##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 2006
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission File Number: 0-17995
 ZIX CORPORATION
 (Exact Name of Registrant as Specified in its Charter)
 Texas
(State of Incorporation)
    
    75-2216818
(I.R.S. Employer Identification Number)
 2711 North Haskell Avenue
Suite 2200, LB 36
Dallas, Texas 75204-2960
(Address of Principal Executive Offices)
 (214) 370-2000
(Registrants Telephone Number, Including Area Code)
 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the Registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o
 Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,
or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in
Rule 12b-2 of the Exchange Act. (Check one):
 Large accelerated filer o Accelerated filer þ Non-accelerated filer o
 Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act). Yes o No þ
 Indicate the number of shares outstanding of each of the issuers classes of common stock, as of
the latest practicable date.
 Class
    
    Outstanding at August 1, 2006Common Stock, par value $.01 per share
    
    59,638,839




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##### 



INDEX
 PageNumberPART  FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets at June 30, 2006 and December 31, 2005
    
    iiCondensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005
    
    iiiCondensed Consolidated Statement of Stockholders Equity for the six months ended June 30, 2006
    
    ivCondensed Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005
    
    vNotes to Condensed Consolidated Financial Statements
    
    1Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    18Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    36Item 4. Controls and Procedures
    
    36PART II-OTHER INFORMATION
    
    37Item 1. Legal Proceedings
    
    37Item 1A. Risk Factors
    
    37Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    43Item 3. Defaults Upon Senior Securities
    
    44Item 4. Submission of Matters to a Vote of Security Holders
    
    44Item 5. Other Information
    
    45Item 6. Exhibits
    
    45Certification of Pursuant to Section 302Certification of Pursuant to Section 302Certification Pursuant to Section 906




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##### Table of Contents



ZIX CORPORATION
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
  June 30,
    
    
    December 31,2006
    
    
    2005ASSETSCurrent assets:Cash and cash equivalents
    
    $
    19,569,000
    
    
    $
    20,240,000Restricted cash
    
    
    
    
    
    
    5,100,000Receivables, net
    
    
    509,000
    
    
    
    149,000Prepaid and other current assets
    
    
    1,421,000
    
    
    
    1,845,000Total current assets
    
    
    21,499,000
    
    
    
    27,334,000Restricted cash
    
    
    35,000
    
    
    
    35,000Property and equipment, net
    
    
    3,100,000
    
    
    
    3,652,000Intangible assets, net
    
    
    199,000
    
    
    
    559,000Goodwill
    
    
    2,161,000
    
    
    
    2,161,000Deferred financing costs and other assets
    
    
    87,000
    
    
    
    374,000$
    27,081,000
    
    
    $
    34,115,000LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    880,000
    
    
    $
    1,313,000Accrued expenses
    
    
    3,496,000
    
    
    
    3,749,000Deferred revenue
    
    
    7,988,000
    
    
    
    7,087,000Customer deposit
    
    
    2,000,000
    
    
    
    1,000,000Capital lease obligations
    
    
    40,000
    
    
    
    165,000Promissory note payable
    
    
    2,437,000
    
    
    
    Short-term note payable
    
    
    115,000
    
    
    
    268,000Convertible promissory note payable
    
    
    
    
    
    
    4,404,000Total current liabilities
    
    
    16,956,000
    
    
    
    17,986,000Long-term liabilities:Deferred revenue
    
    
    1,509,000
    
    
    
    1,261,000Derivative liabilities
    
    
    3,231,000
    
    
    
    Customer deposit
    
    
    
    
    
    
    2,000,000Promissory note payable
    
    
    
    
    
    
    2,226,000Deferred rent
    
    
    349,000
    
    
    
    245,000Total long-term liabilities
    
    
    5,089,000
    
    
    
    5,732,00022,045,000
    
    
    
    23,718,000Contingencies (Note 15)Stockholders equity:Preferred stock, $1 par value, 10,000,000 shares authorized; none issued and outstanding
    
    
    
    
    
    
    Common stock, $0.01 par value, 175,000,000 shares authorized; 61,966,020 issued and
59,638,839 outstanding in 2006 and 51,932,561 issued and 49,605,380 outstanding in 2005
    
    
    620,000
    
    
    
    519,000Additional paid-in capital
    
    
    314,959,000
    
    
    
    308,461,000Treasury stock, at cost; 2,327,181 common shares in 2006 and 2005
    
    
    (11,507,000
    )
    
    
    (11,507,000
    )Accumulated deficit
    
    
    (299,036,000
    )
    
    
    (287,076,000
    )Total stockholders equity
    
    
    5,036,000
    
    
    
    10,397,000$
    27,081,000
    
    
    $
    34,115,000




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##### Table of Contents



ZIX CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
  Three Months Ended June 30,
    
    
    Six Months Ended June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues:Services
    
    $
    4,209,000
    
    
    $
    3,199,000
    
    
    $
    8,104,000
    
    
    $
    6,497,000Hardware
    
    
    
    
    
    
    241,000
    
    
    
    
    
    
    
    426,000Software
    
    
    
    
    
    
    9,000
    
    
    
    
    
    
    
    109,000Total revenues
    
    
    4,209,000
    
    
    
    3,449,000
    
    
    
    8,104,000
    
    
    
    7,032,000Cost of revenues
    
    
    3,090,000
    
    
    
    3,508,000
    
    
    
    6,465,000
    
    
    
    7,399,000Gross margin (loss)
    
    
    1,119,000
    
    
    
    (59,000
    )
    
    
    1,639,000
    
    
    
    (367,000
    )Operating expenses:Research and development expenses
    
    
    1,626,000
    
    
    
    1,535,000
    
    
    
    3,221,000
    
    
    
    3,510,000Selling, general and administrative expenses
    
    
    6,549,000
    
    
    
    6,559,000
    
    
    
    13,141,000
    
    
    
    14,061,000Customer deposit forfeiture
    
    
    
    
    
    
    (960,000
    )
    
    
    (1,000,000
    )
    
    
    (960,000
    )Gain on sale of product lines
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (950,000
    )Total operating expenses
    
    
    8,175,000
    
    
    
    7,134,000
    
    
    
    15,362,000
    
    
    
    15,661,000Operating loss
    
    
    (7,056,000
    )
    
    
    (7,193,000
    )
    
    
    (13,723,000
    )
    
    
    (16,028,000
    )Other (expense) income:Investment and other income
    
    
    294,000
    
    
    
    143,000
    
    
    
    511,000
    
    
    
    286,000Interest expense
    
    
    (477,000
    )
    
    
    (1,996,000
    )
    
    
    (895,000
    )
    
    
    (2,826,000
    )Gain on derivative liabilities
    
    
    2,930,000
    
    
    
    
    
    
    
    2,930,000
    
    
    
    Loss on extinguishment of convertible debt
    
    
    (871,000
    )
    
    
    
    
    
    
    (871,000
    )
    
    
    Total other (expense) income
    
    
    1,876,000
    
    
    
    (1,853,000
    )
    
    
    1,675,000
    
    
    
    (2,540,000
    )Loss before income taxes
    
    
    (5,180,000
    )
    
    
    (9,046,000
    )
    
    
    (12,048,000
    )
    
    
    (18,568,000
    )Income tax benefit
    
    
    94,000
    
    
    
    131,000
    
    
    
    88,000
    
    
    
    81,000Net loss
    
    $
    (5,086,000
    )
    
    $
    (8,915,000
    )
    
    $
    (11,960,000
    )
    
    $
    (18,487,000
    )Basic and diluted loss per common share
    
    $
    (0.09
    )
    
    $
    (0.28
    )
    
    $
    (0.22
    )
    
    $
    (0.57
    )Basic and diluted weighted average common shares outstanding
    
    
    59,200,723
    
    
    
    32,391,777
    
    
    
    54,453,902
    
    
    
    32,343,737




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##### Table of Contents



ZIX CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY
  Stockholders EquityAdditional
    
    
    
    
    
    
    
    
    
    
    TotalCommon Stock
    
    
    Paid-In
    
    
    Treasury
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Deficit
    
    
    EquityBalance, January 1, 2006
    
    
    51,932,561
    
    
    $
    519,000
    
    
    $
    308,461,000
    
    
    $
    (11,507,000
    )
    
    $
    (287,076,000
    )
    
