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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 March 31, 2005 o
    
    TRANSITION REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the transition
period fromto Commission File Number: 0-17995 ZIX CORPORATION (Exact Name of Registrant as Specified in its Charter)
 Texas
    
    75-2216818(State of Incorporation)
    
    (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 an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). Yes þ No o Indicate the number of shares outstanding of each of the issuers classes of common stock, as of
the latest practicable date. Class
    
    Outstanding at April 29, 2005Common Stock, par value $.01 per share
    
    32,327,613




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INDEX PART I-FINANCIAL INFORMATION  
 PageNumberItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets at March 31, 2005 and December 31, 2004
    
    
    3Condensed Consolidated Statements of Operations for the three months ended March 31, 2005 and 2004
    
    
    4Condensed Consolidated Statement of Stockholders Equity for the three months ended March 31, 2005
    
    
    5Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2005 and 2004
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    18Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    35Item 4. Controls and Procedures
    
    
    25PART II-OTHER INFORMATIONItem 6. Exhibits and Reports on Form 8-K
    
    
    35Certification of Chief Executive Officer
    
    
    35Certification of Chief Financial OfficerCertification of Richard D. Spurr , CEO, and Bradley C. Almond, CFOCommon Stock Purchase WarrantEmployment OfferStock Option AgreementCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO and CFO Pursuant to Section 906




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ZIX CORPORATION 
 CONDENSED CONSOLIDATED BALANCE SHEETS
  March 31,
    
    
    December 31,2005
    
    
    2004ASSETSCurrent assets:Cash and cash equivalents
    
    $
    10,480,000
    
    
    $
    3,856,000Marketable securities
    
    
    3,003,000
    
    
    
    16,000,000Accounts Receivable
    
    
    533,000
    
    
    
    561,000Notes receivable, net
    
    
    1,440,000
    
    
    
    Prepaid and other current assets
    
    
    1,555,000
    
    
    
    1,950,000Total current assets
    
    
    17,011,000
    
    
    
    22,367,000Restricted cash
    
    
    10,410,000
    
    
    
    10,374,000Property and equipment, net
    
    
    5,160,000
    
    
    
    5,024,000Intangible assets, net
    
    
    1,889,000
    
    
    
    3,832,000Goodwill
    
    
    6,958,000
    
    
    
    9,119,000Deferred financing costs and other assets
    
    
    1,367,000
    
    
    
    1,526,000$
    42,795,000
    
    
    $
    52,242,000LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,911,000
    
    
    $
    1,234,000Accrued expenses
    
    
    4,169,000
    
    
    
    4,709,000Deferred revenue
    
    
    5,833,000
    
    
    
    6,372,000Customer deposit
    
    
    1,968,000
    
    
    
    968,000Capital lease obligations
    
    
    255,000
    
    
    
    130,000Short-term note payable
    
    
    194,000
    
    
    
    193,000Convertible promissory notes payable
    
    
    3,923,000
    
    
    
    3,848,000Total current liabilities
    
    
    18,253,000
    
    
    
    17,454,000Long-term liabilities:Deferred revenue
    
    
    1,184,000
    
    
    
    1,731,000Customer deposit
    
    
    2,000,000
    
    
    
    3,000,000Convertible promissory notes payable
    
    
    13,573,000
    
    
    
    13,347,000Promissory notes payable
    
    
    1,932,000
    
    
    
    1,840,000Capital lease obligations and other
    
    
    369,000
    
    
    
    105,000Total long-term liabilities
    
    
    19,058,000
    
    
    
    20,023,00037,311,000
    
    
    
    37,477,000Contingencies (Note 13)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; 34,654,794 issued and 32,327,613 outstanding in 2005 and
34,584,406 issued and 32,257,225 outstanding in 2004
    
    
    347,000
    
    
    
    346,000Additional paid-in capital
    
    
    269,696,000
    
    
    
    269,406,000Treasury stock, at cost; 2,327,181 common shares in 2005
and 2004
    
    
    (11,507,000
    )
    
    
    (11,507,000
    )Accumulated deficit
    
    
    (253,052,000
    )
    
    
    (243,480,000
    )Total stockholders equity
    
    
    5,484,000
    
    
    
    14,765,000$
    42,795,000
    
    
    $
    52,242,000
 See notes to condensed consolidated financial statements. 3




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ZIX CORPORATION 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
  Three Months Ended March 31,2005
    
    
    2004Revenues:Services
    
    $
    3,298,000
    
    
    $
    2,516,000Hardware
    
    
    185,000
    
    
    
    Software
    
    
    100,000
    
    
    
    327,000Total revenues
    
    
    3,583,000
    
    
    
    2,843,000Costs and expenses:Cost of revenues
    
    
    3,891,000
    
    
    
    3,174,000Research and development expenses
    
    
    1,975,000
    
    
    
    2,845,000Selling, general and administrative expenses
    
    
    7,502,000
    
    
    
    7,806,000Gain of sale of product lines
    
    
    (950,000
    )
    
    
    Total costs and expenses
    
    
    12,418,000
    
    
    
    13,825,000Operating loss
    
    
    (8,835,000
    )
    
    
    (10,982,000
    )Other (expense) income:Investment and other income
    
    
    143,000
    
    
    
    58,000Interest expense
    
    
    (830,000
    )
    
    
    (55,000
    )Recovery of previously impaired investment
    
    
    
    
    
    
    70,000Total other (expense) income
    
    
    (687,000
    )
    
    
    73,000Loss before income taxes
    
    
    (9,522,000
    )
    
    
    (10,909,000
    )Income taxes
    
    
    (50,000
    )
    
    
    (29,000
    )Net loss
    
    $
    (9,572,000
    )
    
    $
    (10,938,000
    )Basic and diluted loss per common share
    
    $
    (0.30
    )
    
    $
    (0.36
    )Weighted average common shares outstanding
    
    
    32,295,162
    
    
    
    30,199,716
 See notes to condensed consolidated financial statements. 4




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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, 2005
    
    
    34,584,406
    
    
    $
    346,000
    
    
    $
    269,406,000
    
    
    $
    (11,507,000
    )
    
    $
    (243,480,000
    )
    
    $
    14,765,000Issuance of common stock upon
exercise of stock options
    
    
    833
    
    
    
    
    
    
    
    3,000
    
    
    
    
    
    
    
    
    
    
    
    3,000Employee stock compensation expense
    
    
    69,555
    
    
    
    1,000
    
    
    
    242,000
    
    
    
    
    
    
    
    
    
    
    
    243,000Amortization of unearned
stock-based compensation
    
    
    
    
    
    
    
    
    
    
    56,000
    
    
    
    
    
    
    
    
    
    
    
    56,000Other
    
    
    
    
    
    
    
    
    
    
    (11,000
    )
    
    
    
    
    
    
    
    
    
    
    (11,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9,572,000
    )
    
    
    (9,572,000
    )Balance, March 31, 2005
    
    
    34,654,794
    
    
    $
    347,000
    
    
    $
    269,696,000
    
    
    $
    (11,507,000
    )
    
    $
    (253,052,000
    )
    
    $
    5,484,000
 See notes to condensed consolidated financial statements. 5




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ZIX CORPORATION 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
  Three Months Ended March 31,2005
    
    
    2004Operating activities:Net loss
    
    $
    (9,572,000
    )
    
    $
    (10,938,000
    )Non-cash items in net loss:Depreciation and amortization
    
    
    1,135,000
    
    
    
    1,554,000Amortization of debt financing costs
    
    
    159,000
    
    
    
    Amortization of discount on convertible promissory notes
payable
    
    
    301,000
    
    
    
    Amortization of discount on promissory note payable
    
    
    92,000
    
    
    
    Amortization of discount on notes receivable
    
    
    (5,000
    )
    
    
    Employee stock compensation expense
    
    
    243,000
    
    
    
    942,000Common stock issued in lieu of cash compensation
    
    
    
    
    
    
    588,000Amortization of unearned stock-based compensation
    
    
    56,000
    
    
    
    33,000Recovery of investment in Maptuit Corporation
    
    
    
    
    
    
    (70,000
    )Gain on sale of product lines
    
    
    (950,000
    )
    
    
    Changes in operating assets and liabilities, excluding
effects of acquisitions:Accounts receivable
    
    
    28,000
    
    
    
    (224,000
    )Other assets
    
    
    314,000
    
    
    
    56,000Accounts payable
    
    
    677,000
    
    
    
    407,000Deferred revenue
    
    
    460,000
    
    
    
    579,000Customer deposits
    
    
    
    
    
    
    4,000,000Accrued and other liabilities
    
    
    (324,000
    )
    
    
    132,000Net cash used by operating activities
    
    
    (7,386,000
    )
    
    
    (2,941,000
    )Investing activities:Purchases of property and equipment
    
    
    (685,000
    )
    
    
    (883,000
    )Purchases of marketable securities
    
    
    
    
    
    
    (2,485,000
    )Sales and maturities of marketable securities
    
    
    12,997,000
    
    
    
    4,980,000Purchase of restricted cash investment
    
    
    (36,000
    )
    
    
    Proceeds from sale of product lines
    
    
    1,840,000
    
    
    
    Cash received from Maptuit Corporation
    
    
    
    
    
    
    70,000Net cash provided by investing activities
    
    
    14,116,000
    
    
    
    1,682,000Financing activities:Proceeds from exercise of stock options
    
    
    3,000
    
    
    
    3,755,000Proceeds from exercise of warrants
    
    
    
    
    

    
    7,230,000Payment of short term note payable
    
    
    (83,000
    )
    
    
    Payment of capital lease
    
    
    (15,000
    )
    
    
    Proceeds from promissory note payable
    
    
    
    
    
    
    3,000,000Other
    
    
    (11,000
    )
    
    
    Net cash (used) provided by financing activities
    
    
    (106,000
    )
    
    
    13,985,000Inecrease in cash and cash equivalents
    
    
    6,624,000
    
    
    
    12,726,000Cash and cash equivalents, beginning of period
    
    
    3,856,000
    
    
    
    6,599,000Cash and cash equivalents, end of period
    
    $
    10,480,000
    
    
    $
    19,325,000
 See notes to condensed consolidated financial statements. 6




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ZIX CORPORATION 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  1. Basis of Presentation
 The accompanying condensed consolidated financial statements of Zix Corporation (ZixCorp or
the Company) should be read in conjunction with the audited consolidated financial statements
included in the Companys 2004 Annual Report to Shareholders on Form 10-K. These financial
statements are unaudited but have been prepared in the ordinary course of business for the purpose
of providing information with respect to the interim periods. Management of the Company believes
that all adjustments necessary for a fair presentation for such periods have been included and are
of a normal recurring nature. The results of operations for the three-month period ended March 31,
2005 are not necessarily indicative of the results to be expected for the full year. 2. Operational Overview and Liquidity The Company operates in a single reporting segment, providing solutions that protect, manage
and deliver sensitive electronic information. These solutions are grouped into two categories:
eSecure and eHealth. By offering two comprehensive sets of products and services, the Company
protects organizations from viruses and spam, provides the management tools needed for Web access
control and policy-driven email encryption, and provides care delivery solutions for e-prescribing
and e-lab results that enable physicians to leverage technology for better patient care. In 1999, the Company began developing and marketing products and services that bring privacy,
security and convenience to Internet users. ZixMail, a desktop solution for encrypting and securely
delivering email, was first commercially introduced in the first quarter of 2001. In 2002, the
Company began offering additional products. ZixVPM (Virtual Private Messenger) is an e-messaging
gateway solution that provides company-wide privacy protection for inbound and outbound email
communications. ZixAuditor is an assessment service used to analyze email traffic patterns and
monitor compliance with corporate and regulatory policies. ZixPort provides a secure Web-messaging
portal. In July 2003, the Company acquired substantially all of the operating assets and the business
of PocketScript, LLC (PocketScript), a privately-held development stage enterprise that provided
electronic prescription solutions for the healthcare industry. This acquisition enabled the Company
to expand its services into care delivery solutions, specifically, the e-prescribing marketplace. In September 2003, the Company acquired substantially all of the operating assets and the
business of Elron Software, Inc. (Elron Software), a majority-owned subsidiary of Elron
Electronic Industries Ltd. and a provider of anti-spam, email content filtering and Web filtering
solutions. On March 11, 2005 the Web Inspector and Message Inspector product lines, which were
acquired in the Elron acquisition, were sold to CyberGuard Corporation (see Note 6). In January 2004, the Company acquired substantially all of the operating assets and the
business of MyDocOnline, Inc. (MyDocOnline), a subsidiary of Aventis Pharmaceuticals, Inc., the
North American pharmaceuticals business of Aventis SA. MyDocOnline
offered, under the service names
of Connect and Dr. Chart, a variety of Internet-based healthcare services and is a provider of
secure Web-based communications, disease management, and laboratory information solutions. Through
the acquisition, the Company believes it has acquired a fully developed product and an installed
base of physicians already using the Dr. Chart products. On November 4, 2004 the Company announced
that it was terminating the Connect service for online doctor visits. Due to the Companys history of operating spending in excess of customer receipts, liquidity
is of special importance. Essential to liquidity is the ability of the Company to become cash flow
positive, ideally from operations, but augmented as required by financing or investing activities. The Company has material contractual obligations over the next year of $7,871,000 and
$24,159,000 over the next three years consisting of leases and debt obligations. Cash requirements
in excess of these commitments represent operating spending the Company chooses to make in order to
satisfy existing customer contracts and to secure new orders and cover various overhead costs. The
spending in excess of contractual commitments is somewhat flexible and dependant on the Companys
current and future cash receipts. The Company is engaged in two primary markets, eSecure and
eHealth. For several years the spending in eSecure far exceeded cash receipts. As that product
has matured, the gap between cash spending and cash used has narrowed substantially and continues
to do so. The recurring nature of the subscription model makes cash receipts predictable and
additional spending to sustain and continue to stay abreast with market demands in eSecure are not
extensive. The eHealth market is significantly earlier in its development phase relative to
eSecure and thus the Company has chosen to spend money in excess of the cash receipts. The Company
continues to closely monitor developments in the eHealth market and will adjust spending in that
area commensurate with expected future returns and if appropriate will consider additional funding
to augment cash from operations. Based on the above actions, continued growth in the eSecure market, certain other actions that
have been initiated in the first quarter 2005, and flexibility in its discretionary spending the
Company believes it has adequate resources and liquidity to sustain operations through the rest of
2005 and is targeting incremental cash flow improvements throughout the year to augment its
liquidity going into 2006. However, operating in emerging markets involves risk and uncertainties,
and there are no assurances that the 7




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Company will ultimately achieve or achieve in a sufficiently
timely manner its targeted improvements. The Company will further augment
its cash flow position through additional cost reduction measures, sales of non-core assets,
additional financings or a combination of these actions. Operationally, the extent and timing of
success and potential returns in the e-prescribing market will ultimately be the most significant
operational determinant of liquidity. The extent to which the Company views the e-prescribing
market as attractive for investment will determine the Companys willingness to fund additional
operational cash losses with additional financing if required. Should the Company seek financing,
there can be no assurances that it can be obtained at terms that are acceptable and therefore, the
resources available, the business model, and go to market model might have to be altered
accordingly.  3.
    Revenue and Significant Customers The Company recognizes revenue in accordance with accounting principles generally accepted in
the United States of America, as promulgated by SOP 97-2, Software Revenue Recognition,SOP 98-9,
Modification of SOP 97-2, Software Revenue Recognition, With respect to Certain Transactions,
Emerging Issues Task Force (EITF) Abstract No. 00-21, Revenue Arrangements with Multiple
Deliverables,and Securities and Exchange Commission Staff Accounting Bulletin No. 104, Revenue
Recognition in Financial Statements,and other related pronouncements. The Company develops, markets, licenses and supports computer software products and services.
The Companys products can be placed into several key revenue categories where each category has
similar revenue recognition traits; Communications Protection subscription-based services,
perpetual software license sales, the PocketScript e-prescribing application, various transaction
fees and professional services. A majority of the revenues generated by the Company are through
direct sales; however, the Company employs a network of distributors and resellers. Under all
product categories and distribution models, the Company recognizes revenue after all of the
following occur: persuasive evidence of an arrangement exists, delivery has occurred or services
have been rendered, the price is fixed and determinable, and collectability is reasonably assured.
In the event the arrangement has multiple elements with delivered and undelivered elements, revenue
for the delivered elements are recognized under the residual method only when vendor-specific
objective evidence of fair value (VSOE) exists to allocate the fair value of the total fees to the
undelivered elements of the arrangement. Occasionally, when ZixCorp is engaged in a complex product
deployment, customer acceptance may have to occur before the transaction is considered complete. In
this situation no revenue will be recognized until the customer accepts the product. Subscription-based services include the Communication Protection services of ZixMail, ZixVPM,
ZixPort, ZixAuditor, anti-spam signatures subscription, and anti-virus subscriptions as well as
certain products acquired from MyDocOnline. These products include delivering licensed software and
providing customer support and secure electronic communications throughout the subscription period.
The customer is often provided an appliance during the subscription period with pre-installed
software or contractually subscribes to a data center resident service. In a subscription service,
the customer typically does not own a perpetual right to a software license, but is instead granted
the use of that license during the period of the subscription. Subscriptions are generally annual
non-refundable contracts. The subscription period begins on the date specified by the parties when
the service is fully functional for the customer which is consequently deemed to be the date of
acceptance. Revenues from subscription services are recorded as service revenue as the services are
rendered from the date of acceptance over the subscription period. Subscription fees received from
customers in advance are recorded as deferred revenue and recognized as revenues ratably over the
subscription period. In 2004 and first quarter 2005, the Company sold anti-spam filtering, email content filtering,
and Web filtering solutions to customers under perpetual licensing arrangements. These perpetual
software licenses are normally sold as part of multiple-element arrangements that include annual
maintenance and/or subscription, and may include implementation or training services. Acceptance
for these products is generally when delivered if they are self installable by the customer and
upon installation if installation is required to be done by ZixCorp professional services. These
products are primarily self installed. Where VSOE has not been established for undelivered
elements, revenue for all elements is deferred until those elements are delivered or their fair
values determined. However, if VSOE is determinable for all of the undelivered elements, and the
undelivered elements are not essential to the delivered elements, the Company will defer
recognition of the fair value related to the undelivered elements and recognize as revenue the
remaining portion of the arrangement through application of the residual method. Evidence of VSOE
for implementation and training services associated with the anti-spam, email content filtering and
Web filtering arrangements is based upon standard billing rates and the estimated level of effort
for the individuals expected to perform the related services. Installation and training revenues
are recognized as the services are rendered. The Company establishes VSOE for maintenance based
upon maintenance that was sold separately. Maintenance revenue is recognized over the term of the
maintenance agreement, generally one year. On March 11, 2005 the Web Inspector and Message Inspector product lines which perform
anti-spam, e-mail, and Web filtering were sold to CyberGuard Corporation. These product lines were
acquired in September 2003 when the Company purchased Elron Software, Inc. Message Inspector and
Web Inspector contributed $903,000 and $637,000 of revenue for the quarters ended March 31, 2004
and March 31, 2005, respectively. The sale of Message Inspector and Web Inspector is
discussed further in Note 6. The Company recognizes revenue on the PocketScript e-prescribing service as a multiple element
arrangement with separate units of accounting. VSOE is determined for the undelivered elements, and
the residual value is assigned to the hardware device and is recognized upon installation of the
device at an end-user location. Installation is determined by physical delivery of a functioning
product. The fair values of the undelivered elements relate to ongoing services and are recognized
ratably over the period of the service. The Company establishes VSOE for the service elements based
upon contract renewal rates or fair market values if the 8




