##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
 For the quarterly period ended September 30, 2006
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
 For the transition period from  to
 Commission File Number: 0-17995
 ZIX CORPORATION
 (Exact Name of Registrant as Specified in its Charter)
 Texas
(State of Incorporation)
    
    75-2216818
(I.R.S. Employer Identification Number)
 2711 North Haskell Avenue
Suite 2200, LB 36
Dallas, Texas 75204-2960
(Address of Principal Executive Offices)
 (214) 370-2000
(Registrants Telephone Number, Including Area Code)
 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the Registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o
 Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,
or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in
Rule 12b-2 of the Exchange Act. (Check one):
 Large accelerated filer o Accelerated filer þ Non-accelerated filer o
 Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act). Yes o No þ
 Indicate the number of shares outstanding of each of the issuers classes of common stock, as of
the latest practicable date.
 Class
Common Stock, par value $.01 per share
    
    
    

Outstanding
at November 1, 2006

59,638,839




---



##### 



INDEX
 PageNumberPART  FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets at September 30, 2006 (unaudited) and December 31, 2005 (audited)
    
    iiCondensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005
    
    iiiCondensed Consolidated Statement of Stockholders Equity for the nine months ended September 30, 2006
    
    ivCondensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005
    
    vNotes to Condensed Consolidated Financial Statements
    
    1Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    20Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    38Item 4. Controls and Procedures
    
    
    38PART II-OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    39Item 1A. Risk Factors
    
    
    39Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    45Item 3. Defaults Upon Senior Securities
    
    
    45Item 4. Submission of Matters to a Vote of Security Holders
    
    
    46Item 5. Other Information
    
    
    46Item 6. Exhibits
    
    
    46SubleaseLetter of AgreementCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO and CFO Pursuant to Section 906
  i




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ZIX CORPORATION
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 September 30,
    
    
    December 31,2006
    
    
    2005(Unaudited)
    
    
    (Audited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    14,842,000
    
    
    $
    20,240,000Restricted cash
    
    
    
    
    
    
    5,100,000Receivables, net
    
    
    637,000
    
    
    
    149,000Prepaid and other current assets
    
    
    1,586,000
    
    
    
    1,845,000Total current assets
    
    
    17,065,000
    
    
    
    27,334,000Restricted cash
    
    
    35,000
    
    
    
    35,000Property and equipment, net
    
    
    2,676,000
    
    
    
    3,652,000Intangible assets, net
    
    
    93,000
    
    
    
    559,000Goodwill
    
    
    2,161,000
    
    
    
    2,161,000Deferred financing costs and other assets
    
    
    96,000
    
    
    
    374,000$
    22,126,000
    
    
    $
    34,115,000LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,113,000
    
    
    $
    1,313,000Accrued expenses
    
    
    3,076,000
    
    
    
    3,749,000Deferred revenue
    
    
    7,751,000
    
    
    
    7,087,000Customer deposits
    
    
    2,024,000
    
    
    
    1,000,000Capital lease obligations
    
    
    
    
    
    
    165,000Promissory note payable
    
    
    2,548,000
    
    
    
    Short-term note payable
    
    
    37,000
    
    
    
    268,000Convertible promissory note payable
    
    
    
    
    
    
    4,404,000Total current liabilities
    
    
    16,549,000
    
    
    
    17,986,000Long-term liabilities:Deferred revenue
    
    
    1,670,000
    
    
    
    1,261,000Derivative liabilities
    
    
    2,110,000
    
    
    
    Customer deposits
    
    
    
    
    
    
    2,000,000Promissory note payable
    
    
    
    
    
    
    2,226,000Deferred rent
    
    
    343,000
    
    
    
    245,000Total long-term liabilities
    
    
    4,123,000
    
    
    
    5,732,00020,672,000
    
    
    
    23,718,000Contingencies (Note 16)Stockholders equity:Preferred stock, $1 par value, 10,000,000 shares authorized; none issued and outstanding
    
    
    
    
    
    
    Common stock, $0.01 par value, 175,000,000 shares authorized; 61,966,020 issued and
59,638,839 outstanding in 2006 and 51,932,561 issued and 49,605,380 outstanding in 2005
    
    
    620,000
    
    
    
    519,000Additional paid-in capital
    
    
    315,528,000
    
    
    
    308,461,000Treasury stock, at cost; 2,327,181 common shares in 2006 and 2005
    
    
    (11,507,000
    )
    
    
    (11,507,000
    )Accumulated deficit
    
    
    (303,187,000
    )
    
    
    (287,076,000
    )Total stockholders equity
    
    
    1,454,000
    
    
    
    10,397,000$
    22,126,000
    
    
    $
    34,115,000
  ii




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##### Table of Contents



ZIX CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
  Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues:Services
    
    $
    4,710,000
    
    
    $
    3,467,000
    
    
    $
    12,814,000
    
    
    $
    9,964,000Hardware
    
    
    
    
    
    
    17,000
    
    
    
    
    
    
    
    443,000Software
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    109,000Total revenues
    
    
    4,710,000
    
    
    
    3,484,000
    
    
    
    12,814,000
    
    
    
    10,516,000Cost of revenues
    
    
    3,131,000
    
    
    
    3,580,000
    
    
    
    9,596,000
    
    
    
    10,979,000Gross margin (loss)
    
    
    1,579,000
    
    
    
    (96,000
    )
    
    
    3,218,000
    
    
    
    (463,000
    )Operating expenses:Research and development expenses
    
    
    1,630,000
    
    
    
    1,495,000
    
    
    
    4,851,000
    
    
    
    5,005,000Selling, general and administrative expenses
    
    
    5,210,000
    
    
    
    6,192,000
    
    
    
    18,351,000
    
    
    
    20,253,000Customer deposit forfeiture
    
    
    
    
    
    
    
    
    
    
    (1,000,000
    )
    
    
    (960,000
    )(Gain) loss on sale of product lines
    
    
    (11,000
    )
    
    
    4,649,000
    
    
    
    (11,000
    )
    
    
    3,699,000Asset impairment charge
    
    
    125,000
    
    
    
    
    
    
    
    125,000
    
    
    
    Total operating expenses
    
    
    6,954,000
    
    
    
    12,336,000
    
    
    
    22,316,000
    
    
    
    27,997,000Operating loss
    
    
    (5,375,000
    )
    
    
    (12,432,000
    )
    
    
    (19,098,000
    )
    
    
    (28,460,000
    )Other (expense) income:Investment and other income
    
    
    229,000
    
    
    
    178,000
    
    
    
    740,000
    
    
    
    464,000Interest expense
    
    
    (114,000
    )
    
    
    (2,205,000
    )
    
    
    (1,009,000
    )
    
    
    (5,031,000
    )Gain on derivative liabilities
    
    
    1,120,000
    
    
    
    
    
    
    
    4,050,000
    
    
    
    Loss on extinguishment of convertible debt
    
    
    
    
    
    
    
    
    
    
    (871,000
    )
    
    
    Total other (expense) income
    
    
    1,235,000
    
    
    
    (2,027,000
    )
    
    
    2,910,000
    
    
    
    (4,567,000
    )Loss before income taxes
    
    
    (4,140,000
    )
    
    
    (14,459,000
    )
    
    
    (16,188,000
    )
    
    
    (33,027,000
    )Income tax benefit (expense)
    
    
    (11,000
    )
    
    
    (22,000
    )
    
    
    77,000
    
    
    
    59,000Net loss
    
    $
    (4,151,000
    )
    
    $
    (14,481,000
    )
    
    $
    (16,111,000
    )
    
    $
    (32,968,000
    )Basic and diluted loss per common share
    
    $
    (0.07
    )
    
    $
    (0.40
    )
    
    $
    (0.29
    )
    
    $
    (0.98
    )Basic and diluted weighted average common
shares outstanding
    
    
    59,638,839
    
    
    
    36,499,291
    
    
    
    56,201,207
    
    
    
    33,744,143
  iii




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##### Table of Contents



ZIX CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY
  Stockholders EquityAdditional
    
    
    
    
    
    
    
    
    
    
    TotalCommon Stock
    
    
    Paid-In
    
    
    Treasury
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Deficit
    
    
    EquityBalance, January 1, 2006
    
    
    51,932,561
    
    
    $
    519,000
    
    
    $
    308,461,000
    
    
    $
    (11,507,000
    )
    