    $
    10,397,000Issuance of common stock
and related warrants upon
private investment (net
of issuance costs)
    
    
    9,930,000
    
    
    
    100,000
    
    
    
    4,449,000
    
    
    
    
    
    
    
    
    
    
    
    4,549,000Valuation of warrants
issued to brokers of the
private placement of
common stock
    
    
    
    
    
    
    
    
    
    
    199,000
    
    
    
    
    
    
    
    
    
    
    
    199,000Common stock issued to
employees for
compensation in lieu of
cash
    
    
    82,196
    
    
    
    1,000
    
    
    
    156,000
    
    
    
    
    
    
    
    
    
    
    
    157,000Common stock issued in
lieu of cash for
third-party services
    
    
    21,263
    
    
    
    
    
    
    
    30,000
    
    
    
    
    
    
    
    
    
    
    
    30,000Employee share-based
compensation costs
    
    
    
    
    
    
    
    
    
    
    1,440,000
    
    
    
    
    
    
    
    
    
    
    
    1,440,000Valuation of additional
warrants issued relating
to the convertible
promissory notes payable
    
    
    
    
    
    
    
    
    
    
    50,000
    
    
    
    
    
    
    
    
    
    
    
    50,000Valuation of beneficial
conversion feature in
convertible promissory
note resulting from the
private placement of
common stock
    
    
    
    
    
    
    
    
    
    
    459,000
    
    
    
    
    
    
    
    
    
    
    
    459,000Valuation of additional
anti-dilutive warrants
issued upon private
placement of common stock
    
    
    
    
    
    
    
    
    
    
    74,000
    
    
    
    
    
    
    
    
    
    
    
    74,000Valuation of additional
warrants issued upon
retirement of convertible
promissory note
    
    
    
    
    
    
    
    
    
    
    6,000
    
    
    
    
    
    
    
    
    
    
    
    6,000Reversal of unamortized
valuation of beneficial
conversion feature upon
retirement of convertible
promissory note
    
    
    
    
    
    
    
    
    
    
    (365,000
    )
    
    
    
    
    
    
    
    
    
    
    (365,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (11,960,000
    )
    
    
    (11,960,000
    )Balance, June 30, 2006
    
    
    61,966,020
    
    
    $
    620,000
    
    
    $
    314,959,000
    
    
    $
    (11,507,000
    )
    
    $
    (299,036,000
    )
    
    $
    5,036,000




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##### Table of Contents



ZIX CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
  Six Months Ended June 30,2006
    
    
    2005Operating activities:Net loss
    
    $
    (11,960,000
    )
    
    $
    (18,487,000
    )Non-cash items in net loss:Depreciation and amortization
    
    
    1,545,000
    
    
    
    2,195,000Amortization of debt discount / premium, financing costs and other
    
    
    686,000
    
    
    
    2,198,000Value of additional warrants issued
    
    
    10,000
    
    
    
    Common stock issued to employees and non-employee in lieu of cash
    
    
    187,000
    
    
    
    243,000Loss on extinguishment of convertible debt
    
    
    871,000
    
    
    
    Gain on derivative liabilities
    
    
    (2,930,000
    )
    
    
    Employee share-based compensation costs
    
    
    1,440,000
    
    
    
    Customer deposit forfeiture
    
    
    (1,000,000
    )
    
    
    (960,000
    )Changes in deferred taxes
    
    
    (87,000
    )
    
    
    Common stock issued in lieu of cash interest payments
    
    
    
    
    
    
    267,000Non-employee stock-based compensation costs
    
    
    
    
    
    
    119,000Gain on sale of product line
    
    
    
    
    
    
    (950,000
    )Changes in operating assets and liabilitiesAccounts receivable
    
    
    (360,000
    )
    
    
    234,000Other assets
    
    
    443,000
    
    
    
    682,000Accounts payable
    
    
    (393,000
    )
    
    
    (542,000
    )Deferred revenue
    
    
    1,149,000
    
    
    
    1,820,000Accrued and other liabilities
    
    
    (205,000
    )
    
    
    8,000Net cash used by operating activities
    
    
    (10,604,000
    )
    
    
    (13,173,000
    )Investing activities:Purchases of property and equipment
    
    
    (692,000
    )
    
    
    (1,010,000
    )Sales and maturities of marketable securities
    
    
    
    
    
    
    16,000,000Purchase of restricted cash investment
    
    
    
    
    
    
    (38,000
    )Proceeds from restricted cash investments
    
    
    5,100,000
    
    
    
    Proceeds from sale of product lines
    
    
    
    
    
    
    2,309,000Net cash provided by investing activities
    
    
    4,408,000
    
    
    
    17,261,000Financing activities:Proceeds from private placement of common stock
    
    
    11,817,000
    
    
    
    Payment of expenses relating to private placement of common stock
    
    
    (814,000
    )
    
    
    Payment of convertible debt
    
    
    (5,000,000
    )
    
    
    Payment of premium on convertible debt
    
    
    (200,000
    )
    
    
    Payment of short-term note payable, capital leases and other
    
    
    (278,000
    )
    
    
    (274,000
    )Proceeds from exercise of stock options
    
    
    
    
    
    
    3,000Net cash provided (used) by financing activities
    
    
    5,525,000
    
    
    
    (271,000
    )(Decrease) increase in cash and cash equivalents
    
    
    (671,000
    )
    
    
    3,817,000Cash and cash equivalents, beginning of period
    
    
    20,240,000
    
    
    
    3,856,000Cash and cash equivalents, end of period
    
    $
    19,569,000
    
    
    $
    7,673,000




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##### Table of Contents



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




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##### Table of Contents



2




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##### Table of Contents



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




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##### Table of Contents



4. Segment Information
      4




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##### Table of Contents



Three Months Ended June 30, 2006
    
    
    Three Months Ended June 30, 2005Email
    
    
    e-
    
    
    
    
    
    
    
    
    
    
    Email
    
    
    e-Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    Total
    
    
    Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    TotalRevenues
    
    $
    3,369,000
    
    
    $
    840,000
    
    
    $
    
    
    
    $
    4,209,000
    
    
    $
    2,434,000
    
    
    $
    881,000
    
    
    $
    134,000
    
    
    $
    3,449,000Cost of revenues
    
    
    1,319,000
    
    
    
    1,771,000
    
    
    
    
    
    
    
    3,090,000
    
    
    
    1,350,000
    
    
    
    1,731,000
    
    
    
    427,000
    
    
    
    3,508,000Gross margin (loss)
    
    
    2,050,000
    
    
    
    (931,000
    )
    
    
    
    
    
    
    1,119,000
    
    
    
    1,084,000
    
    
    
    (850,000
    )
    
    
    (293,000
    )
    
    
    (59,000
    )Direct expenses
    
    
    2,897,000
    
    
    
    2,745,000
    
    
    
    
    
    
    
    5,642,000
    
    
    
    3,059,000
    
    
    
    2,273,000
    
    
    
    240,000
    
    
    
    5,572,000Segment (loss)
    
    
    (847,000
    )
    
    
    (3,676,000
    )
    
    
    
    
    
    
    (4,523,000
    )
    
    
    (1,975,000
    )
    
    
    (3,123,000
    )
    
    
    (533,000
    )
    
    
    (5,631,000
    )Unallocated (expense) / incomeMarketing, general and administrative expense
    
    
    
    
    
    
    
    
    
    
    (2,533,000
    )
    
    
    (2,533,000
    )
    
    
    
    
    
    
    
    
    
    
    (2,522,000
    )
    
    
    (2,522,000
    )Customer deposit forfeiture
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    960,000
    
    
    
    960,000Gain on derivatives
    
    
    
    
    
    
    
    
    
    
    2,930,000
    
    
    
    2,930,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loss on extinguishment of debt
    
    
    
    
    
    
    
    
    
    
    (871,000
    )
    
    
    (871,000
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Investment and other income
    
    
    
    
    
    
    
    
    
    
    294,000
    
    
    
    294,000
    
    
    
    
    
    
    
    
    
    
    
    143,000
    
    
    
    143,000Interest expense
    
    
    
    
    
    
    
    
    
    
    (477,000
    )
    
    
    (477,000
    )
    
    
    
    
    
    
    
    
    
    
    (1,996,000
    )
    
    
    (1,996,000
    )Total
    
    
    
    
    
    
    
    
    
    
    (657,000
    )
    
