<PAGE>

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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                               ----------------

                                   FORM 10-K

                       FOR ANNUAL AND TRANSITION REPORTS
                     PURSUANT TO SECTION 13 OR 15(D) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
   OF 1934

   For the fiscal year ended December 31, 1999

                                       OR

[_]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 000-26819

                               ----------------

                         WATCHGUARD TECHNOLOGIES, INC.
             (Exact name of registrant as specified in its charter)

<TABLE>
<CAPTION>
                  Delaware                                     91-1712427
       <S>                                                 <C>
       (State or other jurisdiction of                      (I.R.S. Employer
       incorporation or organization)                      Identification No.)
</TABLE>

           316 Occidental Avenue South, Suite 200, Seattle, WA 98104
               (Address of principal executive offices)(zip code)

                                 (206) 521-8340
               Registrant's telephone number, including area code

                               ----------------

          Securities registered pursuant to Section 12(b) of the Act:

                                      None

          Securities registered pursuant to Section 12(g) of the Act:

                         Common Stock, $.001 par value

                               ----------------

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

  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]

  The aggregate market value of the voting stock held by nonaffiliates of the
registrant, based upon the closing sales price of the Common Stock on December
31, 1999 as reported on the Nasdaq National Market, was approximately
$190,970,821. Shares of Common Stock held by each officer and director and by
each person who owns 5% or more of the outstanding Common Stock have been
excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive determination
for other purposes.

  As of February 8, 2000, there were 20,190,472 shares outstanding of the
registrant's Common Stock.

                      DOCUMENTS INCORPORATED BY REFERENCE

1. Portions of the Proxy Statement for the registrant's 2000 Annual Meeting of
   Stockholders are incorporated by reference into Part III of this annual
   report on Form 10-K.

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<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                                   FORM 10-K

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                          Page
                                                                          ----
 <C>      <S>                                                             <C>
                                      PART I

 ITEM 1.  BUSINESS......................................................    3

 ITEM 2.  PROPERTIES....................................................   30

 ITEM 3.  LEGAL PROCEEDINGS.............................................   30

 ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...........   30

                                      PART II

 ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
          SHAREHOLDER MATTERS...........................................   31

 ITEM 6.  SELECTED FINANCIAL DATA.......................................   32

 ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
          AND RESULTS OF OPERATIONS.....................................   33

 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK....   44

 ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...................   45

 ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
          AND FINANCIAL DISCLOSURE......................................   66

                                     PART III

 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............   66

 ITEM 11. EXECUTIVE COMPENSATION........................................   66

 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
          MANAGEMENT....................................................   66

 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................   66

                                      PART IV

 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
          FORM 8-K......................................................   67

 SIGNATURES..............................................................  69
</TABLE>
<PAGE>

                                     PART I

ITEM 1. BUSINESS

Forward-Looking Statements

  Some of our statements in this annual report on Form 10-K are forward-looking
statements that involve risks and uncertainties. These forward-looking
statements include statements about our plans, objectives, expectations,
intentions, future financial performance and other statements that are not
historical facts. We use words such as anticipates, believes, expects, future
and intends, and similar expressions, to identify forward-looking statements,
but the absence of these words does not mean that the statement is not forward-
looking. You should not unduly rely on these forward-looking statements, which
apply only as of the date of this annual report. Our actual results could
differ materially from those anticipated in the forward-looking statements for
many reasons, including the risks described under "Factors Affecting Our
Operating Results, Our Business and Our Stock Price" contained in Part II, Item
7 of this annual report.

Overview

  WatchGuard is a leading provider of Internet security solutions that protect
enterprises or telecommuters using the Internet for electronic commerce and
communications. Our core market is small- to medium-sized enterprises, or SMEs,
and we have recently expanded our marketing focus to include larger enterprises
as well as small offices and home offices, or SOHOs, and telecommuters,
particularly those using broadband Internet connections. According to
The Yankee Group, SMEs represent 98% of U.S. businesses, and account for
approximately 50% of the gross national product. SMEs are increasingly
utilizing the Internet to maintain a competitive advantage and to compete
effectively against enterprises with greater resources. International Data
Corporation, or IDC, estimated that, in the United States alone, approximately
3.5 million SMEs would be connected to the Internet by the end of 1999,
increasing to approximately 4.7 million by the end of 2000.

  Our innovative subscription-based LiveSecurity solution broadcasts threat
responses, software updates, information alerts, expert editorials, support
flashes and virus alerts over the Internet, enabling enterprises to keep their
security systems current with minimal effort. The dynamic nature of our
solution is made possible through an updatable security appliance that executes
software sent from the remote management system receiving our LiveSecurity
broadcasts. Our comprehensive, fully integrated LiveSecurity solution for SMEs
and larger enterprises features a firewall, encryption, user authentication,
virtual private networking, web surfing control and our LiveSecurity broadcast
service. In January 2000, we announced the introduction of our security
solutions for SOHOs and telecommuters, which we expect to begin shipping in the
first quarter of 2000. Our solutions for SOHOs and telecommuters will feature a
firewall, virtual private networking, Internet protocol, or IP, sharing and our
LiveSecurity broadcast service. We make installing, configuring and monitoring
our solutions easy with point-and-click security management.

  With our recent acquisition of BeadleNet, LLC, which is discussed more fully
in Part II, Item 7, and the formation of our new broadband Internet security
division, we have expanded our product line to include security solutions for
SOHOs and telecommuters, particularly those individuals or SOHOs using
broadband Internet connections. We will market this expanded product line to
both SOHOs that operate as a stand-alone business and SOHOs and telecommuters
that act as a branch office or extension of a larger organization and share
corporate resources through remote access to their company's computing systems.
According to IDC, in the United States alone, approximately 10.9 million home
offices will have broadband Internet access at the end of 2000, up from an
estimated 636,000 at the end of 1998.

  Our recently introduced higher-performance security appliance for larger
enterprises enables the WatchGuard LiveSecurity System to support up to 5,000
simultaneously authenticated users and over 50 simultaneously connected virtual
private networks, or VPNs, and delivers faster VPN throughput. The

                                       3
<PAGE>

expanded capacity represents a ten-fold increase in the number of possible
connected users and a five-fold increase in VPN throughput as compared to our
security appliance designed for SMEs. This higher-performance security
appliance, combined with our new security solution designed for SOHOs and
telecommuters and our existing SME security solution, will allow us to offer
larger enterprises integrated solutions to protect the main office, large and
small branch offices, and employees who telecommute.

  Our LiveSecurity solution gives enterprises a security management choice. An
enterprise can manage its own Internet security through our LiveSecurity System
or outsource its security management to an ISP implementing our LiveSecurity
for MSS. Enterprises using the LiveSecurity System may rapidly distribute
security protection from their desktop personal computer to all security
appliances on their corporate network, while retaining centralized control and
administration. Enterprises that do not want to be directly involved with their
security management may outsource the function to an ISP. For the ISP, our
technology improves the economics of managed security services through a
scalable delivery platform that enables the ISP to remotely configure and
manage thousands of sites quickly, easily and economically.

  We sell our Internet security solutions directly and indirectly to ISPs and
indirectly to end-users through more than 310 distributors and resellers
covering 54 countries. We have established relationships with a number of ISPs
to implement LiveSecurity for MSS, including AlphaNet Solutions, Inc., AT&T
Asia/Pacific Group Ltd., GTE Internetworking, Inc., Internet Initiative Japan,
Internet Security Systems, Inc., Interpath Communications, Inc., MIS Corporate
Defense Solutions, Nextcom K.K., PSINet Inc., sunrise communications AG, Verio,
Inc. and You Tools Corporation/FASTNET. As of December 31, 1999, we had shipped
over 12,000 of our security appliances.

  We initially incorporated in Washington in 1996 and reincorporated in
Delaware in 1997. References to "we," "our," "us" and "WatchGuard" in this
annual report refer to WatchGuard Technologies, Inc. and its predecessor. Our
executive offices are located at 316 Occidental Avenue South, Suite 200,
Seattle, Washington 98104, and our telephone number is (206) 521-8340. Our web
site is located at http://www.watchguard.com. Any information that is included
on or linked to our web site is not a part of this annual report.

Industry Background

The growth of the Internet

  The Internet has experienced rapid growth and has developed into a
significant tool for global communications, commerce and media, enabling
millions of people to share information and transact business electronically.
IDC estimates that there were over 38 million web users in the United States
and over 86 million worldwide at the end of 1997. IDC projects the number of
web users to increase to over 177 million users in the United States and 502
million worldwide by the end of 2003. IDC also estimates that the number of
customers buying goods and services on the Internet will grow from
approximately 15 million worldwide in 1997 to 182 million in 2003, with the
value of electronic commerce transactions growing from $15 billion to over $1.3
trillion in the same period.

  The growth in the Internet provides enterprises, regardless of size, with new
revenue opportunities through global distribution of products and services and
with significant reductions of sales and marketing costs through automation and
instantaneous access. Because of its affordability, global reach and
versatility, the Internet is a particularly powerful and necessary tool for
enterprises. Enterprises are increasingly required to establish secure Internet
access to facilitate and support strategic business objectives. In a
marketplace that is becoming more competitive, enterprises are increasingly
utilizing new business tools and initiatives such as remote access, e-commerce,
online customer service and supply chain management to gain competitive
advantage.

The need for Internet security

  The increased importance of electronic commerce and the proliferation and
growth of corporate intranets have dramatically increased the openness of
computer networks, with the Internet becoming a widely accepted

                                       4
<PAGE>

platform for many business-to-business and direct-to-consumer transactions. The
accessibility and the relative anonymity of users in open computing
environments, however, make systems and the integrity of information stored on
them increasingly vulnerable to security threats. Open systems present inviting
opportunities for computer hackers, curious or disgruntled employees,
contractors and competitors to compromise or destroy sensitive information
within the system or to disrupt operations and Internet access. In addition,
open computing environments are complex and typically involve a variety of
hardware, operating systems and applications supplied by a variety of vendors,
making these networks difficult to manage, monitor and protect from
unauthorized access. With the advent of "always on" broadband Internet
connections that leave a user's computer much more vulnerable to security
breaches than a traditional dial-up connection, even SOHOs and telecommuters
face security threats similar to those faced by larger enterprises connected to
the Internet.

  The annual Computer Security Institute survey conducted in early 1999
highlights the potential risks faced by organizations connected to the
Internet. The CSI poll of 521 computer security specialists at U.S.
corporations, government agencies, financial institutions and universities
revealed that 62% of respondents had experienced security breaches within the
past 12 months. The damage caused by a security breach is often difficult to
quantify and may include the loss of irreplaceable proprietary information or
data, damage to business reputation or undetected theft or alteration of
information. The 163 organizations in the CSI poll that were able to quantify
losses reported an average total loss of over $650,000 per organization.
Breached computer security has become such an extensive problem that the U.S.
Federal Bureau of Investigation has recently established the National
Infrastructure Protection Center to prevent and respond to cyber attacks on the
nation's infrastructure.

 The Internet security challenge

  Internet security begins with a firewall, a security component of varying
complexity designed to provide a barrier and control the flow of information
between a company's internal network and the Internet. Firewalls, however, are
often difficult to install, must be configured by skilled personnel and, to
maximize effectiveness, must be continually monitored and updated. A
comprehensive security solution also typically integrates several other
sophisticated security components, such as virtual private networking, which
secures encrypted communications between two points on the Internet, and access
control mechanisms. These components use a complex mixture of technologies,
including user authentication, passwords, packet filters, proxies and
encryption.

  Because enterprises increasingly depend on the Internet for external and
internal communications and for facilitating and conducting business, they need
comprehensive Internet security solutions. Traditional Internet security
solutions, however, are generally difficult to install and expensive to
maintain. Additionally, the technological complexity of traditional solutions
introduces a new set of risks--their many interacting components can easily be
misconfigured. The CSI poll revealed that more than 75% of the reported
successful break-ins took place despite the presence of a firewall. Enterprises
therefore face increasing pressure to hire trained security personnel to ensure
that traditional security solutions are installed and maintained properly. The
scarcity of skilled network and Internet security personnel, however, makes the
cost of hiring in-house personnel prohibitive for many enterprises,
particularly SMEs and SOHOs. Because of the financial and technical resources
necessary to implement, maintain and update these complex security solutions,
they tend to be better suited for larger enterprises than for SMEs, SOHOs and
individual telecommuters.

  Traditional security solutions are also expensive to maintain because they
must be updated continually to maximize effectiveness. These security solutions
tend to be static, while the dangers against which they must protect are
dynamic, with new types of intrusion schemes and other security threats and
vulnerabilities emerging constantly. The Computer Emergency Response Team, a
federally funded research and development center, handled 8,268 security
incidents in 1999, an average of nearly one per hour and more than double the
3,734 security incidents handled in 1998. Even if updates are available to
allow an enterprise's security systems to respond to the changing security
landscape, the enterprise needs dedicated security experts to proactively
identify, obtain and manually implement these updates quickly and correctly.

                                       5
<PAGE>

 The Internet security gap

  The expense and complexity of traditional security solutions incorporating a
firewall puts protection out of the reach of millions of enterprises that do
not have the resources to adopt these solutions, contributing to a security
gap. Comprising 98% of U.S. businesses, SMEs exemplify this gap. Despite the
obvious and compelling reasons for Internet security, most SMEs on the Internet
do not even have a firewall.

  IDC estimated that approximately 3.5 million SMEs in the United States would
be connected to the Internet by the end of 1999. IDC projected, however, that
from 1995, when IDC reports that firewalls first became widely available, until
the end of 1999, less than 450,000 firewalls would be shipped, leaving more
than 3 million SMEs without a firewall. This security gap is increasing, with
IDC projecting that in the United States more than 1.1 million new SMEs will
connect to the Internet in the year 2000, but less than 260,000 firewalls will
be shipped during the same period. We believe that the security gap for SMEs
results from the cost and complexity of traditional comprehensive solutions,
combined with the ineffectiveness of lower-end firewall solutions, which lead
many SMEs to choose not to adopt any Internet security solution. Moreover, many
enterprises that have installed security systems continue to experience
significant security breaches because their systems are either configured
improperly or are not timely or properly updated in response to the latest
security threats. SOHOs and telecommuters that adopt "always-on" broadband
Internet connections, particularly those accessing the corporate resources of a
larger enterprise, face a similar security threat but may have more limited
resources to dedicate to an Internet security solution.

  Enterprises require an easy-to-use, highly effective, fully integrated
Internet security solution with low installation and maintenance costs that can
be installed quickly and kept up to date easily. In addition, many enterprises
would rather outsource the management of any Internet security system to
vendors such as ISPs. ISPs, however, face challenges in economically delivering
affordable security services that can be rapidly deployed to thousands of
customer sites and easily managed from a central location.

The WatchGuard Solution

  WatchGuard's LiveSecurity products and services offer a fundamentally new
approach to Internet security. We provide enterprises with a comprehensive,
easy-to-use and cost-effective Internet security solution that we keep up to
date through our innovative Internet-based broadcast service. Our solution has
the following key benefits:

<TABLE>
 <C>                               <S>
 Comprehensive, fully integrated   For SMEs and larger enterprises, we offer a
 security tailored to the needs of comprehensive security solution integrated
 the user                          into a single package that includes (1) a
                                   firewall, (2) virtual private networking for
                                   secure, encrypted communication between
                                   remote offices, mobile employees and trading
                                   partners, (3) authentication functions that
                                   identify network users and define user-group
                                   security policies, (4) web surfing control
                                   and (5) our LiveSecurity broadcast service.
                                   Our recently announced solution for SOHOs
                                   and telecommuters will offer a more
                                   affordable, comprehensive and integrated
                                   security solution that includes (1) a
                                   firewall, (2) virtual private networking,
                                   (3) IP sharing and (4) our LiveSecurity
                                   broadcast service.
 Dynamic protection                Our subscription-based Internet broadcast
                                   service is designed to keep our security
                                   solutions up to date with (1) security
                                   threat responses that specifically address
                                   newly discovered security vulnerabilities or
                                   hacker techniques, (2) software updates, (3)
                                   information alerts concerning current news
                                   in Internet security, (4) expert editorials
                                   containing Internet security-related feature
                                   articles, (5) support flashes with answers
                                   to commonly asked questions about our
                                   products and services
</TABLE>

                                       6
<PAGE>

<TABLE>
 <C>                       <S>
                           and (6) virus alerts containing information about
                           the latest virus threats and access to Trend Micro's
                           virus protection products. Our SOHO and telecommuter
                           solutions will initially include only access to
                           security threat responses and software updates. We
                           expect to offer the remaining LiveSecurity broadcast
                           service channels as an option for SOHOs and
                           telecommuters in the second quarter of 2000.
 Easy installation and use We offer (1) a security appliance with plug-in
                           installation, (2) management and security software
                           with an automated installation guide and (3) point-
                           and-click centralized management. These features
                           make it easy for the non-security professional to
                           install, configure and monitor our security system
                           and to receive and implement our LiveSecurity
                           broadcasts.
 Viable ISP outsourcing    Through its centralized configuration and management
                           capabilities, LiveSecurity for MSS enables ISPs to
                           provide outsourced Internet security services to
                           thousands of customers quickly, easily and at a
                           price enterprises can afford.
 Affordability             We minimize the overall ownership cost of our
                           security solution with easy deployment and
                           management that reduces the requirements for
                           information technology personnel. Our broadcast
                           updating enables users of LiveSecurity to address
                           their security needs by leveraging our team of
                           security experts.
</TABLE>

Strategy

  Our objective is to be the leading provider of Internet security systems and
services to enterprises worldwide. Our strategy to achieve this goal is based
on the following key elements:

Extend our SME market leadership position in comprehensive security into the
large-enterprise and SOHO/telecommuter markets.

  We intend to maintain our leadership position in comprehensive security for
SMEs by expanding and enhancing our Internet security product and service
offerings. In September 1999, we introduced our security solution for larger
enterprises and, in January 2000, we announced the introduction of our new
security solutions for SOHOs and telecommuters, which we expect to begin
shipping in the first quarter of 2000. We expect to deliver new versions of our
major products, including products designed for the emerging broadband Internet
connectivity market, approximately two to three times per year. We were the
first, and remain the leader, in developing updatable security appliances that
execute software sent from a remote management system. Our architecture allows
enterprises to quickly and easily deploy new products and services from the
central management system, which utilizes a familiar Windows- or web-based
interface. Our distributed architecture also facilitates the scalability
necessary for ISPs to provide our products and services to their customers at a
price enterprises can afford. We intend to continue to enhance our technology
and architecture, hire additional network and Internet security experts and
continue to invest in product development and product and service enhancements.

Expand our strategic relationships with leading Internet service providers.

  To capitalize on the desire of many enterprises to outsource their Internet
security management, we have established relationships with industry-leading
ISPs, including AlphaNet, FASTNET, GTE, Interpath, ISS, PSINet and Verio in the
United States, MIS and sunrise in Europe and AT&T Asia/Pacific Group Ltd., IIJ
and Nextcom in the Asia/Pacific region. We intend to continue to establish
similar relationships with ISPs and expect that these relationships will
facilitate the widespread adoption of our LiveSecurity solution by enabling us
to capitalize on the brand recognition and customer bases of the ISPs. In
addition, these strategic

                                       7
<PAGE>

relationships should enhance WatchGuard brand awareness and provide a powerful
endorsement of our security technology and services. For example, GTE and
PSINet use LiveSecurity for MSS to provide managed security services to their
customer bases, and their marketing of these services prominently features the
WatchGuard brand.

Expand and enhance our innovative LiveSecurity broadcast service.

  We have created an innovative LiveSecurity solution that broadcasts threat
responses, software updates, information alerts, expert editorials and support
flashes over the Internet directly to our subscribers and ISP partners. We plan
to expand and enhance our LiveSecurity broadcast content, and therefore the
value of our subscription service, through additional investment in three
areas:

  .  continued expansion of our rapid response team of internal security
     experts;

  .  expansion of our LiveSecurity advisory council of industry experts,
     including the addition of two outside experts by the end of 2000; and

  .  continued development of one to four third-party industry relationships
     that will allow us to broadcast third-party software and content to our
     subscribers.

As we expand and enhance our broadcast content, we plan to ensure that it
remains easy to implement and use by enterprises and ISPs.

Continue to expand WatchGuard brand awareness.

  We believe that we have an opportunity to make the WatchGuard brand
synonymous with Internet security worldwide. We intend to increase our
telemarketing and direct mail programs to companies that fit our target
subscriber profile. We also plan to develop our web site as a security portal
for enterprises with the goal of establishing www.watchguard.com as the first
location enterprises will visit with questions about Internet security. Our web
site currently features links to the web sites of PSINet and GTE. We plan to
add additional links in 2000 and to further integrate our web sites with the
web sites of our ISP partners. In addition, we intend to continue to invest in
marketing programs jointly executed with our distribution partners around the
world. These programs include WatchGuard web site content and links placed on
many of our reseller sites, regionally targeted public relations activities and
events worldwide, and use of the WatchGuard brand name when ISP partners market
their managed security services.

Continue to expand worldwide sales and distribution.

  We intend to continue to expand our international distribution capabilities
to allow any enterprise with an Internet connection to purchase the WatchGuard
LiveSecurity solution, no matter where the enterprise is located. Our goal is
to make our security solutions the easiest to purchase and deploy, whether by
the enterprise or by the ISP. We plan to expand our base of resellers,
distributors and ISP partners and make our solution available for purchase
through our resellers' web sites. We will continue to invest in web-based
training programs that educate our worldwide resellers and subscribers about
our product and service features and benefits and that assist our customers in
deploying our products and services.