    $
    (287,076,000
    )
    
    $
    10,397,000Issuance of common stock
and related warrants upon
private investment (net
of issuance costs)
    
    
    9,930,000
    
    
    
    100,000
    
    
    
    4,648,000
    
    
    
    
    
    
    
    
    
    
    
    4,748,000Common stock issued to
employees for
compensation in lieu of
cash
    
    
    82,196
    
    
    
    1,000
    
    
    
    156,000
    
    
    
    
    
    
    
    
    
    
    
    157,000Common stock issued in
lieu of cash for
third-party services
    
    
    21,263
    
    
    
    
    
    
    
    30,000
    
    
    
    
    
    
    
    
    
    
    
    30,000Employee share-based
compensation costs
    
    
    
    
    
    
    
    
    
    
    2,008,000
    
    
    
    
    
    
    
    
    
    
    
    2,008,000Valuation of additional
warrants issued relating
to the convertible
promissory notes payable
    
    
    
    
    
    
    
    
    
    
    50,000
    
    
    
    
    
    
    
    
    
    
    
    50,000Valuation of beneficial
conversion feature in
convertible promissory
note resulting from the
private placement of
common stock
    
    
    
    
    
    
    
    
    
    
    459,000
    
    
    
    
    
    
    
    
    
    
    
    459,000Valuation of additional
anti-dilutive warrants
issued upon private
placement of common stock
    
    
    
    
    
    
    
    
    
    
    74,000
    
    
    
    
    
    
    
    
    
    
    
    74,000Valuation of additional
warrants issued upon
retirement of convertible
promissory note
    
    
    
    
    
    
    
    
    
    
    6,000
    
    
    
    
    
    
    
    
    
    
    
    6,000Reversal of unamortized
valuation of beneficial
conversion feature upon
retirement of convertible
promissory note
    
    
    
    
    
    
    
    
    
    
    (365,000
    )
    
    
    
    
    
    
    
    
    
    
    (365,000
    )Other
    
    
    
    
    
    
    
    
    
    
    1,000
    
    
    
    
    
    
    
    
    
    
    
    1,000Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,111,000
    )
    
    
    (16,111,000
    )Balance, September 30, 2006
    
    
    61,966,020
    
    
    $
    620,000
    
    
    $
    315,528,000
    
    
    $
    (11,507,000
    )
    
    $
    (303,187,000
    )
    
    $
    1,454,000
  iv




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##### Table of Contents



ZIX CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
  Nine Months Ended September 30,2006
    
    
    2005Operating activities:Net loss
    
    $
    (16,111,000
    )
    
    $
    (32,968,000
    )Non-cash items in net loss:Depreciation and amortization
    
    
    2,195,000
    
    
    
    3,246,000Amortization of debt discount / premium, financing costs and other
    
    
    797,000
    
    
    
    4,053,000Value of additional warrants issued
    
    
    10,000
    
    
    
    Common stock issued to employees and non-employee in lieu of cash
    
    
    187,000
    
    
    
    1,012,000Loss on extinguishment of convertible debt
    
    
    871,000
    
    
    
    Gain on derivative liabilities
    
    
    (4,050,000
    )
    
    
    Employee share-based compensation costs
    
    
    2,008,000
    
    
    
    Customer deposit forfeiture
    
    
    (1,000,000
    )
    
    
    (960,000
    )Changes in deferred taxes
    
    
    (96,000
    )
    
    
    Asset impairment charge
    
    
    125,000
    
    
    
    Common stock issued in lieu of cash interest payments
    
    
    
    
    
    
    608,000Non-employee stock-based compensation costs
    
    
    1,000
    
    
    
    96,000(Gain) loss on sale of product lines
    
    
    (11,000
    )
    
    
    3,699,000Changes in operating assets and liabilities:Accounts receivable
    
    
    (488,000
    )
    
    
    339,000Other assets
    
    
    278,000
    
    
    
    686,000Accounts payable
    
    
    (73,000
    )
    
    
    (549,000
    )Deferred revenue
    
    
    1,073,000
    
    
    
    2,233,000Accrued and other liabilities
    
    
    (586,000
    )
    
    
    (679,000
    )Net cash used by operating activities
    
    
    (14,870,000
    )
    
    
    (19,184,000
    )Investing activities:Purchases of property and equipment
    
    
    (1,024,000
    )
    
    
    (1,299,000
    )Sales and maturities of marketable securities
    
    
    
    
    
    
    16,000,000Purchase of restricted cash investment
    
    
    
    
    
    
    (39,000
    )Proceeds from restricted cash investments
    
    
    5,100,000
    
    
    
    Proceeds from sale of product lines
    
    
    11,000
    
    
    
    2,809,000Net cash provided by investing activities
    
    
    4,087,000
    
    
    
    17,471,000Financing activities:Proceeds from private placement of common stock
    
    
    11,817,000
    
    
    
    15,016,000Payment of expenses relating to private placement of common stock
    
    
    (836,000
    )
    
    
    (333,000
    )Payment of convertible debt
    
    
    (5,000,000
    )
    
    
    Payment of premium on convertible debt
    
    
    (200,000
    )
    
    
    Payment of short-term note payable, capital leases and other
    
    
    (396,000
    )
    
    
    (401,000
    )Proceeds from exercise of stock options
    
    
    
    
    
    
    28,000Proceeds from exercise of warrants
    
    
    
    
    
    
    1,355,000Other
    
    
    
    
    
    
    (28,000
    )Net cash provided by financing activities
    
    
    5,385,000
    
    
    
    15,637,000(Decrease) increase in cash and cash equivalents
    
    
    (5,398,000
    )
    
    
    13,924,000Cash and cash equivalents, beginning of period
    
    
    20,240,000
    
    
    
    3,856,000Cash and cash equivalents, end of period
    
    $
    14,842,000
    
    
    $
    17,780,000
  v




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##### Table of Contents



ZIX CORPORATION
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  1. Basis of Presentation
  2. Company Overview and Liquidity
    Company History
  
    
    ZixVPM (Virtual Private Messenger): an e-messaging gateway service that
provides company-wide privacy protection for inbound and outbound email communications.
    
    ZixAuditor: an assessment service used to analyze email traffic patterns and
monitor compliance with corporate and regulatory policies.
    
    ZixPort: a secure Web-messaging portal.
   1




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##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30, 2006
    
    
    September 30, 2006Cost of revenues
    
    $
    44,000
    
    
    $
    47,000Research and development expenses
    
    
    79,000
    
    
    
    92,000Selling, general and administrative expenses
    
    
    172,000
    
    
    
    501,000Total one-time termination expense
    
    $
    295,000
    
    
    $
    640,000
  Three Months Ended
    
    
    Nine Months EndedSeptember 30, 2006
    
    
    September 30, 2006Email Encryption
    
    $
    128,000
    
    
    $
    157,000e-Prescribing
    
    
    112,000
    
    
    
    250,000Corporate
    
    
    55,000
    
    
    
    233,000Total one-time termination expense
    
    $
    295,000
    
    
    $
    640,000
  2




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##### Table of Contents



3. Revenue and Significant Customers
 Software
Revenue Recognition, Modification of SOP 97-2, Software Revenue Recognition, With respect
to Certain Transactions, Revenue Arrangements
with Multiple Deliverables, Revenue Recognition in Financial Statements,
   3




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##### Table of Contents



4. Segment Information
    4




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##### Table of Contents



Three Months Ended September 30, 2006
    
    
    Three Months Ended September 30, 2005Email
    
    
    e-
    
    
    
    
    
    
    
    
    
    
    Email
    
    
    e-Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    Total
    
    
    Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    TotalRevenues
    
    $
    3,585,000
    
    
    $
    1,125,000
    
    
    $
    
    
    
    $
    4,710,000
    
    
    $
    2,687,000
    
    
    $
    662,000
    
    
    $
    135,000
    
    
    $
    3,484,000Cost of revenues
    
    
    1,297,000
    
    
    
    1,834,000
    
    
    
    
    
    
    
    3,131,000
    
    
    
    1,284,000
    
    
    
    1,894,000
    
    
    
    402,000
    
    
    
    3,580,000Gross margin (loss)
    