    
    (657,000
    )
    
    
    
    
    
    
    
    
    
    
    (3,415,000
    )
    
    
    (3,415,000
    )Loss before income taxes
    
    $
    (847,000
    )
    
    $
    (3,676,000
    )
    
    $
    (657,000
    )
    
    $
    (5,180,000
    )
    
    $
    (1,975,000
    )
    
    $
    (3,123,000
    )
    
    $
    (3,948,000
    )
    
    $
    (9,046,000
    )
 Six Months Ended June 30, 2006
    
    
    Six Months Ended June 30, 2005Email
    
    
    e-
    
    
    
    
    
    
    
    
    
    
    Email
    
    
    e-Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    Total
    
    
    Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    TotalRevenues
    
    $
    6,702,000
    
    
    $
    1,402,000
    
    
    $
    
    
    
    $
    8,104,000
    
    
    $
    4,477,000
    
    
    $
    1,714,000
    
    
    $
    841,000
    
    
    $
    7,032,000Cost of revenues
    
    
    2,785,000
    
    
    
    3,680,000
    
    
    
    
    
    
    
    6,465,000
    
    
    
    2,664,000
    
    
    
    3,531,000
    
    
    
    1,204,000
    
    
    
    7,399,000Gross margin (loss)
    
    
    3,917,000
    
    
    
    (2,278,000
    )
    
    
    
    
    
    
    1,639,000
    
    
    
    1,813,000
    
    
    
    (1,817,000
    )
    
    
    (363,000
    )
    
    
    (367,000
    )Direct expenses
    
    
    5,723,000
    
    
    
    5,468,000
    
    
    
    
    
    
    
    11,191,000
    
    
    
    6,115,000
    
    
    
    4,932,000
    
    
    
    950,000
    
    
    
    11,997,000Segment (loss)
    
    
    (1,806,000
    )
    
    
    (7,746,000
    )
    
    
    
    
    
    
    (9,552,000
    )
    
    
    (4,302,000
    )
    
    
    (6,749,000
    )
    
    
    (1,313,000
    )
    
    
    (12,364,000
    )Unallocated (expense) / incomeMarketing, general and administrative expense
    
    
    
    
    
    
    
    
    
    
    (5,171,000
    )
    
    
    (5,171,000
    )
    
    
    
    
    
    
    
    
    
    
    (5,574,000
    )
    
    
    (5,574,000
    )Gain of sales of product line
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    950,000
    
    
    
    950,000Customer deposit forfeiture
    
    
    
    
    
    
    
    
    
    
    1,000,000
    
    
    
    1,000,000
    
    
    
    
    
    
    
    
    
    
    
    960,000
    
    
    
    960,000Gain on derivatives
    
    
    
    
    
    
    
    
    
    
    2,930,000
    
    
    
    2,930,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loss on extinguishment of debt
    
    
    
    
    
    
    
    
    
    
    (871,000
    )
    
    
    (871,000
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Investment and other income
    
    
    
    
    
    
    
    
    
    
    511,000
    
    
    
    511,000
    
    
    
    
    
    
    
    
    
    
    
    286,000
    
    
    
    286,000Interest expense
    
    
    
    
    
    
    
    
    
    
    (895,000
    )
    
    
    (895,000
    )
    
    
    
    
    
    
    
    
    
    
    (2,826,000
    )
    
    
    (2,826,000
    )Total
    
    
    
    
    
    
    
    
    
    
    (2,496,000
    )
    
    
    (2,496,000
    )
    
    
    
    
    
    
    
    
    
    
    (6,204,000
    )
    
    
    (6,204,000
    )Loss before income taxes
    
    $
    (1,806,000
    )
    
    $
    (7,746,000
    )
    
    $
    (2,496,000
    )
    
    $
    (12,048,000
    )
    
    $
    (4,302,000
    )
    
    $
    (6,749,000
    )
    
    $
    (7,517,000
    )
    
    $
    (18,568,000
    )
   June 30, 2006
    
    
    December 31, 2005Email
    
    
    e-
    
    
    
    
    
    
    
    
    
    
    Email
    
    
    e-Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    Total
    
    
    Encryption
    
    
    Prescribing
    
    
    Corporate
    
    
    TotalTotal assets
    
    $
    3,315,000
    
    
    $
    1,240,000
    
    
    $
    22,526,000
    
    
    $
    27,081,000
    
    
    $
    3,969,000
    
    
    $
    1,436,000
    
    
    $
    28,710,000
    
    
    $
    34,115,000
 5




---



##### Table of Contents



5. Stock Options and Stock-based Employee Compensation
  Authorized
    
    
    Options
    
    
    Options
    
    
    AvailableShares
    
    
    Outstanding
    
    
    Vested
    
    
    for GrantEmployee and Director Stock Option Plans:1990 Stock Option Plan
    
    
    345,045
    
    
    
    2,500
    
    
    
    2,500
    
    
    
    1992 Stock Option Plan
    
    
    450,000
    
    
    
    65,666
    
    
    
    65,666
    
    
    
    1995 Long-term Incentive Plan
    
    
    1,825,000
    
    
    
    1,340,000
    
    
    
    948,333
    
    
    
    1996 Directors Stock Option Plan
    
    
    225,000
    
    
    
    60,000
    
    
    
    60,000
    
    
    
    1999 Directors Stock Option Plan
    
    
    975,000
    
    
    
    826,153
    
    
    
    770,625
    
    
    
    2001 Stock Option Plan
    
    
    2,525,000
    
    
    
    1,751,892
    
    
    
    878,232
    
    
    
    307,1982001 Employee Stock Option Plan
    
    
    300,000
    
    
    
    215,770
    
    
    
    172,311
    
    
    
    40,6832003 New Employee Stock Option Plan
    
    
    500,000
    
    
    
    463,000
    
    
    
    344,233
    
    
    
    37,0002004 Stock Option Plan
    
    
    3,200,000
    
    
    
    1,767,795
    
    
    
    553,785
    
    
    
    1,432,2052004 Directors Stock Option Plan
    
    
    300,000
    
    
    
    270,833
    
    
    
    160,208
    
    
    
    29,1672006 Directors Stock Option Plan
    
    
    750,000
    
    
    
    194,190
    
    
    
    16,183
    
    
    
    555,810Cook Employee Transferred Options
    
    
    807,127
    
    
    
    18,000
    
    
    
    18,000
    
    
    
    Total employee and director stock option plans
    
    
    12,202,172
    
    
    
    6,975,799
    
    
    
    3,990,076
    
    
    
    2,402,063Executive Stock Option Agreements:John A. Ryan, former Chairman and CEO
    
    
    1,000,000
    
    
    
    1,000,000
    
    
    
    1,000,000
    
    
    
    Richard D. Spurr, Chairman, President and CEO
    
    
    650,000
    
    
    
    650,000
    
    
    
    517,045
    
    
    
    Other executive stock option agreements
    
    
    450,000
    
    
    
    158,665
    
    
    
    158,665
    
    
    
    Total executive stock option agreements
    
    
    2,100,000
    
    
    
    1,808,665
    
    
    
    1,675,710
    
    
    
    Other stock option agreements
    
    
    70,000
    
    
    
    70,000
    
    
    
    70,000
    
    
    
    Total
    
    
    14,372,172
    
    
    
    8,854,464
    
    
    
    5,735,786
    
    
    
    2,402,063
  Employee and Director Stock Option Plans
  Cook Employee Transferred Options
 Executive Stock Option Agreements:
 John A. Ryan
 Richard D. Spurr
 Other Executive Stock Option Agreements
 Other Stock Option Agreements:
  Accounting Treatment
 Share-Based Payment
 6




---



##### Table of Contents



123(R).
   Three Months Ended
    
    
    Six Months EndedJune 30, 2006
    
    
    June 30, 2006Cost of revenues
    
    $
    30,000
    
    
    $
    63,000Research and development expenses
    
    
    26,000
    
    
    
    58,000Selling, general and administrative expenses
    
    
    617,000
    
    
    
    1,319,000Stock-based compensation expense
    
    $
    673,000
    
    
    $
    1,440,000
  Transition Election
Related to Accounting for the Tax Effects of Share-Based Payment Awards,
  Three Months Ended
    
    
    Six Months EndedJune 30, 2005
    
    
    June 30, 2005Net loss, as reported
    
    $
    (8,915,000
    )
    