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element is commonly sold by others. Some of the Companys services incorporate a transaction fee per event occurrence or when
predetermined usage levels have been reached. These fees are recognized as revenue when the
transaction occurs. For contracts with customers to provide certain professional services as
standalone offerings, the Company recognizes revenue as the services are rendered and utilizes the
percentage of completion method when appropriate. The Companys services include various warranty provisions. The Company accrues warranty costs
at the time it recognizes revenues. Warranty expense was not material to any period presented. For the quarter ended March 31, 2005, Blue Cross and Blue Shield of Massachusetts, Inc.,
accounted for approximately 19%, or $674,000 of total revenues. For the quarter ended March 31,
2004, CIGNA Corporation accounted for approximately 10%, or $289,000, of total revenues. No other
single customer accounted for 10% or more of the Companys total revenues for the quarters ended
March 31, 2004 and 2005.  4.
    Stock-based Employee Compensation As permitted by SFAS No. 123, Accounting for Stock-Based Compensation,the Company used the
intrinsic value method to account for stock-based compensation plans under the provisions of APB
No. 25, Accounting for Stock Issued to Employeesand related interpretations. Had compensation cost for the Companys stock-based compensation been determined consistent
with the fair value method of SFAS 123, the Companys net loss and loss per common share would have
been as follows: Three Months Ended March 312005
    
    
    2004Net loss, as reported
    
    $
    (9,572,000
    )
    
    $
    (10,938,000
    )Add employee stock compensation expense
recorded under the intrinsic value
method
    
    
    242,000
    
    
    
    942,000Deduct pro forma stock compensation expense
computed under the fair value method
    
    
    (2,003,000
    )
    
    
    (2,622,000
    )Pro forma net loss
    
    $
    (11,333,000
    )
    
    $
    (12,618,000
    )Basic and diluted loss per common share:As reported
    
    $
    (0.30
    )
    
    $
    (0.36
    )Pro forma
    
    $
    (0.35
    )
    
    $
    (0.42
    )
  5.
    Supplemental Cash Flow Information Supplemental cashflow information relating to interest, taxes and noncash activities: Three Months Ended March
31,2005
    
    

2004Cash paid for interest
    
    $
    276,000
    
    
    $
    Cash paid for income tax
    
    $
    220,000
    
    
    $
    6,000Noncash investing and financing activities:Common stock issued for purchase of MyDocOnline (see Note 6)
    
    $
    
    
    
    $
    9,037,000Insurance premiums financed by short-term note payable
    
    $
    84,000
    
    
    $
    
  6.
    Business Sales and Acquisitions Sale of Web Inspector and Message Inspector Product Lines On March 11, 2005, the Company sold its Web Inspector and Message Inspector product lines
(MI/WI) to CyberGuard Corporation (CyberGuard) for $3,244,000 net of transactions fees of
$317,000, consisting of $2,126,000 in cash and a $1,500,000 note receivable due in three equal
payments of $500,000 on June 15, September 15 and December 15, 2005 with no stated interest rate.
The note receivable was recorded at its present value of $1,435,000 using an imputed interest
rate of 9%. This is estimated to approximate the rate which would have resulted if an independent
borrower and an independent lender had negotiated a similar transaction under comparable terms and
conditions. The resulting discount will be amortized into interest income over the term of the
note. The following summarizes the carrying amount of assets and liabilities that were sold to or
assumed by CyberGuard upon the close of the transaction, the allocation of the goodwill associated
with the portion of the eSecure reporting unit being sold, and the resulting gain of $950,000: 9




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Net assets sold:Equipment, net
    
    $
    15,000Prepaid expenses
    
    
    165,000Intangibles, net
    
    
    1,499,000Deferred revenue
    
    
    (1,546,000
    )Net assets
    
    
    133,000Goodwill
    
    
    2,161,000Net proceeds:Cash
    
    
    2,126,000Note receivable, net
    
    
    1,435,000Transaction fees
    
    
    (317,000
    )Net proceeds
    
    
    3,244,000Gain on sale
    
    $
    950,000
 MI/WI product lines contributed $637,000 and $903,000 in revenue for the quarters ended
March 31, 2005 and 2004, respectively, and approximately the same amount in expense to the
Companys operations in each year. MI/WI does not represent a separate component of the Company as its
operations and cash flows cannot be sufficiently separated from the rest
of the Company, consequently, their results of operations are included in income
from operations in the consolidated statements of income. The sale did not include the accounts receivable
related to the sale of MI/WI products which totaled approximately $189,000, net of allowance for
doubtful accounts as of March 31, 2005. Acquisition of MyDocOnline, Inc. On January 30, 2004, the Company acquired substantially all of the operating assets and the
business and assumed certain liabilities of MyDocOnline, a subsidiary of Aventis Pharmaceuticals,
Inc., the North American pharmaceuticals business of Aventis SA pursuant to an asset purchase
agreement. The consideration for the net assets acquired consisted of 583,411 shares of the
Companys common stock. Subsequent to the acquisition of MyDocOnline, Aventis was acquired by
another company and their name has changed to Sanofi-Aventis. The components of the aggregate cost of the acquisition are as follows: Fair market value of 583,411 shares of the Companys common
stock
    
    $
    9,037,000Transaction costs
    
    
    282,000Total acquisition cost
    
    $
    9,319,000
 The fair market value of the Companys common stock for financial accounting purposes was
calculated using the five-day average of the closing prices on the date that the terms were agreed
to and announced and the two trading days before and after such date. Using third-party valuations of certain intangible assets, the cost of the acquisition of
MyDocOnline has been allocated to in-process research and development and to the identified assets
and liabilities acquired based on estimates of fair values with the remainder recorded as goodwill
as follows: Working capital items:Receivables and prepaid expenses
    
    $
    354,000Deferred revenue
    
    
    (140,000
    )Net working capital acquired
    
    
    214,000Property and equipment
    
    
    1,292,000Customer relationships
    
    
    658,000Developed technology
    
    
    2,051,000Goodwill
    
    
    4,798,000In-process research and development
    
    
    306,000$
    9,319,000
 The value of the acquired developed technology, customer relationships and in-process research
and development was determined by discounting the estimated future net cash flows from the related
assets using a discount rate of 31%. In-process research and development was immediately expensed
and is recorded in research and development expenses in the condensed consolidated statement of
operations. Values assigned to developed technology and customer relationships are being amortized
to cost of revenues and selling, general and administrative expenses, respectively, on a
straight-line basis over three years from the acquisition date. The acquired goodwill is not
expected to be deductible for tax purposes. Subsequent to purchasing MyDocOnline, the Company determined that it would focus on two core
markets and reduce costs relating to the Companys solutions and services in non-core markets.
Management determined that the Company should reduce costs relating to the Connect service which
was a product acquired in the MyDocOnline acquisition. Accordingly, ZixCorp decided to 10




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suspend
research and development investment for the Connect service, cease sales and marketing efforts to
obtain new customers for the Connect service and, where reasonably feasible and appropriate,
migrate existing Connect customers to other vendors. These decisions have significantly and
adversely changed the extent and use of the Connect service, for which the Company has recorded an
identifiable intangible asset. The resulting test for recoverability of the developed technology
resulted in an asset impairment charge of $675,000, which was recognized by the Company in the year
ended December 31, 2004.  7.
    Restricted Cash and Marketable Securities Restricted cash of $10,410,000 at March 31, 2005 relates primarily to a debt covenant on the
convertible promissory notes payable requiring the Company to maintain a minimum of $10,000,000 on
deposit through November 2007 (see Note 11). On April 13, 2005, the Company entered into a contract
that, upon effectiveness, would restructure
the convertible promissory notes payable and related covenants (see Note 15). Marketable securities are recorded at their fair value and consist of asset backed securities
that have certain 28-day interest rate rest features.  8.
    Accounts Receivable March 31,
    
    
    December 31,2005
    
    
    2004Gross accounts receivable
    
    $
    3,686,000
    
    
    $
    3,732,000Allowance for returns and doubtful accounts
    
    
    (116,000
    )
    
    
    (74,000
    )Unpaid portion of deferred revenue
    
    
    (3,037,000
    )
    
    
    (3,097,000
    )Receivables, net
    
    $
    533,000
    
    
    $
    561,000
 The reduction for deferred revenue represents future customer service or maintenance
obligations which have been billed to customers but remain unpaid as of the respective balance
sheet dates. Deferred revenue on the Companys condensed consolidated balance sheets represents
future customer service or maintenance obligations which have been billed and collected as of the
respective balance sheet dates.  9.
    Intangible Assets and Goodwill At March 31, 2005, the Companys intangible assets, all of which are subject to amortization,
were comprised of the following, which resulted from the third quarter 2003 acquisitions of
PocketScript and Elron Software and the first quarter 2004 acquisition of MyDocOnline: March 31, 2005
    
    
    
    
    
    
    
    December 31, 2004Accumulated
    
    
    
    
    
    
    
    
    
    
    AccumulatedCost
    
    
    Amortization
    
    
    Net
    
    
    Cost
    
    
    Amortization
    
    
    NetDeveloped
technology
    
    $
    2,598,000
    
    
    $
    1,156,000
    
    
    $
    1,442,000
    
    
    $
    3,541,000
    
    
    $
    1,347,000
    
    
    $
    2,194,000Customer contract and
relationships
    
    
    658,000
    
    
    
    211,000
    
    
    
    447,000
    
    
    
    1,994,000
    
    
    
    596,000
    
    
    
    1,398,000Trademarks and trade
names
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    432,000
    
    
    
    192,000
    
    
    
    240,000Total intangible
assets
    
    $
    3,256,000
    
    
    $
    1,367,000
    
    
    $
    1,889,000
    
    
    $
    5,967,000
    
    
    $
    2,135,000
    
    
    $
    3,832,000
 During first quarter 2005 the Company evaluated the estimated useful lives of the
intangible assets relating to MyDocOnLine acquisition. As a result the estimated lives for
developed technology and customer relationships were reduced to 3 years from 5 years and 4 years,
respectively. This change in estimate is being accounted for prospectively beginning January 1,
2005. The impact of this change is that an additional amortization expense of $54,000 was recorded
in first quarter 2005. The weighted average useful lives for developed technology and customer
contracts and relationships are 3 years as of March 31, 2005. Amortization expense relating to
intangible assets totaled $444,000 and $417,000 for the quarters ended March 31, 2005 and 2004,
respectively. Changes in the intangible assets for the three-months ended March 31, 2005 were as follows: AccumulatedCost
    
    
    AmortizationBeginning balance at January 1, 2005
    
    $
    5,967,000
    
    
    $
    2,135,000Amortization of intangibles
    
    
    
    
    
    
    444,000Sale of intangibles to CyberGuard
    
    
    (2,711,000
    )
    
    
    (1,212,000
    )Ending balance at March 31, 2005
    
    $
    3,256,000
    
    
    $
    1,367,000
 The expected future intangible amortization expense is as follows: Nine months ended December 31, 2005
    
    $
    863,0002006
    
    
    967,0002007
    
    
    59,000Total
    
    $
    1,889,000
 11




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At December 31, 2004 and March 31, 2005, the Company had recorded goodwill (not subject to
amortization) totaling $9,119,000 and $6,958,000, respectively. Goodwill of $2,161,000 was
included in the carrying value of assets sold to CyberGuard in the sale of the Message Inspector
and Web Inspector product lines (see Note 6). The March 31, 2005 goodwill balance consisted of
$2,160,000 recorded in association with the acquisition of Elron Software in the third quarter 2003
and $4,798,000 recorded in association with the acquisition of MyDocOnline in the first quarter
2004. The Elron Software related goodwill was assigned to the eSecure reporting unit and the
MyDocOnline goodwill was assigned to the eHealth reporting unit. The Company evaluates its goodwill
for impairment annually in the fourth quarter, or when there is reason to believe that the value
has been diminished or impaired. There has been no impairment of value to the carrying amount of
goodwill.  10.
    Customer Deposit A Master Services Agreement was entered into with Aventis, Inc. (Aventis) for $4,000,000 on
the same date as the MyDocOnline acquisition (see Note 6) for the performance, by the Company, of
various future services. The services were to be delivered in minimum amounts of $1,000,000,
$1,000,000 and $2,000,000 prior to January 30, 2005, January 30, 2006, and January 30, 2007,
respectively. The services will be defined on an ongoing basis over the life of the agreement and
valued in accordance with pricing for similar services rendered by the Company to other customers.
Aventis paid the $4,000,000 upon execution of the Master Services Agreement. Since the Companys services to be provided to Aventis have not yet been fully defined, the
$4,000,000 payment has been recorded as a customer deposit. As the services are defined and priced
in individual project agreements, the value of the defined element will be reclassified to deferred
revenues and then recognized as revenue in accordance with applicable revenue recognition criteria.
If the services are not requested by Aventis by the dates outlined above the deposit will be
forfeit and ZixCorp will recognize the deposit as other income. The Company is required to return
to Aventis any unused portion of the deposit only in the event of material breach of the contract
by the Company, in the event the Company or a party employed or engaged by the Company is debarred
pursuant to the Generic Drug Enforcement Act of 1992 or similar state, local, or foreign law, in
the event the Company files for bankruptcy, or in the event of force majeure. The Company believes
that it is unlikely any of these events will occur. The Companys obligations associated with the
Master Services Agreement are secured by a first priority lien on the Companys property and
equipment and accounts receivable. As of March 31, 2005, the Company has provided $40,000 of
services to Sanofi-Aventis under this Master Services Agreement. Subsequent to the MyDocOnline acquisition, Aventis merged with Sanofi and the rights under
this agreement were transferred to the new company, Sanofi-Aventis. The Company and Sanofi-Aventis
agreed to extend the January 30, 2005 deadline for consuming the initial $1,000,000 in services to
April 11, 2005. Sanofi-Aventis will forfeit any unused amounts annually if services are not
requested by Sanofi-Aventis in accordance with the terms of the Master Services Agreement unless
the deadlines are extended by mutual agreement of the parties. The initial $1,000,000 in services
was not consumed by Sanofi-Aventis by April 11, 2005 and the Company advised Sanofi-Aventis that
the $1,000,000 was forfeited to the Company. The Company will record this amount in other income
in the financial statements for the period ended June 30, 2005. The Company also holds an additional $8,000 customer deposit relating to a separate customer
agreement  11.
    Notes Payable Total notes payable at March 31, 2005 are as follows: December 31,
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    March 31,Stated
    
    
    Effective
    
    
    
    
    
    
    2004
    
    
    Additional
    
    
    
    
    
    
    
    
    
    
    2005Interest
    
    
    Interest
    
    
    Note
    
    
    Net Book
    
    
    Debt
    
    
    Discount
    
    
    Payments
    
    
    Net BookRate
    
    
    Rate
    
    
    Expiration
    
    
    Value
    
    
    Incurred
    
    
    Amortization
    
    
    Made
    
    
    ValueConvertible
promissory notes payable
    
    
    5.3
    %
    
    
    14.6
    %
    
    Nov 2008
    
    $
    17,195,000
    
    
    $
    
    
    