  We have not determined a schedule for the continuing expansion of our
international distribution capabilities or for implementing other components of
our strategy. The timing for executing these strategies will depend on market
conditions, the availability of strategic opportunities and the availability of
management resources.

Products and Services

  Our comprehensive LiveSecurity solutions include an integrated suite of
security and management software, an Internet security appliance and a dynamic
broadcast service to keep security defenses current.

                                       8
<PAGE>

Enterprises may use our LiveSecurity System to internally manage their Internet
security or elect to outsource security management to an ISP implementing our
LiveSecurity for MSS.

The LiveSecurity System for enterprise-managed security.

  We designed our LiveSecurity System for use by enterprises that want to
manage their own Internet security. With the LiveSecurity System, an enterprise
can quickly and affordably deploy comprehensive security protection to all
sites on its network, while retaining centralized control and administration.
Our LiveSecurity broadcast service enables enterprises to augment their
information technology staff with our security experts, which we believe
substantially reduces personnel costs. Every new LiveSecurity System includes a
one-year subscription to our broadcast service.

  SMEs and larger enterprises

  For SMEs and larger enterprises, the LiveSecurity System has three key
components: our security management system software with security and
management features, our security appliance and a subscription to our Internet-
based broadcast service.

  Security features. The LiveSecurity System for SMEs and larger enterprises
contains the following security features:

  .  Firewall. Our firewall controls incoming and outgoing traffic between
     the Internet and an enterprise's systems and data. The firewall
     incorporates access control and detection and blocking features.

  .  Authentication. Our authentication features identify network users and
     define user and user-group security policies.

  .  Virtual private networking. Our software enables enterprises to create
     virtual private networks by using encryption technology to allow data to
     flow securely across the Internet between two predetermined points. Our
     remote user VPN secures communications with telecommuters and traveling
     employees, while our branch office VPN secures communications with
     branch offices and trading partners. Our virtual private networking
     solutions implement industry standard protocols.

  .  Web surfing control. Our web-blocking feature enables enterprises to
     restrict site access privileges by user, group, time of day, site type
     or particular site.

  Management features. Our Windows-based software manages and monitors an
enterprise's Internet security with an intuitive, point-and-click user
interface.

  .  Integrated suite of system management tools. Our security management
     system packages, configures and deploys security software, security
     policies and the operating system to an enterprise's security
     appliances. Featuring logging and notification functions and real-time
     monitoring and historical reporting of network, service and bandwidth
     usage, our management tools allow management of multiple security
     appliances from a single location.

  .  Automated installation guide. Our automated installation guide enables
     enterprises to install our system and define user and user-group
     security policies in as quickly as 30 minutes.

  Security appliance. Our security appliances for SMEs and larger enterprises,
the WatchGuard Firebox II, Firebox II Plus and Firebox II Plus with FastVPN,
are standalone Internet security appliances that run the security functions of
the LiveSecurity System. The security capabilities of these security appliances
come entirely from the operating system, security software and security
policies directed to them from the remote management software. They simply plug
in and reside between an enterprise's Internet router and its internal network
of servers and workstations. These Fireboxes have three independent, separately
monitored connections: one to the enterprise's network, one to the Internet and
one to the enterprise's public network for

                                       9
<PAGE>

hosting web and email servers. The LiveSecurity System encrypts communications
between the security appliance and the management software on the in-house
manager's desktop.

  Broadcast service. We keep our security solution current and our customers
informed through a subscription-based broadcast service that securely transmits
new security content over the Internet directly to the in-house manager's
desktop computer. Our broadcasts include

  .  Threat responses. When our rapid response team discovers and neutralizes
     a security vulnerability or new hacker technique, we broadcast software
     that specifically addresses that security threat.

  .  Software updates. We broadcast software updates that enhance the
     function of the LiveSecurity System as a whole.

  .  Information alerts. We notify our customers of breaking Internet
     security news and upcoming enhancements.

  .  Expert editorials. Our team of industry-leading security advisors offer
     their views and provide continuing education on the rapidly changing
     field of Internet security.

  .  Support flashes. Interactive technical tutorials provide our customers
     with answers to frequently asked questions about managing the
     LiveSecurity System and information about new software updates.

  .  Virus alerts. Trend Micro provides information on the latest virus
     threats and offers access to its virus protection products.

  SOHOs and telecommuters

  Our recently announced LiveSecurity System for SOHOs and telecommuters has
three key components: security and management software, our security appliance
and a subscription to our Internet-based broadcast service.

  Security features. The LiveSecurity System for SOHOs and telecommuters
contains the following security features:

  .  Firewall. Our firewall controls incoming and outgoing traffic between
     the Internet and a SOHO's or telecommuter's systems and data. The
     firewall incorporates access control, detection and blocking features
     and IP sharing.

  .  Virtual private networking. Our software enables SOHOs and telecommuters
     to create virtual private networks by using encryption technology to
     allow data to flow securely across the Internet between two
     predetermined points.

  Management features. Our web-based security management software manages and
monitors the SOHO's or telecommuter's Internet security with an intuitive,
point-and-click user interface.

  .  Integrated suite of system management tools. Our web-based security
     management system packages, configures and deploys security software,
     security policies and the operating system to a SOHO's or telecommuter's
     security appliance.

  .  Automated installation guide. Our automated installation guide enables a
     SOHO or telecommuter to install our system and define a security policy
     in as quickly as 15 minutes.

  Security appliance. Our security appliances for SOHOs and telecommuters, the
WatchGuard Firebox SOHO and Firebox Telecommuter, are standalone Internet
security appliances that run the security functions of the LiveSecurity System.
The security capabilities of these security appliances come entirely from the
operating system, security software and security policies directed to them from
the remote management software. They

                                       10
<PAGE>

simply plug in and reside between the SOHO's or telecommuter's Internet router
and cable or digital service line modem and its internal network of servers and
workstations. These Fireboxes have two independent, separately monitored
connections: one to the SOHO's or telecommuter's network and one to the
Internet.

  Broadcast service. We will keep our SOHO and telecommuter security solutions
current and our customers informed through a subscription-based broadcast
service that initially will transmit over the Internet to the SOHO manager's or
telecommuter's desktop computer the threat response and software update
channels of our LiveSecurity broadcast service for SMEs and larger enterprises.
We expect to offer the remaining channels of our LiveSecurity broadcast service
as an option for SOHOs and telecommuters in the second quarter of this year.

LiveSecurity for MSS for Internet service providers

  To serve the needs of SMEs and larger enterprises that want to outsource
their Internet security and the needs of ISPs that want to provide this
service, we have created LiveSecurity for MSS. We expect to introduce a
LiveSecurity for MSS solution for SOHOs and telecommuters in the second quarter
of 2000. LiveSecurity for MSS allows an ISP to centrally configure, monitor and
update the Internet security of thousands of managed customers. The ISP can
economically deliver a full range of security services while their subscribing
customers enjoy the benefit of our up-to-date protection at an affordable
price.

  LiveSecurity for MSS has three main components: our network operations center
security suite software with security and management features, our security
appliances and our LiveSecurity broadcast service. In addition, we offer
optional monitoring software for the ISP's customers.

  Security features. LiveSecurity for MSS includes the same comprehensive set
of security features offered with our LiveSecurity System for SMEs and larger
enterprises.

  Management features. Centrally located at the ISP's network operations
center, our global policy manager software provides security intelligence and
configuration for all customer sites under management. Our software allows the
ISP to create and store various security policy configurations for different
customer groups or service plans. Our scalable WatchGuard event processor
software provides monitoring and reporting for customer sites.

  Security appliances. One or more of our security appliances resides on the
ISP customer's premises. The appliances receive and implement the operating
system, security software and security policies that the ISP sends.

  Broadcast service. Through our LiveSecurity broadcast service, the ISP's
network operations center receives threat responses, system updates,
information alerts, expert editorials and support flashes. The ISP then updates
the security policy of its customers and transmits these policy updates over
its network to those customers.

  Monitoring software for the ISP's customers. The optional Firebox monitor
software allows the ISP's customer to view its network activity on-site while
otherwise leaving the management of its Internet security to the ISP.

  Receiving the benefits of our security solution through an ISP gives an
enterprise a number of added advantages. ISPs

  .  monitor and manage customers' security 24 hours a day, 7 days a week;

  .  define and implement professional, customized Internet security
     policies;

  .  automatically install software updates and threat responses;

                                       11
<PAGE>

  .  regularly review customers' security and provide detailed reporting and
     analysis; and

  .  mitigate the up-front cost of security system purchase and setup.

Implementation

  The WatchGuard LiveSecurity System. Once an enterprise registers on one of
our LiveSecurity web sites, its registration information is automatically
transferred to our LiveSecurity database. Upon verification, the enterprise can
download and install or access our security management system software and
begin receiving our LiveSecurity broadcasts. The security management system
software configures the LiveSecurity System, implements security protection and
manages the installed security features with a point-and-click user interface.
Our LiveSecurity broadcasts go directly to the desktop of the person
responsible for Internet security, who follows our easy installation
instructions to send the updated security software, security policy or
operating system to all of the enterprise's security appliances for automatic
implementation. We send our LiveSecurity broadcasts using technologies such as
digital certificates and public key encryption or emails containing links to
the secured broadcast server.

  LiveSecurity for MSS. Our scalable network operations center, or NOC,
security suite software enables an ISP to economically and efficiently
configure, monitor and update the Internet security of thousands of managed
customers from its network operations center. The ISP uses our global policy
manager's security policy templates to streamline initialization and
configuration of security policies to match the ISP's specific service
offerings and customer needs. The global policy manager then sends the desired
operating system, security software or policy configuration to subscribing
customers' security appliances. The security appliances implement the new
security policies and forward activity logs to WatchGuard event processor
software, which monitors network activity and reports back to the global policy
manager. Communications between the network operations center, the event
processors and the security appliances are encrypted, and we have implemented
automatic failover features to protect valuable log information against being
lost due to hardware or network failure. ISP personnel at the network
operations center use our suite of real-time monitoring tools to track each
security appliance on the ISP's network and transmit LiveSecurity broadcast
content to all ISP subscribers. In addition, the ISP can offer its customers
Firebox monitor software, a Windows-based monitoring tool that allows
subscribers to view their network activity and defenses in real time while
leaving management of the system to the ISP.

  Customer service. We make customer service a priority. Our staff of support
representatives serves our end-users and ISP partners by phone and email from
6:00 a.m. to 5:00 p.m. Pacific standard time, Monday through Friday, excluding
national holidays. As of December 31, 1999, we had 21 customer support
representatives. We also offer 24-hour-a-day, 7-day-a-week web support tools.
Our computerized customer center manages all support requests and allows
customers to check resolution status on-line. We provide on-line answers to
frequently asked questions about our products, descriptions of how to configure
WatchGuard products to work with other products and other technical
information.

The WatchGuard team of experts

  Rapid response team. Our rapid response team identifies, analyzes and
generates responses to new Internet security threats. To identify new threats,
the team continually monitors a wide variety of Internet sources related to
network security, including news groups, vendor web sites and hacker bulletin
boards. When the rapid response team identifies a new security threat, we send
an advisory to our LiveSecurity subscribers while software or configuration
changes to neutralize the threat are developed and tested. We then broadcast
the software updates or configuration recommendations to our subscribers. The
team sends other information of interest as information alerts, which include
cautionary notices, general usage guidelines and other important announcements.

  LiveSecurity advisory council. Our LiveSecurity advisory council provides
continuing education and editorials on the rapidly changing subject of Internet
security. The council also oversees and contributes to the

                                       12
<PAGE>

efforts of our rapid response team. We intend to expand the council as
opportunities arise. Currently, the council is composed of Messrs. Frederick
Avolio and Rik Farrow.

    Frederick Avolio. Mr. Avolio has been involved in Internet computing and
communication since the early 1980s and has worked with Internet security
systems for over 10 years. He assisted in the creation of the first commercial
Internet firewall offering and helped create the commercial security products
division of Trusted Information Systems. His areas of expertise include
firewalls, intrusion detection, cryptography, security management and email
systems. Mr. Avolio is the co-author, with Paul Vixie, of Sendmail Theory and
Practice, published by Digital Press. He holds a B.S. in computer science from
the University of Dayton and an M.S. in computer science from Indiana
University.

    Rik Farrow. Mr. Farrow provides UNIX and Internet security consulting and
training. He has been working with UNIX system security since 1984 and with
TCP/IP networks since 1988. He has taught in a number of countries and for a
variety of organizations. He also consults with firms in designing and
implementing security applications. Mr. Farrow is the author of UNIX System
Security, published by Addison-Wesley, and is the co-author, with Rebecca
Thomas, of UNIX Administrator's Guide to System V, published by Prentice Hall.
He writes a column for ;login:, the magazine of the USENIX Association, and a
network security column for Network magazine.

Licensing and pricing

  For an SME, larger enterprise, SOHO or telecommuter purchasing our
LiveSecurity System, we include in the system price a perpetual license for the
security and management software. Each end-user also receives a renewable one-
year subscription to our LiveSecurity broadcast service, through which it
receives threat responses, software updates, information alerts, expert
editorials and support flashes.

  For LiveSecurity for MSS, an ISP buys a license to use our NOC security suite
management and security software and makes an annual license payment for each
customer security appliance it manages. The licenses, the cost of which varies
depending on the ISP's volume commitment, allow the ISP to manage its
subscribers' security appliances from its network operations center. Each
annual license includes a subscription to our LiveSecurity broadcast service.

                                       13
<PAGE>

  The following table lists our current end-user product prices. We offer
reseller discounts, educational discounts and occasional promotional pricing.


<TABLE>
<CAPTION>
        Product               Components                                        List Price


  <C>                  <S>                                               <C>
                       LiveSecurity System for SMEs                                           $  4,990
                        Security management system software
                        Firebox II security appliance
                        12-month LiveSecurity subscription

                 --------------------------------------------------------------

                       Live Security System for larger enterprises                            $  9,990
                        Security management system software                          (Firebox II Plus)
                        Firebox II Plus security appliance
                        Firebox II with VPN accelerator security                              $ 12,990
                        appliance                                            (Firebox II with FastVPN)
                        12-month LiveSecurity subscription

                 --------------------------------------------------------------
  LiveSecurity System  Live Security System for SOHOs                                         $    449
                        Web-based management and security software
                        Firebox SOHO security appliance (10 users)
                        Firebox Telecommuter security appliance
                        12-month LiveSecurity subscription

                 --------------------------------------------------------------
                       Firebox SOHO user-capability upgrades
                        25 users                                                              $    198
                        50 users                                                              $    449
                        Firebox SOHO VPN                                                      $    449

                 --------------------------------------------------------------

                       LiveSecurity System for telecommuters                                  $    649
                        Web-based management and security software
                        Firebox
                        Telecommuter security appliance
                        12-month LiveSecurity subscription

                 --------------------------------------------------------------
                       LiveSecurity subscription renewal
                        Firebox II                                                            $    995
                        Firebox II Plus                                                       $  1,495
                        SOHO                                                                  $     95
                        Telecommuter                                                          $     65

--------------------------------------------------------------------------------
                       LiveSecurity for MSS platform pack                                     $ 64,475
                        NOC security suite
                        Firebox II for MSS: 5 appliances
                        MSS client licenses: 5 licenses
                        MSS technical certification class: 1 attendee
                        LiveSecurity broadcast service

                 --------------------------------------------------------------
                       NOC security suite software                                            $ 50,000



                 --------------------------------------------------------------
                       Firebox II for MSS security appliance                                  $  1,300


                 --------------------------------------------------------------
                       Firebox II Plus for MSS security appliance                             $  2,900


                 --------------------------------------------------------------
  LiveSecurity for MSS Firebox II Plus for MSS with VPN accelerator                           $  4,400
                        security appliance


                 --------------------------------------------------------------
                       MSS technical certification class                                      $  2,500


                 --------------------------------------------------------------
                       Firebox monitor software                                               $    195


                 --------------------------------------------------------------
                       MSS annual client license
                        Block of 25: $1,695 per license                                       $ 42,375
                        Block of 50: $1,495 per license                                         74,750
                        Block of 100: $1,395 per license                                       139,500
                        Block of 250: $1,295 per license                                       323,750
                        Block of 500: $1,095 per license                                       547,500
                        Block of 1,000: $945 per license                                       945,000
</TABLE>


                                       14
<PAGE>

Sales, Marketing and Distribution

  We employ a global marketing strategy. Because the need for Internet security
crosses geographic and economic boundaries, our business opportunity extends
worldwide to all business segments. Since our inception, we have invested
heavily in worldwide sales and marketing. We currently sell our products and
services in 54 countries. International sales generated over 35% of our
revenues in 1998 and 50% of our revenues in 1999.

  We sell our LiveSecurity System through distributors and value-added
resellers. We may also sell some Firebox SOHO and Firebox Telecommuter products
through retail channels. We sell our LiveSecurity for MSS products and services
directly to ISPs, which resell our products and services to end-users. Over 310
companies resell our products and services, including

  .  distributors, such as Eltrax Systems, Inc., Fujitsu Business Systems,
     Ltd., Ingram Micro, Otsuka Shokai Co., Ltd., Tech Data and Wick Hill
     Group, Plc;

  .  value-added resellers, such as CDW Computer Centers, Inc., Integrated
     Network Technologies, Kent DataComm, Network Computing Architects, Inc.
     and Solunet; and

  .  ISPs, such as AlphaNet, AT&T Asia/Pacific Group Ltd., FASTNET, GTE, IIJ,
     Interpath, ISS, MIS, Nextcom, PSINet, sunrise and Verio.

  Our agreements with our resellers are nonexclusive and provide for discounts
based on the reseller's minimum purchase commitment or the volume that the
reseller purchases or resells.

  We divide our sales organization regionally among North America, Latin
America, Europe and Asia/Pacific, and also between the enterprise and managed
security market segments. In North America, we have sales personnel located in
California, Colorado, Connecticut, Georgia, Illinois, Massachusetts, New
Jersey, Texas and Washington. Internationally, we have sales personnel located
in Argentina, Australia, Germany, Japan, the Netherlands, Sweden and the United
Kingdom. Assisting our reseller network within a specific region is a central
responsibility of our regional sales representatives. Regional sales
representatives manage our relationships with our network of distributors,
resellers and ISPs, help our reseller network sell and support key customer
accounts, and act as liaison between our reseller network and our marketing and
product development organizations. We expect to continue to expand our field
sales organization in support of both the managed security and enterprise
market segments.

  We conduct a number of marketing programs to support the sale and
distribution of our products. These programs inform existing and potential
resellers, distributors, ISPs and end-user customers about the capabilities and
benefits of our products. Marketing activities include advertising, publishing
technical and educational articles in industry journals, participating in
industry tradeshows and product technology conferences, sales training and
marketing on our web site. As of December 31, 1999, we had 50 employees in our
sales and marketing organization.

  As an additional sales tool, we offer end-users, resellers and distributors
free interactive training on our LiveSecurity System solutions through our web
site. Our interactive training system guides customers through the
installation, setup and management of the LiveSecurity System and provides new
product information.

  Our domestic and international sales tend to be lower in the summer months,
when businesses often defer purchasing decisions. Also, as a result of customer
buying patterns and the efforts of our sales force to meet or exceed quarterly
and year-end quotas, historically we have earned a substantial portion of a
quarter's revenues during its last month.

                                       15
<PAGE>

WatchGuard LiveSecurity alliance

  In September 1998, we launched a LiveSecurity alliance, a technology and
marketing program designed to support the LiveSecurity concept and WatchGuard
products and services. The purpose of the alliance program is to enhance the
interoperability of our LiveSecurity products and services with alliance
partner products and services and to engage in cooperative marketing. Vendors
in the alliance include BackWeb Technologies, Clarent Corporation, CRYPTOCard,
FASTNET, Funk Software, IIJ, Interpath, ISS Group, Inc., Netrex, PSINet,
Rainbow Technologies, RSA Data Security, Inc., The Learning Company, Trend
Micro, WebTrends Corporation, Verio and Virtual Media.

Customers

  As of December 31, 1999, we had shipped over 12,000 of our security
appliances to our reseller network, which resold our products and services to
end-users spanning a wide variety of countries and industries. The following is
a representative list of our ISP and end-user customers:

Internet Service           Media                      Retail
Providers                  KSTW-UPN 11 Television     Norm Thompson
AlphaNet Solutions, Inc.   Reader's Digest            Outfitters, Inc.
AT&T Asia/Pacific Group    Australia                  Rebel Sport Limited
Ltd.

                           The Everett Herald         Manufacturing
GTE Internetworking,       University of Toronto
Inc.                       Press

                                                      Bolle Inc.
                           Technology                 Durkan Patterned Carpet,
Internet Initiative        AlphaBlox Corporation      Inc.
Japan, IIJ                 Inc.                       Ferguson
Internet Security          Bentley Systems,           Metals/Aerospace
Systems, Inc.              Incorporated                 Alloys Inc.
Interpath                  e-DOCS.net                 Graham Steel Corporation
Communications, Inc.       JDA Software Group, Inc.   J.E. Dunn Construction
MIS Corporate Defense      Pentax Technologies        Company
Solutions                  Corporation                The Mitchell Gold
                                                      Company

Nextcom KK                 Sheridan Software
                           Systems, Inc.

