended September 30, 2004 from $8.6
million for the same nine months in 2003. The increases in service revenue were primarily due to increases in support and maintenance revenue of $2.2 million and $7.0 million, respectively, for the three and nine months ended September 30, 2004. The
increases in support and maintenance revenue were due to revenue growth in our installed customer base, an expansion of our customer base due to the Valicert acquisition, and the successful customer acceptance of our dynamic anti-spam service which
was released during the three months ended June 30, 2003 and is sold on a subscription service fee basis.



Intellectual property and other revenue increased to $584,000 for the three months ended September 30, 2004 from $404,000 for the same three months in
2003. Intellectual property and other revenue increased to $1.5 million for the nine months ended September 30, 2004 from $935,000 for the same nine months in 2003. The increases in intellectual property and other revenue were due to increases in
patent license agreement revenue of $180,000 and $862,000, respectively, for the three and nine months ended September 30, 2004. This increase for the nine months ended September 30, 2004 was partially offset by $281,000 of revenue from the sale of
distribution rights in 2003 with no comparable revenue in 2004.



Cost of
revenue.Cost of revenue is comprised of product costs and service costs and the amortization of core/developed technology, maintenance agreements, and purchase orders (license) relating to the Valicert, Incubator, and Corvigo acquisitions.
Product costs are primarily comprised of royalties paid to third parties for software licensed by us for inclusion in our products and the cost of hardware included in our appliance products. Service costs are comprised primarily of employee and
employee-related costs for customer support and consulting and contract development projects with third parties. Total cost of revenue increased to $2.0 million for the three months ended September 30, 2004 from $1.6 million for the same three
months in 2003. The increase in total cost of revenue was due to a $293,000 increase in the amortization of intangible assets and a $198,000 increase in product costs, partially offset by a $41,000 decrease in service costs. Total cost of revenue
increased to $5.5 million for the nine months ended September 30, 2004 from $4.5 million for the same nine months in 2003. The increase in total cost of revenue was due to a $793,000 increase in the amortization of intangible assets and a $330,000
increase in product costs, partially offset by a $165,000 decrease in service costs.



Product costs increased to $453,000 for the three months ended September 30, 2004 from $255,000 for the same three months in 2003. Product costs increased to $1.1 million for the nine months ended September 30, 2004
from $748,000 for the same nine months in 2003. The increases in product costs for the three and nine months were primarily due to an increase in costs of hardware included in our appliance products due to an increase in the sales of appliance
products in 2004. The increase in sales of appliance products was driven by sales of the MailGate product acquired in the Corvigo acquisition. We expect product costs to increase on a year-over-year basis in the remainder of 2004 due to the
inclusion of the costs of hardware included in sales of our appliance products.



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Service costs decreased to $1.0 million for the three months ended September 30, 2004 from $1.1 million
for the same three months in 2003. Service costs decreased to $3.1 million for the nine months ended September 30, 2004 from $3.2 million for the same nine months in 2003. The decrease in service costs for the three and nine months was primarily due
to the sale, in the three months ended June 30, 2004, of our offshore development center subsidiary in India, which had supported our engineering, customer support, and consulting functions. This subsidiary was sold to consolidate our offshore
development in our existing Bulgaria location. As a result of the sale of the subsidiary there were no service costs in India in the three months ended September 30, 2004.