    $
    (18,487,000
    )Deduct pro forma stock compensation
expense computed under the fair value
method
    
    
    (1,601,000
    )
    
    
    (3,362,000
    )Pro forma net loss
    
    $
    (10,516,000
    )
    
    $
    (21,849,000
    )Basic and diluted loss per common share:As reported
    
    $
    (0.28
    )
    
    $
    (0.57
    )Pro forma
    
    $
    (0.32
    )
    
    $
    (0.68
    )
   7




---



##### Table of Contents



Share Based Payment,
 Three Months Ended June 30,
    
    Six Months Ended June 30,2006
    
    2005
    
    2006
    
    2005Risk-free interest rate
    
    
    4.95
    %
    
    
    3.45
    %
    
    
    4.62
    %
    
    
    3.22
    %Expected option life
    
    5.5 years
    
    3.6 years
    
    5.8 years
    
    3.6 yearsExpected stock price volatility
    
    
    92.2
    %
    
    
    95.1
    %
    
    
    95.6
    %
    
    
    97.3
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Fair value of options granted
    
    $
    0.68
    
    
    $
    2.03
    
    
    $
    1.24
    
    
    $
    2.47
 Stock Option Activity
  WeightedWeighted
    
    
    AverageAverage
    
    
    Remaining
    
    
    AggregateExercise
    
    
    Contractual
    
    
    IntrinsicShares
    
    
    Price
    
    
    Term
    
    
    ValueOutstanding at January 1, 2006
    
    
    7,595,415
    
    
    $
    7.03Granted at market price
    
    
    15,000
    
    
    $
    1.93Granted above market price
    
    
    2,161,373
    
    
    $
    2.87Cancelled or expired
    
    
    (917,324
    )
    
    $
    6.20Exercised
    
    
    
    
    
    $
    Outstanding at June 30, 2006
    
    
    8,854,464
    
    
    $
    6.09
    
    
    
    6.81
    
    
    $
    Options exercisable at June 30, 2006
    
    
    5,735,786
    
    
    $
    7.27
    
    
    
    5.98
    
    
    $
    
   Common Stock Issued in Lieu of Cash
  Three Months Ended June 30,
    
    
    Six Months Ended June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Common stock issued to employees for compensation in lieu of cash
    
    $
    
    
    
    $
    243,000
    
    
    $
    157,000
    
    
    $
    243,000Stock granted to third parties
    
    
    10,000
    
    
    
    
    
    
    
    30,000
    
    
    
    Total
    
    $
    10,000
    
    
    $
    243,000
    
    
    $
    187,000
    
    
    $
    243,000
 8




---



##### Table of Contents



6. Supplemental Cash Flow Information
  Six Months Ended June 30,2006
    
    
    2005Cash paid for interest
    
    $
    259,000
    
    
    $
    298,000Cash paid for income tax
    
    $
    42,000
    
    
    $
    294,000Noncash investing and financing activities:Assets acquired on capital lease
    
    $
    
    
    
    $
    160,000Issuance of note receivable relating to the sale of Message Inspector
and Web Inspector product lines (Note 7)
    
    $
    
    
    
    $
    1,435,000Revaluation of warrants resulting from restructure of convertible
promissory notes payable (Note 12)
    
    $
    
    
    
    $
    (375,000
    )Accrued expenses relating to private placement of common stock (Note 13)
    
    $
    94,000
    
    
    $
    Valuation of beneficial conversion, net of subsequent reversal (Note 12)
    
    $
    94,000
    
    
    $
    2,518,000Accrued expenses related to fixed asset purchases
    
    $
    40,000
    
    
    $
    Assets sold to customers as part of their subscription service
    
    $
    19,000
    
    
    $
    Value of additional warrants issued (Note 12)
    
    $
    130,000
    
    
    $
    Insurance premiums financed by short-term note payable
    
    $
    
    
    
    $
    84,000
 7. Business Sales and Acquisitions
 Sale of Dr. Chart, a product of MyDocOnline
    Net assets sold (liabilities transferred):Accounts receivable, net
    
    $
    34,000Equipment, net
    
    
    37,000Intangibles, net
    
    
    575,000Deferred revenue
    
    
    (739,000
    )Net
    
    
    (93,000
    )Goodwill
    
    
    4,797,000Net proceeds:Cash receivable
    
    
    150,000Note receivable, net
    
    
    Service obligation
    
    
    (30,000
    )Transaction fees
    
    
    (167,000
    )Net proceeds
    
    
    (47,000
    )Loss on sale of product line
    
    $
    (4,751,000
    )
 9




---



##### Table of Contents



Sale of Web Inspector and Message Inspector Product Lines
   Net assets sold (liabilities transferred):Equipment, net
    
    $
    15,000Prepaid expenses
    
    
    165,000Intangibles, net
    
    
    1,499,000Initial deferred revenue
    
    
    (1,546,000
    )Net
    
    
    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 of product lines
    
    $
    950,000
    8. Restricted Cash
  9. Accounts Receivable
 10




---



##### Table of Contents



June 30,
    
    
    December 31,2006
    
    
    2005Gross trade accounts receivable
    
    $
    3,882,000
    
    
    $
    3,136,000Allowance for returns and doubtful accounts
    
    
    (89,000
    )
    
    
    (35,000
    )Billed but unpaid portion of deferred revenue
    
    
    (3,596,000
    )
    
    
    (2,969,000
    )Trade receivables, net
    
    
    197,000
    
    
    
    132,000Taxes receivable
    
    
    301,000
    
    
    
    Other receivable
    
    
    11,000
    
    
    
    17,000Total receivables, net
    
    $
    509,000
    
    
    $
    149,000
   10. Intangible Assets and Goodwill
  June 30, 2006
    
    
    December 31, 2005Accumulated
    
    
    
    
    
    
    
    
    
    
    AccumulatedCost
    
    
    Amortization
    
    
    Net
    
    
    Cost
    
    
    Amortization
    
    
    NetDeveloped technology
    
    $
    2,034,000
    
    
    $
    1,835,000
    
    
    $
    199,000
    
    
    $
    2,034,000
    
    
    $
    1,475,000
    
    
    $
    559,000
   Six months ended December 31, 2006
    
    $
    176,0002007
    
    
    23,000Total
    
    $
    199,000
  11. Customer Deposit
   11




---



##### Table of Contents



12. Notes Payable
  AdditionalDiscountfromWarrantsDecember 31,
    
    
    and
    
    
    Discount
    
    
    
    
    
    
    June 30,Stated
    
    
    Effective
    
    
    
    
    
    
    2005,
    
    
    Beneficial
    
    
    Amortization /
    
    
    
    
    
    
    2006,Interest
    
    
    Interest
    
    
    
    
    
    
    Net
    
    
    Conversion
    
    
    Reversal /
    
    
    Payments
    
    
    NetRate
    
    
    Rate
    
    
    Term
    
    
    Book Value
    
    
    Feature
    
    
    Write-off
    
    
    Made
    
    
    Book ValueConvertible promissory note payable
    
    
    8.22
    %
    
    
    37.41
    %
    
    NA
    
    
    $
    4,404,000
    
    
    $
    (573,000
    )
    
    $
    1,169,000
    
    
    $
    (5,000,000
    )
    
    $
    Promissory note payable
    
    
    4.50
    %
    
    
    11.00
    %
    
    
    2007
    
    
    
    2,226,000
    
    
    
    
    
    
    
    211,000
    
    
    
    
    
    
    
    2,437,000Short-term promissory notes
    
    
    6.99
    %
    
    
    6.99
    %
    
    
    2006
    
    
    
    268,000
    
    
    
    
    
    
    
    
    
    
    
    (153,000
    )
    
    
    115,000Total notes payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    6,898,000
    
    
    $
    (573,000
    )
    
    $
    1,380,000
    
    
    $
    (5,153,000
    )
    
    $
    2,552,000
 Convertible Promissory Notes Payable
    Accounting treatment of the amended convertible promissory notes payable
 Accounting for Derivative Financial instruments Indexed to, and Potentially Settled in a
Companys Own Stock Accounting for Convertible Debt
and Debt Issued with Stock Purchase Warrants.
 Accounting for Convertible Securities with Beneficial Conversion
 12




---



##### Table of Contents



Features of Contingently
Adjustable Conversion Features Application of Issue No. 98-5 to Certain
Convertible Instruments
  2005 payment activity on the convertible promissory notes payable:
   2005 and first quarter 2006 adjustments to the stock conversion price and warrant exercise
price
   Second quarter 2006 convertible promissory note payable and related warrant activity
 
    
    Per anti-dilution terms included in the amended convertible promissory notes payable,
the Company issued additional warrants to purchases 264,718 shares of common stock.
These warrants expire on the following schedule: 22% in November 2006 and 2007, 10% in
November 2008 and 47% in November 2009. The additional warrants were valued at $74,000
using the BSOPM and recorded as discount against the outstanding note and amortized to
interest expense using the effective interest method.
 13




---



##### Table of Contents




    
    The exercise prices of the warrants relating to the convertible promissory notes
payable were reduced from a range of $1.44 to $5.24 to a range of $1.42 to $4.47.
    