                                                      Government
PSINet Inc.                Education                  City of Bellingham, WA
sunrise communications     Boston Architectural       City of Dandenong,
AG                         Center                     Australia
Verio, Inc.                Canon City Schools         City of Garden Grove, CA
You Tools Corporation/     Huntsville Intermediate    Lenoir County, NC
 FASTNET                    School District

                                                      Mornington Peninsula
Services                   Summit Board of            Shire
Boullioun Aviation         Education                    Council, Australia
Services                   Woodridge School
                           District #68

                                                      North Carolina State
Bull Housser & Tupper      Financial Services         Ports
Camp, Inc.                 Atlantic Mortgage &        Pierce County, WA
Catholic Charities          Investment Corp.           Library Service

Digital Magic              Hudson Valley Federal      Entertainment
hawthorne direct inc.       Credit Union              Argosy Gaming Company
Javelin Technology

                           KDP Investment Advisors    Black Hawk Gaming &
Medical                    McMahan Securities Co.,      Development Company
Bendigo Health Care        LP                         Crave Entertainment,
Group                      Seritis Services Group,    Inc.
CoreCare Systems, Inc.     LLC                        Everton Football Club

Health Technologies Pty    Sunflower Bank             Utilities and
Ltd                                                   Telecommunications
NeoTherapeutics, Inc.                                 Globecomm Systems, Inc.
PATH                                                  MACtel
Southeast Alabama
 Medical Center
Unimed Pharmaceuticals,
Inc.

                                       16
<PAGE>

Case Studies

  The following are profiles of two WatchGuard customers that have successfully
implemented our products and services:

GTE Internetworking, Inc. -- An ISP providing managed Internet security
services

  GTE Internetworking, Inc., part of one of the largest publicly held
telecommunications companies in the world, has been providing managed Internet
access and related services worldwide for more than 20 years. In April 1999,
GTE introduced a new LiveSecurity for MSS-based security service, GTE Security
Advantage(TM), which enables GTE to offer a cost-effective managed Internet
security service to SMEs and branch offices of large corporations.

  GTE has integrated LiveSecurity for MSS into its sophisticated $6 million,
5,000-square-foot network operations center in Burlington, Massachusetts, and
offers GTE Security Advantage to both current and new customers. In the past,
GTE focused its managed security services on Fortune 500 corporations. By
partnering with WatchGuard, however, GTE can expand its range of services by
offering SMEs the same level of security it could only offer in the past to
large enterprises, due to the cost and complexity of its previous service
offerings.

  GTE is a member of our preferred service provider program, which enables GTE
and WatchGuard to combine our marketing expertise and resources in joint
marketing activities that promote GTE Security Advantage through various media.
GTE will also promote the GTE Security Advantage service through its network of
independent local exchange carriers, which deliver telephone service and
Internet connectivity to SMEs.

Bentley Systems, Incorporated -- An enterprise using the WatchGuard
LiveSecurity System

  Bentley Systems, Incorporated is a worldwide leader in quality engineering
software products and user services, serving over 300,000 professionals in
building engineering, geoengineering and mechanical engineering. Its
MicroStation(TM) and ModelServer products, used by over 70% of the largest
engineering firms in the United States, are used to design buildings, airports,
hospitals, facilities, highways, bridges and industrial plants throughout the
world.

  Bentley uses the WatchGuard LiveSecurity System, deploying 11 WatchGuard
Fireboxes. The company has implemented WatchGuard's branch office VPN software
to secure communications between its headquarters in Exton, Pennsylvania and
its branch offices in Huntsville, Alabama and Littleton, Massachusetts, and
uses WatchGuard's remote user VPN software to encrypt communications between
its offices and approximately 55 traveling salespeople. Now that Bentley has
established interconnectivity between offices with its network of WatchGuard
security appliances, it is in the process of moving from a private-frame wide
area network to a virtual private network of Internet sites, which will reduce
its remote access costs by over 60%.

Technology and Architecture

  Our LiveSecurity solution utilizes an innovative distributed architecture
through which a basic processor in a security appliance receives and executes
software directed to it from a remote management system. Because the security
intelligence resides in the software and not in the hardware, we can keep our
customers' Internet security up to date with periodic broadcasts of new
security software and operating system configurations. Our LiveSecurity
solutions come in two forms: solutions for SMEs and larger enterprises and
solutions for SOHOs and telecommuters.

LiveSecurity for SMEs and larger enterprises

  Our LiveSecurity solution for SMEs and larger enterprises encrypts and
authenticates communications between WatchGuard, the management system software
and the security appliance. This allows the

                                       17
<PAGE>

management system and the appliance to be separated within an enterprise's
local or wide area network or between an ISP and its subscriber. Typically, to
install software on a computer using a general-purpose operating system such as
Windows, a person must be physically present at the computer. Our distributed
architecture, however, allows our customers to remotely install our software on
the security appliances and receive updated software broadcasts over the
Internet.

  Security appliance. Our security appliance uses a standard Intel Pentium
processor, which is dedicated solely to running security functions. The
security appliance has no other function and no hard drive memory storage.

  Operating system software. Our security appliance's operating system is a
custom-configured Linux kernel. Using Linux under an open source license, we
have been able to review the source code and generate a flexible, robust and
secure operating system. We use specially designed application programming
interfaces to facilitate secure loading of new operating system and security
software that our management software sends to the appliance.

  Security features. The LiveSecurity solution implements our security features
in a number of software modules. Each module provides the specific function
that the management system defines in security rules and transmits to the
appliance. For example, the firewall features that control network traffic are
based around an extensible set of network service protocols, such as HTTP and
SMTP. The appliance applies the security policies defined by the management
system to all incoming or outgoing traffic. Those network services that require
special security, such as mail and file transfers, are directed to specific
modules. Additional modules implement other security features, such as
authentication and web surfing control, which also are defined in the security
policies that the management system transmits to the appliance. If web surfing
control is activated, for example, the web surfing control software module will
automatically check the details of all outgoing web traffic to make sure it
complies with the defined policies.

  We use an open architectural structure to allow integration with common
standards for network security. For example, our virtual private networking
component currently supports IPSec and PPTP standards, and our authentication
module supports a variety of standard authentication methods. We intend to
adopt additional standards as they mature in the market.

  Management features. Because enterprise and ISP environments are very
different, we designed a separate management system for each. Our LiveSecurity
System management software allows for quick installation and management by a
typical in-house manager using a standard Windows-based system. We designed the
LiveSecurity for MSS management software, on the other hand, for a trained
operator using a dedicated management console to configure and manage the
security of a large subscriber base. Both management systems have the ability
to remotely deploy new security software to the appliances or update their
security engines from the management console. Our ISP customers can choose to
separately and remotely deploy certain security features, such as virtual
private networking and web blocking. This gives ISPs the ability to
incrementally add for-fee services to their basic service offering, without the
expense of sending personnel to their customers' sites.

  To enable ISPs to configure, monitor and manage the Internet security of
thousands of customers, LiveSecurity for MSS includes scalable logging and
monitoring software called WatchGuard event processors. The event processors
run on UNIX-based workstations and can be located in the network operations
center or distributed at the ISP's point of presence. Each event processor
manages the logging and notification features of up to 500 security appliances
through commands issued from the global policy manager at the network
operations center.

  LiveSecurity broadcast. Our scalable LiveSecurity broadcast system is a
collection of secured servers that registers subscribers, facilitates
downloading our software to the desktop computers of registered subscribers and
broadcasts threat responses, software updates, information alerts, expert
editorials, support

                                       18
<PAGE>

flashes and virus alerts to subscribers. To facilitate a high level of security
and authenticity, we protect our servers with our own security system and
strongly encrypt data communication between servers. We also encrypt and
digitally sign broadcasts to ensure that subscribers receive only authentic
LiveSecurity broadcast content. We can replicate and distribute our
LiveSecurity servers throughout the world, which should enable us to meet
growth in demand for our LiveSecurity service. We have initially deployed one
primary server and two replicated servers to reach North America, Asia and
Europe.

LiveSecurity for SOHOs and telecommuters

  Our LiveSecurity solutions for SOHOs and telecommuters are based on a common
hardware and software architecture.

  Security Appliance. Our SOHO and telecommuter security appliances use an
industry-standard MIPS processor, which is dedicated solely to running the
security functions. The security appliances have no other function and no hard
drive memory storage. These solutions provide network address translation and
port address translation, which allows a network to use a single IP address and
allows an Internet service provider to conserve IP addresses while still
accommodating local networks.

  Operating System Software. Our SOHO and telecommuter solutions utilize
WindRiver's industry-standard VxWorks Real Time operating system. These
appliances' architecture includes data encryption hardware that allows high-
speed IPSec performance.

  Security Features. Our SOHO and telecommuter solutions use the same industry-
compatible IPSec protocols found in our solutions for SMEs and larger
enterprises. The firewall is based on stateful packet inspection technology,
which allows the user to access the Internet without exposing the network to
external attacks. Our telecommuter solution includes virtual private networking
to allow the home-based employee to connect to the office via an encrypted,
secure channel. While our SOHO base product does not include virtual private
networking, it may be ordered as an option or obtained as an upgrade.

  Management Features. We have designed our SOHO and telecommuter solutions for
very simple installation and configuration, using a web-based interface. We
anticipate that all telecommuter sites and many SOHO sites will require end-
user installation without the availability of information technology
professional support, and we have designed these products accordingly. In
addition, our SOHO and telecommuter solutions management interfaces allow
customers to immediately download updates into the product with minimal user
intervention. This process is protected with advanced cryptography and is tied
to the serial number of the appliance for additional security. Customers may
also order new features, such as additional user capability or virtual private
networking, from our web site.

  Our SOHO and telecommuter products allow local configuration. The security
appliances may be managed with an Internet browser, such as Netscape Navigator
or Internet Explorer. The systems may also be configured to allow management by
one of our security solutions for SMEs or larger enterprises or, in the near
future, by an ISP using our LiveSecurity for MSS.

  Subscription Services. In addition to accessing our LiveSecurity broadcasts,
SOHOs and telecommuters will be able to subscribe to our URL tracking service.
This service allows those persons supervising the use of Internet access, such
as parents or system administrators, to track sites visited by user, time of
visit, location, frequency of visits or other parameters.

Research and Development

  To maintain our product and service leadership position, we focus our
research and development efforts on enhancing our existing products, developing
new products based on our innovative distributed appliance architecture and
developing services that capitalize on our LiveSecurity broadcast
infrastructure. We utilize a modular design, which allows us to develop new
applications that plug into our existing product line. As a

                                       19
<PAGE>

result, our products can be deployed in stages, whether directly by an
enterprise or by an ISP if the enterprise has outsourced its security
management. As we develop new products, our LiveSecurity end-users and ISP
partners can incorporate the new products into their systems with minimal
system interruption.

  As of December 31, 1999, we employed 75 people on our research and
development staff. Research and development expenses were $2.2 million in 1997,
$4.4 million in 1998 and $7.1 million in 1999. We conduct our product
development activities related to our security solutions for SMEs and larger
enterprises at our principal facility in Seattle, Washington. We conduct our
product development activities related to our security solutions for SOHOs and
telecommuters at our broadband Internet security division in Laguna Hills,
California and at our facility in Seattle.

Competition

  We compete in a market that is new, intensely competitive, highly fragmented
and rapidly changing. We face competition in sales both of products and
services designed for enterprises and of those designed for ISPs. We have
experienced and will continue to experience increased competition from current
and emerging competitors, many of which have significantly greater financial,
technical, marketing and other resources.

  In the market for Internet security solutions, we compete on the basis of
technological expertise and functionality, breadth of service and product
features, ease of installation and management, updatability, scalability, brand
recognition, price and customer support. Currently, the dominant competitors in
our industry are Cisco Systems, Inc., Check Point Software Technologies Ltd.
and Nokia Corporation. We expect the introduction of our SOHO and telecommuter
products to increase competition with SonicWALL Inc., a developer of security
appliances for SOHOs and home users. Other competitors offering security
products include hardware and software vendors such as Axent Technologies,
Inc., Lucent Technologies, Inc. and Network Associates, Inc., operating system
vendors such as Microsoft Corporation, Novell, Inc. and Sun Microsystems, Inc.
and a number of smaller companies.

  Our competitors may be able to respond more quickly to new or emerging
technologies and changes in customer requirements than we can. In addition, our
current and future competitors may bundle their products with other software or
hardware, including operating systems and browsers, in a manner that may
discourage users from purchasing the products and services we offer. Many of
our current and potential competitors have greater name recognition, larger
customer bases to leverage and access to proprietary technology, and could
therefore gain market share to our detriment. In addition, our current and
potential competitors may establish cooperative relationships among themselves
or with third parties that may further enhance their resources, such as the
partnership between Check Point and Nokia. We expect additional competition as
other established and emerging companies enter the Internet security market and
new products and technologies are introduced.

  While most of our competitors have generally targeted large-enterprise
security needs, using complex products that run on general purpose hosts such
as UNIX or Windows NT and require full training and support programs, these
vendors could adapt their existing products to make them more attractive to
SMEs. If our competitors were to focus their greater financial, technical and
marketing resources on the SME market, our business could be adversely
affected. While none of our competitors currently offer a technology similar to
our LiveSecurity solution architecture to address changing security threats,
they could develop such technology as part of any appliance offering. Increased
competition in any of our markets could result in price reductions, fewer
customer orders, reduced gross margins and loss of market share.

Proprietary Rights

  To protect our proprietary rights, we rely primarily on

  .  copyright, trademark, service mark and trade secret laws;

  .  license agreements with third parties, including a standard software
     license included with our products;

                                       20
<PAGE>

  .  confidentiality agreements with our employees and third parties;

  .  invention assignment agreements with our employees and contractors;

  .  protective contractual provisions in our agreements with some of our
     consultants, resellers and customers; and

  .  limited access to our software, documentation and other proprietary
     information.

  WatchGuard(R) is a registered trademark in the United States, Norway, New
Zealand and Japan. Applications to register the WatchGuard trademark are
pending in other foreign jurisdictions. Firebox(TM) and LiveSecurity(TM) are
trademarks in use in the United States, and applications are pending in the
United States for registration of these trademarks. We have no patents, but we
have eight patents pending.

  We currently license and use the following technologies in our products and
services:

  .  BSAFE encryption toolkit from RSA Data Security, Inc. This industry-
     standard product provides us with encryption functions that we use in
     our remote office VPN product. We pay a fee for this perpetual license,
     which we may terminate for any reason with 90 days' notice.

  .  Cyber Patrol database from The Learning Company. This database provides
     blocking of particular web addresses as part of our web-blocking module.

  .  Linux kernel. We use a customized version of the Linux operating system
     for our security appliance platform. This license is a no-cost, open-
     source license.

  .  BackWeb Technologies client software and server. We use this technology
     to facilitate the distribution of our LiveSecurity content.

  .  Internet Security Systems Inc. Internet scanner. We sell an OEM version
     of this software as an optional scanning module for our LiveSecurity for
     MSS ISP customers.

  .  WebTrends Corporation Inc. WebTrends for Firewalls and VPNs. We sell an
     OEM version of this software as an optional reporting module for our
     LiveSecurity for MSS ISP customers.

  .  US Software TCP/IP stack. We use a customized version of this basic
     TCP/IP stack in source code form in our SOHO and telecommuter products.

  .  WindRiver VxWorks Real Time operating system. We use this operating
     system in our SOHO and telecommuter products.

U.S. Government Export Regulation Compliance

  Our products are subject to federal regulations governing the export of
encryption commodities and software. To comply with these regulations, we have
developed two versions of our products: one for the U.S. and Canadian markets
and one for international markets. Recent federal legislation, however, has
relaxed export controls on encryption. U.S. law now allows the export of
encryption commodities and software of any strength to nongovernmental end-
users located in any country except those designated as embargoed or otherwise
restricted by the U.S. government, subject to streamlined reporting
requirements. To satisfy these encryption export reporting requirements, we use
data gathered from end-users during product registration. Encryption
commodities and software previously approved for export by the federal Bureau
of Export Administration, or BXA, under an export license or encryption
licensing arrangement are immediately eligible for export under the revised
regulations without further technical review by the BXA. These commodities and
software include our branch office and remote user VPN software and the VPN
accelerator in our Firebox II Plus with FastVPN security appliance. Our Firebox
Telecommuter and Firebox SOHO products, which also utilize this encryption in
branch office VPN software, are currently under review by the BXA for retail
export status. If we obtain retail export status, we would be eligible to
export these products to all nonembargoed and nonrestricted foreign end-users,
including government entities. We anticipate a favorable ruling by the BXA for
export of the telecommuter and SOHO products as retail encryption commodities.

                                       21
<PAGE>

Manufacturing

  We currently outsource all hardware manufacturing and assembly for our
Firebox II product lines to two companies in California: Smart Modular
Technologies, Inc., our motherboard manufacturer, and Streamlined Electronics
Manufacturing, our final assembly house. The motherboard manufacturer designed
and manufactures the motherboard to our specifications. The manufacturer may
terminate the agreement for breach or insolvency of WatchGuard. For our Firebox
SOHO and Firebox Telecommuter product lines, we currently outsource all
hardware manufacturing and assembly to Productivity Enhancement Products, Inc.
in California. We then distribute the finished products worldwide from our
Seattle distribution center. All three manufacturers test our hardware to
confirm that all components function properly. All three manufacturers are
certified as meeting the International Organization for Standardization's
quality assurance standards: Smart Modular Technologies against ISO 9001 and
9002, Streamlined Electronics Manufacturing against ISO 9002 and Productivity
Enhancement Products against ISO 9001 and 9002.

Employees

  As of December 31, 1999, we had 165 employees. Of these, 50 were employed in
sales and marketing, 19 in finance and administration, 21 in customer support
and 75 in development and operations. We are not parties to any collective
bargaining agreements with our employees and we have not experienced any work
stoppages. We believe we have good relations with our employees.

Factors Affecting Our Operating Results, Our Business and Our Stock Price

  In addition to the other information contained in this annual report, you
should carefully read and consider the following risk factors. If any of these
risks actually occur, our business, financial condition or operating results
could be adversely affected and the trading price of our common stock could
decline.

We have incurred losses since inception and may never be profitable, which
could result in a decline in the value of our common stock.

  We expect our operating losses and negative cash flows to continue. Although
our revenues have increased each year since we began operations, we do not
believe that the historical percentage growth rate of our revenues will be
sustainable as our revenue base increases. Moreover, we currently expect to
increase our operating expenses significantly in connection with

  .  expanding into new geographic markets;

  .  expanding into new product markets;

  .  continuing to develop our technology;

  .  hiring additional personnel;

  .  relocating or expanding our corporate facilities in the next six to
     eight months;

  .  upgrading our information and internal control systems; and

  .  pursuing potential strategic acquisitions.

We may never generate profits, and if we do become profitable, we may be unable
to sustain or increase profitability on a quarterly or annual basis. As a
result, the trading price of our common stock could decline. We have incurred
net losses and experienced negative cash flows in each quarter since we began
doing business. As of December 31, 1999, we had an accumulated deficit of
approximately $29.9 million.

Our operating results fluctuate and could fall below expectations of securities
analysts and investors, resulting in a decrease in our stock price.

  Our quarterly and yearly operating results have varied widely in the past and
will probably continue to fluctuate. For this reason, we believe that period-
to-period comparisons of our operating results are not

                                       22
<PAGE>

meaningful. In addition, our limited operating history makes predicting our
future performance difficult. As a result of these factors, our operating
results for a particular quarter or year may fall below the expectations of
securities analysts and investors, which could result in a decrease in our
stock price.

  We base our spending levels for product development, sales and marketing and
other operating expenses largely on our expected future revenues. Because our
expenses are largely fixed for a particular quarter or year, we may be unable
to adjust our spending in time to compensate for any unexpected quarterly or
annual shortfall in revenues. A failure to so adjust our spending in time also
could cause operating results to fall below the expectations of securities
analysts and investors, resulting in a decrease in our stock price.

Seasonality and concentration of revenues at the end of the quarter could cause
our revenues to fall below the expectations of securities analysts and
investors, resulting in a decrease in our stock price.

  Our domestic and international sales tend to be lower in the summer months,
when businesses often defer purchasing decisions. Also, as a result of customer
buying patterns and the efforts of our sales force to meet or exceed quarterly
and year-end quotas, historically we have earned a substantial portion of a
quarter's revenues during its last month. If expected revenues at the end of
any quarter are delayed, our revenues for that quarter could fall below the
expectations of securities analysts and investors, resulting in a decrease in
our stock price.

Because many potential customers are unaware of the need for Internet security
or may perceive it as costly and difficult to implement, our products and
services may not achieve market acceptance.

  We believe that many potential customers, particularly SMEs, SOHOs and
telecommuters, are not fully aware of the need for Internet security products
and services. Historically, only enterprises having substantial resources have
developed or purchased Internet security solutions. Also, there is a perception
that Internet security is costly and difficult to implement. We will therefore
not succeed unless we can educate our market about the need for Internet
security and convince our potential customers of our ability to provide this
security in a cost-effective and administratively feasible manner. Although we
have spent, and will continue to spend, considerable resources educating
potential customers about the need for Internet security and the benefits of
our products and services, our efforts may be unsuccessful.

If potential customers do not accept our LiveSecurity products and services,
our business will not succeed.

  We currently expect all future revenues to be generated through sales of our
LiveSecurity Internet security products and related services, particularly
subscription and license fees. Our success depends on market acceptance of our
LiveSecurity products and services and our ability and the ability of our ISP
partners to obtain and retain LiveSecurity customers. Our LiveSecurity products
and services, however, are relatively new and unproven. The broadcast portion
of our LiveSecurity products has been available only since February 1999 and
our LiveSecurity for MSS product has been available only since September 1998.
To receive our broadcasts, enterprises will be required to pay an annual
subscription fee, either to us or, if they obtain LiveSecurity through an ISP,
to the ISP. We are not aware of any other Internet security product that allows
enterprises to keep their security solution current by receiving broadcasts of
software updates and related information over the Internet. Enterprises may be
unwilling to pay a subscription fee to keep their Internet security up to date.
Because our broadcast service is relatively new, we cannot predict the rate at
which our customers will renew their annual subscriptions. In addition, most
businesses implementing security services have traditionally managed their own
Internet security rather than seeking the services of third-party service
providers. As a result, our products and services and the outsourcing of
Internet security to third parties may not achieve significant market
acceptance.