    $
    301,000
    
    
    $
    
    
    
    $
    17,496,000Promissory note
payable
    
    
    4.5
    %
    
    
    11.0
    %
    
    Mar 2007
    
    
    1,840,000
    
    
    
    
    
    
    
    92,000
    
    
    
    
    
    
    
    1,932,000Short-term promissory
notes
    
    
    5.1
    %
    
    
    5.1
    %
    
    Oct 2005
    
    
    193,000
    
    
    
    84,000
    
    
    
    
    
    
    
    (83,000
    )
    
    
    194,000Total notes payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    19,228,000
    
    
    $
    84,000
    
    
    $
    393,000
    
    
    $
    (83,000
    )
    
    $
    19,438,000
 Convertible Promissory Notes Payable On November 2, 2004, the Company entered into purchase agreements with Omicron Master Trust
(Omicron) and Amulet Limited (together with Omicron, the Investors), pursuant to which the
Company issued and sold to the Investors $20,000,000 12




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aggregate principal amount of secured,
convertible notes and related warrants. The notes convert into the Companys common stock at a
conversion price of $6.00 per share, which could potentially be adjusted in accordance with certain
anti-dilution adjustments. At the initial conversion price, the notes would convert into an
aggregate of 3,333,333 shares of ZixCorp common stock. The principal was payable in four equal annual installments of $5,000,000 beginning November
2, 2005. If the Companys common stock closes above $6.00 per share for 15 of 20 days before the
annual payment date, the scheduled principal repayments may be made in common stock. The Company
has the right to prepay the principal amount owing under the notes at any time at 105% of the
outstanding principal amount of the notes, plus accrued interest. In addition, the Company must
issue immediately exercisable warrants to the Investors equaling 70% of the common stock that would
be issued to the Investors to retire the principal and interest assuming the notes and interest
were converted to the Companys common stock. The exercise price of these warrants, if issued,
would be $6.00 and the term of this warrant will be identical to the remaining term of the note. On
April 13, 2005, the Company and the Investors entered into agreements that, upon effectiveness, would
restructure these notes and related warrants. The agreements are subject to
certain conditions and are not yet effective (see Note 15). The notes stated interest rate is the six-month LIBOR (2.3% on November 2, 2004) plus 300
basis points and is reset every six months. At the Companys option, interest on the notes is
payable quarterly in cash or common stock valued at a 10% discount to the volume weighted average
price for the Companys common stock for a specified number of trading days preceding the interest
payment date. On April 7, 2005, the Company notified the Investors that it intended to pay
the May 2005 interest payment of $267,000 in shares of the
Companys common stock. The Investors may convert the notes into the Companys common stock at the conversion price at
any time. However, the Company has the right to force the conversion of the notes at $6.00 if the
Companys common stock closes above $11.00 per share for 15 of 20 days before the annual payment
date and if the following conditions are met:  1.
    no event of default or repurchase event, as such terms are defined in the convertible
notes, under the notes has occurred,2.
    there is an effective registration statement on file with the SEC covering the shares of
stock to be issued with respect to the payment of principal and the registration statement
has been effective during the 20 consecutive trading days preceding the principal payment
date and is reasonably expected to be effective for at least 30 days following the issuance
of the shares; and3.
    110% of the sum of the number of common stock shares to be issued to a particular holder
on the scheduled principal payment date, plus the number of common stock shares previously
issued to that holder, plus the number of common stock shares then issuable upon conversion
of the note held by that holder or exercise of the warrants held by that holder is less than
the portion of a maximum share amount allocated to such holder (initially 3,407,801 shares
for each original note holder). The notes have weighted average anti-dilution provisions that would cause an adjustment to the
conversion price and the number of shares issuable under the notes upon the occurrence of issuances
of equity securities or convertible equity securities at prices below the then-effective conversion
price or other specified dilutive events such as stock splits, stock dividends, recapitalizations,
certain repurchases by the Company of its shares, and certain dividends and distributions made by
the Company. The Investors have the right to require the Company to repurchase the notes in cash upon the
occurrence of specified repurchase events, such as a change in control or events of default while
the notes are outstanding. Additionally, the notes contain restrictive covenants, including
covenants that prohibit the Company from incurring certain indebtedness, establishing certain liens
on the Companys assets or issuing any variable priced securities. At March 31, 2005 the Company
was in compliance with all debt requirements. The Company was required to place certain proceeds from the notes into a restricted collateral
account. The amount of cash collateral required to be maintained in this account is 50% of the
aggregate principal amount outstanding (initially $10,000,000). The requirement for the Company to
maintain the collateral account is removed if the Company attains two consecutive quarters of net
income, assuming the Company is otherwise in compliance with its obligations under the convertible
notes and related transaction documents and no event of default or repurchase event, as such
terms are defined in the convertible notes, has occurred. Separately, the Company is required to
maintain cash (including the cash collateral held in the collateral account) and cash equivalents
of $10,000,000 through November 2, 2007, and $5 million thereafter for so long as the notes are
outstanding. In connection with the issuance of the convertible notes, the Company issued, to the
Investors, warrants to purchase 1,000,000 shares of the Companys common stock at an exercise price
of $6.00 a share all of which were outstanding at December 31, 2004. The warrants are immediately
exercisable and expire November 2, 2009. The warrants were valued at $3,033,000 using the
Black-Scholes Option Pricing Model (BSOPM) and the following assumptions: contractual life of
five years, risk free interest rate of 3.34%, volatility of 80% and no dividends payable during the
contractual term. The Company accounted for the notes and related warrants using the provisions of
EITF Abstract No. 00-19 Accounting for Derivative Financial instruments Indexed to, and Potentially
Settled in a Companys Own Stockand APB No. 14 Accounting for Convertible Debt and Debt Issued
with Stock Purchase Warrants.Under the provisions of EITF 00-19 the notes should be recorded as a
liability as they do not meet the requirements of being accounted for as equity. Under the
provisions of APB 14, the proceeds received from the notes should be allocated between the notes
and the warrants based on their relative fair values at the time of issuance. Based on relative
fair values at time of issuance, $3,005,000 of the note proceeds were allocated to the warrants and
recorded as a discount against the note and is being amortized to interest expense using the
effective interest method over the term of the notes. 13




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##### Table of Contents



The Company also incurred $1,092,000 of financing costs related to the issuance of the
convertible notes including $1,000,000 of commission paid to investment bankers. In addition,
ZixCorp issued warrants to the investment bankers to purchase 166,667 shares of the Companys
common stock at an exercise price of $6.00 per share. The warrants are immediately exercisable and
expire November 2, 2009. The warrants were valued at $506,000 using the BSOPM and the same
assumptions that were used to value the Investors warrants. The total financing costs of
$1,598,000 are being amortized to interest expense using the effective interest method over the
term of the notes. For the quarter ended March 31, 2005, $160,000 of financing costs were amortized
into interest and the remaining $1,332,000 is recorded as deferred financing costs on the balance
sheet. The effective interest rate on the notes after discount, financing costs and stated interest
rate are considered is 14.6%. Total interest expense recognized on the notes for the three months
ended March 31, 2005 was $727,000 and consisted of $266,000 of stated interest, $301,000 of
discount amortization and $160,000 of financing cost amortization. On April 13, 2005, the Company and the Investors entered into agreements that, upon effectiveness, would
restructure the $20,000,000 Notes and related warrants
(see Note 15). The classification of the current portion of the notes of $3,923,000
is based on the scheduled cash payments as of March 31, 2005. However, the restructuring would expedite
some payments and provide that the Company will make some reductions in principal using common stock. Promissory Note Payable Concurrent with the MyDocOnline acquisition (see Note 6), Sanofi-Aventis, SA loaned the
Company $3,000,000 due March 15, 2007, which loan bears interest at an annual rate of 4.5%. The
loan is evidenced by a promissory note and secured by the Companys property and equipment and
accounts receivable pursuant to a security agreement. Interest on the note is payable only in
services provided by the Company to Sanofi-Aventis unless there is an event of default. The
principal portion of the note is payable in either cash or shares of the Companys common stock,
based on the then current value of such shares, at the option of the Company and may be prepaid by
the Company at any time without penalty. Additionally, at Sanofi-Aventis discretion and after the
$4,000,000 customer deposit from Sanofi-Aventis under the Master Services Agreement has been
consumed (see Note 10), the principal portion of the note may be paid in the form of additional
services provided to Sanofi-Aventis by the Company pursuant to the terms of such services
agreement. Should Sanofi-Aventis choose to not have the note paid in the form of services, the
Company is required to pay the note in cash or stock at maturity, however, at an amount equal to
90% of the face amount of the loan, or $2,700,000, which the Company considers its minimum
liability. Concurrent with the issuance of the note payable to Sanofi-Aventis, the Company issued
warrants to purchase 145,853 shares of ZixCorp common stock all of which were outstanding at March
31, 2005. The exercise price and term of the warrants is $13.01 per share and three years,
respectively. Based on relative fair values at time of issuance, the loan proceeds were allocated
to the note payable of $1,525,000 and to the warrants of $1,475,000. The fair value of the warrants
was calculated using the BSOPM and the following assumptions: contractual life of three years,
risk-free interest rate of 5%, volatility of 100% and no dividends payable during the contractual
term. The fair value of the note was calculated based on an estimated interest rate that the
Company could obtain independently. The resulting discount of $1,175,000 on the minimum liability
of $2,700,000 represents unamortized debt discount which is being amortized to interest expense
over the three-year loan life to yield an effective interest rate of 11%. This rate approximates a
cost of borrowing valuation estimated by an independent valuation company. Short-term Note Payable In December 2004, ZixCorp issued an 11-month note payable to Cananwill, Inc. (Cananwill) to
finance the Companys 2005 commercial insurance policies. In January 2005 the Cananwill note was
increased by an additional $84,000 to finance the Companys technology errors and omissions
liability coverage. The notes expiration date remains October 2005 with a stated interest rate of
5.15%. Payments are due in equal monthly installments.  12.
    Earnings Per Share and Potential Dilution The amounts presented for basic and diluted loss per common share in the accompanying
statements of operations have been computed by dividing the losses applicable to common stock by
the weighted average number of common shares outstanding. Basic and diluted earnings per share are
equal in amount because the assumed exercise of common stock equivalents would be anti-dilutive due
to a net loss being reported for each period. Common shares that have been excluded from the computation of diluted loss per common share
consist of the following: Three Months Ended March 312005
    
    
    2004Stock options
    
    
    8,199,682
    
    
    
    6,294,000Warrants issued in relation to debt and equity
Arrangements
    
    
    3,573,219
    
    
    
    3,365,000Shares issuable for conversion of convertible
promissory notes payable (see Note 11)
    
    
    3,333,333
    
    
    
    Total antidilutive securities excluded from
earnings per share calculation
    
    
    15,106,234
    
    
    
    9,659,000
 14




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##### Table of Contents



As discussed in Note 11 the convertible promissory notes that are held by the Investors are
convertible into common stock at $6 per share. Interest on the convertible promissory notes can
also be paid in stock at 90% of the then current market price. Additionally, if the Company prepaid
the convertible promissory notes in cash it would have to issue warrants equal to 70% of the shares
that would have been required to convert the then-outstanding balance of the loan to stock. The
exercise price on the warrants would be $6 a share. These were not included in the table above as
the amount of shares is variable based on the stock price of the Company and the amount of the
outstanding notes. On April 13, 2005, the Company and the Investors entered into agreements that, upon effectiveness, would
restructure the convertible promissory notes payable  (see Note 15). The amendments would permit the Company to make certain principal reductions using
Company stock valued at 90% of the trading price of the stock. If ZixCorp chose to repay the
$10,000,000 at April 29, 2005 with stock, the number of shares issued would have been 4,040,404.
These were not included in the above table as the actual amount of shares, if any, required to meet the
principal payment obligations is not known at this time. The promissory notes held by Sanofi-Aventis (see Note 11) can be repaid in stock or cash equal
to 90% of the face amount at maturity. If the Company chooses to pay the note with common stock the
obligation would be satisfied at the then-current stock price. If ZixCorp chose to repay the note
at April 29, 2005 with stock, the number of shares issued would have been 981,818 to satisfy the
minimum liability of $2,700,000.  13.
    Contingencies Beginning in early September 2004, several purported shareholder class action lawsuits and one
purported shareholder derivative lawsuit were filed in the U.S. District Court for the Northern
District of Texas against the Company and certain of its current and former officers and directors.
The purported shareholder class action lawsuits, which seek unspecified monetary damages on behalf
of purchasers of the Companys common stock between October 30, 2003 and May 4, 2004, were
instituted September 3, 2004, September 13, 2004, September 16, 2004, September 21, 2004, and
October 5, 2004. These lawsuits allege that the defendants made materially false and misleading
statements and/or omissions in violation of Sections 10(b) and 20(a)
of the Securities Exchange Act of 1934, as amended
(the Exchange Act) during
this time period. The named defendants are Zix Corporation, John A. Ryan, Daniel S. Nutkis, Steve
M. York, Russell J. Morgan, Wael Mohamed, Dennis F. Heathcote and Ronald A. Woessner. The purported shareholder derivative lawsuit, which was instituted September 29, 2004, relates
to the allegedly materially false and misleading statements and/or omissions that are the subject
of the purported shareholder class action lawsuits. The derivative lawsuit names the Company as a
nominal defendant and as actual defendants the individuals named in the purported shareholder class
action lawsuits mentioned above as well as the Companys outside directors, Michael E. Keane, James
S. Marston, Antonio R. Sanchez III, and Ben G. Streetman. The suit seeks to require the Company to
initiate legal action for unspecified damages against the individual defendants named in the
purported shareholder class action lawsuits. The suit also alleges breaches of fiduciary duty,
abuse of control, insider selling, and misappropriation of information and seeks contribution and
indemnification against the individual defendants. These lawsuits may require significant management time and attention and could result in
significant legal expenses. The Company maintains insurance that may limit the Companys financial
exposure for defense costs and liability for an unfavorable outcome, should the Company not prevail
in the defense of these claims. Following the satisfaction of the deductible amount under the
applicable insurance, the Company expects insurance to cover the remaining legal defense costs of
the lawsuits. While the Company believes these lawsuits are without merit and intends to defend
them vigorously, since these legal proceedings are in the preliminary stages the Company is unable
to predict the scope or outcome of these matters and quantify their eventual impact, if any, on the
Company. An unfavorable outcome could have a material adverse effect on the Companys business,
operating results, cash flow and financial condition. The Company maintains insurance that may limit its financial exposure for defense costs and
liability for an unfavorable outcome in these matters, should it not prevail, for claims covered by
the insurance coverage. The Company has indemnification obligations to the individual defendants above, the terms of
which provide for no limitation to the maximum future payments under such indemnifications. The
Company is unable to develop an estimate of the maximum potential amount of future payments under
the indemnifications due to the inherent uncertainties involved in such litigation. The Company
maintains insurance, subject to limitations set forth in the policies, which is intended to cover
the costs of claims made against the defendants. Under the terms of the Companys software license agreements with its customers, the Company
typically agrees that in the event the software sold infringes upon any patent, copyright,
trademark, or any other proprietary right of a third party, it will indemnify its customer
licensees against any loss, expense, or liability from any damages that may be awarded against its
customer. The Company typically includes this infringement indemnification in all of its software
license agreements and selected managed service arrangements. In the event the customer cannot use
the software or service due to infringement and the Company cannot obtain the right to use, replace
or modify the license or service in a commercially feasible manner so that it no longer infringes
then the Company may terminate the license and provide the customer a pro-rata refund of the fees
paid by the customer for the infringing license or service. The Company has recorded no liability
associated with this indemnification, as it is not aware of any pending or threatened infringement
actions that are probable losses. The Company believes the estimated fair value of these
intellectual property indemnification clauses is minimal. 15