    
    2,288,000
    
    
    
    (709,000
    )
    
    
    
    
    
    
    1,579,000
    
    
    
    1,403,000
    
    
    
    (1,232,000
    )
    
    
    (267,000
    )
    
    
    (96,000
    )Direct expenses
    
    
    2,703,000
    
    
    
    2,452,000
    
    
    
    
    
    
    
    5,155,000
    
    
    
    3,021,000
    
    
    
    2,267,000
    
    
    
    225,000
    
    
    
    5,513,000Segment loss
    
    
    (415,000
    )
    
    
    (3,161,000
    )
    
    
    
    
    
    
    (3,576,000
    )
    
    
    (1,618,000
    )
    
    
    (3,499,000
    )
    
    
    (492,000
    )
    
    
    (5,609,000
    )Unallocated
(expense) / income:Marketing, general
and administrative
expense
    
    
    
    
    
    
    
    
    
    
    (1,685,000
    )
    
    
    (1,685,000
    )
    
    
    
    
    
    
    
    
    
    
    (2,174,000
    )
    
    
    (2,174,000
    )Gain (loss) on
sale of product
line
    
    
    
    
    
    
    
    
    
    
    11,000
    
    
    
    11,000
    
    
    
    
    
    
    
    
    
    
    
    (4,649,000
    )
    
    
    (4,649,000
    )Asset impairment
charge
    
    
    
    
    
    
    
    
    
    
    (125,000
    )
    
    
    (125,000
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Customer deposit
forfeiture
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Gain on derivatives
    
    
    
    
    
    
    
    
    
    
    1,120,000
    
    
    
    1,120,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loss on
extinguishment of
debt
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Investment and
other income
    
    
    
    
    
    
    
    
    
    
    229,000
    
    
    
    229,000
    
    
    
    
    
    
    
    
    
    
    
    178,000
    
    
    
    178,000Interest expense
    
    
    
    
    
    
    
    
    
    
    (114,000
    )
    
    
    (114,000
    )
    
    
    
    
    
    
    
    
    
    
    (2,205,000
    )
    
    
    (2,205,000
    )Total unallocated
    
    
    
    
    
    
    
    
    
    
    (564,000
    )
    
    
    (564,000
    )
    
    
    
    
    
    
    
    
    
    
    (8,850,000
    )
    
    
    (8,850,000
    )Loss before income
taxes
    
    $
    (415,000
    )
    
    $
    (3,161,000
    )
    
    $
    (564,000
    )
    
    $
    (4,140,000
    )
    
    $
    (1,618,000
    )
    
    $
    (3,499,000
    )
    
    $
    (9,342,000
    )
    
    $
    (14,459,000
    )
 Nine Months Ended September 30, 2006
    
    
    Nine Months Ended September 30, 2005Email
    
    
    e-
    
    
    
    
    
    
    
    
    
    
    Email
    
    
    e-Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    Total
    
    
    Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    TotalRevenues
    
    $
    10,287,000
    
    
    $
    2,527,000
    
    
    $
    
    
    
    $
    12,814,000
    
    
    $
    7,164,000
    
    
    $
    2,376,000
    
    
    $
    976,000
    
    
    $
    10,516,000Cost of revenues
    
    
    4,082,000
    
    
    
    5,514,000
    
    
    
    
    
    
    
    9,596,000
    
    
    
    3,948,000
    
    
    
    5,425,000
    
    
    
    1,606,000
    
    
    
    10,979,000Gross margin (loss)
    
    
    6,205,000
    
    
    
    (2,987,000
    )
    
    
    
    
    
    
    3,218,000
    
    
    
    3,216,000
    
    
    
    (3,049,000
    )
    
    
    (630,000
    )
    
    
    (463,000
    )Direct expenses
    
    
    8,426,000
    
    
    
    7,920,000
    
    
    
    
    
    
    
    16,346,000
    
    
    
    9,136,000
    
    
    
    7,199,000
    
    
    
    1,175,000
    
    
    
    17,510,000Segment loss
    
    
    (2,221,000
    )
    
    
    (10,907,000
    )
    
    
    
    
    
    
    (13,128,000
    )
    
    
    (5,920,000
    )
    
    
    (10,248,000
    )
    
    
    (1,805,000
    )
    
    
    (17,973,000
    )Unallocated
(expense) / income:Marketing, general
and administrative
expense
    
    
    
    
    
    
    
    
    
    
    (6,856,000
    )
    
    
    (6,856,000
    )
    
    
    
    
    
    
    
    
    
    
    (7,748,000
    )
    
    
    (7,748,000
    )Gain (loss) on
sales of product
line
    
    
    
    
    
    
    
    
    
    
    11,000
    
    
    
    11,000
    
    
    
    
    
    
    
    
    
    
    
    (3,699,000
    )
    
    
    (3,699,000
    )Asset impairment
charge
    
    
    
    
    
    
    
    
    
    
    (125,000
    )
    
    
    (125,000
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Customer deposit
forfeiture
    
    
    
    
    
    
    
    
    
    
    1,000,000
    
    
    
    1,000,000
    
    
    
    
    
    
    
    
    
    
    
    960,000
    
    
    
    960,000Gain on derivatives
    
    
    
    
    
    
    
    
    
    
    4,050,000
    
    
    
    4,050,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loss on
extinguishment of
debt
    
    
    
    
    
    
    
    
    
    
    (871,000
    )
    
    
    (871,000
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Investment and
other income
    
    
    
    
    
    
    
    
    
    
    740,000
    
    
    
    740,000
    
    
    
    
    
    
    
    
    
    
    
    464,000
    
    
    
    464,000Interest expense
    
    
    
    
    
    
    
    
    
    
    (1,009,000
    )
    
    
    (1,009,000
    )
    
    
    
    
    
    
    
    
    
    
    (5,031,000
    )
    
    
    (5,031,000
    )Total unallocated
    
    
    
    
    
    
    
    
    
    
    (3,060,000
    )
    
    
    (3,060,000
    )
    
    
    
    
    
    
    
    
    
    
    (15,054,000
    )
    
    
    (15,054,000
    )Loss before income
taxes
    
    $
    (2,221,000
    )
    
    $
    (10,907,000
    )
    
    $
    (3,060,000
    )
    
    $
    (16,188,000
    )
    
    $
    (5,920,000
    )
    
    $
    (10,248,000
    )
    
    $
    (16,859,000
    )
    
    $
    (33,027,000
    )
  5




---



##### Table of Contents



September 30, 2006
    
    
    December 31, 2005Email
    
    
    e-
    
    
    
    
    
    
    
    
    
    
    Email
    
    
    e-Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    Total
    
    
    Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    TotalTotal assets
    
    $
    3,321,000
    
    
    $
    1,339,000
    
    
    $
    17,466,000
    
    
    $
    22,126,000
    
    
    $
    3,969,000
    
    
    $
    1,436,000
    
    
    $
    28,710,000
    
    
    $
    34,115,000
 5. Stock Options and Stock-based Employee Compensation
  Authorized
    
    Options
    
    Options
    
    AvailableShares
    
    Outstanding
    
    Vested
    
    for GrantEmployee and Director Stock Option Plans:1990 Stock Option Plan
    
    
    345,045
    
    
    
    2,500
    
    
    
    2,500
    
    
    
    1992 Stock Option Plan
    
    
    450,000
    
    
    
    65,666
    
    
    
    65,666
    
    
    
    1995 Long-term Incentive Plan
    
    
    1,825,000
    
    
    
    1,286,875
    
    
    
    958,125
    
    
    
    1996 Directors Stock Option Plan
    
    
    225,000
    
    
    
    60,000
    
    
    
    60,000
    
    
    
    1999 Directors Stock Option Plan
    
    
    975,000
    
    
    
    826,153
    
    
    
    770,625
    
    
    
    2001 Stock Option Plan
    
    
    2,525,000
    
    
    
    1,836,258
    
    
    
    965,966
    
    
    
    222,8322001 Employee Stock Option Plan
    
    
    300,000
    
    
    
    192,382
    
    
    
    171,571
    
    
    
    64,0712003 New Employee Stock Option Plan
    
    
    500,000
    
    
    
    431,267
    
    
    
    359,950
    
    
    
    68,7332004 Stock Option Plan
    
    
    3,200,000
    
    
    