    The conversion price of the outstanding convertible promissory notes payable was
reduced from $5.24 per share to $4.47 per share. The reduced conversion price caused
the Company to record the intrinsic value of a beneficial conversion feature as the
adjusted conversion price was reset to a price below the market price of the Companys
stock on the date the notes were originally issued (November 2, 2004). The intrinsic
value of the adjusted conversion price is $459,000 and was recorded as additional
discount on the remaining convertible promissory note payable and was amortized to
interest expense using the effective interest method.
  
    
    The Company retired the full $5,000,000 using restricted cash and paid a $200,000
early payment premium plus accrued interest for a total payoff amount of $5,259,000.
    
    In accordance with the terms of the note, the Company issued warrants to the note
holder to purchase an additional 782,998 shares of common stock at $4.47 per share. 50%
of these warrants expire in November 2006 and 50% expire in November 2007. These
warrants were valued at $6,000 using the BSOPM.
  Early payment premium
    
    $
    200,000Write-off of unamortized discount
    
    
    449,000Write-off of unamortized financing costs
    
    
    216,000Value of warrants issued upon extinguishment
    
    
    6,000Loss on extinguishment of debt
    
    $
    871,000
   December 31, 2005
    
    
    
    
    
    
    March 31, 2006
    
    
    
    
    
    
    June 30, 2006Additional
    
    
    
    
    
    
    Adjusted
    
    
    Additional
    
    
    
    
    
    
    AdjustedWarrants
    
    
    Exercise
    
    
    Warrants
    
    
    Warrants
    
    
    Exercise
    
    
    Warrants
    
    
    Warrants
    
    
    ExerciseWarrant Grants:
    
    Outstanding
    
    
    Price
    
    
    Issued
    
    
    Outstanding
    
    
    Price
    
    
    Issued
    
    
    Outstanding
    
    
    PriceConvertible promissory notes payable,
initial warrants
    
    
    450,422
    
    
    $
    5.38
    
    
    
    
    
    
    
    450,422
    
    
    $
    5.24
    
    
    
    241,120
    
    
    
    691,542
    
    
    $
    4.47Re-pricing of initial warrants, Sept 23, 2005
    
    
    118,672
    
    
    
    2.15
    
    
    
    1,942
    
    
    
    120,614
    
    
    
    2.15
    
    
    
    9,698
    
    
    
    130,312
    
    
    
    1.99Re-pricing of initial warrants, Oct 28, 2005
    
    
    87,442
    
    
    
    1.82
    
    
    
    1,432
    
    
    
    88,874
    
    
    
    1.82
    
    
    
    5,168
    
    
    
    94,042
    
    
    
    1.72Re-pricing of initial warrants, Dec 1, 2005
    
    
    125,914
    
    
    
    1.69
    
    
    
    3,364
    
    
    
    129,278
    
    
    
    1.69
    
    
    
    5,586
    
    
    
    134,864
    
    
    
    1.62Re-pricing of initial warrants, Dec 9, 2005
    
    
    217,550
    
    
    
    1.44
    
    
    
    5,812
    
    
    
    223,362
    
    
    
    1.44
    
    
    
    3,146
    
    
    
    226,508
    
    
    
    1.42Additional warrants issued due to repricing
for 2005 Private Placement
    
    
    115,244
    
    
    
    5.38
    
    
    
    17,246
    
    
    
    132,490
    
    
    
    5.24
    
    
    
    
    
    
    
    132,490
    
    
    
    4.47Additional warrants issued due to 2005 cash
payments on convertible promissory notes
payable
    
    
    795,590
    
    
    
    5.38
    
    
    
    21,257
    
    
    
    816,847
    
    
    
    5.24
    
    
    
    
    
    
    
    816,847
    
    
    
    4.47Additional warrants issued due to 2006 cash
payments on convertible promissory notes
payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    782,998
    
    
    
    782,998
    
    
    
    4.47Warrants issued to the broker in conjunction
with the note issuance
    
    
    166,667
    
    
    
    6.00
    
    
    
    
    
    
    
    166,667
    
    
    
    6.00
    
    
    
    
    
    
    
    166,667
    
    
    
    6.00Total
    
    
    2,077,501
    
    
    
    
    
    
    
    51,053
    
    
    
    2,128,554
    
    
    
    
    
    
    
    1,047,716
    
    
    
    3,176,270
 14




---



##### Table of Contents



Effective yield and interest expense
 Promissory Note Payable
   Short-term Note Payable
  13. April 2006 Private Placement of Common Stock
    15




---



##### Table of Contents



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




---



##### Table of Contents



Warrants issued to underwriters
 Common stock
  (Gain)/April 5, 2006
    
    
    Loss on
    
    
    June 30, 2006Derivative Liability
    
    Fair Value
    
    
    Revaluation
    
    
    Fair ValueLiquidated damages related to common stock
    
    $
    77,000
    
    
    $
    (7,000
    )
    
    $
    70,000Warrants issued to investors and related liquidated damages
    
    
    6,024,000
    
    
    
    (2,925,000
    )
    
    
    3,099,000Potential future payments to transaction underwriters
    
    
    60,000
    
    
    
    2,000
    
    
    
    62,000Total
    
    $
    6,161,000
    
    
    $
    (2,930,000
    )
    
    $
    3,231,000
 14. Earnings Per Share and Potential Dilution
   Three Months Ended June 30,
    
    
    Six Months Ended June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Stock options (see Note 5)
    
    
    8,843,752
    
    
    
    8,164,634
    
    
    
    8,482,042
    
    
    
    8,067,509Warrants issued in relation to debt and equity arrangements
    
    
    13,769,011
    
    
    
    3,691,317
    
    
    
    10,721,576
    
    
    
    3,632,594Shares issuable for conversion of convertible promissory notes payable
(see Note 12)
    
    
    1,022,437
    
    
    
    3,333,333
    
    
    
    988,318
    
    
    
    3,333,333Total antidilutive securities excluded from earnings per share calculation
    
    
    23,635,200
    
    
    
    15,189,284
    
    
    
    20,191,936
    
    
    
    15,033,436
  15. Contingencies
  17




---



##### Table of Contents



ITEM 2.
 MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 Overview
   18




---



##### Table of Contents



Developmental History
  
    
    ZixVPM (Virtual Private Messenger): an e-messaging gateway service that provides
company-wide privacy protection for inbound and outbound email communications.
    
    ZixAuditor: an assessment service used to analyze email traffic patterns and
monitor compliance with corporate and regulatory policies.
    