If our relationships with ISPs are unsuccessful, our ability to market and sell
our products and services will be limited.

  We expect a significant percentage of our revenues to be derived from our
relationships with domestic and international ISPs that implement our
LiveSecurity for MSS solution. If these ISPs are unsuccessful in

                                       23
<PAGE>

marketing and implementing our LiveSecurity for MSS solution, our operating
results will be materially harmed. Because our relationships with ISPs are
relatively new, we cannot predict the degree to which the ISPs will succeed in
marketing and selling services based on our products and services. Many of the
ISPs with which we have established relationships have not had an opportunity
to fully develop and implement service offerings incorporating LiveSecurity. We
cannot predict how long our current or potential ISP partners will take to
complete this development and implementation. Until and unless this development
and implementation is achieved, our revenues from ISPs will be limited. If the
ISPs fail to provide adequate installation, deployment and support of our
products and services, end-users could decide not to subscribe, or cease
subscribing, for managed services that use our solution. The ISPs will offer
our products and services in combination with other products and services, some
of which may be competitive with our products and services.

If our third-party resellers and distributors fail to perform, our ability to
sell our products and services will be limited.

  We sell most of our products and services through value-added resellers and
distributors, and we expect our success to continue to depend in large part on
their performance. Our resellers and distributors have the ability to sell
products and services that are competitive with ours, to devote more resources
to those competitive products or to cease selling our products and services
altogether. While no single reseller or distributor currently accounts for more
than 10% of our total revenues, the loss of or reduction in sales to several
value-added resellers or a distributor, particularly to competitive products
offered by other companies, could adversely affect our revenues.

Product returns or retroactive price adjustments could exceed our allowances,
which could adversely affect our operating results.

  We provide some of our distributors and resellers with product return rights
for stock rotation. We also provide some of our distributors and resellers with
price protection rights for inventories of our products held by those
distributors or resellers if we lower our prices for those products. We may
experience significant returns and price adjustments for which we may not have
adequate allowances. The short life cycles of our products and the difficulty
of predicting future sales increase the risk that new product introductions or
price reductions by us or our competitors could result in significant product
returns or price adjustments. In September 1998, when we introduced the Firebox
II security appliance, we experienced an increase in returns of previous
products and product versions. Provisions for returns and allowances for the
years ended December 31, 1997, 1998 and 1999 were $0, $1,655,000 and
$1,083,000, or 0%, 13% and 5% of total revenues before returns and allowances.

If we are unable to compete successfully in the highly competitive market for
Internet security products and services, our business will fail.

  The market for Internet security products is intensely competitive and we
expect competition to intensify in the future. An increase in competitive
pressures in our market or our failure to compete effectively may result in
pricing reductions, reduced gross margins and loss of market share. Currently,
the dominant competitors in our industry are Cisco Systems, Inc., Check Point
Software Technologies Ltd. and Nokia Corporation. We expect the introduction of
our SOHO and telecommuter products to increase competition with SonicWALL Inc.,
a developer of security appliances for SOHOs and home users. Other current and
potential competitors include hardware, software and operating system vendors
such as Axent Technologies, Inc., Lucent Technologies, Inc., Microsoft
Corporation, Network Associates, Inc., Novell, Inc., Sun Microsystems Inc. and
a number of smaller companies. Many of our competitors have longer operating
histories, greater name recognition, larger customer bases and significantly
greater financial, technical, marketing and other resources than we do. In
addition, our current and potential competitors have established or may
establish cooperative relationships among themselves or with third parties that
may further enhance their resources, such as the partnership between Check
Point and Nokia. As a result, they may be able to adapt more quickly to new

                                       24
<PAGE>

technologies and customer needs, devote greater resources to the promotion or
sale of their products and services, initiate or withstand substantial price
competition, take advantage of acquisition or other opportunities more readily
or develop and expand their product and service offerings more quickly. In
addition, our competitors may bundle products competitive with ours with other
products that they may sell to our current or potential customers. These
customers may accept these bundled products rather than separately purchasing
our products.

Rapid changes in technology and industry standards could render our products
and services unmarketable or obsolete, and we may be unable to introduce new
products and services timely and successfully.

  To succeed, we must continually change and improve our products in response
to rapid technological developments and changes in operating systems, Internet
access and communications, application and networking software, computer and
communications hardware, programming tools, computer language technology and
hacker techniques. We may be unable to successfully and timely develop these
new products and services or achieve and maintain market acceptance. The
development of new, technologically advanced products and services is a complex
and uncertain process requiring great innovation and the ability to anticipate
technological and market trends. Because Internet security technology is
complex, it can require long development and testing periods. Releasing new
products and services prematurely may result in quality problems, and releasing
them late may result in loss of customer confidence and market share. In the
past, we have on occasion experienced delays in the scheduled introduction of
new and enhanced products and services, and we may experience delays in the
future. When we do introduce new or enhanced products and services, we may be
unable to manage the transition from the older products and services to
minimize disruption in customer ordering patterns, avoid excessive inventories
of older products and deliver enough new products and services to meet customer
demand.

We may be required to defend lawsuits or pay damages in connection with the
alleged or actual failure of our products and services.

  Because our products and services provide and monitor Internet security and
may protect valuable information, we may face claims for product liability,
tort or breach of warranty relating to our products and services. Anyone who
circumvents our security measures could misappropriate the confidential
information or other property of end-users using our products and services or
interrupt their operations. If that happens, affected end-users or ISPs may sue
us. In addition, we may face liability for breaches caused by faulty
installation of our products by resellers or end-users. Although we attempt to
reduce the risk of losses from claims through contractual warranty disclaimers
and liability limitations, these provisions may be unenforceable. Some courts,
for example, have found contractual limitations of liability in standard
software licenses to be unenforceable because the licensee does not sign them.
Defending a suit, regardless of its merit, could be costly and could divert
management attention. Although we currently maintain business liability
insurance, this coverage may be inadequate or may be unavailable in the future
on acceptable terms, if at all.

A breach of security could harm public perception of our products and services.

  We will not succeed unless the marketplace is confident that we provide
effective Internet security protection. Even networks protected by our software
products may be vulnerable to electronic break-ins and computer viruses. If an
actual or perceived breach of Internet security occurs in an end-user's
systems, regardless of whether the breach is attributable to us, the market
perception of the efficacy of our products and
services could be harmed. This could cause us and our ISP partners to lose
current and potential customers or cause us to lose potential resellers,
distributors and ISP partners. Because the techniques used by computer hackers
to access or sabotage networks change frequently and generally are not
recognized until launched against a target, we may be unable to anticipate
these techniques.

If we are unable to prevent attacks on our internal network system by computer
hackers, public perception of our products and services will be harmed.

  Because we provide Internet security, we have become a greater target of
attacks by computer hackers. We have experienced attacks by computer hackers in
the past and expect attacks to continue. If attacks on our internal network
system are successful, public perception of our products and services will be
harmed.

                                       25
<PAGE>

Failure to address strain on our resources caused by our rapid growth will
result in our inability to effectively manage our business.

  Our current systems, management and resources will be inadequate if we
continue to grow. Our business has grown rapidly in size and complexity in the
last three years. This rapid expansion has placed significant strain on our
administrative, operational and financial resources and has resulted in ever-
increasing responsibilities for our management personnel. We will be unable to
effectively manage our business if we are unable to timely and successfully
alleviate the strain on our resources caused by our rapid growth.

We may be unable to adequately expand our operational systems to accommodate
growth, which could harm our ability to deliver our products and services.

  Our operational systems have not been tested at the customer volumes that may
be required in the future. We may encounter performance difficulties when
operating with a substantially greater number of customers. In implementing our
LiveSecurity products, we have experienced periodic interruptions affecting all
or a portion of our systems, and we believe that interruptions will continue to
occur from time to time. These interruptions could harm our ability to deliver
our products and services. An inability to add software and hardware or to
develop and upgrade existing technology or operational systems to handle
increased traffic may cause unanticipated system disruptions, slower response
times and poor customer service, including problems filling customer orders.

We may be unable to adequately protect our operational systems from damage,
failure or interruption, which could harm our reputation and our ability to
attract and retain customers.

  Our operations, customer service, reputation and ability to attract and
retain customers depend on the uninterrupted operation of our operational
systems. Although we have off-site backup facilities and take other precautions
to prevent damage, failure or interruption of our systems, our precautions may
be inadequate. Any damage, failure or interruption of our computer or
communications systems could lead to service interruptions, delays, loss of
data and inability to accept and fill customer orders and provide customers
with LiveSecurity updates.

We may be unable to deliver our products and services if we cannot continue to
license third-party technology that is important for the functionality of our
products.

  Our success will depend in part on our continued ability to license
technology that is important for the functionality of our products. A
significant interruption in the supply of a third-party technology could delay
our development and sales until we can find, license and integrate equivalent
technology. This could damage our brand and result in loss of current and
potential customers. Although we believe that we could find other sources for
the technology we license, alternative technologies may be unavailable on
acceptable terms, if at all. We depend on our third-party licensers to deliver
reliable, high-quality products, develop new products on a timely and cost-
effective basis and respond to evolving technology and changes in industry
standards. We also depend on the continued compatibility of our third-party
software with future versions of our products.

We may be unable to deliver our products and services if our single-source
manufacturers fail to supply hardware with acceptable quality, quantity and
cost.

  We outsource all of our hardware manufacturing and assembly for each of our
SME and larger-enterprise solutions and our SOHO and telecommuter solutions to
single-source motherboard manufacturers and assembly houses. While the single-
source vendors for our SME and larger-enterprise products have produced
hardware with acceptable quality, quantity and cost in the past, they may be
unable to meet our future demands. Our relationships with the single-source
vendor for our SOHO and telecommuter products are new and unproven. Although we
believe that we could find another manufacturer and assembly house for each of
our product lines, our operations could be disrupted if we have to switch to a
replacement vendor or if our hardware supply is interrupted for an extended
period. This could result in loss of customer orders and revenue.

                                       26
<PAGE>

We may have to reduce or cease operations if we are unable to obtain the
funding necessary to meet our working capital requirements.

  Our future revenues may be insufficient to support the expenses of our
operations and the expansion of our business. We may therefore need additional
equity or debt capital to finance our operations. If we are unable to generate
sufficient cash flow from operations or obtain funds through additional
financing, we may have to reduce some or all of our development and sales and
marketing efforts or cease operations. We believe that existing cash and cash
equivalents balances and our existing line of credit, excluding the potential
net proceeds from our proposed public offering in the first quarter of 2000,
should be sufficient to meet our capital requirements for at least the next 12
months. Our capital requirements depend on several factors, however, including
the rate of market acceptance of our products and services, our ability to
expand our customer base and the growth of our sales and marketing
capabilities. If our capital requirements vary from our current plans, we may
require additional financing sooner than we anticipate. Financing may be
unavailable to us when needed or on acceptable terms.

We may be unable to adequately protect our proprietary rights, which may limit
our ability to compete effectively.

  Despite our efforts to protect our proprietary rights, unauthorized parties
may misappropriate or infringe on our trade secrets, copyrights, trademarks,
service marks and similar proprietary rights. We face additional risk when
conducting business in countries that have poorly developed or inadequately
enforced intellectual property laws. While we are unable to determine the
extent to which piracy of our software products exists, we expect piracy to be
a continuing concern, particularly in international markets and as a result of
the growing use of the Internet. In any event, competitors may independently
develop similar or superior technologies or duplicate the technologies we have
developed, which could substantially limit the value of our intellectual
property.

Intellectual property claims and litigation could subject us to significant
liability for damages and invalidation of our proprietary rights.

  In the future, we may have to resort to litigation to protect our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of the proprietary rights of others. Any litigation,
regardless of its success, would probably be costly and require significant
time and attention of our key management and technical personnel. Litigation
could also force us to

  .  stop or delay selling, incorporating or using products that incorporate
     the challenged intellectual property;

  .  pay damages;

  .  enter into licensing or royalty agreements, which may be unavailable on
     acceptable terms; or

  .  redesign products or services that incorporate infringing technology.

  Although we have not been sued for intellectual property infringement, we may
face infringement claims from third parties in the future. The software
industry has seen frequent litigation over intellectual property rights, and we
expect that participants in the Internet security industry will be increasingly
subject to infringement claims as the number of products, services and
competitors grows and functionality of products and services overlaps.

Undetected product errors or defects could result in loss of revenues, delayed
market acceptance and claims against us.

  Our products and services may contain undetected errors or defects,
especially when first released. Despite extensive testing, some errors are
discovered only after a product has been installed and used by customers. Any
errors discovered after commercial release could result in loss of revenues or
claims against us.

                                       27
<PAGE>

Governmental controls over the export or import of encryption technology could
cause us to lose sales.

  Any additional governmental regulation of imports or exports or failure to
obtain required export approval of our encryption technologies could adversely
affect our international and domestic sales. The United States and various
foreign governments have imposed controls, export license requirements and
restrictions on the import or export of some technologies, especially
encryption technology. In addition, from time to time governmental agencies
have proposed additional regulation of encryption technology, such as requiring
the escrow and governmental recovery of private encryption keys. Additional
regulation of encryption technology could delay or prevent the acceptance and
use of encryption products and public networks for secure communications. This,
in turn, could result in decreased demand for our products and services.

  In addition, some foreign competitors are subject to less stringent controls
on exporting their encryption technologies. As a result, they may be able to
compete more effectively than we can in the U.S. and international Internet
security markets.

If we do not retain our key employees, our ability to execute our business
strategy will be impaired.

  Our future success will depend largely on the efforts and abilities of our
senior management and our key development, technical, operations, information
systems, customer support and sales and marketing personnel and our ability to
retain them. These employees are not obligated to continue their employment
with us and may leave us at any time.

If we do not expand our international operations and successfully overcome the
risks inherent in international business activities, the growth of our business
will be limited.

  Our ability to grow will depend in part on the expansion of our international
sales and operations, which are expected to continue to account for a
significant portion of our revenues. Sales to customers outside of North
America accounted for approximately 56% of our net revenues in 1997, 35% in
1998 and 50% in 1999. The failure of our resellers and distributors to sell our
products internationally would limit our ability to increase our revenues. In
addition, our international sales are subject to the risks inherent in
international business activities, including

  .  cost of customizing products for foreign countries;

  .  export and import restrictions, such as those affecting encryption
     commodities and software;

  .  difficulties in acquiring and authenticating customer information;

  .  reduced protection of intellectual property rights and increased
     liability exposure; and

  .  regional economic and political conditions.

Our international sales currently are U.S. dollar-denominated. As a result, an
increase in the value of the U.S. dollar relative to foreign currencies could
make our products less competitive in international markets.

Undiscovered year 2000-related computer problems could disrupt our operations.

  We believe that the current versions of the internally developed software
technologies incorporated in our products and services, as well as our internal
management and other administrative and external information systems, are year
2000 compliant. When the century changed, we experienced no disruption to our
business operations and no product failures as a result of year 2000 compliance
issues or otherwise. Nonetheless, some year 2000 problems may not appear until
several months after January 1, 2000. As a result, we may still face claims for
undiscovered year 2000 errors in our own products or for year 2000 issues
arising from third-party products that we integrate into our products and
services or with which our systems and products exchange data. In addition, if
our suppliers, vendors or distributors encounter year 2000 software, firmware
and hardware problems, our ability to deliver our products and services could
be disrupted.

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<PAGE>

The integration of BeadleNet, LLC and any future acquisitions may be difficult
and disruptive.

  In October 1999, we acquired BeadleNet, LLC, a privately held developer of
Internet security solutions for small offices and home offices. We are
currently in the process of integrating the BeadleNet business with our
business. This integration is subject to risks commonly encountered in making
acquisitions, including

  .  loss of key personnel;

  .  difficulties in assimilating BeadleNet's technologies, products,
     personnel and operations;

  .  disruption of our ongoing business; and

  .  the inability of our sales force, consultants and development staff to
     adapt to the new product line.

  We may not successfully overcome these or any other problems encountered in
connection with the integration of BeadleNet. As part of our business strategy,
we expect to consider acquiring other companies. We may be unable to
successfully integrate the technologies, products, personnel or operation of
companies that we may acquire in the future.

The concentrated ownership of our common stock could delay or prevent a change
of control, which could reduce the market price of our common stock.

  As of December 31, 1999, our directors, executive officers and their
affiliates beneficially owned, in the aggregate, approximately 67.8% of our
outstanding common stock. If we complete a proposed public offering of our
common stock in the first quarter of 2000, our directors, executive officers
and their affiliates will beneficially own, in the aggregate, approximately
57.37% of our outstanding common stock, or 55.96% if the underwriters exercise
their over-allotment option in full. As a result of their concentrated
ownership, these stockholders are able to exercise control over all matters
requiring stockholder approval, including the election of directors and
approval of significant corporate transactions such as acquisitions, and to
block unsolicited tender offers. This concentration of ownership therefore
could have the effect of delaying or preventing a third party from acquiring
control over us at a premium over the then-current market price of our common
stock, which could result in a decrease in our stock price.

Our stock price is volatile.

  The trading price of our common stock could be subject to fluctuations for a
number of reasons, including

  .  actual or anticipated variations in quarterly or annual operating
     results;

  .  changes in analysts' earning projections or analysts' recommendations;

  .  our inability to successfully implement our business strategy;

  .  changes in business conditions affecting our customers, our competitors
     and us; and

  .  changes in accounting standards that adversely affect our revenues and
     earnings.

  In recent years, moreover, the stock market in general and the market for
Internet-related technology companies in particular have experienced extreme
price and volume fluctuations, often unrelated to the operating performance of
the affected companies. Our common stock has experienced, and is likely to
continue to experience, these fluctuations in price, regardless of our
performance. Market fluctuations or volatility could cause the market price of
our common stock to decline.

Future sales of our common stock may depress our stock price.

  Sales of a substantial number of shares of our common stock in the public
market could adversely affect the market price of our common stock. We have
filed a registration statement relating to a proposed offering of 3,000,000
shares of common stock, plus an additional 450,000 shares subject to the
underwriters' over-

                                       29
<PAGE>

allotment option. Of the shares in the offering, we propose to sell 1,500,000
shares and certain stockholders propose to sell the remaining shares. After the
offering, we will have outstanding 21,136,752 shares of common stock. All the
shares sold in the proposed public offering will be freely tradable. Of the
remaining 18,136,752 shares of common stock that will be outstanding after the
offering, 14,010,545 are restricted as a result of securities laws or lock-up
agreements signed by the holder and will be available for sale in the public
market as follows:

<TABLE>
<CAPTION>
                                                                    Number of
                   Date of Availability for Sale                      Shares
                   -----------------------------                    ----------
<S>                                                                 <C>
On the date of this annual report..................................  1,110,053
90 days after the date of the prospectus related to our proposed
 public offering................................................... 12,491,185
At various times thereafter on the expiration of one-year holding
 periods...........................................................    409,307
</TABLE>

Credit Suisse First Boston Corporation, the managing underwriter for our
proposed offering, may, in its sole discretion and at any time without prior
notice, release all or any portion of the common stock subject to lock-up
agreements.

ITEM 2. PROPERTIES

  Our principal administrative, marketing, sales, development and operations
facility is located in Seattle, Washington. We occupy approximately 30,000
square feet in this facility, under two leases that expire in April 2001. We
also maintain a small office in Laguna Hills, California for our broadband
Internet security division and a 3,000-square-foot warehouse in Seattle for
product fulfillment and distribution. We have the right to lease the Laguna
Hills office on a month-to-month basis until October 2000, but we may terminate
this option before that date. We expect to move our broadband Internet security
division to new offices before that time. The warehouse lease expires in August
2000, but has two one-year renewal options. We will be relocating or expanding
our general office space in both Seattle and Laguna Hills within the next six
to eight months, and we expect adequate space to be available on commercially
reasonable terms.

ITEM 3. LEGAL PROCEEDINGS

  We are currently not a party to any material legal proceedings.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

  No matters were submitted to a vote of our security holders during the fourth
quarter of our fiscal year ended December 31, 1999.

                                       30
<PAGE>

                                    PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

Market Information

  Our common stock began trading on The Nasdaq National Market on July 30, 1999
under the symbol WGRD. The following table lists, for the periods indicated,
the high and low sales prices per share of our common stock as reported on The
Nasdaq National Market.

<TABLE>
<CAPTION>
                                                                   Price Range
                                                                    of Common
                                                                      Stock
                                                                  -------------
                                                                   High   Low
                                                                  ------ ------
   <S>                                                            <C>    <C>
   Year Ended December 31, 1999
   Third quarter (beginning July 30, 1999)....................... $18.38 $10.38
   Fourth quarter................................................  40.00  13.81
</TABLE>

  The last reported sale price of our common stock on The Nasdaq National
Market on February 10, 2000 was $50.00 per share.

Holders

  As of January 31, 2000, there were approximately 80 holders of record of our
common stock. This does not include the number of persons whose stock is in
nominee or "street name" accounts through brokers.

Dividends

  We have never paid cash dividends on our common stock. We currently intend to
retain any future earnings to fund the development and growth of our business
and therefore do not anticipate paying any cash dividends in the foreseeable
future. Furthermore, our line of credit agreement prohibits the payment of
dividends without the bank's prior written consent.