    1,648,911
    
    
    
    673,786
    
    
    
    1,551,0892004 Directors Stock Option Plan
    
    
    300,000
    
    
    
    270,833
    
    
    
    181,667
    
    
    
    29,1672006 Directors Stock Option Plan
    
    
    750,000
    
    
    
    194,190
    
    
    
    32,365
    
    
    
    555,810Total employee and director stock option plans
    
    
    11,395,045
    
    
    
    6,815,035
    
    
    
    4,242,221
    
    
    
    2,491,702Executive Stock Option Agreements:John A. Ryan, former Chairman and CEO
    
    
    1,000,000
    
    
    
    1,000,000
    
    
    
    1,000,000
    
    
    
    Richard D. Spurr, Chairman, President and CEO
    
    
    650,000
    
    
    
    650,000
    
    
    
    561,364
    
    
    
    Other executive stock option agreements
    
    
    450,000
    
    
    
    125,000
    
    
    
    125,000
    
    
    
    Total executive stock option agreements
    
    
    2,100,000
    
    
    
    1,775,000
    
    
    
    1,686,364
    
    
    
    Other stock option agreements
    
    
    70,000
    
    
    
    70,000
    
    
    
    70,000
    
    
    
    Total
    
    
    13,565,045
    
    
    
    8,660,035
    
    
    
    5,998,585
    
    
    
    2,491,702
  Employee and Director Stock Option Plans
  Executive Stock Option Agreements:
 John A. Ryan
 Richard D. Spurr
 6




---



##### Table of Contents



Other Executive Stock Option Agreements
 Other Stock Option Agreements:
  Accounting Treatment
 Share-Based Payment
   Three Months Ended
    
    
    Nine Months EndedSeptember 30, 2006
    
    
    September 30, 2006Cost of revenues
    
    $
    33,000
    
    
    $
    96,000Research and development expenses
    
    
    30,000
    
    
    
    88,000Selling, general and administrative expenses
    
    
    505,000
    
    
    
    1,824,000Stock-based compensation expense
    
    $
    568,000
    
    
    $
    2,008,000
  Transition
Election Related to Accounting for the Tax Effects of Share-Based Payment Awards,
  7




---



##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30, 2005
    
    
    September 30, 2005Net loss, as reported
    
    $
    (14,481,000
    )
    
    $
    (32,968,000
    )Deduct pro forma stock compensation expense computed under the fair value method
    
    
    (1,383,000
    )
    
    
    (4,745,000
    )Pro forma net loss
    
    $
    (15,864,000
    )
    
    $
    (37,713,000
    )Basic and diluted loss per common share:As reported
    
    $
    (0.40
    )
    
    $
    (0.98
    )Pro forma
    
    $
    (0.43
    )
    
    $
    (1.12
    )
   Share Based Payment,
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Risk-free interest rate
    
    
    4.91
    %
    
    
    4.01
    %
    
    
    4.63
    %
    
    
    3.29
    %Expected option life
    
    5.9 years
    
    3.8 years
    
    5.8 years
    
    3.6 yearsExpected stock price volatility
    
    
    92.36
    %
    
    
    91.02
    %
    
    
    95.49
    %
    
    
    96.68
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Fair value of options granted
    
    $
    0.57
    
    
    $
    2.04
    
    
    $
    1.22
    
    
    $
    2.43
 Stock Option Activity
  WeightedWeighted
    
    
    AverageAverage
    
    
    Remaining
    
    
    AggregateExercise
    
    
    Contractual
    
    
    IntrinsicShares
    
    
    Price
    
    
    Term
    
    
    ValueOutstanding at January 1, 2006
    
    
    7,595,415
    
    
    $
    7.03Granted at market price
    
    
    15,000
    
    
    $
    1.93Granted above market price
    
    
    2,265,410
    
    
    $
    2.84Cancelled or expired
    
    
    (1,215,790
    )
    
    $
    5.67Exercised
    
    
    
    
    
    $
    Outstanding at September 30, 2006
    
    
    8,660,035
    
    
    $
    6.11
    
    
    
    6.46
    
    
    $
    Options exercisable at September 30, 2006
    
    
    5,998,585
    
    
    $
    7.14
    
    
    
    5.74
    
    
    $
    
   8




---



##### Table of Contents



Common Stock Issued in Lieu of Cash
  Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Common stock issued to
employees for compensation in
lieu of cash
    
    $
    
    
    
    $
    769,000
    
    
    $
    157,000
    
    
    $
    1,012,000Stock granted to third parties
    
    
    
    
    
    
    
    
    
    
    30,000
    
    
    
    Total
    
    $
    
    
    
    $
    769,000
    
    
    $
    187,000
    
    
    $
    1,012,000
 6. Supplemental Cash Flow Information
  Nine Months Ended September 30,2006
    
    
    2005Cash paid for interest
    
    $
    263,000
    
    
    $
    307,000Cash (refunded) paid for income tax
    
    $
    (21,000
    )
    
    $
    321,000Noncash investing and financing activities:Accrued expenses relating to purchase of fixed asset
    
    $
    127,000
    
    
    $
    Assets sold to customers as part of their subscription service
    
    $
    19,000
    
    
    $
    Accrued expenses related to private placement of common stock (Note 13)
    
    $
    72,000
    
    
    $
    (74,000
    )Value of additional warrants issued (Note 12)
    
    $
    130,000
    
    
    $
    Valuation of beneficial conversion, net of subsequent reversal (Note 12)
    
    $
    94,000
    
    
    $
    2,518,000Assets acquired on capital lease
    
    $
    
    
    
    $
    160,000Issuance of note receivable relating to the sale of Message Inspector
and Web Inspector product lines (Note 7)
    
    $
    
    
    
    $
    1,434,000Stock redemption of convertible promissory notes payable (Note 12)
    
    $
    
    
    
    $
    2,332,000Revaluation of warrants resulting from restructure of convertible
promissory notes payable (Note 12)
    
    $
    
    
    
    $
    (375,000
    )Insurance premiums financed by short-term note payable
    
    $
    
    
    
    $
    84,000
 7. Business Sales and Acquisitions
 Sale of Dr. Chart, a product of MyDocOnline
   9




---



##### Table of Contents



Net assets sold (liabilities transferred):Accounts receivable, net
    
    $
    34,000Equipment, net
    
    
    37,000Intangibles, net
    
    
    575,000Deferred revenue
    
    
    (739,000
    )Net
    
    
    (93,000
    )Goodwill
    
    
    4,797,000Net proceeds:Cash receivable
    
    
    150,000Note receivable, net
    
    
    Service obligation
    
    
    (30,000
    )Transaction fees
    
    
    (150,000
    )Net proceeds
    
    
    (47,000
    )Initial loss on sale of product line
    
    
    (4,734,000
    )Additional transaction fees recorded in fourth quarter 2005
    
    
    (17,000
    )Loss on sale of product line as of December 31, 2005
    
    
    (4,751,000
    )Payment received on fully reserved note receivable
    
    
    11,000Loss on sale of product line
    
    $
    (4,740,000
    )
   Sale of Web Inspector and Message Inspector Product Lines
   Net assets sold (liabilities transferred):Equipment, net
    
    $
    15,000Prepaid expenses
    
    
    165,000Intangibles, net
    
    
    1,499,000Initial deferred revenue
    
    
    (1,546,000
    )Subsequent additional transfer of deferred revenue, net
    
    
    (85,000
    )Net
    
    
    48,000Goodwill
    
    
    2,161,000Net proceeds:Cash
    
    
    2,126,000Note receivable, net
    
    
    1,435,000Transaction fees
    
    
    (317,000
    )Net proceeds
    
    
    3,244,000Gain on sale of product lines
    
    $
    1,035,000
 10




---



##### Table of Contents



8. Restricted Cash
  9. Accounts Receivable
 September 30,
    
    
    December 31,2006
    
    
    2005Gross trade accounts receivable
    
    $
    4,732,000
    
    
    $
    3,136,000Allowance for returns and doubtful accounts
    
    
    (139,000
    )
    
    
    (35,000
    )Billed but unpaid portion of deferred revenue
    
    
    (4,161,000
    )
    
    
    (2,969,000
    )Trade receivables, net
    
    
    432,000
    
    
    