Amortization of intangible assets included in cost of revenue consists of the amortization of intangible assets for
core/developed technology, maintenance agreements, and purchase orders (license) recorded as a result of the Valicert, Incubator, and Corvigo acquisitions. Amortization of intangible assets included in cost of revenue increased to $510,000 in the
three months ended September 30, 2004 from $217,000 for the same three months in 2003. Amortization of intangible assets included in cost of revenue increased to $1.3 million in the nine months ended September 30, 2004 from $534,000 for the same
nine months in 2003. The increases in the amortization of intangible assets included in cost of revenue was due to the acquisitions of Corvigo and Incubator in March of 2004 and the acquisition of Valicert in June of 2003 since there was no related
amortization for the Corvigo and Incubator intangible assets in the nine months ended September 30, 2003 and no related amortization for the Valicert intangible assets in the first quarter of 2003. We expect amortization of intangible assets
included in cost of revenue to increase on a year-over-year basis in the fourth quarter of 2004 as a result of the acquisitions of Corvigo and Incubator in March of 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, 2004 increased to $2.9 million from $2.6 million for the same three months in 2003.
Research and development expenses for the nine months ended September 30, 2004 increased to $8.8 million from $6.6 million for the same nine months in 2003. The increases in research and development expenses were primarily due to increases in
employee and employee-related costs. Employee and employee-related costs increased by $460,000 and $2.1 million, respectively, in the three and nine months ended September 30, 2004 due to an increase in average engineering headcount to 125 employees
for the three months ended September 30, 2004 from 99 employees for the same three months in 2003 and an increase in average engineering headcount to 137 employees for the nine months ended September 30, 2004 from 73 employees for the same nine
months in 2003. The increase in average engineering headcount was driven by our efforts to broaden and upgrade our products including the addition of employees from the Valicert and Corvigo acquisitions. The increase in employee and employee-related
costs for the three months ended September 30, 2004 was partially offset by a decrease in consulting expenses of $87,000 and a decrease in legal expenses of $60,000, both of which were related to the conversion of a number of contract engineers to
Tumbleweed employees in our development center in Bulgaria in September 2003.



Sales and marketing expenses.Sales and marketing expenses are primarily comprised of employee and employee-related costs, including commissions, travel expenses, and costs associated with marketing programs. Sales and marketing
expenses for the three months ended September 30, 2004 increased to $6.5 million from $4.4 million for the same three months in 2003. Sales and marketing expenses for the nine months ended September 30, 2004 increased to $17.4 million from $11.1
million for the same nine months in 2003. The increases in sales and marketing expenses were primarily due to increases in employee and employee-related costs, including commissions, as well as marketing programs and travel expenses. Employee and
employee-related costs, including commissions, increased by $1.3 million and $4.7 million, respectively, in the three and nine months ended September 30, 2004 due to an increase in commissions and an increase in average sales and marketing headcount
to 84 employees for the three months ended September 30, 2004 from 60 employees for the same three months in 2003, and an increase in average sales and marketing headcount to 78 employees for the nine months ended September 30, 2004 from 50
employees for the same nine months in 2003. The increase in average sales and marketing headcount was due to our efforts to increase our marketing resources and expand our sales presence, including the acquisitions of Valicert, Incubator, and
Corvigo. Marketing programs increased by $409,000 and $865,000, respectively, in the three and nine months ended September 30, 2004 due to an increase in marketing initiatives targeted at growing our revenues. Travel expenses increased by $173,000
and $196,000, respectively, in the three and nine months ended September 30, 2004 due to an increase in travel costs associated with our increased revenue.



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, 2004 decreased to $1.3 million from $1.6 million for the same three months in 2003. General and administrative expenses for the nine months ended September 30, 2004 decreased to $3.7 million from $4.5 million for the
same nine months in 2003. The decreases in general and administrative expenses were primarily due to decreases in legal expenses and office expenses. Legal expenses decreased by $91,000 and $461,000, respectively, in the three and nine months ended
September 30, 2004 primarily due to costs associated with the eBay patent matter in the three and nine months ended September 30, 2003. The settlement of our lawsuit and signing of a cross-license agreement with eBay in the three months ended
December 31, 2003 reduced costs associated with this matter in the three and nine months ended September 30, 2004. Office expenses decreased by



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$105,000 and $477,000, respectively, in the three and nine months ended September 30, 2004 primarily due to the renewal
of our headquarters lease in third quarter of 2003 where we received a lower monthly rent cost in exchange for an extension of the lease term.



Stock-based compensation expense.Stock-based compensation expense consists of the amortization of deferred stock-based compensation recorded as a result of
unvested options assumed in the Valicert and Corvigo acquisitions, stock option grants to non-employees, options granted to employees at exercise prices less than the fair value of the underlying stock on the grant date, 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, 2004 increased to
$141,000 from $75,000 for the same three months in 2003. Stock-based compensation expense for the nine months ended September 30, 2004 increased to $522,000 from $124,000 for the same nine months in 2003. The increases in stock-based compensation
expense were due to the amortization of deferred stock-based compensation resulting from unvested options assumed in the Valicert and Corvigo acquisitions and grants of stock options to a non-employee in the three and nine months ended September 30,
2004 with no comparable expense from the Corvigo acquisition and non-employee grant in 2003 and no comparable expense from the Valicert acquisition in the first quarter of 2003. We expect stock-based compensation expense to increase on a
year-over-year basis in the remainder of 2004 as a result of the amortization of deferred compensation recognized as a result of Corvigo acquisition as well as the option grants to a non-employee.