Recent Sales of Unregistered Securities

  On October 19, 1999, in connection with the acquisition of BeadleNet, LLC, we
issued 335,931 shares of our common stock. This transaction was exempt from
Securities Act registration under Section 4(2) of the Securities Act, on the
basis that the transaction did not involve a public offering. Also in
connection with the BeadleNet acquisition, we issued 51,948 shares of
restricted common stock to an employee in connection with an employment
agreement. This transaction was exempt from Securities Act registration under
Rule 701 under the Securities Act on the basis that these securities were
offered and sold in accordance with a written contract related to compensation.

Use of Proceeds

  On July 30, 1999, our registration statement on Form S-1, file number 333-
76587, became effective. The offering date was July 30, 1999. The offering
terminated as a result of all of the shares offered being sold. The managing
underwriters were Dain Rauscher Wessels, Warburg Dillon Read LLC, SoundView
Technology Group, Inc. and Wit Capital Corporation. The offering consisted of
3,879,570 shares of our common stock, including 3,500,000 shares of common
stock offered by WatchGuard and 379,570 shares of common stock offered by our
selling stockholders pursuant to the exercise of the underwriters' over-
allotment option. The aggregate price of the shares offered and sold by us was
$45.5 million, and the aggregate price of the shares offered and sold by the
selling shareholders was $4.9 million. After accounting for approximately $3.2
million in underwriting discounts and commissions and $1.5 million in other
expenses, we received proceeds of $40.8 million.

                                       31
<PAGE>

  We are using the net proceeds raised in our initial public offering for
additional working capital, repayment of short-term indebtedness and general
corporate purposes, including increased domestic and international sales and
marketing expenditures, increased research and development expenditures and
capital expenditures made in the ordinary course of business. We also intend to
use these proceeds for possible acquisitions of businesses, products and
technologies that are complementary to ours, such as our acquisition of the
assets of BeadleNet, LLC. Although we have no current agreements or
understandings with respect to any such transactions, we do from time to time
evaluate these opportunities. Pending their use, the majority of the net
proceeds have been invested in investment-grade, interest-bearing instruments,
all of which are short-term.

  We used $6.6 million of the net proceeds of the offering to repay all debt
affiliated with Matrix IV Management Co., L.P., OVMC III, L.P. and OVMC IV,
LLC, all of which are principal stockholders of WatchGuard. Andrew W. Verhalen,
a director of WatchGuard, serves as general partner of Matrix IV Management
Co., L.P. and Charles P. Waite, Jr., a director of WatchGuard, serves as a
general partner of OVMC III, L.P. and as a managing member of OVMC IV, LLC.

ITEM 6. SELECTED FINANCIAL DATA

  When you read this selected financial data, it is important that you also
read the historical financial statements and related notes included in this
annual report, as well as the section of this annual report entitled
"Management's Discussion and Analysis of Financial Condition and Results of
Operations." The historical results are not necessarily indicative of future
results. See note 7 of Notes to Financial Statements for an explanation of the
method used to determine the number of shares used in computing pro forma basic
and diluted net loss per share.

<TABLE>
<CAPTION>
                                    Period From            Year Ended
                                 February 14, 1996        December 31,
                                  (Inception) to   ----------------------------
                                 December 31, 1996   1997      1998      1999
                                 ----------------- --------  --------  --------
                                    (In thousands, except per share data)
<S>                              <C>               <C>       <C>       <C>
Statement of Operations Data:
 Revenues, net:
  Product......................       $  329       $  4,975  $ 10,678  $ 17,329
  Service......................            2            123       701     3,290
                                      ------       --------  --------  --------
   Total revenues..............          331          5,098    11,379    20,619
 Cost of revenues..............          104          1,610     3,925     7,964
                                      ------       --------  --------  --------
 Gross margin..................          227          3,488     7,454    12,655
 Operating expenses:
  Sales and marketing..........          224          4,369     8,519    13,512
  Research and development.....          274          2,192     4,442     7,118
  General and administrative...          191          1,323     2,454     3,646
  Stock-based compensation.....          --             --      1,039       926
  Acquired in-process
   technology and amortization
   of intangible assets
   acquired....................          --             --        --      3,626
                                      ------       --------  --------  --------
   Total operating expenses....          689          7,884    16,454    28,828
                                      ------       --------  --------  --------
 Operating loss................         (462)        (4,396)   (9,000)  (16,173)
 Interest income (expense),
  net..........................           (6)            62      (119)      155
                                      ------       --------  --------  --------
 Net loss......................       $ (468)      $ (4,334) $ (9,119) $(16,018)
                                      ======       ========  ========  ========
 Basic and diluted net loss per
  share........................          N/A       $ (17.17) $ (11.34) $  (1.80)
                                      ======       ========  ========  ========
 Shares used in calculation of
  basic and diluted net loss
  per share....................          N/A            252       804     8,903
                                      ======       ========  ========  ========
 Pro forma basic and diluted
  net loss per share
  (unaudited)..................                                        $  (0.96)
                                                                       ========
 Shares used in calculation of
  pro forma basic and diluted
  net loss per share
  (unaudited)..................                                          16,664
                                                                       ========
</TABLE>

                                       32
<PAGE>

<TABLE>
<CAPTION>
                                                        December 31,
                                                -------------------------------
                                                 1996    1997   1998     1999
                                                ------  ------ -------  -------
                                                       (In thousands)
<S>                                             <C>     <C>    <C>      <C>
Balance Sheet Data:
 Cash, cash equivalents and marketable
  securities................................... $  232  $  603 $ 1,712  $26,401
 Working capital (deficit) ....................   (464)    658    (274)  24,395
 Total assets..................................    597   3,303   9,032   41,311
 Total stockholders' equity (deficit)..........   (318)  1,382     881   32,245
</TABLE>

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS

Overview

  WatchGuard is a leading provider of Internet security solutions designed to
protect enterprises or telecommuters using the Internet for electronic commerce
and communications. Our core market is small- to medium-sized enterprises, or
SMEs, and we have recently expanded our marketing focus to include larger
enterprises as well as small offices and home offices, or SOHOs, and
telecommuters, particularly those using broadband Internet connections. Our
innovative subscription-based LiveSecurity solution broadcasts threat
responses, software updates, information alerts, expert editorials, support
flashes and virus alerts over the Internet, enabling enterprises to keep their
security systems current with minimal effort.

  Since our inception, we have invested heavily in the development of our
products and services. In September 1996, we introduced our initial Internet
security appliance and began selling our products both domestically and
internationally. In 1997, we significantly expanded our sales force, adding 12
sales employees to recruit indirect channel partners around the world, and
expanded our distribution efforts in the European and Asia/Pacific markets. In
September 1998, we launched our managed security service offering for ISPs. We
also continued to recruit and hire additional employees in marketing,
development, technical support and finance and invested in our operational
infrastructure to support our growth. In February 1999, we launched the
broadcast portion of our LiveSecurity products. In July 1999, we completed the
initial public offering of our common stock. In October 1999, we acquired
BeadleNet, LLC, a developer of Internet security solutions for SOHOs, and
formed our new broadband Internet security division. In January 2000, we
announced the introduction of our security solutions for SOHOs and
telecommuters, which we expect to begin shipping in the first quarter of 2000,
and in the second quarter of 2000, we expect to introduce MSS solutions for
SOHOs and telecommuters.

  Our revenues were $5.1 million in 1997, our first full year of operations.
Our revenues totaled $11.4 million in 1998, representing a 123% increase over
1997, and grew to $20.6 million in 1999, representing an 81% increase over
1998. Product revenues as a percentage of total revenues were 98% in 1997, 94%
in 1998 and 84% in 1999. Service revenues, although small, are growing and are
expected to be a significant component of our revenues in the future as we
expand our LiveSecurity subscription-based broadcast service. Service revenues
as a percentage of total revenues were 2% in 1997, 6% in 1998 and 16% in 1999.
As a result of our investments in our worldwide sales and distribution
channels, development of new products and services, brand development and our
operational infrastructure, we have incurred net losses in each fiscal quarter.
As of December 31, 1999, we had an accumulated deficit of approximately $29.9
million. We anticipate significant growth in our operating expenses as we
continue to expand our business, particularly with respect to the expected
expansion of our corporate facilities in the next six to eight months. In the
future, however, we expect our operating expenses to begin to decline as a
percentage of total revenues.

Sources of Revenues and Revenue Recognition Policy

  We generate revenues through

  .  sales of products and service subscriptions through our indirect
     distribution partners at a discount from list price, which historically
     has averaged approximately 40%;

                                       33
<PAGE>

  .  sales of products and service subscriptions directly and, from time to
     time, indirectly through our distributors, to our ISP customers at
     volume pricing rates; and

  .  from time to time, sales of service subscription renewals directly to
     our enterprise customers at list price.

  Product revenues include perpetual software license fees and sales of our
security appliance. Service revenues include fees for access to our
LiveSecurity broadcast service for product updates, security threat responses,
general security information and technical support. Service revenues also
include annual fees for our LiveSecurity for MSS, which allows our ISP
customers access to the LiveSecurity broadcast service and the ability to
manage and update a specific number of their customers' security appliances. To
date, service subscription renewals directly from our enterprise customers have
not been material.

  We recognize revenues only when a contract or agreement has been executed,
delivery has occurred, the fee is fixed and determinable and we believe
collection is probable. We recognize product revenues upon shipment and service
subscription revenues ratably on a monthly basis, generally over a one-year
period.

Recent Acquisition

  In October 1999, we acquired substantially all of the assets of BeadleNet,
LLC for $9.6 million. The acquisition cost was comprised of

  .  $3.4 million cash, paid at closing;

  .  335,931 unregistered shares of WatchGuard common stock with a fair value
     of approximately $4.9 million, issued at closing;

  .  an additional $1.0 million in contingent consideration, comprised of
     $400,000 in cash and 20,189 unregistered shares of WatchGuard common
     stock with a fair value of $600,000, which became due on completion of
     specified technology items in late December 1999 and was paid in January
     2000; and

  .  estimated direct acquisition costs of $300,000.

  The aggregate purchase price was allocated, based on estimated fair values on
the acquisition date, as follows:

<TABLE>
     <S>                                                             <C>
     Inventory and equipment........................................ $   74,000
     Intangibles:
       Acquired workforce...........................................    204,000
       Trade names..................................................    409,000
       Developed technology.........................................    503,000
       Goodwill.....................................................  4,985,000
                                                                     ----------
         Total intangibles..........................................  6,101,000
     Acquired in-process research and development...................  3,381,000
                                                                     ----------
     Total purchase price........................................... $9,556,000
                                                                     ==========
</TABLE>

  We determined values assigned to acquired in-process research and
development, developed technology and trade names using a discounted cash flow
analysis. The value we assigned to the workforce in place was based on
replacement cost.

  To determine the value of in-process research and development, we considered,
among other factors, the state of development of each project, the time and
cost needed to complete each project, expected income and associated risks,
which included the inherent difficulties and uncertainties in completing the
project and achieving technological feasibility and risks related to the
viability of and potential changes to future target

                                       34
<PAGE>

markets. As a result of this analysis we assigned amounts to in-process
research and development projects that had not yet reached technological
feasibility and do not have alternative future uses. We expensed the entire
$3,381,000 allocated to acquired in-process research and development on the
date of acquisition.

  The in-process projects, which were to be replacement products for those
products being sold at the acquisition date and which were included in the
acquired developed technology, were designed to provide a low-cost firewall and
networking solution for personal computers using existing telephone wiring and
external connections to the Internet using a cable or digital subscribing line,
or DSL, modem. At the time of the acquisition, most of the hardware development
for the products had been completed. However, the software architecture for
virtual private network integration and the scalability of installing the
virtual private network architecture into a DSL technology had not yet been
completed.

  We completed production-ready prototypes in late December 1999 and introduced
the new products in January 2000 for delivery during the first quarter of 2000.
The total costs to complete the in-process projects after the acquisition date
were approximately $635,000.

  To determine the value of the developed technology, we discounted the
expected future cash flows of the existing technology product, taking into
account risks related to the characteristics and applications of each product,
existing and future markets, and assessments of the life-cycle stage of each
project. Based on this analysis, we capitalized the existing technology that
had reached technological feasibility.

  We assigned to the identified intangible assets lives ranging from two to
four years and to goodwill a life of five years. Amortization expense for these
intangibles was $245,000 in the fourth quarter of 1999.

  In connection with the acquisition, we entered into an employment agreement
and a stock vesting agreement with Mr. Beadle. Pursuant to the employment
agreement, we granted Mr. Beadle an option, vesting over a period of four
years, to purchase 250,000 shares of WatchGuard common stock at an exercise
price of $14.44 per share, the fair value of the stock on the date the option
was granted. In consideration of some of Mr. Beadle's obligations in the
employment agreement, including his agreement not to compete with WatchGuard
for a period of three years after his employment terminates, we also issued to
Mr. Beadle 51,948 unregistered shares of WatchGuard common stock, valued at
$750,000 on the closing date of the acquisition. We have recorded the value of
this stock as deferred stock compensation expense and are amortizing the value
of the deferred stock compensation on a straight-line basis over the two-year
employment agreement period. Amortization of this deferred stock compensation
was $73,000 in the fourth quarter of 1999. Under the stock vesting agreement,
34,632 of these shares will be subject to forfeiture if Mr. Beadle's employment
is terminated for cause or if he resigns. One half of these shares will no
longer be subject to forfeiture on October 19, 2000 and the remainder will no
longer be subject to forfeiture on October 19, 2001.

                                       35
<PAGE>

Results of Operations

  The following table provides financial data for the periods indicated as a
percentage of total revenues:

<TABLE>
<CAPTION>
                                                           Year Ended
                                                          December 31,
                                                        ---------------------
                                                        1997    1998    1999
                                                        -----   -----   -----
<S>                                                     <C>     <C>     <C>
Revenues:
 Product...............................................  97.6 %  93.8 %  84.0 %
 Service...............................................   2.4     6.2    16.0
                                                        -----   -----   -----
   Total revenues...................................... 100.0   100.0   100.0
Cost of revenues.......................................  31.6    34.5    38.6
                                                        -----   -----   -----
Gross margin...........................................  68.4    65.5    61.4
Operating expenses:
 Sales and marketing...................................  85.6    74.9    65.5
 Research and development..............................  43.0    39.0    34.5
 General and administrative............................  26.0    21.6    17.7
 Stock-based compensation..............................   --      9.1     4.5
 Acquired in-process technology and amortization of
  intangible assets acquired...........................   --      --     17.6
                                                        -----   -----   -----
   Total operating expenses............................ 154.6   144.6   139.8
                                                        -----   -----   -----
Operating loss......................................... (86.2)  (79.1)  (78.4)
Interest income (expense), net.........................   1.2    (1.0)    0.7
                                                        -----   -----   -----
Net loss............................................... (85.0)% (80.1)% (77.7)%
                                                        =====   =====   =====
</TABLE>

Years Ended December 31, 1998 and 1999

Total Revenues

  Total revenues, which consist of product revenues and service revenues,
increased from $11.4 million in 1998 to $20.6 million in 1999, an increase of
81%. During these periods, no one customer accounted for 10% or more of total
revenues. The increase in total revenues was primarily due to increases in
sales volume caused by increased distribution in the European, Asia/Pacific and
North American markets. Total international revenues represented approximately
35% of total revenues in 1998 and 50% in 1999.

  Product revenues include (1) the perpetual software license fees for our
security management system and the sale of our security appliance as part of
the LiveSecurity System and (2) the sale of our NOC, or network operations
center, security suite software license and our security appliance as part of
LiveSecurity for MSS. Product revenues increased from $10.7 million in 1998 to
$17.3 million in 1999, an increase of 62%. As a percentage of total revenues,
product revenues decreased from 94% in 1998 to 84% in 1999. We do not believe
that the historical percentage growth rates of product revenues will be
sustainable as our revenue base increases. Historically, we have generated the
majority of our revenues from our product sales, which, until the introduction
of LiveSecurity for MSS in late 1998, consisted primarily of the sale of our
LiveSecurity System for the enterprise. Product revenues from LiveSecurity for
MSS are growing and are expected to be a more significant component of our
revenues in the future.

  Service revenues include the annual fee for our LiveSecurity broadcast
service, which is sold as a part of the LiveSecurity System and LiveSecurity
for MSS. Service revenues increased from $701,000 in 1998 to $3.3 million in
1999, an increase of 369%. As a percentage of total revenues, service revenues
increased from 6% in 1998 to 16% in 1999.

  Revenues from our LiveSecurity for MSS have been increasing in amount during
each quarter since we introduced the product. Total revenues for the
LiveSecurity System increased from $10.4 million in 1998 to

                                       36
<PAGE>

$17.7 million in 1999, while total revenues from LiveSecurity for MSS increased
from $1.0 million in 1998 to $2.9 million in 1999. As a percentage of total
revenues, LiveSecurity for MSS revenues increased from 9% in 1998 to 14% in
1999. During the fourth quarter of 1999, LiveSecurity for MSS revenues reached
16% of total revenues. The increase in LiveSecurity for MSS revenues, both in
dollars and as a percentage of total revenues, is attributable to the growing
number of enterprises seeking security protection through their ISPs and an
increase in the number of ISPs with which we contract to offer the LiveSecurity
for MSS service.

  We established a returns and allowances reserve in 1998 to address the return
rights and pricing protection rights of some of our customers, primarily
related to anticipated returns originating from the introduction of a new
version of our security appliance, the Firebox II, during the last half of
1998. The provision for sales returns and allowances was $1.7 million, or 13%
of total revenues before returns and allowances, in 1998 and $1.1 million, or
5% of total revenues before returns and allowances, in 1999. Returns and
allowances before that time were immaterial. The provision in 1999 as compared
to 1998, as a percentage of total revenues, reflects a reduction in the
expected returns and pricing protection allowances based on actual results over
the last several quarters and no recent introduction of replacement products.

Cost of Revenues

  Cost of revenues consists of product and service costs, which include the
costs of manufacturing our security appliance, product packaging, third-party
product licensing fees and our technical support organization, including costs
associated with our LiveSecurity broadcast service. Historically, cost of
revenues has increased in total dollar amount and as a percentage of total
revenues in each year. Cost of revenues increased from $3.9 million in 1998 to
$8.0 million in 1999. As a percentage of total revenues, cost of revenues
increased from 35% in 1998 to 39% in 1999.

  The dollar increases in cost of revenues were primarily due to increases in
sales volume. The increase in cost of revenues as a percentage of total
revenues reflects an increase in the cost of manufacturing our Firebox II
security appliance and an increase in personnel-related costs of our service
organization, but is offset by the increased leverage of our service costs
relative to an increasing rate of service revenues. In the third quarter of
1998, we released an enhanced version of our security appliance, the Firebox
II, which incorporated additional features required to support our LiveSecurity
for MSS product. The Firebox II is more expensive to manufacture than the
previous version of our security appliance, which increased our cost of
revenues. Over time, as volume levels increase, we expect the unit cost to
manufacture the Firebox II to decrease. However, we cannot predict if or when
this reduction will occur.

  We expect service costs to increase in total dollar amount as our enterprise
customer base expands and our LiveSecurity for MSS product for ISPs is
deployed. Depending on our product and service mix, which may affect our
margins, we expect our gross margin to remain at or slightly below our fourth
quarter 1999 level for the short term. For the longer term, as revenues from
service subscriptions increase and become a greater percentage of total
revenues, we expect our gross margin to increase.

Operating Expenses

  Sales and Marketing. Sales and marketing expenses include salaries,
commissions and related expenses and some variable marketing expenses,
including public relations costs, marketing collateral and trade show expenses.
Overall sales and marketing expenses increased from $8.5 million in 1998 to
$13.5 million in 1999, an increase of 59%. As a percentage of total revenues,
sales and marketing expenses decreased from 75% in 1998 to 66% in 1999. The
dollar increase in sales and marketing expenses was primarily due to
recruiting, training and supporting our domestic and international resellers
and distributors and, to a lesser extent, to establishing brand recognition of
our products and services. Specifically, major components of the increase
included

  .  an increase in payroll and related expenses from $3.9 million to $6.6
     million;


                                       37
<PAGE>

  .  an increase in travel expenses from $1.4 million to $2.5 million; and

  .  an increase in marketing costs from $2.0 million to $3.4 million.

The sales and marketing expense in 1998 included a one-time charge of $470,000
for a common stock warrant issued to a customer.

  The decrease in sales and marketing expenses as a percentage of total
revenues reflects both increased productivity of and efficiencies in managing
our indirect channel network and realization of our previous investments to
expand distribution, capture market share and establish brand recognition of
our products. We expect to see a gradual reduction in sales and marketing
expenses as a percentage of total revenues.

  Research and Development. Research and development expenses consist of
salaries, computing equipment and software tools, nonrecurring costs associated
with our security appliance prototypes and payment of designers and
contractors. Research and development expenses increased from $4.4 million in
1998 to $7.1 million in 1999, an increase of 60%. As a percentage of total
revenues, research and development expenses decreased from 39% in 1998 to 35%
in 1999. The dollar increase in research and development expenses reflects the
growth of our research and development organization to expand and enhance our
enterprise product line, development and enhancement of our LiveSecurity for
MSS product and our efforts in researching and evaluating new and emerging
security threats through our LiveSecurity broadcast service. Specifically,
major components of the increase included

  .  an increase in payroll and related expenses from $2.5 million to $4.9
     million;

  .  an increase in contract labor and consulting services from $445,000 to
     $555,000; and

  .  an aggregate of $562,000 in costs incurred by our broadband Internet
     security division in connection with completion of our SOHO and
     telecommuter products originating from the acquisition of BeadleNet.

  We will continue to increase our research and development expenses in total
dollar amounts to enhance and expand our current product offerings, develop new
products and enhance our rapid response team and advisory council, which
analyze new security vulnerabilities and threats and provide continuing
education to our employees on Internet security. We expect that research and
development expenses will continue to increase in total dollar amounts but will
decrease as a percentage of total revenues.