    132,000Taxes receivable
    
    
    198,000
    
    
    
    Other receivable
    
    
    7,000
    
    
    
    17,000Total receivables, net
    
    $
    637,000
    
    
    $
    149,000
   10. Intangible Assets and Goodwill
  September 30, 2006
    
    
    December 31, 2005Accumulated
    
    
    
    
    
    
    
    
    
    
    AccumulatedCost
    
    
    Amortization
    
    
    Net
    
    
    Cost
    
    
    Amortization
    
    
    NetDeveloped technology
    
    $
    2,034,000
    
    
    $
    1,941,000
    
    
    $
    93,000
    
    
    $
    2,034,000
    
    
    $
    1,475,000
    
    
    $
    559,000
  11




---



##### Table of Contents



Three months ended December 31, 2006
    
    $
    70,0002007
    
    
    23,000Total
    
    $
    93,000
  11. Customer Deposit
    12. Notes Payable
  AdditionalDiscountfromWarrantsDecember 31,
    
    
    and
    
    
    Discount
    
    
    
    
    
    
    September 30,Stated
    
    
    Effective
    
    
    
    
    
    
    2005,
    
    
    Beneficial
    
    
    Amortization /
    
    
    
    
    
    
    2006,Interest
    
    
    Interest
    
    
    
    
    
    
    Net
    
    
    Conversion
    
    
    Reversal /
    
    
    Payments
    
    
    NetRate
    
    
    Rate
    
    
    Term
    
    
    Book Value
    
    
    Feature
    
    
    Write-off
    
    
    Made
    
    
    Book ValueConvertible
promissory note payable
    
    
    8.22
    %
    
    
    37.41
    %
    
    NA
    
    
    $
    4,404,000
    
    
    $
    (573,000
    )
    
    $
    1,169,000
    
    
    $
    (5,000,000
    )
    
    $
    Promissory note payable
    
    
    4.50
    %
    
    
    11.00
    %
    
    
    2007
    
    
    
    2,226,000
    
    
    
    
    
    
    
    322,000
    
    
    
    
    
    
    
    2,548,000Short-term promissory notes
    
    
    6.99
    %
    
    
    6.99
    %
    
    
    2006
    
    
    
    268,000
    
    
    
    
    
    
    
    
    
    
    
    (231,000
    )
    
    
    37,000Total notes payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    6,898,000
    
    
    $
    (573,000
    )
    
    $
    1,491,000
    
    
    $
    (5,231,000
    )
    
    $
    2,585,000
 12




---



##### Table of Contents



Convertible Promissory Notes Payable
    Accounting treatment of the amended convertible promissory notes payable
 Accounting for Derivative Financial instruments Indexed to, and Potentially Settled in a
Companys Own Stock Accounting for Convertible Debt and Debt Issued with Stock
Purchase Warrants.
 Accounting for Convertible Securities with Beneficial Conversion Features of Contingently
Adjustable Conversion Features Application of Issue No. 98-5 to Certain
Convertible Instruments
  2005 payment activity on the convertible promissory notes payable:
  13




---



##### Table of Contents



2005 and first quarter 2006 adjustments to the stock conversion price and warrant exercise
price
   Second
quarter 2006 convertible promissory note payable and related warrant activity
 
    
    Per anti-dilution terms included in the amended convertible promissory notes
payable, the Company issued additional warrants to purchases 264,718 shares of common
stock. These warrants expire on the following schedule: 22% in November 2006 and 2007,
10% in November 2008 and 46% in November 2009. The additional warrants were valued at
$74,000 using the BSOPM and recorded as discount against the outstanding note and
amortized to interest expense using the effective interest method.
    
    The exercise prices of the warrants relating to the convertible promissory
notes payable were reduced from a range of $1.44 to $5.24 to a range of $1.42 to $4.47.
    
    The conversion price of the outstanding convertible promissory notes payable
was reduced from $5.24 per share to $4.47 per share. The reduced conversion price
caused the Company to record the intrinsic value of a beneficial conversion feature as
the adjusted conversion price was reset to a price below the market price of the
Companys stock on the date the notes were originally issued (November 2, 2004). The
intrinsic value of the adjusted conversion price is $459,000 and was recorded as
additional discount on the remaining convertible promissory note payable and was
amortized to interest expense using the effective interest method.
  
    
    The Company retired the full $5,000,000 using restricted cash and paid a
$200,000 early payment premium plus accrued interest for a total payoff amount of
$5,259,000.
    
    In accordance with the terms of the note, the Company issued warrants to the
note holder to purchase an additional 782,998 shares of common stock at $4.47 per
share. 50% of these warrants expire in November 2006 and 50% expire in November 2007.
These warrants were valued at $6,000 using the BSOPM.
 14




---



##### Table of Contents



Early payment premium
    
    $
    200,000Write-off of unamortized discount
    
    
    449,000Write-off of unamortized financing costs
    
    
    216,000Value of warrants issued upon extinguishment
    
    
    6,000Loss on extinguishment of debt
    
    $
    871,000
   Activity during NineMonths Ended SeptemberDecember 31, 2005
    
    30, 2006
    
    September 30, 2006Additional
    
    
    
    
    
    
    
    
    
    AdjustedWarrants
    
    Exercise
    
    Warrants
    
    Exercise
    
    Warrants
    
    ExerciseWarrant Grants:
    
    Outstanding
    
    Price
    
    Issued
    
    Price Adjustment
    
    Outstanding
    
    PriceConvertible promissory notes payable, initial warrants
    
    
    450,422
    
    
    $
    5.38
    
    
    
    241,120
    
    
    $
    (0.91
    )
    
    
    691,542
    
    
    $
    4.47Re-pricing of initial warrants, Sept 23, 2005
    
    
    118,672
    
    
    
    2.15
    
    
    
    11,640
    
    
    
    (0.16
    )
    
    
    130,312
    
    
    
    1.99Re-pricing of initial warrants, Oct 28, 2005
    
    
    87,442
    
    
    
    1.82
    
    
    
    6,600
    
    
    
    (0.10
    )
    
    
    94,042
    
    
    
    1.72Re-pricing of initial warrants, Dec 1, 2005
    
    
    125,914
    
    
    
    1.69
    
    
    
    8,950
    
    
    
    (0.07
    )
    
    
    134,864
    
    
    
    1.62Re-pricing of initial warrants, Dec 9, 2005
    
    
    217,550
    
    
    
    1.44
    
    
    
    8,958
    
    
    
    (0.02
    )
    
    
    226,508
    
    
    
    1.42Additional warrants issued due to repricing for 2005 Private Placement
    
    
    115,244
    
    
    
    5.38
    
    
    
    17,246
    
    
    
    (0.91
    )
    
    
    132,490
    
    
    
    4.47Additional
warrants issued due to 2005 cash payments on convertible promissory notes payable
    
    
    795,590
    
    
    
    5.38
    
    
    
    21,257
    
    
    
    (0.91
    )
    
    
    816,847
    
    
    
    4.47Additional
warrants issued due to 2006 cash payments on convertible promissory notes payable
    
    
    
    
    
    
    
    
    
    
    782,998
    
    
    
    
    
    
    
    782,998
    
    
    
    4.47Warrants issued to the broker in conjunction with the note issuance
    
    
    166,667
    
    
    
    6.00
    
    
    
    
    
    
    
    
    
    
    
    166,667
    
    
    
    6.00Total
    
    
    2,077,501
    
    
    
    
    
    
    
    1,098,769
    
    
    
    
    
    
    
    3,176,270
  Effective
yield and interest expense
 Promissory Note Payable
  15




---



##### Table of Contents



Short-term Note Payable
  13. April 2006 Private Placement of Common Stock
     Accounting for Derivative Instruments and Hedging Activities Accounting for Derivative Financial instruments Indexed to, and Potentially Settled
in a Companys Own Stock The Effect of Liquidated damages Clause on
Freestanding Financial Instruments Subject to Issue No. 00-19 .
  Gross proceeds
    