Amortization of intangible assets and write-off of in-process research and development.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. Amortization of intangible assets included in operating expenses for the three months ended September 30, 2004 increased to $421,000 from $206,000 for the same three months in 2003. Amortization of intangible assets included in
operating expenses for the nine months ended September 30, 2004 increased to $1.1 million from $226,000 for the same nine months in 2003. The increases in the amortization of intangible assets included in operating expenses was due to the
acquisitions of Corvigo and Incubator in March 2004 and the acquisition of Valicert in June of 2003 since there was no related amortization for the Corvigo and Incubator intangible assets in the nine months ended June 30, 2003 and no related
amortization for the Valicert intangible assets in the first quarter of 2003. We expect amortization of intangible assets included in operating expenses to increase on a year-over-year basis in the remainder of 2004 as a result of the acquisitions
of Corvigo and Incubator in March 2004.



Merger-related and other costs.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 on June 2, 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. Merger-related and other costs of $549,000 for the three months ended September 30, 2003, consist of
$285,000 of merger-related marketing programs, $223,000 of severance costs for Tumbleweed employees terminated in connection with the Valicert acquisition, and $41,000 of other merger-related costs. Merger-related and other expenses of $2.4 million
for the nine months ended September 30, 2003, consist primarily of $1.1 million of severance costs for Tumbleweed employees terminated in connection with the Valicert acquisition, $285,000 of merger-related marketing programs, $41,000 of other
merger-related costs, and a $996,000 charge related to anticipated losses on an operating lease. The operating lease was assumed during the acquisition of Interface, Inc. in 2000 and covers approximately 13,000 square feet of office space in Slough,
United Kingdom. The lease is for a term ending in 2020 with quarterly rent payments of approximately $65,000. This office space had been subleased to a tenant who was providing Tumbleweed with quarterly rent payments of approximately $65,000 until
the sublease was terminated effective July 2003. Anticipated future sublease rental income is expected to be less than the rent expense due to a weak office rental market in and around Slough.



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. Additionally in the three months ended September 30, 2004, this category included losses on disposal of assets of $113,000, primarily resulting from the sale
of certain computer equipment, and in the nine months ended September 30, 2004 included a gain of $66,000 related to the recovery of amounts due from current and former employees previously deemed uncollectible, and a gain of approximately $100,000
from the sale of a product line. In the three and nine months ended September 30, 2003 this category included a gain of approximately $500,000 recorded from the sale, net of related commissions, of an intellectual property asset acquired in the
acquisition of Valicert. The change to a loss of $113,000 in the three



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months ended September 30, 2004 from a gain of $512,000 for the same three months in 2003 and the decrease in income to
$141,000 in the three months ended September 30, 2004 from $577,000 for the same nine months in 2003 was primarily due to these four items.



LIQUIDITY AND CAPITAL RESOURCES



Since inception, we have financed our operations primarily through the issuance of equity securities. As of September 30, 2004, we had approximately $20.6
million in cash and cash equivalents.



Net cash used in
operating activities for the nine months ended September 30, 2004 decreased to $619,000 from $8.2 million for the same nine months in 2003. Net cash used in operating activities for the nine months ended September 30, 2004 was primarily the result
of our net loss of $6.6 million and adjustments to reconcile net loss to net cash used in operating activities including a decrease in accounts receivable balances of $2.5 million as a result of improved collections, and non-cash charges for
depreciation and amortization expenses of $3.6 million and stock-based compensation expense of $522,000. The reduction in net cash used in operating activities was primarily due to a reduction in our net loss of $1.9 million, the reduction in
accounts receivable balances, and increases in non-cash charges for depreciation and amortization expenses and stock-based compensation expense of $1.8 million and $398,000, respectively, partially offset by a decrease in accrued liabilities due to
the payment of an additional payroll in the three months ended September 30, 2004 that resulted in an additional outflow of cash of $1.0 million. This extra payment related to a timing event, and although it did decrease cash, had no impact on
expenses.