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The Company has severance agreements with certain employees that would require the Company to
pay approximately $1,818,000 if all such employees separated from employment with the Company
following a change of control, as defined in the severance agreements. The Company is involved in other legal proceedings that arise in the ordinary course of
business. In the opinion of management, the outcome of pending legal proceedings will not have a
material adverse effect on the Companys condensed consolidated financial statements.  14.
    Related Party Transactions In February 2004, the Company exchanged one million shares of Maptuit common stock for $70,000
in cash. The Company had previously recorded an impairment of this related party investments and
the partial recovery of the Companys investment in Maptuit has been recorded in the Companys
condensed consolidated statements of operations in the quarter ended March 31, 2004 as realized
gains on investments.  15.
    Subsequent Events Restructuring of $20,000,000 Convertible Promissory Notes Payable On April 13, 2005, the Company entered into amendments (the Purchase Agreement Amendments)
to the Original Purchase Agreements with each of the Investors. The closing of the Purchase
Agreement Amendments is subject to the satisfaction of certain conditions, principally obtaining
SEC registration of the shares that may be issued under the
convertible notes in the redemptions described below, by June 6,
2005. If the Purchase Agreement Amendments do
not become effective, the original terms of the convertible notes will continue to be in effect. In connection with the closing of the Purchase Agreement Amendments, the Company will issue an
Amended and Restated Convertible Note and an Amended and Restated Common Stock Purchase Warrant and
enter into an Amended and Restated Registration Rights Agreement with each of the Investors
(collectively, the Other Amendment Documents, and, together with the Purchase Agreement
Amendments, the Amendment Transaction Documents). Set forth below is a summary of the material
terms of the Purchase Agreement Amendments and the Other Amendment Documents.  
    Under the terms of the Amendment Transaction Documents, the Company will agree to redeem at 105% of principal
with shares of its common stock (i) the $5 million of principal amount of the convertible
notes originally due on November 2, 2005 on or before July 31, 2005 and (ii) the $5 million
of principal amount of the convertible notes originally due on November 2, 2008 on or
before December 31, 2005 (referred to herein as the 2005 Redemptions). The Company may
effect the 2005 Redemptions, in whole at any time, or in part from time to time, on or
before the scheduled redemption dates. The 2005 Redemptions will require that the Company
issue to the Investors a number of shares of its common stock valued at a 10% discount to
the daily volume weighted average price (VWAP) of the common stock for the 15 trading days
preceding the date of redemption. Assuming the VWAP approximates our stock price at April
29, 2005 of $2.75 per share, such $10 million mandatory redemptions would be payable with
approximately 4.7 million shares of our common stock. If the Company is unable to complete
the 2005 Redemptions using common stock, it must complete the redemptions by the redemption
dates using cash and issue additional warrants as described below.
    The warrants to purchase common stock originally issued to the Investors, currently
covering 1,000,000 shares of common stock at an exercise price of $6.00 per share, will be
amended, such that the exercise price for a pro-rata portion of the warrants will be
reduced to the price of the Companys common stock as and when the convertible notes are
redeemed, if the redemption value per share of common stock is lower than $6.00 per share.
    The amount of cash balances the Company is required to retain will be reduced following
the completion of the 2005 Redemptions. Once the Company has redeemed $10 million of the
principal amount by December 31, 2005, a covenant that would have required the company to
maintain cash balances of $10 million (including amounts in the collateral account) until
November 2007 will be reduced to $9 million. The required cash balance will further
decrease to $5 million in November 2006 at the time of payment or retirement of the $5
million principal amount of the convertible notes due November 2006.
    Under the terms of the Amendment Transaction Documents, the maximum number of shares of
common stock that the Company may issue to the Investors under the terms of the Amendment
Transaction Documents is subject to the limitation arising as a result of certain rules of
the Nasdaq National Market applicable to the Company. Because of this limitation, the
Company may not, without the approval of its shareholders, issue more than approximately
6.2 million shares of its common stock (or 19.99% of the Companys common stock
outstanding, measured as of the date of the Original Purchase Agreements) in connection
with 16




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o
    the 2005 Redemptions;o
    any other payment or redemption of the principal amount of the convertible notes;o
    the possible conversion by the Investors of the convertible notes at $6.00 per share;o
    the possible exercise by the Investors of the warrants; ando
    the payment of interest on the convertible notes.  The actual number of shares of the Companys common stock issued to effect the 2005
Redemptions will depend on the market price of the Companys common stock at the time of
redemption.
    If the approximate 6.2 million shares of common stock is not enough to enable the
Company to complete the 2005 Redemptions, or if the Company is unable to complete the 2005
Redemptions for any other reason (e.g., insufficient trading volume), then the Company
would be required to (i) redeem for cash the principal balance of the convertible notes
that could not be redeemed in the 2005 Redemptions and (ii) if the Investors so elect after
January 1, 2006, redeem for cash the remaining $10 million principal balance of the
convertible notes. Further, if the number of shares is sufficient to complete the 2005
Redemptions, but at any time after January 1, 2006 there are not enough shares left of the
approximately 6.2 million shares to permit the Investors to convert the remaining
outstanding principal amount of the convertible notes to common stock at $6.00 per share
(subject to adjustment as provided in the convertible notes) and exercise the warrants,
then, if the Investors so elect, the Company would be required to redeem any remaining
principal balance of the convertible notes for which there are not sufficient shares
available to convert to common stock at $6.00 per share (subject to adjustment). In each
such case, the convertible notes would be redeemed at 105 percent of principal and the
Company would be required to issue a warrant exercisable for 70% of the number of shares
into which the redeemed convertible note would have been convertible in the absence of the
share limitation. Any reductions of the principal amounts outstanding as a result of the
cash redemptions described above would also reduce the cash balances the Company is
required to maintain under the covenants described above, such that the cash balances would
not exceed the principal amounts outstanding under the convertible notes. The terms governing the convertible notes due November 2, 2006 and November 2, 2007, which are
$5 million principal amount each, generally remain unchanged (except as to possible early
redemption, which is described in the last bullet point above). Under these terms, the Company can
choose to repay the 2006 and 2007 convertible notes upon maturity if the holders have not elected
conversion into common stock. Alternatively, the Company can redeem the 2006 and 2007 convertible
notes prior to maturity in cash at 105% of the principal amount, plus accrued interest and the
issuance of an immediately exercisable supplemental warrant exercisable for 70% of the common stock
that would be issuable to the holders of the convertible notes upon conversion in respect to the
principal amount thereof if the convertible notes were to remain outstanding. The interest rates and interest payment dates remain unchanged. 
 17




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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS Summary The Company operates in a single reporting segment, providing solutions that protect, manage,
and deliver sensitive electronic information. These solutions are grouped into two product lines:
eSecure and eHealth. The eSecure products include the suite of secure messaging solutions (ZixVPM,
ZixPort, ZixMail, and ZixAuditor) and the Message Inspector and Web Inspector (both Inspector
products were sold to CyberGuard on March 11, 2005). The eHealth products include the PocketScript
e-prescribing product and the Dr. Chart lab results delivery product. In the first quarter 2005, the Company experienced the following significant items:  
    Sold the Message Inspector and Web Inspector product lines on March 11, 2005.
    Experienced a 26% increase in revenue in Q1 2005 versus Q1 2004.
    Reduced the company-wide workforce by approximately 10% in mid-January, 2005.
    Cash (restricted and unrestricted) and marketable securities decreased by $6,337,000. The sale of the Message Inspector and Web Inspector product lines had an immediate in quarter
effect on the financials: the revenues from those products ceased on the date of sale; the Company
received cash consideration; and the carrying amount of various assets and liabilities assumed by
the purchaser were removed from the Companys balance sheet. Revenue in the first quarter 2005 for
the Message Inspector and Web Inspector product lines was $637,000 compared to $903,000 in first
quarter 2004. The $266,000 decrease is attributed to the timing of the sale, and the resulting
loss of support and maintenance revenue following the sale and the loss of normally occurring late
in-quarter sales of new software licenses. The sale of these product lines increased the Companys
cash balances by the $2,126,000 received from the purchaser at closing. The Company also received
from the purchaser a note for $1,500,000 due in 2005 and incurred transaction fees of $317,000. In mid-January, the Company reduced its total workforce by approximately 10% by eliminating 27
positions. Employee costs are 18




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##### Table of Contents



the single greatest component of the Companys cost structure. The
cuts were spread across multiple geographies and multiple product areas. The Company sought to
become more focused on its two core markets, secure messaging and e-prescribing and to become more
efficient by increasingly sharing resources across all company initiatives. While headcount cost
reductions take 30-90 days to fully realize, the Companys total spending declined from $14,109,000
in the fourth quarter of 2004 to $12,867,000 in the first quarter of 2005. Additional savings are
expected to materialize in the second quarter and the Company is continuing its efforts to reduce
additional costs. As the Company is investing in emerging markets, significant net use of cash continued in the
quarter. The cash (restricted and non restricted) and marketable securities declined from a total
(restricted and unrestricted) balance of $30,230,000 to $23,893,000 for a net decrease of
$6,337,000. Cash receipts in total declined relative to the prior quarter as receipts declined for
Message Inspector and Web Inspector due to the sale and declined for PocketScript as the Company
completed the 2004 deployment efforts. The cash receipts for Secure Messaging improved on
increased order input and continued strength in renewals. In addition, to the above items, the Company restructured the $20,000,000 of convertible
promissory notes payable on April 13, 2005. Overview Since January 1999, the Company has developed and marketed products and services that bring
privacy, security, and convenience to Internet users. In the first quarter of 2001, the Company
first introduced ZixMail, a desktop solution for encrypting and securely delivering email, and
began focusing its sales and marketing efforts toward the commercial market. In 2002 and 2003, the
Company significantly expanded its portfolio of commercial services and rebuilt its sales and
marketing work force under new executive leadership. The expanded communications protection
portfolio of commercial products and services included: ZixVPM (Virtual Private Messenger), an
e-messaging gateway solution 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; and ZixPort, a secure Web-messaging
portal. Further, the Company has targeted the healthcare sector, where the legislated mandates of
the Health Insurance Portability and Accountability Act (HIPAA), a 1996 law that requires protected
health information to be safeguarded over open networks, are driving demand. The privacy
regulations for this law took effect in April 2003 and the security regulations is scheduled to go
into effect in April 2005. In July 2003, the Company acquired substantially all of the operating assets and the business
of Ohio-based PocketScript, LLC (PocketScript), a privately-held development-stage enterprise
that provides electronic prescription solutions for the healthcare industry. This acquisition
enabled the Company to expand its services into care delivery solutions, specifically, the
e-prescribing marketplace, which is expected to grow significantly as more physicians leverage
technology in delivering care. This expansion is paired with the fact that the number of
prescriptions written annually in the United States continues to increase and confidence in the
safety of written prescriptions declines. In September 2003, the Company acquired substantially all
of the operating assets and the business of Elron Software, Inc. (Elron Software or Elron), a
majority-owned subsidiary of Elron Electronic Industries Ltd. and a provider of anti-spam, email
content filtering and Web filtering solutions. In January 2004, the Company acquired substantially
all of the operating assets and the business of MyDocOnline, Inc. (MyDocOnline), a subsidiary of
Aventis Pharmaceuticals, Inc., the North American pharmaceuticals business of Aventis SA.
MyDocOnline offers a variety of Internet-based healthcare services and is a provider of secure
Web-based communications, disease management, online doctor visits, and laboratory information
solutions. On November 4, 2004, the Company announced that it was terminating the Connect service
for online doctor visits, which is one of the products acquired in the MyDocOnline acquisition. On
March 11, 2005, the Web Inspector and Message Inspector product lines, which were acquired in the
Elron acquisition, were sold to CyberGuard Corporation (see Note 6 to the condensed consolidated
financial statements). The foundation of the Companys business model is centered on the financial leverage expected
to be generated by its various subscription and transaction-based revenues that are believed to be
predominantly recurring in nature and an efficient cost structure for its secure data center
operations, the core of which is expected to remain relatively stable. Subscription fees are
expected to be collected at the beginning of the subscription period, generally on an
annual basis and are recognized as revenue on a prorated basis over the length of the subscription
period. Operating in emerging markets involves risks and uncertainties, and there are no assurances
that the Company will be successful in its efforts. Successful growth of an early-stage enterprise
is costly and highly competitive. The Companys growth depends on the timely development and market
acceptance of its products and services. In 2004, the Company has incurred significant operating
losses and the use of cash resources has continued at a substantial level. The Company anticipates
further operating losses in 2005. In 2005, the Company continues to place a strong emphasis on actions to become cash flow
breakeven. This emphasis might entail cost reductions in the near term. Cost reductions could come
in the form of workforce reductions, decreased investments in certain areas of the business,
business divestitures (sales or shut down), or geographic consolidation. The Companys plan is to
eliminate cost in the areas of the business that are expected to continue to result in cash
outflows and emphasize the areas of the business that can become cash flow positive in the near to
medium term. Strategic actions intended to achieve the goal of cash flow breakeven might have
intended or unintended short-term adverse effects on certain financial performance metrics for the
Company. 19




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Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in accordance with accounting
principles generally accepted in the United States requires the Companys management to make
estimates and assumptions that affect the amounts reported in the Companys condensed consolidated
financial statements and accompanying notes. Actual results could differ from these estimates and
assumptions. Critical accounting policies and estimates are defined as those that are both most
important to the portrayal of the Companys financial condition and results and require
managements most subjective judgments. The Companys most critical accounting policies and
estimates are described below. Long-Lived Assets The accounting policies and estimates relating to the long-lived assets are considered
critical because of the significant impact that impairment or obsolescence could have on the
Companys operating results. The Companys long-lived assets subject to amortization are comprised of identified intangibles
and property and equipment aggregating $7,049,000 or 16% of total assets at March 31, 2005. The
intangible assets are reviewed for impairment when certain triggering events occur where there is
reason to believe that the value has been diminished or impaired. The amount of a potential
impairment is determined by comparing the carrying amount of an asset to the value determined from
a projected discounted cash flow method, using a discount rate that is considered to be
commensurate with the risk inherent in the Companys current business model. Assumptions are made
with respect to future net cash flows expected to be generated by the related asset. An impairment
charge would be recorded for an amount by which the carrying value of the asset exceeded the
discounted projected net cash flows. Also, even where a current impairment charge is not
necessary, the remaining useful lives are evaluated. During first
quarter of 2005, the Company
evaluated the estimated useful lives of the intangible assets relating to MyDocOnLine acquisition
and the lives for developed technology and customer relationships were reduced to 3 years from 5
years and 4 years, respectively. This change in estimate is accounted for prospectively beginning
January 1, 2005 and resulted in an additional amortization expense of $54,000 in the first quarter. During 2003 and 2004, the Company completed three acquisitions using the purchase method of
accounting. The amounts assigned to the identifiable assets and liabilities acquired in connection
with these acquisitions were based on estimated fair values as of the date of the acquisition, with
the remainder recorded as goodwill. The fair values were determined by management, generally based
upon information supplied by the management of the acquired entities, and in two instances
valuations were prepared by independent appraisal experts. The fair values have been based
primarily upon future cash flow projections for the acquired assets, discounted to present value
using a risk-adjusted discount rate. Goodwill, totaling $6,958,000 or 16% of total assets at March 31, 2005, represents the cost in
excess of fair value of net assets acquired in the September 2003 acquisition of Elron Software,
net of the portion of goodwill associated with the net asset sold to CyberGuard (see Note 6 to the
condensed consolidated financial statements) and the January 2004 acquisition of MyDocOnline. The
Company evaluates its goodwill for impairment annually in the fourth quarter or when there is
reason to believe that the value has been diminished or impaired. Evaluations for possible
impairment are based upon a comparison of the estimated fair value of the reporting unit to which
the goodwill has been assigned to the sum of the carrying value of the assets and liabilities of
that unit including the assigned goodwill value. The fair values used in this evaluation are
estimated based upon discounted future cash flow projections for the unit, market values of
comparable businesses where available or the Companys market capitalization based on outstanding
stock values. An impairment is deemed to exist if the net book value of the unit exceeds its
estimated fair value. The sale of the Message Inspector and Web Inspector products, which were a
significant part of the Elron acquisition, caused the Company to evaluate the goodwill associated
with the sales of net assets representing a portion of the eSecure reporting unit. As a result, the
Company reduced goodwill by $2,161,000 as part of the carrying value of the net assets related to
that transaction (see Note 6 to the condensed consolidated financial statements). This represented
50% of the acquired goodwill from the Elron acquisition. Future changes made to the current estimates or assumptions, including such factors as order
volumes and price levels, life spans of purchased technology, continuity of acquired customers,
alternative uses for property and equipment and levels of operating expenses, could result in an
unanticipated impairment charge from the write-down of the Companys long-lived assets or goodwill. Deferred Tax Assets These balances are considered critical because of the relative size of the deferred tax assets
and related valuations, and the potential expiration of tax assets if profitability is not obtained
within a specified period. As required by SFAS No. 109, Accounting for Income Taxes,the Company
recognizes deferred tax assets on its condensed consolidated balance sheet if it is more likely
than not that the subject net operating loss carryforwards and unused tax credits will be realized
on future federal income tax returns. At March 31, 2005, the Company continued to provide a full
valuation allowance against accumulated U.S. deferred tax assets of approximately $95,860,000,
reflecting the Companys historical losses and the uncertainty of future taxable income. If the Company begins to generate U.S. taxable income in a future period or if the facts and
circumstances on which its estimates and assumptions are based were to change, thereby impacting
the likelihood of realizing the deferred tax assets, judgment would have to be applied in
determining the amount of valuation allowance no longer required. Reversal of all or a part of this
valuation allowance could have a significant positive impact on operating results in the period
that it becomes more likely than not that certain of the Companys deferred tax assets will be
realized. The Companys net operating loss carryforwards and tax credits have various expiration
dates beginning in 2009 and going through 2024. 20