    $
    11,817,000Less:Fair value of warrants and liquidated damages to investors
    
    
    (6,024,000
    )Liquidated damages for common stock
    
    
    (77,000
    )Potential future payments to brokers
    
    
    (60,000
    )Warrants issued to underwriters
    
    
    (199,000
    )Cash issuance costs
    
    
    (908,000
    )Proceeds allocated to common stock
    
    $
    4,549,000
 16




---



##### Table of Contents



Warrants issued to investors in the private placement and related liquidated damages
  Liquidated damages related to common stock
  Potential future payments to transaction underwriters
  Warrants issued to underwriters
 Common stock
  17




---



##### Table of Contents



(Gain)/April 5, 2006
    
    
    Loss on
    
    
    September 30, 2006Derivative Liability
    
    Fair Value
    
    
    Revaluation
    
    
    Fair ValueWarrants issued to investors and related liquidated damages
    
    $
    6,024,000
    
    
    $
    (4,038,000
    )
    
    $
    1,986,000Liquidated damages related to common stock
    
    
    77,000
    
    
    
    (16,000
    )
    
    
    61,000Potential future payments to transaction underwriters
    
    
    59,000
    
    
    
    4,000
    
    
    
    63,000Total
    
    $
    6,160,000
    
    
    $
    (4,050,000
    )
    
    $
    2,110,000
 14. Asset Impairments
  15. Earnings Per Share and Potential Dilution
   Three Months Ended September 30,
    
    Nine Months Ended September 30,2006
    
    2005
    
    2006
    
    2005Stock options (see Note 5)
    
    
    8,579,264
    
    
    
    8,136,794
    
    
    
    8,501,575
    
    
    
    8,087,683Warrants issued in relation to
debt and equity arrangements
    
    
    14,760,729
    
    
    
    3,918,502
    
    
    
    12,082,755
    
    
    
    3,810,345Shares issuable for conversion
of convertible promissory
notes payable (see Note 12)
    
    
    
    
    
    
    3,441,422
    
    
    
    658,878
    
    
    
    3,369,759Total antidilutive securities
excluded from earnings per
share calculation
    
    
    23,339,993
    
    
    
    15,496,718
    
    
    
    21,243,208
    
    
    
    15,267,787
  16. Contingencies
    18




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##### Table of Contents



19




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##### Table of Contents



ITEM 2.
 MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 Overview
    Developmental History
  
    
    ZixVPM (Virtual Private Messenger): an e-messaging gateway service that
provides company-wide privacy protection for inbound and outbound email communications.
    
    ZixAuditor: an assessment service used to analyze email traffic patterns and
monitor compliance with corporate and regulatory policies.
    
    ZixPort: a secure Web-messaging portal.
   20




---



##### Table of Contents



Critical Accounting Policies and Estimates
  Long-Lived
Assets
   Goodwill and Other Intangible Assets,
 21




---



##### Table of Contents



Deferred Tax Assets
 Derivative Liabilities Accounting for Derivative
Instruments and Hedging Activities Accounting for Derivative Financial
instruments Indexed to, and Potentially Settled in a Companys Own Stock The
Effect of Liquidated damages Clause on Freestanding Financial Instruments Subject to Issue No.
00-19 .
 Revenue Software Revenue Recognition; Modification of SOP 97-2, Software Revenue Recognition, With respect to Certain
Transactions; Revenue Arrangements with
Multiple Deliverables; Revenue Recognition in Financial Statements,
   22




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##### Table of Contents



Deferred Cost of Revenues
 Stock-based compensation Share-Based Payment Accounting for Stock Issued to Employees
  23




---



##### Table of Contents



Share Based Payment,
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Risk-free interest rate
    
    
    4.91
    %
    
    
    4.01
    %
    
    
    4.63
    %
    
    
    3.29
    %Expected option life
    
    5.9 years
    
    3.8 years
    
    5.8 years
    
    3.6 yearsExpected stock price volatility
    
    
    92.36
    %
    
    
    91.02
    %
    
    
    95.49
    %
    
    
    96.68
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Fair value of options granted
    
    $
    0.57
    
    
    $
    2.04
    
    
    $
    1.22
    
    
    $
    2.43
   Three Months Ended
    
    
    Nine Months EndedSeptember 30, 2005
    
    
    September 30, 2005Net loss, as reported
    
    $
    (14,481,000
    )
    
    $
    (32,968,000
    )Deduct pro forma stock compensation expense computed under the fair value method
    
    
    (1,383,000
    )
    
    
    (4,745,000
    )Pro forma net loss
    
    $
    (15,864,000
    )
    
    $
    (37,713,000
    )Basic and diluted loss per common share:As reported
    
    $
    (0.40
    )
    
    $
    (0.98
    )Pro forma
    
    $
    (0.43
    )
    
    $
    (1.12
    )
 Results of Operations
 Third Quarter 2006 Summary of Operations
 Financial Statement
 
    
    Revenue for the quarter ended September 30, 2006, was $4,710,000 from all products compared with $3,484,000 for the same
period 2005.
    
    Net loss for the quarter ended September 30, 2006, was $4,151,000 compared with $14,481,000 for the same period in 2005.
Included in the net loss for the quarter ended September 30, 2006, is a gain on revaluation of derivative liabilities of
$1,120,000. Included in the net loss for the quarter ended September 30, 2005 is a loss from the sale of a product line
of $4,649,000 and interest expense of $2,205,000 associated with debt restructuring.
    
    The Companys unrestricted cash balance was $14,842,000 on September 30, 2006.
    
    Cash used from operations in the quarter ended September 30, 2006 was $4,266,000, which is a $792,000 reduction in cash
used when compared to the second quarter of 2006 and a $1,745,000 reduction when compared to the third quarter of 2005.
 24




---



##### Table of Contents



Operations
 
    
    The Company secured new first-year orders in the quarter ended September 30, 2006, totaling $1,233,000 for its Email
Encryption services and maintained over 95% renewal rate of its Email Encryption customers.
    
    The Company deployed 460 new e-Prescribing devices to physicians under sponsorship arrangements with several large
insurance payors.
    
    The Company achieved approximately 1,284,000 electronic prescriptions transacted in the three months ended September 30,
2006, through its e-Prescribing service, which compares to 1,300,000 electronic prescriptions for the preceding quarter
in 2006.
 2006 Reduction in Force
  Revenues
  3-monthVariance
    
    
    
    
    
    
    
    
    
    
    9-monthVarianceThree Months Ended September 30,
    
    
    2006 vs. 2005
    
    
    Nine Months Ended September 30,
    
    
    2006 vs. 20052006
    
    
    2005
    
    
    $
    
    
    %
    
    
    2006
    
    
    2005
    
    
    $
    
    
    %Services
    
    $
    4,710,000
    
    
    $
    3,467,000
    
    
    $
    1,243,000
    
    
    
    36
    %
    
    $
    12,814,000
    
    
    $
    9,964,000
    
    
    $
    2,850,000
    
    
    
    29
    %Hardware
    
    
    
    
    
    
    17,000
    
    
    
    (17,000
    )
    
    
    (100
    %)
    
    
    
    
    
    
    443,000
    
    
    
    (443,000
    )
    
    
    (100
    %)Software
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    109,000
    
    
    
    (109,000
    )
    
    
    (100
    %)Total revenues
    
    $
    4,710,000
    
    
    $
    3,484,000
    
    
    $
    1,226,000
    
    
    
    35
    %
    
    $
    12,814,000
    
    
    $
    10,516,000
    
    
    $
    2,298,000
    
    
    
    22
    %
   3-month Variance
    
    
    
    
    
    
    
    
    
    
    9-month VarianceThree Months Ended, September 30
    
    
    2006 vs. 2005
    
    
    Nine Months Ended, September 30,
    
    
    2006 vs. 20052006
    
    
    2005
    
    
    $
    
    
    %
    
    
    2006
    
    
    2005
    
    
    $
    
    
    %Email Encryption
    
    $
    3,585,000
    
    
    $
    2,687,000
    
    
    $
    898,000
    
    
    
    33
    %
    
    $
    10,287,000
    
    
    $
    7,164,000
    
    
    $
    3,123,000
    
    
    
    44
    %e-Prescribing
    
    
    1,125,000
    
    
    
    662,000
    
    
    
    463,000
    
    
    
    70
    %
    
    
    2,527,000
    
    
    
    2,376,000
    
    
    
    151,000
    
    
    
    6
    %Subtotal before
divested products
or services
    
    
    4,710,000
    
    
    