Net cash used in investing activities for the nine
months ended September 30, 2004 was $4.5 million. Net cash used in investing activities was comprised of $3.5 million for the acquisitions of Incubator and Corvigo, net of cash acquired, and $965,000 of purchases of property and equipment. 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. Net cash provided by investing activities for the nine months ended
September 30, 2003 was comprised of inflows related to the acquisition of Valicert, partially offset by purchases of property and equipment.



Net cash provided by financing activities for the nine months ended September 30, 2004 decreased to $374,000 from $1.6 million for the same nine months in
2003. Net cash provided by financing activities for the nine months ended September 30, 2004 was comprised of an inflow of $574,000 for the proceeds from the issuance of common stock as a result of the exercises of stock options and warrants,
partially offset by an outflow of $200,000 related to repayments on outstanding debt originally assumed in the acquisition of Valicert. Net cash provided by financing activities for the nine months ended September 30, 2003 resulted primarily from
the proceeds from the issuance of common stock as a result of the exercises of stock options and warrants of $1.7 million and a net cash outflow related to the refinancing of outstanding debt assumed in the acquisition of Valicert.



As of September 30, 2004, our principal commitments consisted of obligations
related to outstanding operating leases, a bank loan, 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.



As a result of the Interface acquisition, we assumed an operating lease in Slough, United Kingdom. The lease is for a term ending in 2020 with current
quarterly rent payments of approximately $65,000. We subleased this office space to a tenant who was providing us with quarterly rent payments of approximately $65,000 until the sublease was terminated effective July 2003. Anticipated future
sublease rental income is expected to be less than the rent expense due to a weak office rental market in and around Slough. In the second quarter of 2003 we recognized a charge of $996,000 related to anticipated losses on this lease that was
included in our consolidated statement of operations as Merger-related and other costs. We are currently attempting to find a new sublessee.



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. 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. In the three months ended September 30, 2004 we
recognized a charge of $183,000 related to anticipated losses on this lease that was included in our consolidated statement of operations as Merger-related and other costs. 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. We are currently attempting to find a sublessee.



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In the acquisition of Valicert, we assumed debt of $855,000 resulting from equipment leases with two
financing companies. During the three months ended September 30, 2003 this debt was refinanced with an $800,000 loan from the same bank from whom we previously had obtained equipment loan facilities. The new debt bears interest at prime rate plus
0.63%, is due and payable in 36 equal monthly installments, and is secured by certain of our assets.



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 indebtedness, 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. Additionally, equity or debt financing may not be available to us on favorable terms, if at all.



We regularly evaluate acquisition candidates that have products, technologies, or customers that may complement our own, and expect to continue this
practice.



At September 30, 2004, 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, 2004, are as follows (in thousands):



|                                   |  |      |     |      |   |       |  |      |       |      |   |           |  |       |     |  |   |       |  |   |      
|---------------------------------- |  | ---- | --- | ---- | - | ----- |  | ---- | ----- | ---- | - | --------- |  | ----- | --- |  | - | ----- |  | - | -----
|                                   |  | 2004 |     | 2005 |   | 2006  |  | 2007 |       | 2008 |   | After2008 |  | Total
|Debt obligations                   |  | $    | 73  |      | $ | 283   |  | $    | 204   |      | $ |          |  | $     |    |  | $ |      |  | $ | 560  
|Operating leases                   |  |      | 499 |      |   | 1,573 |  |      | 1,379 |      |   | 1,087     |  |       | 931 |  |   | 3,120 |  |   | 8,589
|Unconditional purchase obligations |  |      | 365 |      |   | 359   |  |      |      |      |   |          |  |       |    |  |   |      |  |   | 724  
|                                   |  |      |     |      |   |       |  |      |       |      |   |           |  |       |     |  |   |       |  |   |      
|Total                              |  | $    | 937 |      | $ | 2,215 |  | $    | 1,583 |      | $ | 1,087     |  | $     | 931 |  | $ | 3,120 |  | $ | 9,873
|                                   |  |      |     |      |   |       |  |      |       |      |   |           |  |       |     |  |   |       |  |   |      



The amounts above will
be offset by sublease payments of $52,000 in 2004 and $34,000 in 2005.