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Revenue Recognition The Company recognizes revenue in accordance with accounting principles generally accepted in
the United States of America, as promulgated by SOP 97-2, Software Revenue Recognition,SOP 98-9,
Modification of SOP 97-2, Software Revenue Recognition, With respect to Certain Transactions,
Emerging Issues Task Force (EITF) Abstract No. 00-21, Revenue Arrangements with Multiple
Deliverables,and Securities and Exchange Commission Staff Accounting Bulletin No. 104, Revenue
Recognition in Financial Statements,and other related pronouncements. Accounting for revenue is
complex due to the long-term nature of Zixs contracts with customers and the potential for
incorrect application of accounting guidance requires that revenue recognition be considered a
critical accounting policy. The Company develops, markets, licenses and supports computer software products and services.
The Companys products can be placed into several key revenue categories where each category has
similar revenue recognition traits; Communications Protection subscription-based services,
perpetual software license sales, the PocketScript e-prescribing application, various transaction
fees and professional services. A majority of the revenues generated by the Company are through
direct sales; however, the Company employs a network of distributors and resellers. Under all
product categories and distribution models, the Company recognizes revenue after all of the
following occur: persuasive evidence of an arrangement exists, delivery has occurred or services
have been rendered, the price is fixed and determinable, and collectability is reasonably assured.
In the event the arrangement has multiple elements with delivered and undelivered elements, revenue
for the delivered elements are recognized under the residual method only when vendor-specific
objective evidence of fair value (VSOE) exists to allocate the fair value of the total fees to the
undelivered elements of the arrangement. Occasionally, when ZixCorp is engaged in a complex product
deployment, customer acceptance may have to occur before the transaction is considered complete. In
this situation no revenue will be recognized until the customer accepts the product. Subscription-based services include the Communication Protection services of ZixMail, ZixVPM,
ZixPort, ZixAuditor, anti-spam signatures subscription, and anti-virus subscriptions as well as
certain products acquired from MyDocOnline. These products include delivering licensed software and
providing customer support and secure electronic communications throughout the subscription period.
The customer is often provided an appliance during the subscription period with pre-installed
software or contractually subscribes to a data center resident service. In a subscription service,
the customer typically does not own a perpetual right to a software license, but is instead granted
the use of that license during the period of the subscription. Subscriptions are generally annual
non-refundable contracts. The subscription period begins on the date specified by the parties when
the service is fully functional for the customer which is consequently deemed to be the date of
acceptance. Revenues from subscription services are recorded as service revenue as the services are
rendered from the date of acceptance over the subscription period. Subscription fees received from
customers in advance are recorded as deferred revenue and recognized as revenues ratably over the
subscription period. In 2004 and first quarter 2005, the Company sold anti-spam filtering, email content filtering
and Web filtering solutions to customers under perpetual licensing arrangements. These perpetual software
licenses are normally sold as part of multiple-element arrangements that include annual maintenance
and/or subscription, and may include implementation or training services. Acceptance for these
products is generally when delivered if they are self installable by the customer and upon
installation if installation is required to be done by ZixCorp professional services. These
products are primarily self installed. Where VSOE has not been established for undelivered
elements, revenue for all elements is deferred until those elements are delivered or their fair
values determined. However, if VSOE is determinable for all of the undelivered elements, and the
undelivered elements are not essential to the delivered elements, the Company will defer
recognition of the fair value related to the undelivered elements and recognize as revenue the
remaining portion of the arrangement through application of the residual method. Evidence of VSOE
for implementation and training services associated with the anti-spam, email content filtering and
Web filtering arrangements is based upon standard billing rates and the estimated level of effort
for the individuals expected to perform the related services. Installation and training revenues
are recognized as the services are rendered. The Company establishes VSOE for maintenance based
upon maintenance that was sold separately. Maintenance revenue is recognized over the term of the
maintenance agreement, generally one year. On March 11, 2005 the Web Inspector and Message Inspector product lines which perform
anti-spam, e-mail and Web filtering, were sold to CyberGuard Corporation. These product lines were
acquired in September 2003 when the Company purchased Elron Software, Inc. Message Inspector and
Web Inspector contributed $903,000 and $637,000 of revenue for the quarters ended March 31, 2004
and March 31, 2005, respectively. The sale of Message Inspector and Web Inspector is
discussed further in Note 6 to the condensed consolidated financial statements. The Company recognizes revenue on the PocketScript e-prescribing service as a multiple element
arrangement with separate units of accounting. VSOE is determined for the undelivered elements, and
the residual value is assigned to the hardware device and is recognized upon installation of the
device at an end-user location. Installation is determined by physical delivery of a functioning
product. The fair values of the undelivered elements relate to ongoing services and are recognized
ratably over the period of the service. The Company establishes VSOE for the service elements based
upon contract renewal rates or fair market values if the element is commonly sold by others. Some of the Companys services incorporate a transaction fee per event occurrence or when
predetermined usage levels have been reached. These fees are recognized as revenue when the
transaction occurs. For contracts with customers to provide certain professional services as
standalone offerings, the Company recognizes revenue as the services are rendered and utilizes the
percentage of completion method when appropriate. 21




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The Companys services include various warranty provisions. The Company accrues warranty
costs at the time it recognizes revenues. Warranty expense was not material to any period
presented. Results of Operations Revenues The
Companys revenues grew during first quarter of 2005 relative to
the first quarter of 2004. The
year on year increase is from growth in the secure e-messaging market, primarily influenced by
HIPAA requirements in the healthcare industry, and from the 2003 acquisitions of new technologies,
primarily anti-spam, Web filtering and e-prescribing. The Companys future revenue growth is
primarily influenced by continued increases in the secure messaging market, both in the healthcare
industry and expanding into new industries as well as a broader market adoption of the
e-prescribing technology. The sale of the Message Inspector and Web Inspector products, which
occurred on March 11, 2005, caused a decline in the revenues from these products in the first
quarter of 2005 relative to the first quarter of 2004. There will be a further decline in revenues
from these products in 2005 relative to 2004 as all revenues from these products ceased as of March
11, 2005. The
following table sets forth a quarter-over-quarter comparison of the key components of
the Companys revenues: VarianceThree Months Ended March 31,
    
    
    2005 vs. 20042005
    
    
    2004
    
    
    $
    
    
    %Services
    
    $
    3,298,000
    
    
    $
    2,516,000
    
    
    $
    782,000
    
    
    
    31
    %Hardware
    
    
    185,000
    
    
    
    
    
    
    
    185,000
    
    
    
    Software
    
    
    100,000
    
    
    
    327,000
    
    
    
    (227,000
    )
    
    
    (69
    %)Total revenues
    
    $
    3,583,000
    
    
    $
    2,843,000
    
    
    $
    740,000
    
    
    
    26
    %
 Secure e-messaging services are primarily subscription-based services; the Elron software
products were primarily sold as perpetual licenses with annual maintenance and/or subscription
contracts; the PocketScript e-prescribing service is sold as a subscription service with initial
deployment and hardware fees; and the Dr. Chart services and products fall into either a
subscription-based arrangement or a perpetual license sale. All or part of these products might
incorporate a transaction-fee element where a per-event occurrence can generate service revenue.
Additionally, the Company offers certain professional services as standalone offerings or in
conjunction with its products. The Company recognizes these as revenue as the services are rendered
or over the life of a related service contract and utilizes the percentage of completion method
when appropriate. The subscription period begins on customer acceptance of the ordered services,
which subsequently commences the appropriate revenue recognition application. Sales returns and
allowances occur infrequently and are immaterial in dollar value. Further, revenues result
primarily from direct sales efforts, although the Company employed a network of distributors and
resellers for the recently sold Elron software products and increasingly for the secure e-messaging
services. The Companys revenues increased from $2,843,000 for the three months ended March 31, 2004 to
$3,583,000 ($2,680,000 from eSecure and $903,000 from eHealth) for the corresponding period in
2005. This increase of $740,000 was from an increase in the Secure Messaging revenue (service
subscription fees) of $368,000 and an increase in revenues from PocketScript of $691,000.
Offsetting these gains were decreases of $266,000 in quarter-on-quarter revenue caused by the
sale of the Message Inspector and Web Inspector and $53,000 decrease in Dr. Chart revenues. The
revenue from Secure Messaging products increased from new customer subscriptions that were
activated throughout 2004 and from very low attrition rates in the existing customer base. As a
subscription service, the revenue naturally increases in a predictable fashion as long as new
customers sign up for the service and attrition of existing customers remains low. The
PocketScript revenues increased as the number of base subscription customers increased through 2004
and because installations in the first quarter of 2005 were greater than those in the first quarter
of 2004. Under the existing contracts for e-prescribing, there is
some immediate revenue
recognition on installation and an amortizing subscription fee. A recent trend experienced by the
Company is a decline in installations from the immediately preceding quarters. This trend will
cause decreases in e-Prescribing revenue in the short term and a leveling off in the long term
unless new, significant customers emerge for the product. A Master Services Agreement was entered into with Aventis, Inc. (Aventis) for $4,000,000 on
the same date as
the MyDocOnline acquisition (see Note 6) for the performance, by the Company, of various
future services. The services were to be delivered in minimum amounts of $1,000,000, $1,000,000 and
$2,000,000 prior to January 30, 2005, January 30, 2006, and January 30, 2007, respectively. The
services will be defined on an ongoing basis over the life of the agreement and valued in
accordance with pricing for similar services rendered by the Company to other customers. Aventis
paid the $4,000,000 upon execution of the Master Services Agreement. Since the Companys services to be provided to Aventis have not yet been fully defined, the
$4,000,000 payment has been recorded as a customer deposit. As the services are defined and priced
in individual project agreements, the value of the defined element will be reclassified to deferred
revenues and then recognized as revenue in accordance with applicable revenue recognition criteria.
If the services are not requested by Aventis by the dates outlined above the deposit will be
forfeit and ZixCorp will recognize the deposit as other income. The Company is required to return
to Aventis any unused portion of the deposit only in the event of material breach of the contract
by the Company, in the event the Company or a party employed or engaged by the Company is debarred
pursuant to the Generic Drug Enforcement Act of 1992 or similar state, local, or foreign law, in
the event the Company files for bankruptcy, or in the event of force majeure. The Company believes
that it is unlikely any of these events will occur. The 22




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Companys obligations associated with the
Master Services Agreement are secured by a first priority lien on the Companys property and
equipment and accounts receivable. As of March 31, 2005, the Company had provided $40,000 of
services to Sanofi-Aventis under this Master Services Agreement. Subsequent to the MyDocOnline acquisition, Aventis merged with Sanofi and the rights under
this agreement were transferred to the new company, Sanofi-Aventis. The Company and Sanofi-Aventis
agreed to extend the January 30, 2005 deadline for consuming the initial $1,000,000 in services to
April 11, 2005. Sanofi-Aventis will forfeit any unused amounts annually if services are not
requested by Sanofi-Aventis in accordance with the terms of the Master Services Agreement unless
the deadlines are extended by mutual agreement of the parties. The initial $1,000,000 in services
was not consumed by Sanofi-Aventis by April 11, 2005 and the Company advised Sanofi-Aventis that
the $1,000,000 was forfeited to the Company. The Company will record this amount in other income
in the financial statements for the quareter ended June 30, 2005. On March 11, 2005, the Web Inspector and Message Inspector product lines, which were acquired
in the Elron acquisition, were sold to CyberGuard Corporation. These product lines contributed
revenues of $637,000 in the first quarter 2005 and $903,000 in the same period of 2004. Also,
deferred revenue was assumed by CyberGuard as part of the purchase agreement, which reduced the
backlog by $1,546,000 (see Note 6 to the condensed consolidated financial statements). The revenues
from those products ceased on the date of sale and therefore, the expected revenues and additions
to the backlog in the future quarters is zero for these products. After the sale of Message
Inspector and Web Inspector, the Company now generates only limited revenues from the sale of
perpetual software licenses. Management follows several general metrics to gauge business performance and the results of
these metrics can have an effect on managements estimate of future revenue. These metrics include:
order input, backlog, renewal rate (customer retention) of secure e-messaging service contracts,
observations of the mix of single-year verses multi-year service contracts for secure e-messaging
and deployments to physicians of the e-prescribing products. Company-wide order bookings for first quarter 2005 increased 24% over the same period in 2004.
The Companys end-user order backlog as of March 31, 2004, is approximately $22,700,000 and is
comprised of the following elements: $2,960,000 from the original $4,000,000 customer deposit from
Sanofi-Aventis for future services (described above), $7,120,000 of deferred revenue that has been
billed and paid, $3,040,000 billed but unpaid, and approximately $9,580,000 of unbilled contracts.
The Companys end-user order backlog is comprised of contractually bound agreements that the
Company expects to fully amortize into revenue and excludes $1,546,000 which was acquired by
CyberGuard in the Message Inspector and Web Inspector purchase (see Note 6 to the condensed
consolidated financial statements). The renewal rate for secure e-messaging customers was in excess of 95% throughout the first
quarter of 2005, which is consistent with 2004 results. In addition, the Company continues to see
an increase in the number of customers who subscribe to use the Companys secure messaging service
for a three-year term verses a one year term. The Company expects this preference for a longer
contract term to continue for the rest of 2005, as the Company has priced its services in a manner
that encourages longer term contractual commitments from customers. The primary driver of demand for the Companys e-prescribing devices and services in 2004 was
insurance payors purchasing the devices and related services from the Company for physicians in a
sponsorship arrangement, whereby the payor sponsored certain physicians to receive the device and
services from the Company. During 2004 the Company deployed its PocketScript e-prescribing service
to approximately 2,500 physicians under two such initiatives. The larger of the two was the eRx
Collaborative initiative (a collaborative effort between Tufts Health Plan and Blue Cross Blue
Shield Massachusetts, and Neighborhood Health Plan). In the first quarter of 2005, Blue Cross Blue
Shield Massachusetts verified that ZixCorp had met various contractual requirements, which led to
the release of a contingency on 300 additional units and the eRx Collaborative placed an order for
an additional 300 units to be deployed in 2005. The Company believes that the sponsorship model is
currently the prevalent market demand model. While the Company has additional deployments to
conduct under existing sponsorship agreements, growth in this area will require additional payor
sponsors or a change in the market demand model. Cost of Revenues In the quarter ended March 31, 2005, the Companys costs of revenue increased 23% as the
Companys revenues increased 26%. The increase in 2005 versus 2004 was almost entirely in the
eHealth e-Prescribing services and was caused by investments made to enter and remain in the
eHealth market. While revenues grew in eSecure with little or no increase in costs of revenue for
those products year on year, this potential increase in the gross margin was almost entirely offset
by the increases required for the eHealth products. At March 31, 2005, a substantial amount of the Companys cost of revenues is not directly
variable to revenues. These costs represent the base cost required to provide the various service
offerings such as the data center and the customer support function. The Company believes it has
the capacity to grow revenues further, assuming market demand, while maintaining a growth in costs
of revenue less than the revenue growth rate. The trend in secure messaging has been the ability
to grow revenues without increasing, or only marginally increasing, the costs of revenues as more
efficient methods of product delivery and service have been implemented. While this trend is
expected to continue, it is not expected to continue to the extent it has in the past. Eventually,
additional efficiencies become more difficult to achieve and costs of revenues could rise more in
line to increases in revenue. e- 23




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##### Table of Contents



Prescribing costs of revenues have risen significantly in the last
year as the Company builds the required base of resources to provide and service these products.
E-prescribing cost of revenues has a sizable fixed component but also has a variable component
associated with the cost of devices, physician recruiting, installation and training. Additional
increases in e-prescribing revenue, should demand occur, is expected to result in a corresponding
increase in the related costs of goods sold. The following table sets forth a quarter-over-quarter comparison of the Companys cost of
revenues: VarianceThree Months Ended March 31,
    
    
    2005 vs. 20042005
    
    
    2004
    
    
    $
    
    
    %Total cost of
revenues
    
    $
    3,891,000
    
    
    $
    3,174,000
    
    
    $
    717,000
    
    
    
    23
    %
 Cost of revenues increased $717,000 primarily due to personnel additions totaling
$549,000 and non-personnel cost increases totaling $168,000, both of which were necessary to expand
the Companys deployment and client services capabilities to support primarily the order growth of
the Companys e-prescribing products and services. Non-personnel costs primarily include expenses
for data center maintenance and support, deployment-related costs for the e-prescribing hand-held
devices and systems, outside consultants and travel. The specific increases between reporting
periods included $160,000 relating to the hardware and data communications elements of the
e-Prescribing hand-held device deployments, and $113,000 for travel expenses. These increases in
non-personnel costs were partially offset by a $95,000 reduction in depreciation and amortization
of property and equipment resulting from certain data center equipment becoming fully depreciated. A significant portion of the Companys cost of revenues relates to the cost of operating and
maintaining the ZixData Center which is currently not fully utilized. Accordingly, costs associated
with the data center and other fixed assets are expected to grow at a slower pace than revenue.
Cost of revenues also includes the activities of field deployment, professional services and
customer service and support. The Company has two product groupings,
eSecure and eHealth. The two categories have both distinct and shared costs of revenues. Most
notable of the shared costs is the ZixData Center. Management estimates and makes assumptions
regarding these shared costs to calculate an estimated cost of revenues per reporting unit. The
total cost of revenues of $3,891,000 is estimated to be comprised of $1,653,000 relating to eSecure
and $2,238,000 relating to eHealth, including allocations of shared costs. The results show that
eSecure has revenue in excess of the estimated costs of revenue and that additional revenue in this
product line requires only modest increases in the costs of revenues. Research and Development Expenses Research and development expenses decreased 31% in the three months ended March 31, 2005
relative to the three months ended March 31, 2004. The decrease was the result of higher spending
in 2004 related to newly acquired products from business acquisition. Since the acquisition, these
costs have been significantly reduced by merging various initiatives into the core research and
development spending and thus the overall costs have decreased. Additionally, spending has been
reduced from the cancellation of the Connect product and from the partial months savings from
selling Message Inspector and Web Inspector products on March 11, 2005. The following table sets forth a quarter-over-quarter comparison of the Companys research
and development expenses: VarianceThree Months Ended March 31,
    