    3,349,000
    
    
    
    1,361,000
    
    
    
    41
    %
    
    
    12,814,000
    
    
    
    9,540,000
    
    
    
    3,274,000
    
    
    
    34
    %MI/WI Products
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    646,000
    
    
    
    (646,000
    )
    
    
    (100
    %)Dr. Chart
    
    
    
    
    
    
    135,000
    
    
    
    (135,000
    )
    
    
    (100
    %)
    
    
    
    
    
    
    330,000
    
    
    
    (330,000
    )
    
    
    (100
    %)Subtotal divested
products or
services
    
    
    
    
    
    
    135,000
    
    
    
    (135,000
    )
    
    
    (100
    %)
    
    
    
    
    
    
    976,000
    
    
    
    (976,000
    )
    
    
    (100
    %)Total revenues
    
    $
    4,710,000
    
    
    $
    3,484,000
    
    
    $
    1,226,000
    
    
    
    35
    %
    
    $
    12,814,000
    
    
    $
    10,516,000
    
    
    $
    2,298,000
    
    
    
    22
    %
 Email Encryption 
 25




---



##### Table of Contents



e-Prescribing 
  Divested Products:
 Revenue Summary:
 26




---



##### Table of Contents



Revenue Indicators  Backlog, Orders, and Deployments
 Company-wide backlog 
   Email Encryption Orders 
 New First-Year Orders for theEmail Encryption ServiceThree month period ended:September 30, 2006
    
    $
    1,233,000June 30, 2006
    
    
    1,402,000March 31, 2006
    
    
    1,010,000December 31, 2005
    
    
    1,065,000Total new
first-year orders for the twelve
months ended September 30, 2006
    
    $
    4,710,000Total new first-year orders for the twelve
months ended September 30, 2005
    
    $
    5,774,000
  e-Prescribing Deployments and Active Users 
 27




---



##### Table of Contents



e-Prescribing Transaction and Usage Fees 
  Cost of Revenues
  3-month Variance
    
    
    
    
    
    
    
    
    
    
    9-month VarianceThree Months Ended, September 30,
    
    
    2006 vs. 2005
    
    
    Nine Months Ended, September 30,
    
    
    2006 vs. 20052006
    
    
    2005
    
    
    $
    
    
    %
    
    
    2006
    
    
    2005
    
    
    $
    
    
    %Email Encryption
    
    $
    1,297,000
    
    
    $
    1,284,000
    
    
    $
    13,000
    
    
    
    1
    %
    
    $
    4,082,000
    
    
    $
    3,948,000
    
    
    $
    134,000
    
    
    
    3
    %e-Prescribing
    
    
    1,834,000
    
    
    
    1,894,000
    
    
    
    (60,000
    )
    
    
    (3
    %)
    
    
    5,514,000
    
    
    
    5,425,000
    
    
    
    89,000
    
    
    
    2
    %Subtotal before
divested products or
services
    
    
    3,131,000
    
    
    
    3,178,000
    
    
    
    (47,000
    )
    
    
    (1
    %)
    
    
    9,596,000
    
    
    
    9,373,000
    
    
    
    223,000
    
    
    
    2
    %Divested products
(MI/WI and Dr. Chart)
    
    
    
    
    
    
    402,000
    
    
    
    (402,000
    )
    
    
    (100
    %)
    
    
    
    
    
    
    1,606,000
    
    
    
    (1,606,000
    )
    
    
    (100
    %)Total cost of revenues
    
    $
    3,131,000
    
    
    $
    3,580,000
    
    
    $
    (449,000
    )
    
    
    (13
    %)
    
    $
    9,596,000
    
    
    $
    10,979,000
    
    
    $
    (1,383,000
    )
    
    
    (13
    %)
  28




---



##### Table of Contents



Email Encryption 
 e-Prescribing 
 Divested Products 
 Research and Development Expenses
  3-month Variance
    
    
    
    
    
    
    
    
    
    9-month VarianceThree Months Ended, September 30,
    
    2006 vs. 2005
    
    Nine Months Ended, September 30,
    
    2006 vs. 20052006
    
    2005
    
    $
    
    %
    
    2006
    
    2005
    
    $
    

%Total research
and development
    
    $
    1,630,000
    
    
    $
    1,495,000
    
    
    $
    135,000
    
    
    
    9
    %
    
    $
    4,851,000
    
    
    $
    5,005,000
    
    
    $
    (154,000
    )
    
    
    (3
    %)
  29




---



##### Table of Contents



Selling, General and Administrative Expenses
  3-month Variance
    
    
    
    
    
    
    
    
    
    9-month VarianceThree Months Ended, September 30,
    
    2006 vs. 2005
    
    Nine Months Ended, September 30,
    
    2006 vs. 20052006
    
    2005
    
    $
    
    %
    
    2006
    
    2005
    
    $
    
    %Total selling,
general and
administrative
expenses
    
    $
    5,210,000
    
    
    $
    6,192,000
    
    
    $
    (982,000
    )
    
    
    (16
    %)
    
    $
    18,351,000
    
    
    $
    20,253,000
    
    
    $
    (1,902,000
    )
    
    
    (9
    %)
     Customer Deposit Forfeitures
  30




---



##### Table of Contents



Gain/Loss on Sale of Product Line
     Asset Impairments
  Investment and Other Income
  Interest Expense
   DiscountStated
    
    
    Amortization /
    
    
    Financing
    
    
    
    
    
    
    TotalInterest
    
    
    Premium
    
    
    Cost
    
    
    Warrants
    
    
    Intereston Notes
    
    
    Accretion
    
    
    Amortization
    
    
    Issued
    
    
    ExpenseConvertible promissory note payable
    
    $
    185,000
    
    
    $
    354,000
    
    
    $
    122,000
    
    
    $
    10,000
    
    
    $
    671,000Promissory note payable
    
    
    
    
    
    
    321,000
    
    
    
    
    
    
    
    
    
    
    
    321,000Short-term promissory note
    
    
    9,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,000Capital leases
    
    
    6,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,000Other
    
    
    2,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,000Total notes payable
    
    $
    202,000
    
    
    $
    675,000
    
    
    $
    122,000
    
    
    $
    10,000
    
    
    $
    1,009,000
 31




---



##### Table of Contents



DiscountStated
    
    
    Amortization /
    
    
    Financing
    
    
    
    
    
    
    TotalInterest
    
    
    Premium
    
    
    Cost
    
    
    Warrants
    
    
    Intereston Notes
    
    
    Accretion
    
    
    Amortization
    
    
    Issued
    
    
    ExpenseConvertible promissory note payable
    
    $
    890,000
    
    
    $
    3,190,000
    
    
    $
    635,000
    
    
    $
    
    
    
    $
    4,715,000Promissory note payable
    
    
    
    
    
    
    285,000
    
    
    
    
    
    
    
    
    
    
    
    285,000Short-term promissory note
    
    
    6,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,000Capital leases
    
    
    25,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    25,000Total notes payable
    
    $
    921,000
    
    
    $
    3,475,000
    
    
    $
    635,000
    
    
    $
    
    
    
    $
    5,031,000
   Gain on Valuation of Derivative Liability
  Income Taxes
   Liquidity and Capital Resources
 Overview
  32




---



##### Table of Contents




    
    New subscriptions (termed new first-year orders) for the Email Encryption service
    
    Renewal rates for the Email Encryption service
    
    New insurance payor sponsorships of the e-Prescribing service to physicians
    
    Successful adoption and usage of the e-Prescribing service by physicians
    
    Retention of the users (physicians) of the e-Prescribing service
    
    Future transaction fees (or related fees) associated with the use of the e-Prescribing service
    
    The ability to increase the business volume with reasonable cost increases
 Email Encryption
 e-Prescribing
  33




---



##### Table of Contents



Sources and Uses of Cash Summary
   Nine Months Ended, September 30,2006
    
    
    2005
    
    
    VarianceOperating Cash Receipts (Products existing on December 31, 2005)
    
    $
    13,803,000
    
    
    $
    11,457,000
    
    
    $
    2,346,000Operating Cash Receipts (Products divested in 2005)
    
    
    
    
    
    
    1,736,000
    
    
    
    (1,736,000
    )Net Operating Cash Spending
    
    
    (28,673,000
    )
    