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 new and rapidly
evolving technology markets like ours. We incurred net losses of $9.2 million, $20.9 million, and $114.2 million in 2003, 2002, and 2001, respectively. As of September 30, 2004, we had incurred cumulative net losses of $285.9 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.



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We expect to continue making strategic investments and acquisitions, 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. Acquisitions of companies, divisions of companies, or products, including our acquisitions of Valicert, Incubator, and Corvigo
entail numerous risks, including:



| | potential inability to successfully integrate acquired operations and products or to realize cost savings or other anticipated benefits from integration;
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| | diversion of managements attention;
|- | ------------------------------------



| | loss of key employees of acquired operations;
|- | ---------------------------------------------



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



| | integrating technologies and product lines;
|- | -------------------------------------------



| | the difficulty of assimilating geographically dispersed operations and personnel of the acquired companies;
|- | -----------------------------------------------------------------------------------------------------------



| | the potential disruption of our ongoing business;
|- | -------------------------------------------------



| | expenses related to such integration;
|- | -------------------------------------



| | the correct assessment of 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;
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | the impairment of relationships with employees and customers of either an acquired company or our business; and
|- | ---------------------------------------------------------------------------------------------------------------



| | the potential unknown liabilities associated with acquired business.
|- | --------------------------------------------------------------------



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.



If we do not successfully optimize our marketing and distribution capacity, our business
could be harmed.



If we do not optimize our methods of
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 product performance
and integration, platform coverage, worldwide sales infrastructure and 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



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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.



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 the number of 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.



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. For the three and nine months ended September 30, 2004 and 2003, respectively, no single customer
comprised 10% or more of our revenue. During the three months ended September 30, 2004 and 2003, five customers comprised approximately 25% and 26% of our revenue, respectively. For the nine months ended September 30, 2004 and 2003, five customers
comprised approximately 11% and 17% 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. In addition, we have experienced, and expect to continue to experience, fluctuations in revenue and operating results from quarter to quarter for other reasons, including, but not limited
to:



| |  | target customers electing to adopt and implement our technology;
| | - | ----------------------------------------------------------------



| |  | the substantial decrease in information technology spending in general, and among our target customers in particular;
| | - | ---------------------------------------------------------------------------------------------------------------------



| |  | customers choosing to delay their purchase commitments or purchase in smaller amounts than expected due to a general downturn in the economy;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to continue to license our patents, the timing of such licenses, and the costs necessary to defend our patents;
| | - | ---------------------------------------------------------------------------------------------------------------------------



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| |  | the amount and timing of operating costs and capital expenditures relating to our business, operations and infrastructure;
| | - | --------------------------------------------------------------------------------------------------------------------------



| |  | our ability to accurately estimate and control costs;
| | - | -----------------------------------------------------



| |  | our ability to timely collect fees owed by customers;
| | - | -----------------------------------------------------



| |  | 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; and
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | acquisitions that we complete or propose.
| | - | -----------------------------------------



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 one or
more future quarters may fail to meet the expectations of securities analysts or 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.



Economic conditions 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.



In addition, the financial, political, economic and other uncertainties
following the terrorist attacks upon the United States and the United States involvement in Iraq have led to a further weakening of the global economy, and have created an uncertain economic environment. We cannot predict the impact of these
events, any subsequent terrorist acts or any related military action, on our customers or business. Subsequent terrorist acts and/or the threat of future outbreak or continued escalation of hostilities involving the United States or other countries
could adversely affect spending on information technology and on our software license revenue, as well as have an adverse effect on our business, financial condition or results of operations.



Companies changes to their procurement cycles in response to the Sarbanes-Oxley Act
of 2002, may delay sales of our products.



Many companies
have recently instituted changes to their corporate governance practices, internal control policies and audit committee procedures in response to the Sarbanes-Oxley Act of 2002. These changes, in turn, may require increased oversight by these
companies of their procurement practices. To the extent our potential customers must direct additional management attention and resources to their procurement processes, our sales cycle could lengthen and our revenue could be adversely affected.