    
    2005 vs. 20042005
    
    
    2004
    
    
    $
    
    
    %Total research and
development
    
    $
    1,975,000
    
    
    $
    2,845,000
    
    
    $
    (870,000
    )
    
    
    (31
    %)
 The $870,000 decrease consists primarily of $220,000 for headcount reductions relating to
Elron Software and MyDocOnline products, $214,000 for reduced consulting fees primarily relating to
MyDocOnline, $162,000 for 2004 non-cash compensation involving employee bonuses and severance costs
and $306,000 for the one-time charge of allocated in-process research and development amortization
expense associated with the 2004 acquisition of MyDocOnline. These cost decreases were partially
offset by increased occupancy costs of $72,000. Selling, General and Administrative Expenses Selling, general and administration expenses decreased 4% in the three months ended March 31,
2005 relative to the three months ended March 31, 2004. The general trend is a reduction in
expenses as the Company consolidates various marketing initiatives from acquired companies into a
centrally managed initiative and as the Company focuses on its two core markets. These reductions
have been offset with increases in marketing and sales for the e-prescribing products and increases
in the costs of being a publicly held company. While the publicly traded company costs increased
in 2004 in order to comply with Sarbanes-Oxley requirements, they are not expected to significantly
abate in 2005 as continued compliance remains expensive. The following table sets forth a quarter-over-quarter comparison of the Companys selling,
general and administrative expenses: 24




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VarianceThree Months Ended March 31,
    
    
    2005 vs. 20042005
    
    
    2004
    
    
    $
    
    
    %Total selling, general
and administrative
expenses
    
    $
    7,502,000
    
    
    $
    7,806,000
    
    
    $
    (304,000
    )
    
    
    (4
    %)
 The $304,000 decrease in selling, general and administrative expenses is primarily due to
a $888,000 decrease in personnel costs consisting primarily of the non-recurrence of employee
severance costs paid in 2004. These decreases were partially offset by a net increase in
non-personnel costs totaling $584,000 and consisting of $157,000 for increased advertising and
marketing programs, $644,000 for increased legal and accounting related consulting and professional
services, $99,000 for various taxes and other sundry expenses. These increases in non-personnel
costs were partially offset by $316,000 in reduced travel expenses. Interest Expense Interest expense in first quarter 2005 is $830,000 compared to $55,000 for the same period in
2004. The 2004 interest is solely from the promissory note issued in connection with the
acquisition of MyDocOnline in January 2004. The first quarter 2005 interest expense consists of
the following: Stated
    
    
    
    
    
    
    Financing
    
    
    TotalInterest
    
    
    Discount
    
    
    Cost
    
    
    Intereston Notes
    
    
    Amortization
    
    
    Amortization
    
    
    ExpenseConvertible promissory
notes payable
    
    $
    266,000
    
    
    $
    301,000
    
    
    $
    160,000
    
    
    $
    727,000Promissory note payable
    
    
    
    
    
    
    92,000
    
    
    
    
    
    
    
    92,000Short-term promissory notes
    
    
    3,000
    
    
    
    
    
    
    
    
    
    
    
    3,000Capital Leases
    
    
    8,000
    
    
    
    
    
    
    
    
    
    
    
    8,000Total notes payable
    
    $
    277,000
    
    
    $
    393,000
    
    
    $
    160,000
    
    
    $
    830,000
 The promissory note payable is the Sanofi-Aventis note payable referenced in Note 11 to
the condensed consolidated financial statements. This note bears interest at an annual rate of
4.5% and is payable only in services provided by the Company to Sanofi-Aventis unless there is an
event of default. As of March 31, 2005, Sanofi-Aventis has requested no services in-lieu of
interest and the Company believes that it is not probable that Sanofi-Aventis will request such
services. In addition, the potential costs of delivering any unspecified services cannot be
estimated. Therefore, no interest expense or liabilities have been recorded in relation to the
stated interest rate on the note. Investment and Other Income Investment income increased from $58,000 in first quarter 2004 to $143,000 in 2005 primarily
due to an increase in invested cash and marketable securities. Recovery of Previously Impaired Investment In February 2004, the Company exchanged one million shares of previously impaired Maptuit
stock for $70,000 in cash resulting in a gain of this amount. Gain on Sale of Product Line On March 11, 2005, the Company sold its Web Inspector and Message Inspector product lines to
CyberGuard Corporation. The total sales price was $3,626,000 consisting of $2,126,000 in cash and
a $1,500,000 note receivable due in three equal payments in 2005. The net gain recognized on the
sale was $950,000 (see Note 6 to the condensed consolidated financial statements). Income Taxes The Companys income taxes increased from $29,000 for the three months ended March 31, 2004 to
$50,000 for the corresponding period in 2005 and represents non-U.S. taxes payable resulting from
the operations of the Companys Canadian subsidiary. The Company has fully reserved its U.S. net
deferred tax assets due to the uncertainty of future taxable income. Currently, the Companys net operating loss carryforwards do not have limitations due to
ownership changes as defined by Section 382 of the Internal Revenue Code. However, future ownership
changes may limit the Companys ability to fully utilize the net operating loss carryforwards
against any future taxable income. Net Loss As a result
of the foregoing, the Company s net loss was $9,572,000 for the three months ending
March 31, 2005 and $10,938,000 for the corresponding period in 2004. 25




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##### Table of Contents



Liquidity and Capital Resources Due to the Companys history of operating spending in excess of customer receipts, liquidity
is of special importance. Essential to liquidity is the ability of the Company to become cash flow
positive, ideally from operations, but augmented as required by financing or investing activities. The Company has material contractual obligations over the next year of $7,871,000 and
$24,159,000 over the next three years consisting of leases and debt obligations. Cash requirements
in excess of these commitments represent operating spending the Company chooses to make in order to
satisfy existing customer contracts and to secure new orders and cover various overhead costs. The
spending in excess of contractual commitments is somewhat flexible and dependant on the Companys
current and future cash receipts. The Company is engaged in two primary markets, eSecure and
eHealth. For several years the spending in eSecure far exceeded cash receipts. As that product
has matured the gap between cash receipts and cash used has narrowed substantially and continues to
do so. The recurring nature of the subscription model makes cash receipts predictable and
additional spending to sustain and continue to stay abreast with market demands in eSecure are not
extensive. The eHealth market is significantly earlier in its development phase relative to
eSecure and thus the Company has chosen to spend money in excess of the cash receipts. The Company
continues to closely monitor developments in the eHealth market and will adjust spending in that
area commensurate with expected future returns and, if appropriate and available, will consider
additional funding to augment cash from operations. Sources and Uses of Cash Net cash used by operations was $7,386,000 for the three months ended March 31, 2005 compared
to $2,941,000 for the corresponding period in 2004. The increase in cash used for operating
activities totaling $4,445,000 was primarily due to the $4,000,000 customer deposit from Aventis
received in the first quarter of 2004. Additionally, the Company experienced a $1,136,000 decrease
in the 2005 non-cash operating expenses in the areas of depreciation and amortization of intangible
and tangible assets, amortization of debt-related financing costs and discounts and stock-based
compensation, the $950,000 gain on the sale of the Web Inspector and Message Inspector product
lines, a $186,000 decrease in trade payables and accrued expenses and a decrease in deferred
revenue totaling $119,000, partially offset by a 12% decrease in the Companys net loss, totaling
$1,366,000, a decrease in non-acquired accounts receivable and prepaid expenses totaling $510,000
and $70,000 pertaining to the 2004 partial recovery of a previous investment in Maptuit Corporation
Net cash used by operating activities for the three months ending March 31, 2005 was funded
primarily by existing cash resources and investing and financing activities described below. Additionally, in the three months ending March 31, 2005 the Company collected customer
receipts of $4,073,000. This is a 14% increase over the same period in 2004. Included in the
$4,073,000 are cash receipts from the Message Inspector and Web Inspector products totaling
$711,000. The Company expects to collect an additional $189,000 attributable to Message Inspector
and Web Inspector products in the second quarter of 2005, but thereafter the cash receipts from
these products is expected to be zero as these products were sold as described above. Net cash flows provided by investing activities was $14,116,000 for the three months ended
March 31, 2005 compared to $1,682,000 for the corresponding period in 2004. The $12,434,000
increase in investing cash flows was primarily attributable to a net decrease in marketable
securities totaling $10,502,000, net proceeds of $1,840,000 from the sale of the Web Inspector and
Message Inspector product lines, decreased purchases of property and equipment totaling $198,000,
partially offset by $70,000 received in 2004 as partial recovery of the Companys investment in
Maptuit Corporation and $36,000 relating to purchase of a restricted cash investments. Net cash used by financing activities was $106,000 for the three months ended March 31, 2005
compared to cash provided of $13,985,000 for the corresponding period in 2004. The $14,091,000
decrease in financing cash flows was attributable to the lack of stock option and warrant exercises
by employees and outside holders in the first quarter of 2005 compared to the same period in 2004;
the decrease being $10,982,000. Also in 2004, the Company received $3,000,000 in exchange for a
promissory note from Aventis, Inc., involving the acquisition of MyDocOnline, Inc. Further in 2005,
the Company began repaying short-term and capital lease obligations totaling
$98,000, which were originally negotiated in 2004.  Debt Instruments and Related Covenants Concurrent with the MyDocOnline acquisition, at closing, Aventis, Inc. (Aventis) loaned the
Company $3,000,000 due March 15, 2007, with a stated annual interest rate of 4.5%. The loan is
evidenced by a secured promissory note. Interest on the note is payable only in services provided
by the Company to Aventis unless there is an event of default. The principal portion of the note is
payable in either cash or shares of the Companys common stock, based on the then current value of
such shares, at the option of the Company and may be prepaid by the Company at any time without
penalty. Additionally, at Aventis discretion and after the $4,000,000 customer deposit from
Aventis under the Master Services Agreement described below has been consumed, the principal
portion of the note may be paid in the form of additional services provided to Aventis by the
Company pursuant to the terms of such services agreement. Should Aventis choose to not have the
note paid in the form of services, the Company is required to pay the note in cash or stock at
maturity, however, at an amount equal to 90% of the face amount of the loan, or $2,700,000, which
the Company considers its minimum liability. Concurrent with the issuance of the note payable to Aventis, the Company issued warrants,
which remain outstanding at March 31, 2005, to purchase 145,853 shares of the companys common
stock. The exercise price and term of the warrants is $13.01 per share and three years,
respectively. Based on relative fair values at time of issuance, the loan proceeds were allocated
to the note payable of 26




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##### Table of Contents



$1,525,000 and to the warrants of $1,475,000. The fair value of the warrants
was calculated using the Black-Scholes pricing model. The fair value of the note was calculated
based on an estimated interest rate that the Company could obtain independently. The resulting
discount of $1,175,000 on the minimum liability of $2,700,000 represents unamortized debt discount
which is being amortized to interest expense over the three year loan life to yield an effective
interest rate of 11%. This rate approximates a cost of borrowing valuation estimated by an
independent valuation company. The loan is secured by the Companys property and equipment and
accounts receivable pursuant to a security agreement. On November 2, 2004, the Company entered into purchase agreements with Omicron Master Trust
(Omicron) and Amulet Limited (together with Omicron, the Investors), pursuant to which the
Company issued and sold to the Investors $20,000,000 aggregate principal amount of secured,
convertible notes (the Notes) and related warrants (the Warrants). The Notes convert into the
Companys common stock at an initial conversion price of $6.00 per share, which could potentially
be adjusted in accordance with certain anti-dilution adjustments. At the initial conversion price,
the Notes would convert into an aggregate of 3,333,333 shares of the Companys common stock. The principal is to be repaid in four equal annual installments of $5,000,000 beginning
November 2, 2005. Under certain circumstances, primarily if the Companys common stock trades in
excess of $6.00 a share, the scheduled principal repayments may be made in common stock. The
Company has the right to prepay the principal amount owing under the Notes at 105% of the par
(principal) amount of the Notes, plus accrued interest, plus issue an immediately exercisable
supplemental warrant exercisable for 70% of the common stock that would be issued to the holders of
the Notes in respect of the principal amount thereof if the Notes were to remain outstanding. The
exercise price of this warrant, should it be issued, will be the conversion price of the Notes and
the term of this warrant will be identical to the remaining term of the note. The Notes bear interest at the six-month LIBOR (2.34% on November 2, 2004) plus 300 basis
points. Interest on the Notes is payable quarterly in cash or common stock valued at a 10% discount
to the volume weighted average price (VWAP) for the common stock for a specified number of
trading days preceding the interest payment date, at the Companys option. The holders of the Notes may convert the Notes into the common stock at the conversion price.
The Company has the right to force the conversion of the Notes (any outstanding principal) at the
conversion price if the common stock closes above $11.00 per share for a specified number of
trading days and if other specified conditions are met. Further, the Notes have anti-dilution
provisions that would cause an adjustment to the conversion price and the number of shares issuable
under the Notes upon the occurrence of issuances of equity securities or convertible equity
securities at prices below the then-effective conversion price or other specified events. The holders of the Notes have the right to require the Company to repurchase the Notes in cash
upon the
occurrence of specified repurchase events, such as a change in control or events of default
while the Notes are outstanding. The Notes contain restrictive covenants, including covenants that
prohibit the Company from incurring certain indebtedness, establishing certain liens on the
Companys assets or issuing any variable priced securities. The Company is required to hold certain proceeds from the Notes issuance in a restricted,
segregated collateral account. The amount of cash collateral required to be maintained in this
account is 50% of the aggregate principal amount then owing under the Notes (initially
$10,000,000). The requirement for the collateral account is lifted should the Company meet certain
operating objectives and other specified criteria. Separately, the Company is required to maintain
cash (including the cash collateral held in the collateral account) and cash equivalents equal to
$10,000,000 through November 2, 2007, and $5,000,000 thereafter for so long as the Notes are
outstanding. Failure to maintain these balances will cause the Notes to enter into default. The Company issued to the Investors warrants to purchase 1,000,000 shares of common stock at
an exercise price of $6.00 a share. The Warrants are immediately exercisable and expire November 2,
2009. The Company paid Rodman and Renshaw as brokers to the transaction $1,092,000 and warrants to
purchase 166,667 shares of common stock at an exercise price of $6.00 a share with a fair value of
$506,000. The warrants are immediately exercisable and expire November 2009. Based on relative fair values at time of issuance, the loan proceeds were allocated to the
convertible promissory notes payable of $16,995,000 and to the Warrants of $3,005,000. The fair
value of the Warrants was calculated using the Black-Scholes pricing model. Taking into account the
stated interest rate, the allocated value of the 1,000,000 warrants and the financing costs
required to secure the debt, the Notes yield an effective interest rate of 14.6%. On
April 13, 2005, the Company, and the Investors entered into
agreement that, upon effectiveness, would restructured the $20,000,000 Notes and related warrants (see
Note 15 to the condensed consolidated financial statements). The
restructuring would expedite some
payments and allow the Company to make some payments in common stock. The affect on the Companys
liquidity arising from this restructuring is that the Company is to pay the first and last
scheduled $5,000,000 payments using Company stock (at accelerated payment dates), rather than using
cash. However, this is subject to the restructuring amendments becoming effective per Note 15 of
the condensed consolidated financial statements.  Cash Requirements The Companys cash requirements consist principally of the Companys contractual commitments
and funding its operating losses 27