    ZixPort: a secure Web-messaging portal.
         19




---



##### Table of Contents



Critical Accounting Policies and Estimates
  Long-Lived Assets
   Goodwill and Other Intangible Assets,
  Deferred Tax Assets
 Derivative Liabilities Accounting for Derivative
Instruments
 20




---



##### Table of Contents



and Hedging Activities Accounting for Derivative Financial
instruments Indexed to, and Potentially Settled in a Companys Own Stock The
Effect of Liquidated damages Clause on Freestanding Financial Instruments Subject to Issue No.
00-19 .
 Revenue Software Revenue Recognition; Modification of SOP 97-2, Software Revenue Recognition, With respect to Certain
Transactions; Revenue Arrangements with
Multiple Deliverables; Revenue Recognition in Financial Statements,
      21




---



##### Table of Contents



Deferred Cost of Revenues
 Stock-based compensation Share-Based Payment Accounting for Stock Issued to Employees
   Three Months Ended June 30,
    
    Six Months Ended June 30,2006
    
    2005
    
    2006
    
    2005Risk-free interest rate
    
    
    4.95
    %
    
    
    3.45
    %
    
    
    4.62
    %
    
    
    3.22
    %Expected option life
    
    5.5 years
    
    3.6 years
    
    5.8 years
    
    3.6 yearsExpected stock price volatility
    
    
    92.2
    %
    
    
    95.1
    %
    
    
    95.6
    %
    
    
    97.3
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Fair value of options granted
    
    $
    0.68
    
    
    $
    2.03
    
    
    $
    1.24
    
    
    $
    2.47
   22




---



##### Table of Contents



Three Months Ended
    
    
    Six Months EndedJune 30, 2005
    
    
    June 30, 2005Net loss, as reported
    
    $
    (8,915,000
    )
    
    $
    (18,487,000
    )Deduct pro forma stock compensation
expense computed under the fair value
method
    
    
    (1,601,000
    )
    
    
    (3,362,000
    )Pro forma net loss
    
    $
    (10,516,000
    )
    
    $
    (21,849,000
    )Basic and diluted loss per common share:As reported
    
    $
    (0.28
    )
    
    $
    (0.57
    )Pro forma
    
    $
    (0.32
    )
    
    $
    (0.68
    )
 Results of Operations
 Second Quarter 2006 Summary of Operations
 Financial Statement
 
    
    Revenue for the quarter ended June 30, 2006, was $4,209,000 from all products compared with $3,449,000 for the same
period 2005.
    
    Net loss for the quarter ended June 30, 2006, was $5,086,000 compared with $8,915,000 for the same period in 2005.
Included in the net loss for the quarter ended June 30, 2006, is a gain on revaluation of derivative liabilities of
$2,930,000.
    
    The Companys unrestricted cash balance was $19,569,000 on June 30, 2006.
    
    The Company paid off the remaining $5,000,000 balance of its convertible promissory note payable ahead of the maturity
date and recorded an $871,000 loss on the extinguishment of that note.
    
    The Company completed a private placement of its common stock and warrants to purchase common stock in April for net
proceeds of $10,909,000 (see Note 13 to the condensed consolidated financial statements).
    
    Cash used from operations was $5,058,000, and overall cash and cash equivalent balances increased by $5,411,000 in the
quarter ended June 30, 2006.
 Operations
 
    
    The Company secured new first-year orders in the quarter ended June 30, 2006, totaling $1,402,000 for its Email
Encryption services and maintained over 95% renewal rate of its Email Encryption customers.
    
    The Company deployed 445 new e-Prescribing devices to physicians under sponsorship arrangements with several large
insurance payors.
    
    The Company exceeded 1,300,000 electronic prescriptions transacted in the three months ended June 30, 2006, through its
e-Prescribing service.
    
    The Company successfully introduced a new product, ZixDirect, as an addition to its Email Encryption product line.
    
    The Company announced in the second quarter of 2006 that it was in the process of reducing its quarterly spending by a
15% reduction in workforce, principally in non-revenue-related headcount positions. Further, non-workforce costs would
be reviewed and appropriate reductions in these cost areas would also be made with a 15% reduction target. On August 8,
2006, the Company announced that the targeted cost reductions would be increased from 15% to 25% by the end of 2006. As
of August 1, 2006, the Company has taken actions to achieve roughly half of the planned cost reductions. The purpose of
these reductions is to
streamline the Companys operating costs in order to strengthen the Companys liquidity position
by more closely matching its cost structure to short-term revenue opportunities.
 23




---



##### Table of Contents



Revenues
  3-monthVariance
    
    
    
    
    
    
    
    
    
    
    6-monthVarianceThree Months Ended June 30,
    
    
    2006 vs. 2005
    
    
    Six Months Ended June 30,
    
    
    2006 vs. 20052006
    
    
    2005
    
    
    $
    
    
    %
    
    
    2006
    
    
    2005
    
    
    $
    
    
    %Services
    
    $
    4,209,000
    
    
    $
    3,199,000
    
    
    $
    1,010,000
    
    
    
    32
    %
    
    $
    8,104,000
    
    
    $
    6,497,000
    
    
    $
    1,607,000
    
    
    
    25
    %Hardware
    
    
    
    
    
    
    241,000
    
    
    
    (241,000
    )
    
    
    (100
    %)
    
    
    
    
    
    
    426,000
    
    
    
    (426,000
    )
    
    
    (100
    %)Software
    
    
    
    
    
    
    9,000
    
    
    
    (9,000
    )
    
    
    (100
    %)
    
    
    
    
    
    
    109,000
    
    
    
    (109,000
    )
    
    
    (100
    %)Total revenues
    
    $
    4,209,000
    
    
    $
    3,449,000
    
    
    $
    760,000
    
    
    
    22
    %
    
    $
    8,104,000
    
    
    $
    7,032,000
    
    
    $
    1,072,000
    
    
    
    15
    %
   3-month Variance
    
    
    
    
    
    
    
    
    
    
    6-month VarianceThree Months Ended, June 30,
    
    
    2006 vs. 2005
    
    
    Six Months Ended, June 30,
    
    
    2006 vs. 20052006
    
    
    2005
    
    
    $
    
    
    %
    
    
    2006
    
    
    2005
    
    
    $
    
    
    %Email Encryption
    
    $
    3,369,000
    
    
    $
    2,434,000
    
    
    $
    935,000
    
    
    
    38
    %
    
    $
    6,702,000
    
    
    $
    4,477,000
    
    
    $
    2,225,000
    
    
    
    50
    %e-Prescribing
    
    
    840,000
    
    
    
    881,000
    
    
    
    (41,000
    )
    
    
    (5
    %)
    
    
    1,402,000
    
    
    
    1,714,000
    
    
    
    (312,000
    )
    
    
    (18
    %)Subtotal before
divested products or
services
    
    
    4,209,000
    
    
    
    3,315,000
    
    
    
    894,000
    
    
    
    27
    %
    
    
    8,104,000
    
    
    
    6,191,000
    
    
    
    1,913,000
    
    
    
    31
    %MI/WI Products
    
    
    
    
    
    
    9,000
    
    
    
    (9,000
    )
    
    
    (100
    %)
    
    
    
    
    
    
    646,000
    
    
    
    (646,000
    )
    
    
    (100
    %)Dr. Chart
    
    
    
    
    
    
    125,000
    
    
    
    (125,000
    )
    
    
    (100
    %)
    
    
    
    
    
    
    195,000
    
    
    
    (195,000
    )
    
    
    (100
    %)Subtotal
divested products or
services
    
    
    
    
    
    
    134,000
    
    
    
    (134,000
    )
    
    
    (100
    %)
    
    
    
    
    
    
    841,000
    
    
    
    (841,000
    )
    
    
    (100
    %)Total revenues
    
    $
    4,209,000
    
    
    $
    3,449,000
    
    
    $
    760,000
    
    
    
    22
    %
    
    $
    8,104,000
    
    
    $
    7,032,000
    
    
    $
    1,072,000
    
    
    
    15
    %
 Email
Encryption -
 24




---



##### Table of Contents



e-Prescribing
-
   Divested Products:
 Revenue Summary:
 Revenue
Indicators - Backlog, Orders, and Deployments
 Company-wide
backlog -
   25




---



##### Table of Contents



Email
Encryption Orders -
  e-Prescribing
Deployments and Active Users -
  e-Prescribing
Transaction and Usage Fees -
 26




---



##### Table of Contents



Cost of Revenues
  3-month Variance
    
    
    
    
    
    
    
    
    
    
    6-month VarianceThree Months Ended, June 30,
    
    
    2006 vs. 2005
    
    
    Six Months Ended, June 30,
    
    
    2006 vs. 20052006
    
    
    2005
    
    
    $
    
    
    %
    
    
    2006
    
    
    2005
    
    
    $
    
    
    %Email Encryption
    
    $
    1,319,000
    
    
    $
    1,350,000
    
    
    $
    (31,000
    )
    
    
    (2
    %)
    
    $
    2,785,000
    
    
    $
    2,664,000
    
    
    $
    121,000
    
    
    
    5
    %e-Prescribing
    
    
    1,771,000
    
    
    
    1,731,000
    
    
    
    40,000
    
    
    
    2
    %
    
    
    3,680,000
    
    
    
    3,531,000
    
    
    
    149,000
    
    
    