  General and Administrative. General and administrative expenses include costs
of executive, human resource, finance and administrative support functions,
provision for uncollectable accounts and legal and accounting professional
services. General and administrative expenses increased from $2.5 million in
1998 to $3.6 million in 1999, an increase of 49%. As a percentage of total
revenues, general and administrative expenses decreased from 22% in 1998 to 18%
in 1999. The dollar increase in general and administrative expenses reflects
the expansion of our infrastructure to manage the growth of our operations.
Specifically, major components of the increase included

  .  an increase in payroll and related expenses from $786,000 to $1.4
     million; and

  .  an increase in professional fees from $218,000 to $672,000, related to
     legal and accounting costs incurred primarily in conjunction with the
     revision and implementation of our employee benefit plans and the
     expansion of our international operations.

  We expect that these expenses will continue to increase in total dollar
amounts but will decrease as a percentage of total revenues.

  Stock-Based Compensation. Deferred compensation is recorded for the
difference between the exercise price of options we granted and the deemed fair
value for financial reporting purposes of our common stock during the periods
in which the options were granted and for the value of common stock issued in
connection

                                       38
<PAGE>

with an employment agreement associated with the acquisition of BeadleNet. We
recorded $912,000 of deferred compensation in 1999, which included $750,000
related to the same employment agreement, and $2.5 million of deferred
compensation in 1998, which included $628,000 in stock-based compensation
related to options exchanged for services from a former employee. Deferred
compensation is amortized over the vesting periods of the options. Amortization
of deferred compensation, or stock-based compensation, expenses were
$1.0 million in 1998 and $926,000 in 1999. The allocation of the stock-based
compensation expense associated with the functional operating expense
categories of sales and marketing, research and development and general and
administrative was $148,000, $829,000 and $62,000, respectively, for 1998 and
$307,000, $491,000 and $128,000, respectively, for 1999.

Interest Income (Expense)

  Interest expense of $203,000 in 1998 resulted from borrowings on our bank
line of credit and our equipment term loan, and was offset by $84,000 of
interest income generated from our investment of proceeds from the sale of
preferred stock. Interest expense of $485,000 in 1999 resulted from borrowings
on our bank line of credit, our equipment term loan and our convertible note
agreements, and was offset by $640,000 of interest income generated from our
investment of proceeds from the sale of preferred stock in private transactions
and the sale of common stock in our initial public offering.

Income Taxes

  We have experienced losses since inception, resulting in a net operating loss
carryforward position of approximately $24.0 million as of December 31, 1999.
These carryforwards, if not utilized, will begin to expire in 2011, and may be
subject to limitations under Section 382 of the Internal Revenue Code.

Years Ended December 31, 1997 and 1998

Total Revenues

  Total revenues increased from $5.1 million in 1997 to $11.4 million in 1998,
an increase of 123%. During these periods, no one customer accounted for 10% or
more of total revenues. Product revenues increased from $5.0 million in 1997 to
$10.7 million in 1998, an increase of 115%. As a percentage of total revenues,
product revenues decreased from 98% in 1997 to 94% in 1998. Service revenues
increased from $123,000 in 1997 to $701,000 in 1998. As a percentage of total
revenues, service revenues increased from 2% in 1997 to 6% in 1998.

  The increase in total revenues was primarily due to increases in sales volume
caused by increased distribution in the European and Asia/Pacific markets and
increased market awareness of our products in North America. Total
international revenues represented 56% of total revenues in 1997 and 35% in
1998.

  The establishment of reserves for sales returns and allowances negatively
impacted our revenues for 1998. The provision for sales returns and allowances
in 1998 was $1.7 million, or approximately 13% of total revenues before giving
effect to the provision. The returns and allowances reserve was established in
1998 primarily to address return rights and price protection rights for some of
our customers, including anticipated returns originating from the introduction
of the Firebox II. Before 1998, we did not experience any material returns and
therefore provided no reserve.

Cost of Revenues

  Cost of revenues increased from $1.6 million in 1997 to $3.9 million in 1998.
As a percentage of total revenues, cost of revenues increased from 32% in 1997
to 35% in 1998. The dollar increases in cost of revenues were primarily due to
increases in sales volume. The increase in cost of revenues as a percentage of
total revenues was primarily due to an increase in the cost of manufacturing
our security appliance. As

                                       39
<PAGE>

discussed above, the Firebox II, which we released in the third quarter of
1998, is more expensive to manufacture than the previous version of our
security appliance.

Operating Expenses

  Sales and Marketing. Sales and marketing expenses increased from $4.4 million
in 1997 to $8.5 million in 1998. As a percentage of total revenues, sales and
marketing expenses decreased from 86% in 1997 to 75% in 1998.

  The dollar increase in sales and marketing expenses was primarily due to
recruiting, training and supporting our domestic and international resellers
and distributors and, to a lesser extent, to establishing brand recognition of
our products and services. Specifically, components of the increase from 1997
to 1998 included

  .  an increase in payroll and related expenses from $2.0 million to $3.9
     million;

  .  an increase in travel expenses from $771,000 to $1.4 million;

  .  an increase in marketing costs from $1.1 million to $2.0 million; and

  .  a $470,000 charge for a common stock warrant in 1998 issued to a
     customer.

  The decrease in 1998 sales and marketing expenses as a percentage of total
revenues reflects increased productivity of and efficiencies in managing our
indirect channel network and our utilization of our prior years' investment to
expand distribution, capture market share and establish brand recognition of
our products.

  Research and Development. Research and development expenses increased from
$2.2 million in 1997 to $4.4 million in 1998. As a percentage of total
revenues, research and development expenses decreased from 43% in 1997 to 39%
in 1998.

  The dollar increase in research and development expenses reflects the growth
of our research and development organization to expand our enterprise product
line, development of our LiveSecurity for MSS product and our efforts to
respond to new and emerging security threats through our LiveSecurity broadcast
service. Specifically, components of the increase from 1997 to 1998 included an
increase in payroll and related expenses from $1.5 million to $2.5 million.

  General and Administrative. General and administrative expenses increased
from $1.3 million in 1997 to $2.5 million in 1998. As a percentage of total
revenues, general and administrative expenses decreased from 26% in 1997 to 22%
in 1998.

  The dollar increases in general and administrative expenses primarily reflect
the increase in personnel and related expenses and other overhead items in
connection with the expansion of our business. Specifically, components of the
increase from 1997 to 1998 included

  .  an increase in payroll and related expenses from $516,000 to $786,000;

  .  an increase in the provision for uncollectable amounts from $122,000 to
     $418,000, reflecting additional exposure related to the overall growth
     of our operations; and

  .  an increase in professional fees from $150,000 to $218,000.

  The decrease in expenses as a percentage of total revenues from 1996 to 1998
reflects increased efficiencies of scale resulting from a larger revenue base.

  Stock-Based Compensation. Amortization of deferred compensation totaled $1.0
million for 1998. The allocation of the stock-based compensation expense
associated with the functional operating expense categories of sales and
marketing, research and development and general and administrative was
$148,000, $829,000 and $62,000, respectively.

                                       40
<PAGE>

Interest Income (Expense)

  Interest income of $88,000 in 1997 was generated from our investment of
proceeds from the sale of preferred stock, and was partially offset by $26,000
of interest expense that resulted from borrowings. Interest expense of $203,000
in 1998 resulted from borrowings on our bank line of credit and equipment term
loan, and was partially offset by $84,000 of interest income generated from our
investment of proceeds from the sale of preferred stock.

Quarterly Results of Operations

  The following tables provide our unaudited results of operations both in
dollar amounts and expressed as a percentage of total revenues for each quarter
in the six-quarter period ended December 31, 1999. In our opinion, this
unaudited information has been prepared on the same basis as our audited
financial statements. This information includes all adjustments, consisting
only of normal recurring adjustments, necessary for a fair presentation of the
information for the quarters presented, when read in conjunction with our
financial statements and the notes to the financial statements. The results of
operations for any quarter are not necessarily indicative of our future
results.

<TABLE>
<CAPTION>
                                          Three Months Ended
                         ----------------------------------------------------------
                          Sept.    Dec. 31,  Mar. 31,  June 30,   Sept.    Dec. 31,
                         30, 1998    1998      1999      1999    30, 1999    1999
                         --------  --------  --------  --------  --------  --------
                                            (In thousands)
<S>                      <C>       <C>       <C>       <C>       <C>       <C>
Statement of Operations
 Data:
Revenues, net:
  Product............... $  2,544  $  3,274  $  3,387  $  3,831  $  4,614  $ 5,497
  Service...............      205       339       551       806       907    1,026
                         --------  --------  --------  --------  --------  -------
    Total revenues......    2,749     3,613     3,938     4,637     5,521    6,523
Cost of revenues........    1,038     1,396     1,635     1,846     2,085    2,398
                         --------  --------  --------  --------  --------  -------
Gross margin............    1,711     2,217     2,303     2,791     3,436    4,125
Operating expenses:
  Sales and marketing...    2,258     2,447     2,841     3,242     3,612    3,817
  Research and
   development..........    1,233     1,430     1,426     1,614     1,700    2,378
  General and
   administrative.......      622       864       912       862       842    1,030
  Stock-based
   compensation.........      312       587       253       258       186      229
  Acquired in-process
   technology and
   amortization of
   intangible assets
   acquired.............      --        --        --        --        --     3,626
                         --------  --------  --------  --------  --------  -------
    Total operating
     expenses...........    4,425     5,328     5,432     5,976     6,340   11,080
                         --------  --------  --------  --------  --------  -------
Operating loss..........   (2,714)   (3,111)   (3,129)   (3,185)   (2,904)  (6,955)
Interest income
 (expense), net.........       24       (60)      (84)     (263)      118      384
                         --------  --------  --------  --------  --------  -------
Net loss................ $ (2,690) $ (3,171) $ (3,213) $ (3,448) $ (2,786) $(6,571)
                         ========  ========  ========  ========  ========  =======
</TABLE>

                                       41
<PAGE>

<TABLE>
<CAPTION>
                                           Three Months Ended
                         ----------------------------------------------------------
                         Sept. 30, Dec. 31,  Mar. 31,  June 30,  Sept. 30, Dec. 31,
                           1998      1998      1999      1999      1999      1999
                         --------- --------  --------  --------  --------- --------
<S>                      <C>       <C>       <C>       <C>       <C>       <C>
Statement of Operations
 Data:
Revenues, net:
  Product...............    92.5 %   90.6 %    86.0 %    82.6 %     83.6 %    84.3 %
  Service...............     7.5      9.4      14.0      17.4       16.4      15.7
                           -----    -----     -----     -----      -----    ------
    Total revenues......   100.0    100.0     100.0     100.0      100.0     100.0
Cost of revenues........    37.8     38.6      41.5      39.8       37.8      36.8
                           -----    -----     -----     -----      -----    ------
Gross margin............    62.2     61.4      58.5      60.2       62.2      63.2
Operating expenses:
  Sales and marketing...    82.1     67.7      72.1      69.9       65.4      58.5
  Research and
   development..........    44.9     39.6      36.2      34.8       30.8      36.4
  General and
   administrative.......    22.6     23.9      23.1      18.6       15.3      15.8
  Stock-based
   compensation.........    11.3     16.2       6.4       5.5        3.4       3.5
  Acquired in-process
   technology and
   amortization of
   intangible assets
   acquired.............     --       --        --        --         --       55.6
                           -----    -----     -----     -----      -----    ------
    Total operating
     expenses...........   161.0    147.5     137.9     128.9      114.8     169.8
                           -----    -----     -----     -----      -----    ------
Operating loss..........   (98.8)   (86.1)    (79.5)    (68.7)     (52.6)   (106.6)
Interest income
 (expense), net.........     0.9     (1.7)     (2.1)     (5.7)       2.1       5.9
                           -----    -----     -----     -----      -----    ------
Net loss................   (97.9)%  (87.8)%   (81.6)%   (74.3)%    (50.5)%  (100.7)%
                           =====    =====     =====     =====      =====    ======
</TABLE>

Liquidity and Capital Resources

  Since our inception, we have financed our operations primarily through
private placements of convertible preferred stock, and most recently through
the sale of common stock in our initial public offering. To date, net proceeds
from private placements of preferred stock and our initial public offering
totaled $54.0 million. We have also financed our operations through equipment
financing, traditional accounts receivable financing arrangements, bridge
financing arrangements and convertible notes.

  We have a working-capital revolving line of credit with a bank, secured by
our accounts receivable. The amount available under this facility is limited to
the greater of our borrowing base or $4.5 million. For purposes of this loan,
the borrowing base means the sum of 75% of the net amount of our eligible
domestic accounts receivable and 50% of the net amount of our eligible foreign
accounts receivable. As of December 31, 1999, we had no borrowings on this line
of credit, which expires in November 2000 and bears interest at prime plus 2%
per year. At December 31, 1999, our borrowing base was $2.1 million. We are
currently renegotiating this line of credit.

  We also have two term-loan facilities with the same bank to finance new
capital equipment purchases. The first facility closed to further advances on
March 5, 1998 and is being repaid in 36 equal monthly payments beginning April
5, 1998. The loan, which bears interest at prime plus 1.5% per year, matures on
March 5, 2001, at which time all unpaid principal and interest will be due and
payable. The second facility closed to further advances on December 31, 1998
and is being repaid in 36 equal monthly payments beginning January 1999. The
loan, which bears interest at prime plus 1% per year, matures on December 31,
2002, at which time all unpaid principal and interest will be due and payable.
As of December 31, 1999, we had a combined principal balance of $383,000 due
under these term loans.

  The agreements under which the line of credit and term loans were established
contain financial covenants, including a provision requiring us to maintain
specified financial ratios. At December 31, 1999, we were not in compliance
with one of the financial covenants, but we obtained a waiver for
noncompliance.

  As of December 31, 1999, we had $26.4 million in cash, cash equivalents and
short-term investments, invested primarily in high-quality money market
accounts and marketable securities. We believe that the

                                       42
<PAGE>

market risk arising from our holdings of these financial instruments is not
material. Our working capital as of December 31, 1999 was $24.4 million.

Operating Activities

  Our operating activities resulted in net cash outflows of $7.6 million in
1998 and $7.9 million in 1999. The operating cash outflows in 1998 and 1999
resulted primarily from significant investments in sales and marketing and
research and development, all of which led to operating losses. Cash used in
operating activities was net of noncash charges totaling $3.9 million in 1998
and $6.6 million in 1999. These noncash charges were primarily associated with
depreciation and amortization of capital assets, provisions for bad debts and
sales returns and allowances, compensation charges resulting from the issuance
of stock options and warrants and a one-time charge for in-process research and
development associated with the acquisition of BeadleNet. Cash used in
operating activities from working capital components impacting operating
activities was $2.4 million in 1998, and cash provided from working capital
components for operating activities was $1.5 in 1999. In 1999, there were large
fluctuations within some major working capital components, as described below.

  Receivables. Our receivables increased from $3.5 million at December 31, 1998
to $3.8 million at December 31, 1999, while revenues increased from $3.6
million in the three months ended December 31, 1998 to $6.5 million in the
three months ended December 31, 1999. We implemented enhanced credit and
collection processes during 1999 that contributed to improved collection
periods. Days sales outstanding, or DSO, were 86 days for the quarter ended
December 31, 1998 compared to 52 days for the quarter ended December 31, 1999.
Based upon sales mix, timing differences arising from varying payment cycles
and terms in our customer agreements, we expect our DSO to generally range from
50 days to 70 days. Reserves for uncollectable accounts were $449,000 at
December 31, 1998 and $177,000 at December 31, 1999. The decrease reflects
reduced exposure attributed to our improved credit and collection processes
referred to above. Our returns and allowance reserve was $615,000 at December
31, 1998 and $550,000 at December 31, 1999, and reflects our estimate of
returns and allowances associated with the return rights and price protection
rights of some of our customers. The reserve may fluctuate from time to time
depending upon the timing of product introductions and pricing program changes.

  Deferred revenue. Deferred revenue increased from $1.8 million at December
31, 1998 to $4.2 million at December 31, 1999, an increase of 130%. The
increase reflects service subscriptions and annual client licenses associated
with the continued growth of product sales and, to a lesser extent, with
service subscription renewals. Deferred revenue from service subscriptions and
annual client licenses is generally amortized ratably over a one-year period.

Investing Activities

  Cash used in investing activities totaled $1.0 million in 1998 and $30.1
million in 1999, and reflects capital expenditures for computing equipment and
furniture, payments made in connection with the acquisition of BeadleNet and
investment in marketable securities of the net proceeds from our initial public
offering.

Financing Activities

  Cash provided by financing activities totaled $9.7 million in 1998 and $38.2
million in 1999. These activities primarily reflect proceeds from the sale of
preferred stock in 1998, borrowings on our line of credit during 1998 and 1999
and proceeds from our initial public offering in 1999, offset to some extent by
borrowing and repayments under our bank line of credit and various bridge
financing arrangements.

  We believe that existing cash and cash equivalents balances and our lines of
credit, excluding the potential net proceeds from our proposed public offering
in the first quarter of 2000, will be sufficient to meet our anticipated cash
needs for working capital and capital expenditures for at least the next 12
months. The underlying assumed levels of revenues and expenses may prove to be
inaccurate, however, and we may need to seek additional funding through public
or private financings or other arrangements before that time.

                                       43
<PAGE>

Year 2000 Compliance

  We believe that we have successfully rendered our products, internal
management and other administrative systems and external information systems
year 2000 compliant. In addition, we have surveyed the vendors of the third-
party technologies we incorporate into our products and services and applied
updates or arrangements to correct potential year 2000 compliance problems.
Since January 1, 2000, we have experienced no disruptions in our business
operations as a result of year 2000 compliance problems or otherwise, and we
have received no reports of any year 2000 compliance problems with our products
and services. We are continuing to monitor third-party vendors of incorporated
technologies for additional recommended year 2000 upgrades, which we will apply
as soon as they become available. To date, the total cost of our efforts to
address year 2000 compliance has not been material.

  Nonetheless, some problems related to year 2000 risks may not appear until
several months after January 1, 2000. Year 2000 issues could include problems
with our own products and services or with third-party products or technology
that we use or with which our products exchange data. Any problems that are not
identified and corrected successfully and completely could adversely affect our
business. We expect that the cost to fix any year 2000 problems that may be
identified, however, will involve internal labor-hours and will not be
material.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

  Interest Rate Risk. We do not hold derivative financial instruments or
derivative equity securities in our investment portfolio. Our cash equivalents
consist of high-quality securities, as specified in our investment policy
guidelines. Our policy limits the amount of credit exposure to any one issue or
issuer to a maximum of 20% of the total portfolio or $5 million per issuer,
with the exception of treasury securities and money market funds, which are
exempt from this size limitation. Our policy limits all investments to those
that mature in two years or less, with the average maturity of our investments
equal to one year or less. The securities are subject to interest-rate risk and
will decrease in value if interest rates increase. Due to the short-term nature
of our investments and our investment policies and procedures, however, we
believe that the risk associated with interest-rate fluctuations related to
these securities does not pose a material risk to WatchGuard.

  Foreign Currency Risk. All of our sales and the majority of our expenses are
currently denominated in U.S. dollars. As a result, we have not experienced
significant foreign exchange gains and losses. While we conducted some
transactions in foreign currencies during 1999 and expect to continue to do so
in the future, we do not anticipate that foreign exchange gains or losses will
be material to WatchGuard. Although we have not engaged in foreign currency
hedging to date, we may do so in the future.

                                       44
<PAGE>

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

Board of Directors and Stockholders
WatchGuard Technologies, Inc.

  We have audited the accompanying balance sheets of WatchGuard Technologies,
Inc. as of December 31, 1998 and 1999 and the related statements of operations,
stockholders' equity, and cash flows for each of the three years in the period
ended December 31, 1999. Our audits also included the financial statement
schedule listed in the Index at Item 14(a). These financial statements and
schedule are the responsibility of WatchGuard's management. Our responsibility
is to express an opinion on these financial statements and schedule based on
our audits.

  We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

  In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of WatchGuard Technologies, Inc.
at December 31, 1998 and 1999, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 1999, in
conformity with accounting principles generally accepted in the United States.
Also, in our opinion, the related financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.

                                                    ERNST & YOUNG LLP

Seattle, Washington
February 4, 2000

                                       45
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                                 BALANCE SHEETS
                       (In thousands, except share data)

<TABLE>
<CAPTION>
                                                               December 31,
                                                             -----------------
                                                               1998     1999
                                                             --------  -------
ASSETS
<S>                                                          <C>       <C>
Current assets:
  Cash and cash equivalents................................. $  1,712  $ 1,903
  Securities available for sale.............................      --    24,498
  Trade accounts receivable, net............................    3,458    3,772
  Inventories...............................................    2,156    2,013
  Prepaid expenses and other receivables....................      483    1,275
                                                             --------  -------
Total current assets........................................    7,809   33,461
Equipment and furniture, net................................    1,140    1,927
Goodwill....................................................      --     4,830
Other intangibles and other assets..........................       83    1,093
                                                             --------  -------
Total assets................................................ $  9,032  $41,311
                                                             ========  =======

<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
<S>                                                          <C>       <C>
Current liabilities:
  Line of credit............................................ $  2,500  $   --
  Accounts payable..........................................    2,185    2,088
  Accrued expenses..........................................    1,016    2,362
  Deferred revenue..........................................    1,841    4,233
  Equipment term loan.......................................      609      383
                                                             --------  -------
Total current liabilities...................................    8,151    9,066
Commitments
Stockholders' equity:
  Preferred stock, $0.001 par value:
    Authorized shares: 10,000,000
    Shares issued and outstanding: 6,712,658 at December 31,
     1998 and 0 at December 31, 1999........................        6      --
  Common stock, $0.001 par value:
    Authorized shares: 80,000,000
    Shares issued and outstanding: 1,362,744 at December 31,
     1998 and 19,511,752 at December 31, 1999...............        1       19
  Additional paid-in capital................................   16,261   63,694
  Stock-based compensation..................................   (1,466)  (1,452)
  Accumulated other comprehensive loss......................      --       (77)
  Accumulated deficit.......................................  (13,921) (29,939)
                                                             --------  -------
    Total stockholders' equity..............................      881   32,245
                                                             --------  -------
    Total liabilities and stockholders' equity.............. $  9,032  $41,311
                                                             ========  =======
</TABLE>

                            See accompanying notes.