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##### Table of Contents



as it pursues a leadership position in the emerging markets in
which it operates and capital expenditures, primarily for data center expansion and refurbishment
and for computer equipment to support new customer orders. The Company anticipates further losses
in 2005 and the use of cash resources for operating activities continues at a substantial level.
The Company acquired the assets and the businesses of PocketScript, Elron Software and MyDocOnline
in July 2003, September 2003 and January 2004, respectively, in exchange for certain equity
securities of the Company. While no significant cash was required to make these acquisitions, each
of these businesses incurred operating losses in recent years. The Company significantly reduced
the substantial historical operating losses of Elron Software and MyDocOnline. In late 2004 the
Company embarked on a pronounced initiative to focus its efforts on its two most promising markets
 eSecure and eHealth. Pursuant to this focus in late 2004 the Company shut down the Connect product which had been
acquired in the purchase of MyDocOnLine, and, in mid-March 2005, the Company sold the assets and
business acquired in the Elron acquisition (see Note 6 to the condensed consolidated financial
statements). The Company expects to incur additional operating losses in the near term from the
operation of its PocketScript operations as it continues to invest in new personnel and other
resources necessary to effectively deploy its e-prescription devices.  Cash Sources Essential to the Companys operating cash sources is the contractual backlog that has not yet
been billed, newly acquired customers for Secure Messaging and new e-prescribing contracts. Should
the Company continue operating with negative operating cash flows for a significant period of time,
additional sources of cash would be required which could include additional financing, additional
debt restructuring, strategic partnering, sales of other non essential assets, and other
alternatives. Backlog The Companys end-user order backlog is comprised of contractually bound agreements.
The amount that has not yet been collected in cash as of March 31, 2004 was $12,620,000. These
contracts are almost all time based subscription contracts with billings in advance of annual
service periods. Most customers elect to commit to multiple years of service and are invoiced
annually. Continued Growth of Secured e-Messaging Business:The Company expects incremental cash
receipts in 2005 the range of $3,500,000 to $5,500,000 compared to 2004 for the Secure Messaging
products. This growth is somewhat predictable based on past trends due to the subscription nature
of the business, whereby, the Company has been consistently adding new annual service contracts
while experiencing very minimal attrition of existing and renewing customers. At the low end of
this range, the Company assumes they will collect contractually billed amounts, experience
continued renewal rates of 95%, and continue new customer orders at the same rate demonstrated over
the last 2 years. Should new first year customer orders increase 20% quarter on quarter throughout
2005, the high end of the range should be reached. In the first quarter, new first year customer
orders increased approximately 14%. New e-Prescribing Payors The Companys go to market model in e-Prescribing has been to sell
to large insurance payors who in turn sponsor physicians for the service. The Company believes
that this model is the most cost effective method of addressing the market in large quantities.
The Company has demonstrated initial selling and deployment success with this model with the eRx
Collaborative initiative in Massachusetts. The costs associated with the e-Prescribing product is
extensive and the Company is relying upon additional success with other payors to cover and exceed
these costs.  Cash Management In 2004, the Company used cash for recurring operating expenses of $26,800,000. Based on the
Companys organization, operations and debt agreements that existed on December 31,
2004, it was likely that the Company would require an equivalent amount of cash in 2005 plus an additional
$5,300,000 to service debt obligations and fund on-going operations. Without action, this would
result in the Company requiring an additional $12,244,000 in cash funding (based on cash balances
at December 31, 2004), increased customer receipts, cost reductions or a combination thereof in
2005. The Company took actions in the first quarter of 2005 to improve its operating efficiency,
cash position and to manage the Companys liquidity through 2005. These include the following:  Actions Taken in the First Four Months of 2005:  
    Sale of Web Inspector/Message Inspector (collectively the Inspector) Product Line:
In mid-March, 2005, the Company sold the Inspector product line to CyberGuard for
$3,309,000 in cash, net of transaction fees totaling $317,000 (see Note 6 to the condensed
consolidated financial statements). These products operated on a cash neutral basis so
their elimination will not impact the Companys on-going operating cash requirements. The
sale did not include the current Inspector accounts receivable totaling approximately
$189,000, net of allowance for doubtful accounts as of March 31, 2005.
    Workforce Reductions:In January 2005, the Company reduced its workforce by
approximately 10%. This was done selectively to avoid adversely impacting the core business
operations and sales momentum. The Company forecasts that the reduction will result in a
net improvement of $2,500,000 to $3,000,000 in cash expenditures during 2005.
    Restructured $20,000,000 Convertible Promissory Notes Payable:On April 13, 2005, the
Company entered into amendments (the Purchase Agreement Amendments) to the Original
Purchase Agreements with the Investors (see Note 15 to the condensed consolidated financial
statements). The closing of the Purchase Agreement Amendments is subject to the satisfaction
of certain conditions, principally obtaining SEC registration of the shares that may be
issued under the convertible notes in the share redemptions described below, by June 6, 2005
If the Purchase Agreement Amendments do not become effective, the original terms of the
convertible notes will continue to be in effect. The new terms allow the Company to repay
the first and last $5,000,000 installments, which were scheduled to be paid in cash in
November 2005 and 2008, in stock during 2005. Should 28




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the Purchase Agreement Amendments not
become effective, the Company would be required to repay the first $5,000,000 in cash as
previously scheduled on November 2, 2005. The Company
would take whatever steps were necessary to effect this payment including one or some
combination of significant cost reductions, sale of non-core assets, external financing, or
further debt restructuring. Based on the above actions, continued growth in the eSecure market, certain other actions that
have been initiated in the first quarter 2005, and flexibility in its discretionary spending, the
Company believes it has adequate resources and liquidity to sustain operations through the rest of
2005 and is targeting incremental cash flow improvements throughout the year to augment its
liquidity going into 2006. However, operating in emerging markets involves risk and uncertainties,
and there are no assurances that the Company will ultimately achieve or achieve in a sufficiently
timely manner its targeted improvements. The Company will further augment its cash
flow position through additional cost reduction measures, sales of non-core assets, additional
financings or a combination of these actions. Operationally, the extent and timing of success and
potential returns in the eHealth market will ultimately be the most significant operational
determinant of liquidity. The extent to which the Company views the eHealth market as attractive
for investment will determine the Companys willingness to fund additional operational cash losses
with additional financing if required. Should the Company seek financing, there can be no
assurances that it can be obtained at terms that are acceptable; therefore, the resources
available, the business model, and go to market model might have to be altered accordingly. Options and Warrants of ZixCorp Common Stock In 2004, the Company raised significant cash from individuals who hold warrants and options in
the Companys common stock as they exercised these warrants and options. The Company continues to
have significant warrants and options outstanding that are currently vested. The extent of future
cash inflow from additional warrant and option activity is not certain. The following table
summarizes the warrants and options that are outstanding as of March 31, 2005. The vested shares
are a subset of the outstanding shares. The value of the shares is the number of shares multiplied
by the exercise price for each share. Summary of Outstanding Options and WarrantsVested SharesTotal Value
    
    
    (included in
    
    
    Total ValueOutstanding
    
    
    of Outstanding
    
    
    outstanding
    
    
    of VestedExercise Price Range
    
    Shares
    
    
    Shares
    
    
    shares)
    
    
    Shares$2.50 - $4.99
    
    
    3,834,987
    
    
    $
    15,884,000
    
    
    
    2,179,149
    
    
    $
    8,905,000$5.00 - $5.75
    
    
    1,822,468
    
    
    
    9,423,000
    
    
    
    1,401,774
    
    
    
    7,318,000$6.00 - $8.89
    
    
    3,077,314
    
    
    
    19,741,000
    
    
    
    1,961,850
    
    
    
    12,666,000$9.00 - $19.75
    
    
    1,874,437
    
    
    
    21,920,000
    
    
    
    1,223,925
    
    
    
    15,025,000$21.38 - $57.60
    
    
    1,163,695
    
    
    
    59,552,000
    
    
    
    1,163,695
    
    
    
    61,141,000Total
    
    
    11,772,901
    
    
    $
    126,520,000
    
    
    
    7,930,393
    
    
    $
    105,055,000
 Off-Balance Sheet Arrangements None. Contractual Obligations, Contingent Liabilities and Commitments The following table aggregates the Companys material contractual cash obligations as of March
31, 2005: Payments Due by PeriodTotal
    
    
    < 1 Year
    
    
    1-3 Year
    
    
    3-5 Years
    
    
    > 5 YearsLong-term debt
    
    $
    22,893,000
    
    
    $
    5,193,000
    
    
    $
    12,700,000
    
    
    $
    5,000,000
    
    
    $
    Operating leases
    
    
    9,469,000
    
    
    
    1,402,000
    
    
    
    2,278,000
    
    
    
    1,797,000
    
    
    
    3,992,000Capital lease
    
    
    349,000
    
    
    
    244,000
    
    
    
    105,000
    
    
    
    
    
    
    
    Total cash
obligations
    
    
    32,711,000
    
    
    
    6,839000
    
    
    
    15,083,000
    
    
    
    6,797,000
    
    
    
    3,992,000Interest on
obligations
    
    
    2,437,000
    
    
    
    1,032,000
    
    
    
    1,205,000
    
    
    
    200,000
    
    
    
    Total
    
    $
    35,148,000
    
    
    $
    7,871,000
    
    
    $
    16,288,000
    
    
    $
    6,997,000
    
    
    $
    3,992,000
 The Company has not entered into any material, non-cancelable purchase commitments at
March 31, 2005. The Companys $20,000,000 convertible promissory notes have a stated interest rate that is
reset every six months based on the six-month LIBOR plus 300 basis points. For the information
shown above, the Company has assumed that the rate will remain at the current level (5.3%) for the
term of the loan. Actual interest will vary based on changes in the six-month LIBOR. The Company
has the option to pay this interest in common stock (see Note 11 to the condensed consolidated
financial statements). On April 13, 2005, the Company, and the
Investors entered into agreements that. upon effectiveness, would restructure the $20,000,000 convertible
promissory notes payable and related warrants (see Note 15 to the condensed consolidated financial
statements). The Company has severance agreements with certain employees which would require the Company to
pay approximately $1,818,000 if all such employees separated from employment with the Company
following a change of control, as defined in the severance agreements. 29




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Risks and Uncertainties (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. The risks
described below are not the only ones that we face. Additional risks that we do not yet know of or
that we currently think are immaterial may also impair our business operations. If any of the
following risks actually occurs, our business, financial condition, or results of operations 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 condensed consolidated financial statements and
the related notes. We continue to use significant amounts of cash. Our businesses operate in emerging markets and developing these businesses is costly and the
market is highly competitive. Emerging market businesses involve risks and uncertainties, and there
are no assurances that we will be successful in our efforts. Based on our organization, operations
and debt agreements that existed as of March 31, 2005, we would have had cash requirements for the
remainder of 2005 greater than our March 31, 2005 balance of unrestricted cash and marketable
securities of $13,483,000. At March 31, 2005, we have in process certain activities that were
initiated in the first quarter of 2005 including cost reductions, sale of two product lines, and
the amendments to the terms of the $20 million convertible notes to reduce our anticipated cash
requirements for 2005. On April 13, 2005, the Company entered into amendments (the Purchase
Agreement Amendments) to the Original Purchase Agreements with each of the Investors (see Note 15
to the condensed consolidated financial statements). The closing of the Purchase Agreement
Amendments is subject to the satisfaction of certain conditions, principally obtaining SEC
registration of the shares that may be issued under the convertible notes in the share redemptions
described below, by June 6, 2005 If the Purchase Agreement Amendments do not become effective, the
original terms of the convertible notes will continue to be in effect. There is no guarantee that
the SEC will approve our requested registration within the required time limit. We plan to take future actions, as necessary, to ensure that we have sufficient cash resources to
fund our operations. These actions could include further cost reductions or capital funding
alternatives. There is no assurance that we will be able to raise additional capital on
satisfactory terms if and when needed. The market may not broadly accept our e-messaging and e-prescribing products and services and
related applications and services, which would prevent us from operating profitably. We must be able to achieve broad market acceptance for our e-messaging and e-prescribing
products and services and related applications and services in order to operate profitably. We have
not yet been able to do this. To our knowledge, there are currently no secure e-messaging
protection businesses similar to our ZixCorp-branded business that currently operate at the scale
that we would require, at our current expenditure levels and pricing, to become profitable.
Furthermore, PocketScript, our e-prescribing service, is a start-up venture in an emerging market.
There is no assurance that any of our services will become generally accepted or that they will be
compatible with any standards that become generally accepted, nor is there any assurance that
enough paying users will ultimately be obtained to enable us to operate these businesses
profitably. Failure to enter into new sponsorship agreements for or generate other revenue opportunities
from our PocketScript e-prescribing services could harm our business. Our PocketScript business has incurred significant operating losses. In 2004, orders for our
PocketScript e-prescribing service came  exclusively from sponsorship agreements with healthcare payors,
such as health insurance companies, pharmacy benefit managers, or self-insured companies. Under our
payor-sponsorship business model, the healthcare payor typically pays for the cost of deploying the
PocketScript services to the end-user physician and for the cost of a one-year subscription to use
the service. All end-user physicians who are using the PocketScript services and for whom we are
currently recognizing revenue are doing so under a subscription arrangement that has been paid for
by a healthcare payor. Although we believe that physicians will pay to use the PocketScript service
following the one year of service paid for by the healthcare payors or that healthcare payors will
extend their sponsorship, there is no assurance that they will do so. Failure to sign a follow-on order with a healthcare payor from which a significant portion of
our revenues are received or signing new sponsorship agreements with other payors in the coming
months, or in identifying other revenue opportunities for our e-prescribing services, such as
add-on applications, prescription transaction fees, and/or new uses for the transaction data
itself, will prevent us from achieving significant revenues from our e-prescribing services. Competition in our businesses is expected to increase, which could cause our business to fail. Our ZixCorp-branded solutions are targeted to the secure e-messaging protection and
e-transaction services market. Our PocketScript®and MyDocOnline businesses are
targeted toward the emerging markets for electronic prescriptions and online communication among
the healthcare community. As the publics and governmental authorities awareness about the need
for privacy and security of electronic communications has increased over the past few years, an
increasing number of competitors have entered the market. 30




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Although there are many large, well-funded participants in the information technology security
industry, few currently participate in the secure e-messaging protection and e-transaction services
market in which our ZixCorp-branded solutions compete. Most other product-only solutions in this
market require extensive increases in overhead to implement and deploy them. Our ZixCorp-branded
solutions can be made operational in a very short period of time compared to the longer procurement
and deployment cycles common with the solutions of many of our competitors. Our service offerings
are focused on the secure communications market, including secure e-messaging and protection
management. Companies that compete with our ZixCorp-branded secure e-messaging and protection
business include content management and secure delivery companies, such as Tumbleweed
Communications Corp. and other secure delivery participants such as
Voltage Security, PGP Corporation, Certified Mail, Authentica, and
Sigaba Corporation. In addition, we face competition from vendors of Internet server appliances, operating
systems, networking hardware, network management solutions and security software, many of which
now, or may in the future, develop or bundle secure e-messaging, messaging/spam protection and/or
Web filtering capabilities into their products. We may face increased competition as these competitors partner with others or develop new
product and service offerings to expand the functionality that they can offer to their customers.
We believe that the secure e-messaging, e-prescribing and e-transaction services market is growing,
unlike many segments of the information technology security industry which are not growing. Our
competitors may, over time, develop new technologies that are perceived as being more secure,
effective or cost efficient than our own. These competitors could successfully garner a significant
share of the market, to the exclusion of our company. Furthermore, increased competition could
result in pricing pressures, reduced margins or the failure of our business to achieve or maintain
market acceptance, any of which could harm our business. Our PocketScript e-prescribing services applies the benefits of e-messaging to the medical
prescription process by enabling providers to write and transmit prescriptions electronically from
anywhere directly to the pharmacy. Our PocketScript service is expected to grow as more physicians
leverage technology in delivering healthcare services, coupled with the fact that the number of
prescriptions written annually in the United States continues to increase. Participants in the
e-prescribing space include AllScripts Healthcare Solutions, Ramp Corporation, Dr. First, Inc.,
InstantDX LLC, and iScribe. Competition from these companies and from vendors in related areas,
such as
electronic medical records vendors  who are expected to include e-prescribing services as an
element of their service offering  is expected to increase. Our MyDocOnline business offers an Internet-based healthcare service, Dr. Chart®.
Dr. Chart is a Web-based communication tool that connects healthcare providers and laboratories by
allowing doctors to initiate lab orders, check medical necessity compliance and view results
rapidly and accurately using a secure Internet connection. Competitors include 4Medica, Inc., Atlas
Development Corporation, CareEvolve, and Labtest Systems, Inc. All of the competitors offer the
same basic services that Dr. Chart offers. We expect to face increasing competition in this arena
and our competitors may develop products and services that are perceived to be better than ours. Our inability to successfully and timely develop and introduce new e-messaging, e-prescribing
and e-transaction products and related applications and services and to implement technological
changes could harm our business. The emerging nature of the secure e-messaging, e-prescribing and e-transaction services
business and its rapid evolution require us to continually develop and introduce new products and
related applications and services and to improve the performance, features and reliability of our
existing solutions and related applications and services, particularly in response to competitive
offerings. We also have under development new feature sets for our current ZixCorp-branded service
offerings and are considering new services. The success of new or enhanced services depends on
several factors  primarily market acceptance. We may not succeed in developing and marketing new
or enhanced services that respond to competitive and technological developments and changing
customer needs. This could harm our business. If the market for secure e-messaging, e-prescribing and e-transaction products and related
applications and services does not continue to grow, demand for our products and services will be
adversely affected. The market for secure electronic communications is a developing market. Continued growth of
the secure e-messaging, e-prescribing, and e-transaction products and related applications and
services market will depend, to a large extent, on the market recognizing the need for secure
electronic communications, such as email encryption, e-prescribing and electronic lab (e-lab)
results. Failure of this market to grow would harm our business. If healthcare providers fail to adopt the PocketScript and MyDocOnline Solutions, we will fail
to achieve the critical mass of physicians and patients to build a successful business. Our PocketScript e-prescribing service and our MyDocOnline service are targeted to the
emerging market for providing secure communications among healthcare providers to deliver
information in an efficient, economical manner. These are emerging markets, and the success of our
PocketScript and MyDocOnline services is dependent, in large measure, on physicians and other
healthcare providers changing the manner in which they conduct their medical practices by beginning
to use secure wireless and Internet communications channels to communicate with medical
laboratories, payors, pharmacies, and others. Our challenge is to make these new businesses
profitable. To do so may require us to invest significant resources, including significant amounts
of cash. There is no assurance that enough paying users will ultimately be obtained to enable us to
operate these businesses profitably. In early November 2004, we announced a material charge for
impairment to an intangible asset of approximately $675,000, which was reflected in our third
quarter 2004 financial results. The asset impairment resulted from a decision of our management to
suspend 31