    4
    %Subtotal before
divested products or
services
    
    
    3,090,000
    
    
    
    3,081,000
    
    
    
    9,000
    
    
    
    0
    %
    
    
    6,465,000
    
    
    
    6,195,000
    
    
    
    270,000
    
    
    
    4
    %Divested products
(MI/WI and Dr. Chart)
    
    
    
    
    
    
    427,000
    
    
    
    (427,000
    )
    
    
    (100
    %)
    
    
    
    
    
    
    1,204,000
    
    
    
    (1,204,000
    )
    
    
    (100
    %)Total cost of revenues
    
    $
    3,090,000
    
    
    $
    3,508,000
    
    
    $
    (418,000
    )
    
    
    (12
    %)
    
    $
    6,465,000
    
    
    $
    7,399,000
    
    
    $
    (934,000
    )
    
    
    (13
    %)
   Email
Encryption -
 e-Prescribing
-
 27




---



##### Table of Contents



Divested
Products -
 Research and Development Expenses
  3-month Variance
    
    
    
    
    
    
    
    
    
    6-month VarianceThree Months Ended, June 30,
    
    2006 vs. 2005
    
    Six Months Ended, June 30,
    
    2006 vs. 20052006
    
    2005
    
    $
    
    %
    
    2006
    
    2005
    
    $
    
    %Total research and development
    
    $
    1,626,000
    
    
    $
    1,535,000
    
    
    $
    91,000
    
    
    
    6
    %
    
    $
    3,221,000
    
    
    $
    3,510,000
    
    
    $
    (289,000
    )
    
    
    (8
    %)
   Selling, General and Administrative Expenses
  3-month Variance
    
    
    
    
    
    
    
    
    
    6-month VarianceThree Months Ended, June 30,
    
    2006 vs. 2005
    
    Six Months Ended, June 30,
    
    2006 vs. 20052006
    
    2005
    
    $
    
    %
    
    2006
    
    2005
    
    $
    
    %Total selling,
general and
administrative
expenses
    
    $
    6,549,000
    
    
    $
    6,559,000
    
    
    $
    (10,000
    )
    
    
    0
    %
    
    $
    13,141,000
    
    
    $
    14,061,000
    
    
    $
    (920,000
    )
    
    
    (7
    %)
    28




---



##### Table of Contents



Customer Deposit Forfeitures
  Interest Expense
   Stated
    
    
    
    
    
    
    Financing
    
    
    
    
    
    
    TotalInterest
    
    
    Discount
    
    
    Cost
    
    
    Warrants
    
    
    Intereston Notes
    
    
    Amortization
    
    
    Amortization
    
    
    Issued
    
    
    ExpenseConvertible promissory note payable
    
    $
    185,000
    
    
    $
    354,000
    
    
    $
    122,000
    
    
    $
    10,000
    
    
    $
    671,000Promissory note payable
    
    
    
    
    
    
    211,000
    
    
    
    
    
    
    
    
    
    
    
    211,000Short-term promissory note
    
    
    7,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,000Capital leases
    
    
    6,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,000Total notes payable
    
    $
    198,000
    
    
    $
    565,000
    
    
    $
    122,000
    
    
    $
    10,000
    
    
    $
    895,000
  DiscountStated
    
    
    Amortization /
    
    
    Financing
    
    
    
    
    
    
    TotalInterest
    
    
    Premium
    
    
    Cost
    
    
    Warrants
    
    
    Intereston Notes
    
    
    Accretion
    
    
    Amortization
    
    
    Issued
    
    
    ExpenseConvertible promissory note payable
    
    $
    570,000
    
    
    $
    1,656,000
    
    
    $
    392,000
    
    
    $
    
    
    
    $
    2,618,000Promissory note payable
    
    
    
    
    
    
    187,000
    
    
    
    
    
    
    
    
    
    
    
    187,000Short-term promissory note
    
    
    5,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,000Capital leases
    
    
    16,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    16,000Total notes payable
    
    $
    591,000
    
    
    $
    1,843,000
    
    
    $
    392,000
    
    
    $
    
    
    
    $
    2,826,000
   29




---



##### Table of Contents



Investment and Other Income
  Gain on Sale of Product Line
  Gain on Valuation of Derivative Liability
 .
 Income Taxes
   Liquidity and Capital Resources
 Overview
   30




---



##### Table of Contents




    
    New subscriptions (termed new first-year orders) for the Email Encryption service
    
    Renewal rates for the Email Encryption service
    
    New insurance payor sponsorships of the e-Prescribing service to physicians
    
    Successful adoption and usage of the e-Prescribing service by physicians
    
    Retention of the users (physicians) of the e-Prescribing service
    
    Future transaction fees (or related fees) associated with the use of the e-Prescribing service
    
    The ability to increase the business volume with reasonable cost increases
 Email Encryption
 e-Prescribing
   31




---



##### Table of Contents



Sources and Uses of Cash Summary
   Six Months Ended, June 30,2006
    
    
    2005
    
    
    VarianceOperating Cash Receipts (Products existing on December 31, 2005)
    
    $
    9,388,000
    
    
    $
    7,760,000
    
    
    $
    1,628,000Operating Cash Receipts (Products divested in 2005)
    
    
    
    
    
    
    1,400,000
    
    
    
    (1,400,000
    )Net Operating Cash Spending
    
    
    (19,992,000
    )
    
    
    (22,333,000
    )
    
    
    2,341,000Net Cash Used by Operating Activities
    
    $
    (10,604,000
    )
    
    $
    (13,173,000
    )
    
    $
    2,569,000
     32




---



##### Table of Contents



Cash Sources
  
    
    contractual backlog
    
    Email Encryption growth and retention
    
    e-Prescribing growth and retention
    
    e-Prescribing transaction and performance-based fees
 Backlog
 Email Encryption growth and retention
 e-Prescribing growth and retention
 e-Prescribing transaction and performance-based fees
 33




---



##### Table of Contents



Cash Requirements
    Debt Instruments and Related Covenants
  1.
    
    Promissory Note Payable: $2,700,0002.
    
    Short-term Promissory Note: $115,000
 Promissory Note Payable
 Short-term Promissory Notes
 Liquidity Summary
 34




---



##### Table of Contents




    
    Relatively low contractual spending commitments in 2006
    
    Historically high renewal rates for Email Encryption
    
    Continued growth in the Email Encryption business
    
    Increased mix of cash receipts attributable to the more profitable out-years of contracts
    
    The discretionary nature of the cash spending in excess of cash receipts in the emerging area of e-Prescribing
    
    General flexibility of spending in other areas
  Options and Warrants of ZixCorp Common Stock
  Summary of Outstanding Options and WarrantsVested SharesTotal Value
    
    
    (included in
    
    
    Total ValueOutstanding
    
    
    of Outstanding
    
    
    outstanding
    
    
    of VestedExercise Price Range
    
    Shares
    
    
    Shares
    
    
    shares)
    
    
    Shares$1.44 - $1.92
    
    
    6,662,014
    
    
    $
    10,258,000
    
    
    
    455,414
    
    
    $
    702,000$1.93 - $3.50
    
    
    6,002,442
    
    
    
    17,478,000
    
    
    
    4,294,644
    
    
    
    12,843,000$3.51 - $4.99
    
    
    5,268,380
    
    
    
    22,772,000
    
    
    
    4,412,650
    
    
    
    19,235,000$5.00 - $5.99
    
    
    1,706,968
    
    
    
    8,825,000
    
    
    
    1,706,968
    
    
    
    8,825,000$6.00 - $8.99
    
    
    1,480,715
    
    
    
    9,581,000
    
    
    
    1,164,048
    
    
    
    7,632,000$9.00 - $19.99
    
    
    1,439,848
    
    
    
    15,665,000
    
    
    
    1,251,365
    
    
    
    13,682,000$21.38 - $57.60
    
    
    1,138,695
    
    
    
    60,571,000
    
    
    
    1,138,695
    
    
    
    60,571,000Total
    
    
    23,699,062
    
    
    $
    145,150,000
    
    
    
    14,423,784
    
    
    $
    123,490,000
 Off-Balance Sheet Arrangements
 35




---



##### Table of Contents



Contractual Obligations, Contingent Liabilities and Commitments
  Payments Due by PeriodTotal
    