                                       46
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                            STATEMENTS OF OPERATIONS
                     (In thousands, except per share data)

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                                  ----------------------------
                                                    1997      1998      1999
                                                  --------  --------  --------
<S>                                               <C>       <C>       <C>
Revenues:
  Product........................................ $  4,975  $ 10,678  $ 17,329
  Service........................................      123       701     3,290
                                                  --------  --------  --------
    Total revenues...............................    5,098    11,379    20,619
Cost of revenues.................................    1,610     3,925     7,964
                                                  --------  --------  --------
Gross margin.....................................    3,488     7,454    12,655
Operating expenses:
  Sales and marketing............................    4,369     8,519    13,512
  Research and development.......................    2,192     4,442     7,118
  General and administrative.....................    1,323     2,454     3,646
  Stock-based compensation.......................      --      1,039       926
  Acquired in-process technology and amortization
   of intangible assets acquired.................      --        --      3,626
                                                  --------  --------  --------
    Total operating expenses.....................    7,884    16,454    28,828
                                                  --------  --------  --------
Operating loss...................................   (4,396)   (9,000)  (16,173)
Interest income..................................       88        84       640
Interest expense.................................      (26)     (203)     (485)
                                                  --------  --------  --------
Net loss......................................... $ (4,334) $ (9,119) $(16,018)
                                                  ========  ========  ========
Basic and diluted net loss per share............. $ (17.17) $ (11.34) $  (1.80)
                                                  ========  ========  ========
Shares used in calculation of basic and diluted
 net loss per share..............................      252       804     8,903
                                                  ========  ========  ========
</TABLE>


                            See accompanying notes.

                                       47
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                      STATEMENTS OF STOCKHOLDERS' EQUITY
                       (In thousands, except share data)

<TABLE>
<CAPTION>
                                                                                    Accumulated
                      Preferred Stock      Common Stock    Additional                  Other                     Total
                     ------------------  -----------------  Paid-in   Stock-Based  Comprehensive Accumulated Stockholders'
                       Shares    Amount    Shares   Amount  Capital   Compensation     Loss        Deficit      Equity
                     ----------  ------  ---------- ------ ---------- ------------ ------------- ----------- -------------
<S>                  <C>         <C>     <C>        <C>    <C>        <C>          <C>           <C>         <C>
Balance, January 1,
 1997..............   3,000,004  $   3          --  $ --    $    147    $    --        $ --       $    (468)   $   (318)
 Sale of Series B
  preferred stock,
  net of issuance
  costs of $21.....   2,316,666      2          --    --       5,977         --          --             --        5,979
 Issuance of
  common stock in
  settlement of
  royalty
  payments.........         --     --       400,000   --          52         --          --             --           52
 Exercise of
  common stock
  options and
  warrants.........         --     --       132,916   --           3         --          --             --            3
 Net loss..........         --     --           --    --         --          --          --          (4,334)     (4,334)
                     ----------  -----   ---------- -----   --------    --------       -----      ---------    --------
Balance, December
 31, 1997..........   5,316,670      5      532,916   --       6,179         --          --          (4,802)      1,382
 Sales of Series B
  preferred
  stock............      38,610    --           --    --         100         --          --             --          100
 Sales of Series C
  preferred stock,
  net of issuance
  costs of $25.....   1,357,378      1          --    --       6,974         --          --             --        6,975
 Issuance of stock
  warrant to a
  customer.........         --     --           --    --         470         --          --             --          470
 Stock-based
  compensation.....         --     --           --    --       2,505      (2,505)        --             --          --
 Amortization of
  stock-based
  compensation.....         --     --           --    --         --        1,039         --             --        1,039
 Exercise of
  common stock
  options and
  warrants.........         --     --       829,828     1         33         --          --             --           34
 Net loss..........         --     --           --    --         --          --          --          (9,119)     (9,119)
                     ----------  -----   ---------- -----   --------    --------       -----      ---------    --------
Balance, December
 31, 1998..........   6,712,658      6    1,362,744     1     16,261      (1,466)        --         (13,921)        881
 Proceeds from
  issuance of
  common stock
  from initial
  public offering,
  net of offering
  costs............         --     --     3,500,000     3     40,666         --          --             --       40,669
 Conversion of
  preferred stock
  into common
  stock............  (6,712,658)    (6)  13,425,316    13         (7)        --          --             --          --
 Stock-based
  compensation.....         --     --           --    --         162        (162)        --             --          --
 Issuance of
  common stock to
  an employee......         --     --        51,948   --         750        (750)        --             --          --
 Amortization of
  stock-based
  compensation.....         --     --           --    --         --          926         --             --          926
 Issuance of
  common stock in
  connection with
  acquisition......         --     --       335,931   --       5,450         --          --             --        5,450
 Issuance of stock
  warrants.........         --     --           --    --         195         --          --             --          195
 Exercise of
  common stock
  options and
  warrants.........         --     --       835,813     2        217         --          --             --          219
 Comprehensive
  loss:
   Net unrealized
    loss on
    securities
    available for
    sale...........         --     --           --    --         --          --          (77)           --          (77)
   Net loss........         --     --           --    --         --          --          --         (16,018)    (16,018)
                                                                                                               --------
   Comprehensive
    loss...........                                                                                             (16,095)
                     ----------  -----   ---------- -----   --------    --------       -----      ---------    --------
Balance, December
 31, 1999 .........         --   $ --    19,511,752 $  19   $ 63,694    $ (1,452)      $ (77)     $ (29,939)   $ 32,245
                     ==========  =====   ========== =====   ========    ========       =====      =========    ========
</TABLE>

                            See accompanying notes.

                                       48
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                            STATEMENTS OF CASH FLOWS
                                 (In thousands)

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                                  ----------------------------
                                                    1997      1998      1999
                                                  --------  --------  --------
<S>                                               <C>       <C>       <C>
Operating activities:
Net loss........................................  $ (4,334) $ (9,119) $(16,018)
Adjustments to reconcile net loss to net cash
 used in operating activities:
  Depreciation..................................       207       235       602
  Amortization of intangible assets.............        52        86       259
  Amortization of stock-based compensation......       --      1,039       926
  Loss on disposal of equipment.................       --        --         57
  Warrant issued in exchange for services.......       --        470       --
  Acquired in-process research and development..       --        --      3,381
  Provision for sales returns and allowances....       --      1,655     1,083
  Provision for bad debt expense................       122       418       129
  Noncash interest expense......................       --        --        195
  Changes in operating assets and liabilities:
   (Increase) in accounts receivable............    (1,551)   (3,968)   (1,526)
   (Increase) decrease in inventories...........      (214)   (1,938)      148
   (Increase) in prepaid expenses and other.....      (113)     (288)     (792)
   (Increase) decrease in other assets..........      (325)      183        12
   Increase in accounts payable and accrued
    expenses....................................       868     2,093     1,249
   Increase (decrease) in deferred revenue......       (22)    1,528     2,392
                                                  --------  --------  --------
Net cash used in operating activities...........    (5,310)   (7,606)   (7,903)

Investing activities:
Purchases of equipment and furniture............      (391)   (1,003)   (1,387)
Purchase of intangible assets...................       (70)      --        --
Proceeds from sale of marketable securities.....       --        --      1,000
Purchases of marketable securities..............       --        --    (25,575)
Net cash paid in connection with BeadleNet
 acquisition....................................       --        --     (4,106)
                                                  --------  --------  --------
Net cash used in investing activities...........      (461)   (1,003)  (30,068)

Financing activities:
Borrowings on line of credit, long-term debt and
 notes payable..................................       700     2,663     7,280
Issuance of warrants............................       --        --        195
Principal repayments on line of credit, long-
 term debt and notes payable....................      (540)      (54)  (10,201)
Proceeds from sale of preferred stock...........     5,979     7,075       --
Proceeds from sale of common stock, net of
 expenses.......................................       --        --     40,669
Proceeds from exercise of common stock options
 and warrants...................................         3        34       219
                                                  --------  --------  --------
Net cash provided by financing activities.......     6,142     9,718    38,162
                                                  --------  --------  --------
Net increase in cash and cash equivalents.......       371     1,109       191
Cash and cash equivalents at beginning of period
 ...............................................       232       603     1,712
                                                  --------  --------  --------
Cash and cash equivalents at end of period......  $    603  $  1,712     1,903
                                                  ========  ========  ========
Supplemental disclosure of cash flow
 information:
Cash paid for interest..........................  $     21  $    179  $    508
                                                  ========  ========  ========
</TABLE>

                            See accompanying notes.

                                       49
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                         NOTES TO FINANCIAL STATEMENTS

1. Accounting Policies

Description of Business

  WatchGuard Technologies, Inc. is a provider of Internet security solutions
designed to protect enterprises or telecommuters using the Internet for
electronic commerce and communications.

Revenue Recognition

  Statement of Position (SOP) 97-2, "Software Revenue Recognition," was issued
in October 1997 by the American Institute of Certified Public Accountants
(AICPA) and was amended by SOP 98-4. In December 1998, the AICPA issued SOP 98-
9, which amends SOP 97-2 and 98-4 and is effective for transactions entered
into after March 15, 1999. WatchGuard adopted SOP 97-2, as amended by SOP 98-9,
effective January 1, 1998. Based upon its interpretation of SOP 97-2 and SOP
98-9, WatchGuard believes its current revenue recognition policies and
practices are consistent with the SOPs.

  WatchGuard generates revenues through sales of its Firebox products,
including related software licenses, and subscriptions for its LiveSecurity
broadcast service, which includes threat responses, information alerts,
software updates and maintenance. Software license revenues are generated from
licensing the rights to use WatchGuard's products directly to end-users, from
sublicense fees from resellers, distributors and, beginning in late 1998, from
sales of its products to Internet service providers (ISPs), which utilize the
product to provide managed security services to the ISPs' customers. Revenues
from LiveSecurity subscriptions are recognized ratably over the term of the
contract, typically one year.

  Revenues from software license agreements are generally recognized upon
delivery of software if persuasive evidence of an arrangement exists,
collection is probable and the fee is fixed or determinable, and vender-
specific objective evidence exists to allocate the total fee to elements of the
arrangement. Payment terms do not extend beyond a year. A limited number of
WatchGuard's distributors have the right to delay payment until the product is
sold to the end-user. Revenues from these arrangements are not recognized until
sale to the end-user occurs. WatchGuard provides unspecified upgrades on a when
and if available basis. These upgrades are considered post-contract customer
support (PCS) and are recognized as revenues ratably over the terms of the PCS
arrangement. Vendor-specific objective evidence is typically based on the price
charged when an element is sold separately or, in the case of an element not
sold separately, on the price established by authorized management, if it is
probable that the price, once established, will not change before market
introduction. WatchGuard uses the residual method, as defined in SOP 98-9, to
allocate revenue to delivered elements once it has established vendor-specific
objective evidence for all undelivered elements. Under the residual method, any
discount in the arrangement is allocated to the delivered element. WatchGuard
provides for return rights and pricing protection rights for some of its
customers. The return rights included in these customer agreements are
generally limited to a percentage of purchases by these customers for the
previous quarter. The pricing protection rights in these agreements are
generally limited to 60 to 90 days after notification of a price change.
Revenues are reduced by the provision for estimated returns and allowance at
the time the sale is made. The reserves are reviewed and revised as needed.

Fair Values of Financial Instruments

  At December 31, 1999, WatchGuard had the following financial instruments:
cash and cash equivalents, accounts receivable, accounts payable, accrued
liabilities and equipment loans. The carrying value of cash and cash
equivalents, accounts receivable, accounts payable and accrued liabilities
approximates their fair value based on the liquidity of these financial
instruments or based on their short-term nature. The carrying value of debt
approximates fair value based on the market interest rates available to
WatchGuard for debt of similar risk and maturities.

                                       50
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)



Cash Equivalents

  WatchGuard considers all highly liquid investments purchased with an initial
maturity of three months or less to be cash equivalents. Cash equivalents are
carried at fair market value.

Securities Available for Sale

  WatchGuard's investments are classified as available for sale, and are stated
at fair value on the balance sheet with the unrealized gains and losses
included as a component of stockholders' equity. Interest earned on securities
is included in interest income. The amortized cost of investments is adjusted
for amortization of premiums and accretion of discounts to maturity. These
amortization and accretions are included in interest income. The cost of
securities sold is calculated using the specific identification method.
WatchGuard's investment guidelines state that the maximum life of any one
security shall be two years, with the maximum weighted average life of the
investment portfolio being one year.

Inventories

  Inventories are stated at the lower of cost (first-in, first-out basis) or
market. WatchGuard outsources all of its hardware manufacturing and assembly to
one manufacturer and one assembler. The inability of the manufacturer and
assembler to supply product in a timely manner and on terms acceptable to
WatchGuard could severely affect WatchGuard's ability to meet customers'
demands.

Equipment and Furniture

  Equipment and furniture is stated at cost, less accumulated depreciation.
Equipment and furniture is depreciated using the straight-line method over
estimated useful lives ranging from three to five years.

Goodwill and Other Intangibles

  Goodwill and other intangibles represent the excess of the purchase price
over the fair value of net tangible assets acquired. Goodwill and other
intangibles are being amortized on a straight-line basis over lives ranging
from two to five years.

Long-Lived Assets

  In accordance with Financial Accounting Standards Board (FASB) Statement of
Financial Accounting Standard (SFAS) No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed of," the carrying
value of intangible assets and other long-lived assets is reviewed on a regular
basis for the existence of facts or circumstances, both internal and external,
that may suggest impairment. To date, no such impairment has been indicated.
Should there be an impairment in the future, WatchGuard will measure the amount
of the impairment based on undiscounted expected future cash flows from the
impaired assets. The cash flow estimates that will be used will contain
management's best estimates, using assumptions and projections appropriate and
customary at the time.

Research and Development

  Research and development costs are expensed as incurred and consist primarily
of software development costs. Financial accounting standards require the
capitalization of certain software development costs after technological
feasibility of the software is established. In the development of WatchGuard's
new products and enhancements to existing products, the technological
feasibility of the software is not established until

                                       51
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)


substantially all product development is complete, including the development of
a working model. Internal software development costs that were eligible for
capitalization were insignificant and were charged to research and development
expense in the accompanying statements of operations.

Net Loss per Share

  Basic and diluted net loss per share is calculated using the average number
of shares of common stock outstanding. Other common stock equivalents,
including preferred stock, stock options and warrants, are excluded from the
computation as their effect is antidilutive.

Advertising Costs

  WatchGuard expenses advertising costs as incurred. Total expenses were
$199,500, $60,000 and $234,000 in 1997, 1998 and 1999, respectively.

Concentration of Credit Risk

  WatchGuard is subject to concentrations of credit risk primarily from cash
investments and accounts receivable. WatchGuard's credit risk is managed by
investing its excess cash in high-quality money market instruments and
securities available for sale. In addition, substantially all of WatchGuard's
accounts receivable are due from WatchGuard's resellers, distributors and ISPs
located throughout the world. International sales were $2.8 million, $4.0
million and $10.3 million, or 56%, 35% and 50% of total revenues for 1997, 1998
and 1999, respectively. No single customer or foreign country accounted for
more than 10% of revenues in the periods presented, except that in 1997
revenues from one customer in Japan accounted for 17% of total revenues.
Foreign geographic regions accounting for 10% or more of revenues were Europe,
with 22%, 18% and 26% of total revenues, and Asia, with 24%, 10% and 16% of
total revenues, for 1997, 1998 and 1999, respectively.

Stock Compensation

  WatchGuard has elected to apply the disclosure-only provisions of SFAS No.
123, "Accounting for Stock-Based Compensation." Accordingly, WatchGuard
accounts for stock-based compensation using the intrinsic value method
prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations. Compensation cost for stock
options is measured as the excess, if any, of the fair value of WatchGuard's
common stock at the date of grant over the stock option exercise price.

Income Taxes

  WatchGuard recognizes deferred tax assets and liabilities based on
differences between the financial reporting and tax bases of assets and
liabilities using the enacted tax rates and laws that are expected to be in
effect when the differences are expected to be recovered. WatchGuard provides a
valuation allowance for deferred tax assets that cannot be currently recognized
due to WatchGuard's losses and the uncertainty of future profitability.

Comprehensive Loss

  As of January 1, 1998, WatchGuard adopted SFAS No. 130, "Reporting
Comprehensive Income," which establishes standards for the reporting and
display of comprehensive income and its components (revenues, expenses, gains
and losses) in a full set of general-purpose financial statements. WatchGuard's
comprehensive loss includes all items that comprise net loss and the effect of
unrealized gains or losses on securities available for sale. Comprehensive loss
is shown on the statement of stockholders' equity.

                                       52
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)


Use of Estimates

  The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the amounts reported in the financial statements and accompanying
notes. Actual results could differ from those estimates.

Reclassifications

  Certain prior-year items have been reclassified to conform to the current-
year presentation.

New Accounting Pronouncements

  In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivatives and
Hedging Activities," which establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments embedded in
other contracts (collectively referred to as derivatives), and for hedging
activities. Because WatchGuard has never used nor currently intends to use
derivatives, management does not anticipate that the adoption of this new
standard will have a significant effect on earnings or the financial position
of WatchGuard.

2. Balance Sheet Account Detail

Trade Accounts Receivable, Net

  Trade accounts receivable, net consisted of the following:

<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1998     1999
                                                               -------  -------
                                                               (In thousands)
     <S>                                                       <C>      <C>
     Trade accounts receivable................................ $ 4,522   $4,499
     Reserve for returns......................................    (615)    (550)
     Allowance for uncollectable accounts.....................    (449)    (177)
                                                               -------  -------
                                                                $3,458   $3,772
                                                               =======  =======

Inventories

  Inventories consisted of the following:

<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1998     1999
                                                               -------  -------
                                                               (In thousands)
     <S>                                                       <C>      <C>
     Finished goods........................................... $ 1,203  $ 1,093
     Components...............................................     953      920
                                                               -------  -------
                                                               $ 2,156  $ 2,013
                                                               =======  =======
</TABLE>


                                       53
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)

Equipment and Furniture

  Equipment and furniture consisted of the following:

<TABLE>
<CAPTION>
                                                                 December 31,
                                                                ---------------
                                                                 1998    1999
                                                                ------- -------
                                                                (In thousands)
     <S>                                                        <C>     <C>
     Computer equipment........................................ $   831 $ 1,615
     Furniture and fixtures....................................     337     576
     Software..................................................     302     638
                                                                ------- -------
                                                                  1,470   2,829
     Less accumulated depreciation.............................     330     902
                                                                ------- -------
                                                                $ 1,140 $ 1,927
                                                                ======= =======
</TABLE>

Accrued Expenses

  Accrued expenses consisted of the following:

<TABLE>
<CAPTION>
                                                                  December 31,
                                                                 ---------------
                                                                  1998    1999
                                                                 ------- -------
                                                                 (In thousands)
     <S>                                                         <C>     <C>
     Accrued payroll-related expenses........................... $   526 $ 1,323
     Acquisition-related liabilities............................     --      531
     Other......................................................     490     508
                                                                 ------- -------
                                                                 $ 1,016 $ 2,362
                                                                 ======= =======
</TABLE>

  Of the liabilities related to WatchGuard's acquisition of BeadleNet, LLC,
$400,000 relates to contingent consideration earned before December 31, 1999.
The remaining acquisition-related liabilities relate to estimated acquisition
costs. See Note 12.

3. Securities Available for Sale

  Securities available for sale consist of the following:

<TABLE>
<CAPTION>
                                                  Gross      Gross
                                        Market  Unrealized Unrealized Amortized
                                        Value     Gains      Losses     Cost
                                       -------- ---------- ---------- ---------
                                                    (In thousands)
<S>                                    <C>      <C>        <C>        <C>
December 31, 1999:
  Corporate debt securities........... $ 23,485   $ --       $ (75)   $ 23,560
  U.S. Government and agency
   obligations........................    1,013     --          (2)      1,014
                                       --------   -----      -----    --------
                                       $ 24,498   $ --       $ (77)   $ 24,574
                                       ========   =====      =====    ========
</TABLE>


                                       54
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)

  WatchGuard's gross realized gains or losses in 1999 on sales of available-
for-sale securities were immaterial. The contractual maturities of WatchGuard's
available-for-sale securities are shown below:

<TABLE>
<CAPTION>
                                                        Estimated Fair Amortized
                                                         Market Value    Cost
                                                        -------------- ---------
                                                             (In thousands)
<S>                                                     <C>            <C>
December 31, 1999:
  Due in one year or less..............................    $14,449      $14,472
  Due in one year through two years....................     10,049       10,103
                                                           -------      -------
                                                           $24,498      $24,575
                                                           =======      =======
</TABLE>

4. Acquisition of Intangibles

  In March 1996, WatchGuard acquired certain technology (source code for its
software products) from Mazama Software Labs, Inc. for $50,000. Additionally,
WatchGuard was required to make royalty payments for a three-year period on the
sale of products that utilized the Mazama technology, with the total royalty
payments not to exceed $4 million. In June 1997, WatchGuard and Mazama agreed
to a buy-out of the royalty payments due Mazama, with WatchGuard paying $70,000
in cash and issuing 400,000 shares of its common stock valued at $52,000, the
deemed fair value at that date, which was based on the board of directors' best
estimate of fair value. As of December 31, 1999, this amount was fully
amortized.