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research and development and terminate sales and marketing efforts for our Connect
service, which was one of the products offered by the MyDocOnline portion of our business, because
continuing to operate the service was not consistent with our goal of achieving cash flow
breakeven. It is possible that we may incur further charges for other asset impairments in the
future as we evaluate the prospects of our various lines of business. Capacity limits on our technology and network hardware and software may be difficult to
project, and we may not be able to expand and upgrade our systems to meet increased use, which
would result in reduced revenues. While we have ample through-put capacity to handle our customers requirements for the medium
term, at some point we may be required to materially expand and upgrade our technology and network
hardware and software. We may not be able to accurately project the rate of increase in usage on
our network, particularly since we have
significantly expanded our potential customer base by our acquisition of PocketScript and
MyDocOnline, whose service offerings are supported by our ZixData Center. In addition, we may not
be able to expand and upgrade our systems and network hardware and software capabilities in a
timely manner to accommodate increased traffic on our network. If we do not timely and
appropriately expand and upgrade our systems and network hardware and software, we may lose
customers and revenues. 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 products and
services. Our business depends on the uninterrupted operation of our data centers  currently, our
ZixData Center located in Dallas, Texas; the Austin, Texas data center used for fail-over and
business continuity services; and the Mason, Ohio data center used for quality assurance and
staging of new customers of our PocketScript e-prescribing service. We must protect these centers
from loss, damage or interruption caused by fire, power loss, telecommunications failure or other
events beyond our control. Any damage or failure that causes interruptions in our data centers
operations could materially harm our business, financial condition, and results of operations. In addition, our ability to issue digitally-signed certified time-stamps and public encryption
codes in connection with our ZixCorp-branded services and to support PocketScripts e-prescribing
service and MyDocOnlines service depends on the efficient operation of the Internet connections
between customers and our data centers. We depend on Internet service providers efficiently
operating these connections. These providers have experienced periodic operational problems or
outages in the past. Any of these problems or outages could adversely affect customer satisfaction. Furthermore, it is critical that our facilities and infrastructure remain secure and the
market perceives them to be secure. Despite our implementation of network security measures, our
infrastructure may be vulnerable to physical break-ins, computer viruses, attacks by hackers, and
similar disruptions from unauthorized tampering with our computer systems. In addition, we are
vulnerable to coordinated attempts to overload our systems with data, resulting in denial or
reduction of service to some or all of our users for a period of time. We do not carry insurance to
compensate us for losses that may occur as a result of any of these events; therefore, it is
possible that we may have to use additional resources to address these problems. Secure messages sent through our ZixPort®and ZixMessage CenterTMmessaging portals, in connection with the operation of our secure e-messaging protection and
e-transaction services, include personal healthcare information as well as personal financial
information. This information will reside, for a user-specified period of time, in our secure data
center network; individual prescription histories transmitted through our PocketScript system will
reside in our secure data center network; and the personal healthcare information transmitted
through our MyDocOnline Dr. Chart system will reside in our secure data center network. Federal and
state laws impose significant financial penalties for unauthorized disclosure of personal
healthcare information and personal financial information. Exposure of this information, resulting
from any physical or electronic break-ins or other security breaches or compromises of this
information, could expose us to significant liability, and customers could be reluctant to use our
Internet-related services. Pending litigation could have a material impact on our operating results and financial
condition. Beginning in early September 2004, several purported shareholder class action lawsuits and one
purported shareholder derivative lawsuit were filed in the U.S. District Court for the Northern
District of Texas against us and certain of our current and former officers and directors. The
purported class action lawsuits seek unspecified monetary damages on behalf of purchasers of
ZixCorps common stock between October 30, 2003 and May 4, 2004. The purported shareholder class
action lawsuits allege that the defendants made materially false and misleading statements and/or
omissions in violation of Sections 10(b) and 20(a) of the Exchange Act during this time period. The purported shareholder derivative lawsuit relates to the allegedly materially false and
misleading statements and/or omissions that are the subject of the purported shareholder class
action lawsuits. The derivative lawsuit names ZixCorp as a nominal defendant and as actual
defendants the individuals named in the purported shareholder class action lawsuits mentioned
above, as well as ZixCorps outside directors. The suit seeks to require ZixCorp to initiate legal
action for unspecified damages against the individual defendants named in the purported shareholder
class action lawsuits. The suit also alleges breaches of fiduciary duty, abuse of control, insider
selling and misappropriation of information and seeks contribution and indemnification against the
individual defendants. These lawsuits may require significant management time and attention and could result in
significant legal expenses. While we believe these lawsuits are without merit and intend to defend
them vigorously, since these legal proceedings are in the preliminary stages we are unable to
predict the scope or outcome of these matters and quantify their eventual impact, if any, on our
company. An 32




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unfavorable outcome could have a material adverse effect on our business, operating
results, cash flow, and financial condition. We maintain insurance that may limit our financial
exposure for defense costs and liability for an unfavorable outcome, should we not prevail, for
claims covered by the insurance coverage. 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. We may have to defend our intellectual property rights or defend against claims that we are
infringing the rights of others. Intellectual property litigation and controversies are disruptive
and expensive. Infringement claims could require us to develop non-infringing products or enter
into royalty or licensing arrangements. Royalty or licensing arrangements, if required, may not be
obtainable on terms acceptable to us. Our business could be significantly harmed if we are not able
to develop or license the necessary technology. Furthermore, it is possible that others may
independently develop substantially equivalent intellectual property, thus enabling them to
effectively compete against us. Defects or errors in our services could harm our business. We subject our ZixCorp-branded products solutions to quality assurance testing prior to
release. There is no assurance that the quality and assurance testing previously conducted by the
businesses we acquired on their current products and services conform to our standards for quality
assurance testing. Regardless of the level of quality assurance testing, any of our solutions could
contain undetected defects or errors. In particular, our PocketScript system is used to dispense
prescription drugs. Defects or errors in our PocketScript system could result in inaccurate
prescriptions being generated, which could result in injury or death to patients. Thus, undetected
defects or errors could result in loss of or delay in revenues, failure to achieve market
acceptance, diversion of development resources, injury to our reputation, litigation claims,
increased insurance costs, or increased service and warranty costs. Any of these could prevent us
from implementing our business model and achieving the revenues we need to operate profitably. Public key cryptography technology is subject to risks. Our ZixCorp-branded solutions, the PocketScript e-prescribing service and the MyDocOnline
service employ, and future products and services may employ, public key cryptography technology.
With public key cryptography technology, a public key and a private key are used to encrypt and
decrypt messages. The security afforded by this technology depends, in large measure, on the
integrity of the private key, which is dependent, in part, on the application of certain
mathematical principles. The integrity of the private key is predicated on the assumption that it
is difficult to mathematically derive the private key from the related public key. Should methods
be developed that make it easier to derive the private key, the security of encryption products
using public key cryptography technology would be reduced or eliminated and such products could
become unmarketable. This could require us to make significant changes to our products, which could
damage our reputation and otherwise hurt our business. Moreover, there have been public reports of
the successful decryption of certain encrypted messages. This or related publicity could adversely
affect public perception of the security afforded by public key cryptography technology, which
could harm our business. We depend on key personnel. We depend on the performance of our senior management team  including our Chief Executive
Officer, President and Chief Operating Officer Richard D. Spurr, and our Vice President of Finance
and Administration, Chief Financial Officer and Treasurer Bradley C. Almond, and their direct
reports and other key employees, particularly highly skilled technical personnel. Our success
depends on our ability to attract, retain and motivate these individuals. There are no binding
agreements with any of our employees that prevent them from leaving our
company at any time. There is competition for these personnel. In addition, we do not maintain key
person life insurance on any of our personnel. The loss of the services of any of our key employees
or our failure to attract, retain and motivate key employees could harm our business. We could be affected by government regulation. Exports of software products using encryption technology, such as our ZixCorp-branded
services, are generally restricted by the U.S. government. Although we have obtained U.S.
government approval to export our products to almost all countries, the list of countries to which
our solutions cannot be exported could be revised in the future. Furthermore, some countries impose
restrictions on the use of encryption products, such as ours. Failure to obtain the required
governmental approvals would preclude the sale or use of our solutions in international markets. Furthermore, boards of pharmacy in the various states in which our PocketScript business
operates regulate the process by which physicians write prescriptions. While regulations in the
states in which these businesses currently generally operate permit the electronic writing of
prescriptions, such regulations could be revised in the future. Moreover, regulations in states in
which these businesses do not currently operate may not be as favorable and may impede our ability
to develop business in these states. Furthermore, future state or federal regulation could mandate
standards for the electronic writing of prescriptions or for the secure electronic transmittal of
personal health information through the Internet that our technology and systems do not comply
with, which would require us to modify our technology and systems. 33




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Our stock price may be volatile. The market price of our common stock has fluctuated significantly in the past and is likely to
fluctuate in the future. Our stock price may decrease as a result of the dilutive effect caused by
the additional number of shares that may become available in the market due to the issuances of our
common stock in connection with the capital funding and acquisition transactions we completed over
the last year. As of April 15, 2005, there was a short position in our common stock of 6,831,377. Our directors and executive officers own a substantial percentage of our securities. Their
ownership could allow them to exercise significant control over corporate decisions and to
implement corporate acts that are not in the best interests of our shareholders as a group. Our directors and executive officers beneficially own shares of our securities that represent
approximately 17.1% (measured as of the date of this Form 10 Q  of
the combined voting power eligible to vote on matters brought before our shareholders, including
securities and associated warrants beneficially owned by Antonio R. Sanchez, Jr., a former director
and father of a current director (Antonio R. Sanchez, III), and current beneficial owner of
approximately 7.8% (measured as of the date of this Form 10 Q  of our
outstanding common stock) and John A. Ryan, our chairman. Therefore, our
directors and executive officers, if they acted together, could exert substantial influence over
matters requiring approval by our shareholders. These matters would include the election of
directors. This concentration of ownership and voting power may discourage or prevent someone from
acquiring our business. One investor owns a large percentage of our outstanding stock and could significantly
influence the outcome of actions. George W. Haywood and an IRA for the benefit of Mr. Haywood beneficially own approximately
14.8% of our outstanding common stock (measured as of the date of
this Form 10 Q without giving effect to the
potential issuance of our common stock pursuant to the notes and the warrants held by the selling
shareholders). Therefore, Mr. Haywood could exert substantial influence over all matters requiring
approval by our shareholders, including the election of directors. Mr. Haywoods interests may not
be aligned with the interests of our other shareholders. This concentration of ownership and voting
power may discourage or prevent someone from acquiring our business. We have a substantial amount of debt and may be unable to service or refinance this debt or
servicing this debt may restrict cash available for our business operations. As of March 31, 2005, our total outstanding indebtedness, including capital leases, requires
us to make payments totalling $23.2 million payable over the next four years. This high level of
debt could have negative consequences. For example, it could:  
    result in our inability to comply with the financial and other restrictive covenants in
the notes, which, among other things, require us to maintain specified cash levels and
limit our ability to incur debt and sell assets, which could in turn result in an event of
default that, if not cured or waived, could have a material adverse effect on our
operations;
    require us to dedicate a substantial portion of our cash flow from operations to make
scheduled principal payments on our debt or to meet required cash reserves, thereby
reducing the availability of our cash flow for working capital, capital investments and
other business activities;
    increase our vulnerability to adverse industry and general economic conditions;
    limit our ability to obtain additional financing to fund future working capital, capital
investments and other business activities;
    limit our ability to refinance our indebtedness on terms that are commercially reasonable or at all; and
    limit our flexibility to plan for, and react to, changes in our business and our industry. We have a significant amount of convertible securities, including the convertible notes and
the warrants, outstanding and may issue additional equity securities in the future. Conversion or
redemption of the notes into our common stock, exercise of the warrants and issuance or conversion
of other securities will dilute the ownership interests of existing shareholders. The convertible notes may be converted by the holders of the Companys $20,000,000 of
convertible promissory notes at an initial conversion price of $6.00 per share. If fully converted
at this price, we would be obligated to issue an additional 3,333,333 shares of our common stock.
However, we have agreed to redeem $5,000,000 of the convertible notes with shares of our common
stock by July 31, 2005 and an additional $5,000,000 of the convertible notes with shares of our
common stock by December 31, 2005 at (i) 105% of the par (principal) amount, plus accrued interest
and (ii) a redemption rate that will require that we issue shares of our common stock valued at a
10% discount to the daily volume weighted average price (VWAP) of our common stock for a
specified number of trading days preceding the applicable redemption date. Assuming the VWAP
approximates our stock price at April 29, 2005 of $2.75 per share, such $10 million mandatory
redemptions would be payable with approximately 4.7 million shares of our common stock. In
addition, we have the option to pay accrued interest on the notes using our common stock shares,
valued at a 10% discount to the volume weighted average price for the common stock for a specified
number of trading days preceding the interest payment date. We have also issued warrants covering
1,000,000 shares of our common stock to the holders of the notes and additional warrants to
purchase 166,667 shares of common stock were issued to the broker of the debt transaction. The
issuances of these shares of common stock in respect of the notes and the warrants would result in
a substantial dilution of our stockholders. Any sales in the public market of the common stock
issuable upon such conversion or redemption of the notes or exercise of the warrants could
adversely affect prevailing market prices of our common stock. 34




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In addition, at some point in the future we may determine to seek additional capital funding
or to acquire additional businesses. These events could involve the issuance of one or more types
of equity securities, including convertible debt, common and convertible preferred stock and
warrants to acquire common or preferred stock. Such equity securities could be issued at or below
the then prevailing market price of our common stock. In addition, we incent our employees and
attract new employees by issuing shares of our common stock and options to purchase shares of our
common stock. The interest of our existing shareholders may be diluted by any equity securities
issued in capital funding financings or business acquisitions and would be diluted by any such
future share issuances and stock option grants to employees. We may have liability for indemnification claims arising from the sale of our Web Inspector
and Message Inspector product lines. We disposed of our Web Inspector and Message Inspector product line on March 11, 2005. In
selling those products, we agreed to provide customary indemnification to the purchasers of those
businesses for breaches of representations and warranties, covenants, and other specified matters.
Indemnification claims could be asserted against us with respect to these matters. We may encounter other unanticipated risks and uncertainties in the markets we serve or in
developing new products and services, and we cannot assure that we will be successful in responding
to any unanticipated risks or uncertainties. There are no assurances that we will be successful or that we will not encounter other, and
even unanticipated, risks. We discuss other operating, financial or legal risks or uncertainties in
our periodic filings with the SEC. We are, of course, also subject to general economic risks. NOTE ON FORWARD-LOOKING STATEMENTS AND RISK FACTORS This document contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 (the Act) and Section 21E of the Exchange Act. All statements other than
statements of historical fact are forward-looking statements for purposes of federal and state
securities laws, including: any projections of future business, market share, earnings, revenues or
other financial items; any statements of the plans, strategies and objectives of management for
future operations; any statements concerning proposed new products, services or developments; any
statements regarding future economic conditions or performance; any statements of belief; and any
statements of assumptions underlying any of the foregoing. Forward-looking statements may include
the words may, will, predict, plan, should, goal, estimate, intend, continue,
believe, expect, anticipate and other similar words. Such forward-looking statements may be
contained in the Risk Factors section above, among other places. Although we believe that the expectations reflected in any of our forward-looking statements
are reasonable, actual results could differ materially from those projected or assumed in any of
our forward-looking statements. Our future financial condition and results of operations, as well
as any forward-looking statements, are subject to change and to inherent risks and uncertainties,
such as those disclosed in this document. We do not intend, and undertake no obligation, to update
any forward-looking statement. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For the three-month period ended March 31, 2005, the Company did not experience any material
changes in market risk exposures with respect to its cash investments and marketable securities
that affect the quantitative and qualitative disclosures presented in the Companys 2004 Annual
Report to Shareholders on Form 10-K in Part II, item 7A which are incorporated by reference into
this Report on Form 10 Q. 
 ITEM 4. CONTROLS AND PROCEDURES An evaluation was carried out under the supervision and with the participation of the
Companys management, including its Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of the Companys disclosure controls and procedures (as
defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of March 31,
2005. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the design and operation of these disclosure controls and procedures were effective. There
have been no significant changes in the Companys internal control over financial reporting that
occurred during the quarter ended March 31, 2005 that has materially affected, or is reasonably
likely to materially affect, the Companys internal control over financial reporting. 
 PART II  OTHER INFORMATION 
 ITEM 6. EXHIBITS a. Exhibits The following is a list of exhibits filed as part of this Quarterly Report on Form 10-Q: Exhibit No.
    
    Description of Exhibits4.1*
    
    Warrant to purchase 166,667 shares
of common stock of Zix Corporation issued by Zix Corporation to
Rodman & Renshaw, LLC., dated as of November 2, 2004.10.1*
    
    Employment Offer Letter of Zix Corporation, dated March 23, to Richard D. Spurr.
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Exhibit No.
    
    Description of Exhibits10.2*
    
    Stock Option Agreement, dated March 23, 2005, between Zix Corporation and
Richard D. Spurr.31.1*
    
    Certification of Richard D. Spurr, Chief Executive Officer, President, and
Chief Operating 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, Chief Executive Officer, President, and
Chief Operating 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. 36




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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the
Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly
authorized. ZIX CORPORATION(Registrant)Date: May 9, 2005
    
    By: /s/ Bradley C. AlmondBradley C. AlmondVice President, Chief Financial Officer, andTreasurer(Principal Financial Officer andDuly Authorized Officer)
 37