    
    < 1 Year
    
    
    1-3 Year
    
    
    3-5 Years
    
    
    > 5 YearsNotes payable
    
    $
    2,815,000
    
    
    $
    2,815,000
    
    
    $
    
    
    
    $
    
    
    
    $
    Operating leases
    
    
    8,196,000
    
    
    
    1,344,000
    
    
    
    2,195,000
    
    
    
    1,774,000
    
    
    
    2,883,000Capital lease
    
    
    40,000
    
    
    
    40,000
    
    
    
    
    
    
    
    
    
    
    
    401k funding obligation
    
    
    116,000
    
    
    
    116,000
    
    
    
    
    
    
    
    
    
    
    
    John Ryan consulting agreement
    
    
    110,000
    
    
    
    110,000
    
    
    
    
    
    
    
    
    
    
    
    Total cash obligations
    
    
    11,277,000
    
    
    
    4,425,000
    
    
    
    2,195,000
    
    
    
    1,774,000
    
    
    
    2,883,000Interest on obligations
    
    
    2,000
    
    
    
    2,000
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    11,279,000
    
    
    $
    4,427,000
    
    
    $
    2,195,000
    
    
    $
    1,774,000
    
    
    $
    2,883,000
   Potential payment of liquidated damages related to April 5, 2006 Private Placement
  
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  
 ITEM 4. CONTROLS AND PROCEDURES
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PART II  OTHER INFORMATION
 
 ITEM 1. Legal Proceedings
  
 ITEM 1A. Risk Factors
 (In these risk factors, we, us, our, and ZixCorp refer to Zix Corporation and its
wholly-owned subsidiaries.)
 An investment in our common stock involves a high degree of risk. You should carefully
consider the following risk factors in evaluating an investment in our common stock. If any of the
following risks actually occurs, our business, financial condition, results of operations or cash
flow could be materially and adversely affected. In such case, the trading price of our common
stock could decline, and you could lose all or part of your investment. You should also refer to
the other information set forth in this report, including our consolidated financial statements and
the related notes.
 We have incurred significant operating losses in previous years and we continue to use
significant amounts of cash for our business operations, which could result in us having
insufficient cash to fund our operations under our current business plan.
   The market may not broadly accept our Email Encryption and e-Prescribing solutions and
services, which would prevent us from operating profitably.
  Failure to enter into additional or to maintain existing sponsorship agreements for our
PocketScript e-Prescribing service and generate other revenue opportunities from PocketScript could
harm our business.
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Healthcare providers may fail to adopt our PocketScript service.
  Failure to significantly increase our base of PocketScript users or obtain significant
prescription transaction fees, or other fees may result in failure to achieve the critical mass of
physicians and revenue to build a successful business.
    Competition in our businesses is expected to increase, which could cause our business to fail.
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Our inability to successfully execute timely development and introduction of new Email
Encryption and e-Prescribing services and related services and to implement technological changes
could harm our business.
   Future asset impairments could affect our financial results.
   Capacity limits on our technology and network hardware and software may be difficult to
project, and we may not be able to expand and/or upgrade our systems to meet increased use, which
would result in reduced revenues.
  Security interruptions to our data centers could disrupt our business, and any security
breaches could expose us to liability and negatively impact customer demand for our solutions and
services.
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Pending litigation could have a material impact on our operating results and financial
condition.
     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.
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Defects or errors in our services could harm our business.
  Public key cryptography technology is subject to risks.
  We depend on key personnel.
  We rely on third parties.
   We could be affected by government regulation.
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Our stock price may be volatile.
   We have a significant amount of stock options and warrants outstanding and may issue
additional equity securities in the future.Exercise of the outstanding options and warrants, and
future issuances of other securities will dilute the ownership interests of existing shareholders.
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The Company may be required to pay liquidated damages in the event one or more of the
registration statements it has filed with the SEC for the benefit of third parties ceases to be
effective.
  We may have liability for indemnification claims arising from the sale of our Web Inspector,
Message Inspector, and Dr. Chart ® product lines.
  NOTE ON FORWARD-LOOKING STATEMENTS AND RISK FACTORS
   
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
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ITEM 3. DEFAULTS UPON SENIOR SECURITIES
  
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  1.
    
    The shareholders elected as directors of the Company, Robert C. Hausmann, Charles N. Kahn
III, James S. Marston, Antonio R. Sanchez III, Paul E. Schlosberg, Richard D. Spurr, and Dr.
Ben G. Streetman. The following tabulation shows the votes with respect to this matter:
 SharesNominee
    
    Shares For
    
    WithheldRobert C. Hausmann
    
    
    46,052,976
    
    
    
    4,149,077Charles N. Kahn III
    
    
    46,052,648
    
    
    
    4,149,405James S. Marston
    
    
    46,011,876
    
    
    
    4,190,177Antonio R. Sanchez III
    
    
    43,592,356
    
    
    
    6,609,697Paul E. Schlosberg
    
    
    46,035,192
    
    
    
    4,166,861Richard D. Spurr
    
    
    45,899,607
    
    
    
    4,302,446Dr. Ben G. Streetman
    
    
    46,040,869
    
    
    
    4,161,184
 2.
    
    The shareholders voted to approve the adoption of the Zix Corporation 2006 Directors
Stock Option Plan. The following tabulation shows the votes with respect to this matter:
 For
    
    
    18,595,293Against
    
    
    6,074,416Abstain
    
    
    255,591Broker NonVotes
    
    
    25,276,753
 3.
    
    The shareholders voted to approve the adoption of an amendment to the Zix Corporation
2005 Stock Compensation Plan. The following tabulation shows the votes with respect to this
matter:
 For
    
    
    18,669,741Against
    
    
    6,002,449Abstain
    
    
    253,110Broker NonVotes
    
    
    25,276,753
 4.
    
    The shareholders voted to approve the issuance of shares in excess of the share cap in
relation to the convertible notes and warrants issued November 1, 2004:
 For
    
    
    13,908,268Against
    
    
    10,014,120Abstain
    
    
    251,648Broker NonVotes
    
    
    26,028,017
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ITEM 5. OTHER INFORMATION
  
 ITEM 6. EXHIBITS
 a. Exhibits
  Exhibit No.
    
    Description of Exhibits3.1
    
    Restated Articles of Incorporation of Zix Corporation, as filed with the Texas Secretary of
State on November 10, 2005. Filed as Exhibit 3.1 to Zix Corporations Annual Report on Form
10-K for the year ended December 31, 2005, and incorporated herein by reference.3.2
    
    Restated Bylaws of Zix Corporation, dated October 30, 2002. Filed as Exhibit 3.2 to Zix
Corporations Quarterly Report on Form 10-Q for the quarterly period ended September 30,
2002, and incorporated herein by reference.4.1
    
    Securities Purchase Agreement, dated as of April 4, 2006, by and between Zix Corporation and
the Purchasers listed on Schedule A thereto. Filed as Exhibit 4.1 to the Companys Form 8-K,
dated April 5, 2006.4.2
    
    Form of Warrant to purchase shares of Common Stock of Zix Corporation issued in connection
with the Securities Purchase Agreement noted in 4.1. Filed as Exhibit 4.2 to the Companys
Form 8-K, dated April 5, 2006.10.1
    
    Zix Corporation 2006 Directors Stock Option Plan. Filed as Exhibit 10.1 to the Companys
Form 8-K, dated June 14, 2006, and incorporated herein by reference.10.2
    
    Zix Corporation 2005 Stock Compensation Plan (amended and restated as of June 13, 2006).
Filed as Exhibit 10.2 to the Companys Form 8-K, dated June 14, 2006, and incorporated herein
by reference.31.1*
    
    Certification of Richard D. Spurr, President and Chief Executive Officer of the Company,
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2*
    
    Certification of Bradley C. Almond, Vice President, Chief Financial Officer, and Treasurer of
the Company, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1**
    
    Certification of Richard D. Spurr, President and Chief Executive Officer of the Company, and
Bradley C. Almond, Vice President, Chief Financial Officer, and Treasurer of the Company,
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 *
    
    Filed herewith.**
    
    Furnished herewith. 45




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SIGNATURE
  ZIX CORPORATION(Registrant)Date: August 9, 2006
    
    By: /s/ Bradley C. AlmondBradley C. AlmondVice President, Chief Financial Officer and Treasurer(Principal Financial Officer and Duly Authorized Officer)
 46