Our stock price could be adversely affected if we are unable 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.



Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and beginning with our Annual Report on Form 10-K for the year
ending December 31, 2004, our management will be required to report on, and our independent auditors to attest to, the effectiveness of our internal controls over financial reporting as of December 31, 2004. The rules governing the standards that
must be met are new and complex, and require significant documentation, testing, and possible remediation. We are currently in the process of reviewing, documenting and testing our internal controls over financial reporting, which has and will
likely continue to result in increased expenses and the devotion of significant management and other internal resources. 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



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reporting. In addition, in connection with the attestation process by our independent auditors, we may encounter 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, or if our independent auditors are
unable to provide an unqualified report on our assessment, 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.



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



The 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 provides for a classified Board of Directors and prohibits
stockholder action by written consent. These provisions require 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. This could have the effect of delaying, deferring or preventing a change in control. The issuance of preferred
stock also could effectively limit the voting power of the holders of our common stock.



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.



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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.



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.



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 (other than purchasers of our initial public offering) from August 6, 1999 to October 18, 2000. The case is now pending in the United States District Court for the Southern District of New York. In September
2004, the Court granted plaintiffs motion for leave to file a third amended complaint, and Tumbleweed filed a motion to dismiss this case pursuant to Fed. R. Civ. P. 12(b). 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 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 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 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. The loss of the services of any of our executive officers or other key employees, including recent additions to our management team as a result of our acquisitions of Incubator and Corvigo, could
significantly delay or prevent the achievement of our development and strategic objectives. We do not have long-term employment agreements with any of our key personnel. The loss of services of any of our executive officers or other key personnel
could significantly harm our business and prospects.



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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 Tumbleweeds international customers accounted for 11% and 2% of our revenues for the three months ended September 30, 2004 and 2003, respectively and 11% and 5% of our revenues for the nine months ended September 30, 2004 and 2003,
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.



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, 2004, none of our cash
equivalents were subject to market risk.



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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, evaluated the
effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act) as of September 30, 2004, and, based on that evaluation, our
chief executive officer and chief financial officer concluded that, as of September, 30, 2004, 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 we file under the Exchange Act



(b) Changes in internal controls.



There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(d) and 15d-15(d) under the Exchange Act) during the three months ended September 30, 2004 that have materially
affected, or are reasonably likely to materially affect, our internal control over financial reporting.



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 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 (other than purchasers of our initial public offering) from
August 6, 1999 to October 18, 2000. The case is now pending in the United States District Court for the Southern District of New York. In September 2004, the Court granted plaintiffs motion for leave to file a third amended complaint, and
Tumbleweed filed a motion to dismiss this case pursuant to Fed. R. Civ. P. 12(b). 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 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.



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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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ITEM 6EXHIBITS AND REPORTS ON FORM 8-K



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                                                                                                        
|              | 
|31.1          |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|              | 
|31.2          |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, 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 (File No. 79687), filed June 29, 1999.
|--- | ----------------------------------------------------------------------------------------------------------



b. Reports on Form 8-K:



On October 21, 2004, we filed a report on Form 8-K, which announced our financial results for the three months and nine
months ended September 30, 2004.



On July 22, 2004, we filed a
report on Form 8-K, which announced our financial results for the three months and six months ended June 30, 2004.



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SIGNATURES



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



|                       |  |                                 |  |                                                                                                 
|---------------------- |  | ------------------------------- |  | ------------------------------------------------------------------------------------------------
|                       |  | TUMBLEWEED COMMUNICATIONS CORP.
|                       |  |                                
|Date: November 9, 2004 |  | By:                             |  | /s/ JEFFREY C. SMITH                                                                            
|                       |  |                                 |  | Jeffrey C. Smith Chairman of the Board and Chief Executive Officer (Principal Executive Officer)



|                       |  |     |  |                                                                                                                                              
|---------------------- |  | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------
|Date: November 9, 2004 |  | 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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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                                                                                                        
|              | 
|31.1          |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|              | 
|31.2          |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, 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 (File No. 79687), filed June 29, 1999.
|--- | ----------------------------------------------------------------------------------------------------------



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