    
    (32,377,000
    )
    
    
    3,704,000Net Cash Used by Operating Activities
    
    $
    (14,870,000
    )
    
    $
    (19,184,00
    )
    
    $
    4,314,000
    34




---



##### Table of Contents



Cash Sources
  
    
    contractual backlog
    
    Email Encryption growth and retention
    
    e-Prescribing growth and retention
    
    e-Prescribing transaction and performance-based fees
 Backlog
 Email
Encryption growth and retention
 e-Prescribing growth and retention
 e-Prescribing transaction and performance-based fees
 35




---



##### Table of Contents



Cash Requirements
    Debt Instruments and Related Covenants
    Promissory Note Payable
 Short-term Promissory Notes
 Liquidity Summary
  36




---



##### Table of Contents



e-Prescribing
 Options and Warrants of ZixCorp Common Stock
  Summary of Outstanding Options and WarrantsVested SharesTotal Value
    
    
    (included in
    
    
    Total ValueOutstanding
    
    
    of Outstanding
    
    
    outstanding
    
    
    of VestedExercise Price Range
    
    Shares
    
    
    Shares
    
    
    shares)
    
    
    Shares$1.42 - $1.92
    
    
    6,687,014
    
    
    $
    10,231,000
    
    
    
    467,914
    
    
    $
    721,000$1.93 - $3.50
    
    
    5,951,864
    
    
    
    17,320,000
    
    
    
    4,450,223
    
    
    
    13,262,000$3.51 - $4.99
    
    
    4,616,621
    
    
    
    20,128,000
    
    
    
    3,921,809
    
    
    
    17,256,000$5.00 - $5.99
    
    
    1,706,968
    
    
    
    8,825,000
    
    
    
    1,706,968
    
    
    
    8,825,000$6.00 - $8.99
    
    
    1,449,215
    
    
    
    9,362,000
    
    
    
    1,190,882
    
    
    
    7,776,000$9.00 - $19.99
    
    
    1,439,848
    
    
    
    15,666,000
    
    
    
    1,295,683
    
    
    
    14,162,000$20.00 - $57.60
    
    
    1,138,695
    
    
    
    60,567,000
    
    
    
    1,138,695
    
    
    
    60,567,000Total
    
    
    22,990,225
    
    
    $
    142,099,000
    
    
    
    14,172,174
    
    
    $
    122,569,000
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Off-Balance Sheet Arrangements
  Contractual Obligations, Contingent Liabilities and Commitments
  Payments Due by PeriodTotal
    
    
    < 1 Year
    
    
    1-3 Year
    
    
    3-5 Years
    
    
    > 5 YearsNotes payable
    
    $
    2,737,000
    
    
    $
    2,737,000
    
    
    $
    
    
    
    $
    
    
    
    $
    Operating leases
    
    
    8,285,000
    
    
    
    1,326,000
    
    
    
    2,307,000
    
    
    
    1,991,000
    
    
    
    2,661,000401(k) employer funding obligation
    
    
    155,000
    
    
    
    155,000
    
    
    
    
    
    
    
    
    
    
    
    John Ryan consulting agreement
    
    
    80,000
    
    
    
    80,000
    
    
    
    
    
    
    
    
    
    
    
    Total cash obligations
    
    $
    11,257,000
    
    
    $
    4,298,000
    
    
    $
    2,307,000
    
    
    $
    1,991,000
    
    
    $
    2,661,000
   Potential
payment of liquidated damages related to April 5, 2006 Private Placement
  
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  
 ITEM 4. CONTROLS AND PROCEDURES
  38




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PART II  OTHER INFORMATION
 
 ITEM 1. Legal Proceedings
  
 ITEM 1A. Risk Factors
 (In these risk factors, we, us, our, and ZixCorp refer to Zix Corporation and its
wholly-owned subsidiaries.)
 An investment in our common stock involves a high degree of risk. You should carefully
consider the following risk factors in evaluating an investment in our common stock. If any of the
following risks actually occurs, our business, financial condition, results of operations or cash
flow could be materially and adversely affected. In such case, the trading price of our common
stock could decline, and you could lose all or part of your investment. You should also refer to
the other information set forth in this report, including our consolidated financial statements and
the related notes.
 We have incurred significant operating losses in previous years and we continue to use
significant amounts of cash for our business operations, which could result in us having
insufficient cash to fund our operations under our current business plan.
   The market may not broadly accept our Email Encryption and e-Prescribing solutions and
services, which would prevent us from operating profitably.
  Failure to enter into additional or to maintain existing sponsorship agreements for our
PocketScript e-Prescribing service and generate other revenue opportunities from PocketScript could
harm our business.
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Healthcare providers may fail to adopt our PocketScript service.
  End-users of our PocketScript service may not continue to use the service .
  Failure to significantly increase our base of PocketScript users or obtain significant
prescription transaction fees, or other fees may result in failure to achieve the critical mass of
physicians and revenue to build a successful business.
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Competition in our businesses is expected to increase, which could cause our business to fail.
    Our inability to successfully execute timely development and introduction of new Email
Encryption and e-Prescribing services and related services and to implement technological changes
could harm our business.
   Future asset impairments could affect our financial results.
   Capacity limits on our technology and network hardware and software may be difficult to
project, and we may not be able to expand and/or upgrade our systems to meet increased use, which
would result in reduced revenues.
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Security interruptions to our data centers could disrupt our business, and any security
breaches could expose us to liability and negatively impact customer demand for our solutions and
services.
     Pending litigation could have a material impact on our operating results and financial
condition.
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We may have to defend our rights in intellectual property that we use in our services, which
could be disruptive and expensive to our business.
  Defects or errors in our services could harm our business.
  Public key cryptography technology is subject to risks.
  We depend on key personnel.
  We rely on third parties.
   We could be affected by government regulation.
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Our
stock price may be volatile and we may forfeit our NASDAQ listing.
   We have a significant amount of stock options and warrants outstanding and may issue
additional equity securities in the future. Exercise of the outstanding options and warrants, and
future issuances of other securities will dilute the ownership interests of existing shareholders.
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The Company may be required to pay liquidated damages in the event one or more of the
registration statements it has filed with the SEC for the benefit of third parties ceases to be
effective.
  We may have liability for indemnification claims arising from the sale of our Web Inspector,
Message Inspector, and Dr. Chart (R) product lines.
  NOTE ON FORWARD-LOOKING STATEMENTS AND RISK FACTORS
   
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
  
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  
 ITEM 5. OTHER INFORMATION
  
 ITEM 6. EXHIBITS
 a. Exhibits
  Exhibit No.
    
    Description of Exhibits3.1
    
    Restated Articles of Incorporation of Zix Corporation, as filed with the Texas Secretary of State
on November 10, 2005. Filed as Exhibit 3.1 to Zix Corporations Annual Report on Form 10-K for the
year ended December 31, 2005, and incorporated herein by reference.3.2
    
    Restated Bylaws of Zix Corporation, dated October 30, 2002. Filed as Exhibit 3.2 to Zix
Corporations Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002, and
incorporated herein by reference.10.1*
    
    Sublease dated as of July 20, 2006, between ZixCorp Canada, Inc., as Tenant, and Peleton Photonic
Systems, Inc., as Subtenant.10.2*
    
    Letter of agreement, dated September 12, 2006, between Zix Corporation and MITEM Corporation
relating to promissory note payable by MITEM Corporation to Zix Corporation, which is filed as
Exhibit 2.2 to the Companys Form 8-K, dated October 5, 2005.31.1*
    
    Certification of Richard D. Spurr, President and Chief Executive Officer of the Company, pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.31.2*
    
    Certification of Bradley C. Almond, Vice President, Chief Financial Officer, and Treasurer of the
Company, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1**
    
    Certification of Richard D. Spurr, President and Chief Executive Officer of the Company, and
Bradley C. Almond, Vice President, Chief Financial Officer, and Treasurer of the Company, pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 *
    
    Filed herewith.**
    
    Furnished herewith. 46




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SIGNATURE
  ZIX CORPORATION
(Registrant)Date: November 9, 2006
    
    By: /s/ Bradley C. AlmondBradley C. AlmondVice President, Chief Financial Officer and Treasurer(Principal Financial Officer and Duly Authorized Officer)
 47