5. Borrowing Agreements

Line of Credit and Term Loans

  At December 31, 1999, WatchGuard had borrowings outstanding under (a) a $4.5
million working capital revolving line of credit; (b) a $95,000 equipment term
loan; and (c) a $288,000 equipment term loan. All three facilities are from a
commercial bank.

  The revolving line of credit is for operating needs and expires in November
2000. Principal and interest are due at maturity. Borrowings under the line of
credit bear interest at the bank's prime interest rate plus 1.0% (9.5% at
December 31, 1999). The borrowing base for the line is to be monitored on a
monthly basis and is to consist of the sum of up to 75% of eligible domestic
and 50% of eligible foreign accounts receivable. The line of credit is
collateralized by substantially all of WatchGuard's assets. There was no
balance outstanding on this line at December 31, 1999 and $2.1 million was
available for borrowing. The weighted average interest rate on WatchGuard's
short-term borrowings for 1999 was 8.7%.

  The $95,000 term loan bears interest at the bank's prime interest rate plus
1.5% (10.0% at December 31, 1999) and matures in March 2001. The $288,000 term
loan bears interest at the bank's prime interest rate plus 1% (9.5% at December
31, 1999) and matures in December 2001. The term loans require monthly
principal and interest payments, with the principal payments fixed at $6,327
and $11,995, respectively, and are collateralized by equipment.

  At December 31, 1999, WatchGuard was not in compliance with one of its
covenants related to the line of credit and term loans, but obtained a waiver
for noncompliance.

Convertible Note Financing and Warrants

  In March 1999, WatchGuard entered into convertible note agreements with its
existing investors for an aggregate of $3,000,000. In connection with these
note agreements, WatchGuard issued warrants to purchase

                                       55
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)

42,856 shares of common stock at an exercise price of $7.00 per share, all of
which were exercisable immediately. WatchGuard assigned the warrants a fair
value of $155,139 based upon the Black Scholes pricing model, based upon a fair
value of the underlying stock of $8.00 per share, a risk-free interest rate of
6%, a dividend yield rate of 0%, volatility of 0.6 and an expected life of one
year. WatchGuard amortized the resulting discount on the notes over the
expected term of the notes. Upon completion of WatchGuard's initial public
offering, the notes were repaid and the warrants were exercised.

Bridge Loan

  In May and June 1999, WatchGuard amended its loan and security agreement with
its bank. The amendments primarily provided for a secured bridge loan facility
that immediately made available to WatchGuard an additional $4.25 million, of
which $2.0 million was guaranteed by existing investors. WatchGuard granted the
bank warrants to purchase up to 14,500 shares of common stock, at an exercise
price of $13.00 per share. The loan was repaid with proceeds from the initial
public offering.

6. Stockholders' Equity

Reincorporation

  WatchGuard was incorporated as Seattle Software Labs, Inc. in the state of
Washington in February 1996. In March 1996, WatchGuard sold 1,000,000 shares of
Series A preferred stock to its two cofounders for $0.05 per share, resulting
in aggregate proceeds of $50,000. In July 1996, WatchGuard sold 350,878 shares
of what was originally characterized as Series B preferred stock to the
cofounders for $0.29 per share, resulting in aggregate proceeds of $100,000. In
connection with the restatement of its Articles of Incorporation in March 1997,
WatchGuard reclassified the preferred shares originally characterized as Series
B preferred stock into 2,000,004 Series A preferred shares. The financial
statements have been restated to reflect this recapitalization.

Stock Split

  On May 26, 1999, the board of directors authorized a two-for-one split of
WatchGuard's common stock and approved an amendment to the certificate of
incorporation to increase the number of authorized common and preferred shares
to 80,000,000 and 10,000,000 shares, respectively. The stock split was effected
on July 8, 1999. The related common share, preferred share and per share data
in the accompanying financial statements have been restated to reflect the
stock split.

Preferred Stock

  In May 1997, WatchGuard completed a Series B preferred stock offering by
selling 2,316,666 shares at $2.59 per share, aggregating gross proceeds of $6.0
million. In March 1998, WatchGuard issued an additional 38,610 shares of Series
B preferred stock at $2.59 per share, aggregating gross proceeds of $100,000.
In April 1998, WatchGuard completed a Series C preferred stock offering by
selling 1,357,378 shares at $5.16 per share, aggregating gross proceeds of
approximately $7.0 million.

  Holders of Series A, B, and C preferred stock had preferential rights to
dividends when and if declared by the board of directors. Series A, B and C
preferred stockholders had the right to one vote for each share of common stock
into which these Series A, B, and C preferred stock could then be converted
and, with respect to that vote, had full voting rights and powers equal to
those of the holders of common stock.

  In the event of liquidation, the holders of Series A, B, and C preferred
stock had preferential rights to liquidation payments of $0.05, $2.59, and
$5.16 per share, respectively, plus any declared, but unpaid,

                                       56
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)


dividends. Series A, B, and C preferred stock was convertible into common stock
at a price per share of $0.05, $2.59, and $5.16, respectively, at the option of
the holder, or automatically upon the vote or written consent of a majority of
the preferred stockholders in the case of Series A or Series B, or 75% in the
case of Series C, or upon the closing of an initial public offering of
WatchGuard's common stock from which the aggregate proceeds were not less than
$15 million and a price per share is paid by the public of at least $10.31.
Each share of Series A, B, and C preferred stock converted into two shares of
common stock at the closing of WatchGuard's initial public offering.

  The following is a summary of terms and conditions for each series of
preferred stock before their conversion:

<TABLE>
<CAPTION>
                                                     Approximate     Annual
                                                      Aggregate     Dividend
                         Shares     Shares    Stated Liquidation     Rate--
                       Designated Outstanding Value     Value    Non-Cumulative
                       ---------- ----------- ------ ----------- --------------
   <S>                 <C>        <C>         <C>    <C>         <C>
   Series A........... 3,000,004   3,000,004  $ 0.05 $  150,000      $ 0.01
   Series B........... 2,374,581   2,355,276    2.59  6,100,000        0.16
   Series C........... 1,357,378   1,357,378    5.16  7,000,000        0.31
</TABLE>

Initial Public Offering

  On July 30, 1999, WatchGuard issued 3,500,000 shares of its common stock at
an initial public offering price of $13.00 per share. The proceeds to
WatchGuard from the offering were approximately $40.7 million, net of $4.8
million in offering expenses, underwriting discounts and commissions. At the
closing of the offering, all 6,712,658 shares of preferred stock automatically
converted into 13,425,316 shares of common stock.

Stock Options

  In 1996, WatchGuard adopted the 1996 Stock Incentive Compensation Plan (the
Plan), which provides for the granting of incentive and nonqualified stock
options to employees, officers, directors, agents, consultants and independent
contractors. In May 1999, the board of directors and stockholders approved
amendments to the Plan that provide for a 900,000-share increase in the
authorized number of shares to be granted under the Plan, plus an automatic
increase to be added on the first day of each fiscal year, the first of which
occurred on January 1, 2000, equal to the least of (a) 750,000 shares, (b) 3.0%
of the average common shares outstanding as used to calculate fully diluted
earnings per share as reported in WatchGuard's annual financial statements for
the preceding year, and (c) a lesser amount determined by the board of
directors.

  As of December 31, 1999, WatchGuard had authorized 8,634,986 shares of common
stock for possible grant under the Plan. Options under the Plan generally are
granted at fair market value on the date of grant. The shares of common stock
covered by the options generally vest at the rate of 25% on the first
anniversary, with the remaining shares covered by the option vesting at 2.08%
every month thereafter, and with all shares becoming fully vested on the fourth
anniversary date of the date of grant. Stock options under the Plan have a term
of ten years unless modified by the plan administrator.

                                       57
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)


  The following table summarizes WatchGuard's stock option activity during
1997, 1998 and 1999:

<TABLE>
<CAPTION>
                         December 31, 1997   December 31, 1998   December 31, 1999
                         ------------------- ------------------- -------------------
                                    Weighted            Weighted            Weighted
                                    Average             Average             Average
                                    Exercise            Exercise            Exercise
                          Options    Price    Options    Price    Options    Price
                         ---------  -------- ---------  -------- ---------  --------
<S>                      <C>        <C>      <C>        <C>      <C>        <C>
Balance at beginning of
 period................. 1,156,994   $ 0.03  5,227,580   $ 0.08  5,145,268   $ 0.16
Granted................. 4,970,526     0.08  1,212,500     0.44  2,248,314    13.26
Exercised...............   (12,916)    0.03   (819,828)    0.04   (774,563)    0.09
Canceled................  (887,024)    0.04   (474,984)    0.09   (116,339)    5.67
                         ---------           ---------           ---------
Balance at end of
 period................. 5,227,580     0.08  5,145,268     0.16  6,502,680     4.60
                         =========           =========           =========
Exercisable at end of
 period.................   428,300           1,618,038           2,359,707
Shares of common stock
 available for grant
 under the plan.........                                           524,999
Weighted average fair
 value of options
 granted during period
  Granted at fair
   value................ 4,970,526     0.02    308,000     0.01  2,086,314    13.75
  Granted at below fair
   value................       --       --     904,500     2.08    162,000     7.00
</TABLE>

  The weighted average remaining contractual life and weighted average exercise
price of options outstanding and options exercisable at December 31, 1999 for
selected exercise price ranges is as follows:

<TABLE>
<CAPTION>
                                                                  Options
                                 Options Outstanding            Exercisable
                         ----------------------------------- ------------------
                                   Weighted Average Weighted           Weighted
                                      Remaining     Average            Average
                                     Contractual    Exercise           Exercise
       Exercise Prices    Shares   Life (in years)   Price    Shares    Price
       ---------------   --------- ---------------- -------- --------- --------
     <S>                 <C>       <C>              <C>      <C>       <C>
     $  0.03-1.13....... 4,269,491       7.38        $ 0.16  2,265,924  $ 0.13
     $  2.25-13.00...... 1,609,767       9.37         12.26     83,471   10.74
     $ 14.30-15.94......   597,922       9.21         14.50     10,312   14.30
     $ 32.13-32.13......    25,500       9.95         32.13        --      --
                         ---------                           ---------
                         6,502,680       8.05        $ 4.60  2,359,707  $ 0.57
                         =========                           =========
</TABLE>

  WatchGuard uses the intrinsic value-based method to account for all of its
employee stock-based compensation arrangements. Accordingly, no compensation
cost has been recognized for its stock options in the accompanying financial
statements because the fair value of the underlying common stock equals or
exceeds the exercise price of the stock options at the date of grant, except
with respect to certain options granted during 1998 and 1999. WatchGuard
recorded deferred stock compensation expense of $2.5 million relating to
options granted during the year ended December 31, 1998, which includes
$628,000 related to the 48,000 option shares described below. An additional
expense of $162,000 was recorded in 1999. These amounts represent the
difference between the exercise price and the deemed fair value for financial
reporting purposes of WatchGuard's common stock on the date the options were
granted. Amounts recorded as deferred stock compensation expense are generally
being amortized over a four-year vesting period using a graded vesting
approach. Under this approach, 52% of the deferred stock compensation is
amortized in the first year after grant, 27% in the second year, 15% in the
third year and the remaining 6% in the fourth year. Amortization of deferred
stock compensation originating from stock option grants of $1.0 million and
$853,000 were recognized for the years ended December 31, 1998 and 1999,
respectively. Amortization of deferred stock compensation originating from
stock option grants will be $461,000 in 2000, $237,000 in 2001 and $78,000 in
2002. See Note 12.

                                       58
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)


  The following pro forma information regarding stock-based compensation has
been determined as if WatchGuard had accounted for its employee stock options
under the fair market value method of SFAS 123. The fair value of these options
was estimated at the date of grant using a minimum value option pricing model
through the date of WatchGuard's initial public offering in July 1999 and using
the Black-Scholes pricing model thereafter. The following weighted average
assumptions were used in the pricing model: risk-free interest rates ranging
from 6.0% to 4.9% from 1997 through 1999; a dividend yield rate of 0% for all
periods; volatility of 0.85 since the initial public offering date; and an
expected life ranging from two to five years.

  For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting periods. WatchGuard's
pro forma information is as follows:

<TABLE>
<CAPTION>
                                             Year Ended December 31,
                                      ----------------------------------------
                                          1997          1998          1999
                                      ------------  ------------  ------------
                                      (In thousands, except per share data)
     <S>                              <C>           <C>           <C>
     Net loss--as reported..........  $     (4,334) $     (9,119) $    (16,018)
     Net loss--pro forma............        (4,363)       (9,166)      (19,837)
     Net loss per share--as
      reported......................        (17.17)       (11.34)        (1.80)
     Net loss per share--pro forma..        (17.30)       (11.42)        (2.23)
</TABLE>

  Under SFAS 123, compensation expense representing the fair value of the
option grant is recognized over the vesting period. The initial impact on pro
forma net loss may not be representative of compensation expense in future
years, when the effect of amortization of multiple awards would be reflected in
pro forma earnings.

  In December 1997 WatchGuard granted approximately 48,000 options with
exercise prices ranging from $0.05 to $0.26 to a consultant in connection with
a one-year consulting agreement. The options vested at the December 1998
termination date of the consulting agreement. WatchGuard has recorded
compensation expense of approximately $628,000 based on the fair value of the
options at the termination of the consulting agreement.

Common Stock Warrants

  During 1996, WatchGuard issued warrants for 145,000 shares of common stock at
an exercise price of $0.03 per share to various consultants and vendors for
technical and marketing services, including public relations and technical
writing. The warrants expire five years from date of issuance, beginning in
July 2001. During 1997, 1998 and 1999, 100,000, 10,000 and 20,000 shares,
respectively, of these warrants were exercised.

  In January 1997, WatchGuard granted warrants for 20,000 shares at an exercise
price at $0.03 per share to an individual for recruiting services. In July
1997, the warrant was exercised for all 20,000 shares.

  In March 1998, WatchGuard granted a warrant to purchase 10,000 shares of
common stock at an exercise price of $0.13 per share to a bank in connection
with a debt financing. These warrants were exercised in 1999.

  WatchGuard performed an analysis to value all warrants using the Black
Scholes pricing model based upon the exercise prices described above, a risk-
free interest rate of 6%, a dividend yield rate of 0%, volatility of 0.6 and an
expected life of one year. The fair value associated with these warrants was
immaterial.

  In June 1998, WatchGuard entered into a two-year license and sales agreement
with a customer, under which the customer has committed to minimum purchase
quantities. This agreement may be terminated by either party for
nonperformance. The only recourse for nonperformance is the return of all
product and

                                       59
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)


promotional material. Because of the promotional value of this customer,
WatchGuard granted it a warrant to purchase 200,000 shares of common stock at
an exercise price of $0.39 per share. The warrant is fully vested,
nonforfeitable and fully exercisable at the date of grant. The fair value of
the warrant, approximately $470,000, was recorded as sales and marketing
expense during the last six months of 1998, the period in which WatchGuard
derived its promotional value from its customer. The warrant is not tied to any
performance commitments under the license and sales agreement.

  Warrants were also granted in connection with the bridge loan and convertible
notes discussed in Note 5. At December 31, 1999 WatchGuard had 225,000 warrants
outstanding.

1999 Employee Stock Purchase Plan

  In May 1999, the board of directors and stockholders approved the 1999
Employee Stock Purchase Plan (ESPP). WatchGuard implemented the ESPP upon the
effectiveness of its initial public offering. Subject to certain limitations,
the ESPP permits eligible employees of WatchGuard to purchase common stock
through payroll deductions of up to 15% of their compensation. WatchGuard
authorized the issuance under the ESPP of a total of 600,000 shares of common
stock, plus an automatic annual increase to be added on the first day of each
fiscal year, the first of which occurred on January 1, 2000, equal to the least
of (a) 400,000 shares, (b) 1.5% of the average common shares outstanding as
used to calculate fully diluted earnings per share as reported in WatchGuard's
annual financial statements for the preceding year, and (c) a lesser amount
determined by the board of directors.

Common Stock Grant

  In connection with the employment and stock vesting agreement granted to an
employee in connection with the BeadleNet acquisition, WatchGuard issued 51,948
unregistered shares of its common stock, valued at $750,000, on the closing
date of the acquisition. See Note 12.

Common Shares Reserved

  At December 31, 1999, common stock reserved for future issuance was as
follows:

<TABLE>
     <S>                                                               <C>
     Exercise of common stock options................................. 7,027,679
     Exercise of common stock warrants................................   225,000
                                                                       ---------
                                                                       7,252,679
                                                                       =========
</TABLE>


                                       60
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)

7. Net Loss per Share

  Basic and diluted net loss per common share is calculated by dividing net
loss by the weighted average number of common shares outstanding. Pro forma net
loss per share is computed using the weighted average number of shares used for
basic and diluted per share amounts and the weighted average convertible
preferred stock outstanding as if such shares were converted to common stock at
the time of issuance.

<TABLE>
<CAPTION>
                                                   Years Ended December 31,
                                                  ----------------------------
                                                    1997      1998      1999
                                                  --------  --------  --------
                                                  (In thousands, except per
                                                         share data)
<S>                                               <C>       <C>       <C>
Net loss........................................  $ (4,334) $ (9,119) $(16,018)
                                                  ========  ========  ========
Basic and diluted net loss per common share.....  $ (17.17) $ (11.34) $  (1.80)
                                                  ========  ========  ========
Weighted average number of common shares used
 for basic and diluted per share amounts........       252       804     8,903
                                                  ========  ========
Weighted average common shares issuable upon
 pro forma conversion of preferred stock........                         7,761
                                                                      --------
Weighted average number of shares used for pro
 forma per share amounts........................                        16,664
                                                                      ========
Pro forma basic and diluted net loss per share..                      $  (0.96)
                                                                      ========
</TABLE>

  For the years ended December 31, 1997, 1998 and 1999, options to purchase
5,227,580, 5,145,268 and 6,502,680 shares of common stock, respectively, and
warrants to purchase 245,000, 45,000 and 225,000 shares of common stock,
respectively, were excluded from the computation of actual and pro forma
diluted net loss per common share, as their effect is antidilutive.

8. Income Taxes

  At December 31, 1999, WatchGuard had a net operating loss carryforward for
federal tax purposes of approximately $24 million. The carryforwards begin to
expire in 2011. Utilization of net operating loss carryforwards may be subject
to certain limitations under Section 382 of the Internal Revenue Code. A
valuation allowance has been established to reflect the uncertainty of
generating future taxable income necessary to utilize available tax loss
carryforwards.

  Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components
of WatchGuard's deferred tax assets and liabilities are as follows:

<TABLE>
<CAPTION>
                                                           December 31,
                                                     --------------------------
                                                      1997     1998      1999
                                                     -------  -------  --------
                                                          (In thousands)
     <S>                                             <C>      <C>      <C>
     Deferred tax assets:
       Net operating loss carryforwards............. $ 1,423  $ 3,358  $  8,216
       Acquisition intangibles......................     --       --      1,179
       Research and development tax credit..........      92      218       313
       Returns reserve..............................     --       215       253
       Allowance for bad debts......................      42      153        60
       Accrued expenses.............................      43      102       214
                                                     -------  -------  --------
     Total deferred tax assets......................   1,600    4,046    10,235
     Valuation allowance............................  (1,600)  (4,046)  (10,235)
                                                     -------  -------  --------
     Net deferred taxes............................. $   --   $   --   $    --
                                                     =======  =======  ========
</TABLE>


                                       61
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)

  WatchGuard's valuation allowance increased by $1,441,000, $2,446,000 and
$6,189,000 in 1997, 1998 and 1999, respectively.

9. 401(k) Retirement Plan

  WatchGuard sponsors a 401(k) plan that is available to all employees who
satisfy certain eligibility requirements relating to minimum age, length of
service and hours worked. Eligible employees may elect to contribute up to 15%
of their pre-tax gross earnings, subject to statutory limitations regarding
maximum contributions. WatchGuard may also make a discretionary contribution to
the plan. No such contributions have been made by WatchGuard.

10. Commitments

  WatchGuard leases office space and equipment under noncancelable operating
leases. Future minimum payments at December 31, 1999 under these leases are as
follows (in thousands):

<TABLE>
     <S>                                                                    <C>
     2000.................................................................. $468
     2001..................................................................  182
     2002..................................................................   24
     2003..................................................................   14
                                                                            ----
                                                                            $688
                                                                            ====
</TABLE>

  Two of the officers of WatchGuard are guarantors of part of the office lease.

  Rent expense for 1997, 1998 and 1999 was $134,000, $273,000 and $512,000,
respectively.

11. International Revenues

  WatchGuard licenses and markets its Internet security products and services
throughout the world, and operates in a single industry segment. While certain
expenses for sales and marketing activities are incurred in various
geographical regions, substantially all of WatchGuard's assets are located, and
the majority of its operating expenses are incurred, at its corporate
headquarters. Revenue information by geographic region is the only segment
information presented as follows:

<TABLE>
<CAPTION>
                                                        Year Ended December 31,
                                                        ------------------------
                                                         1997     1998    1999
                                                        ------- -------- -------
                                                             (In thousands)
     <S>                                                <C>     <C>      <C>
     United States....................................  $ 2,262 $  7,401 $10,303
     Rest of World
       Europe.........................................    1,140    2,049   5,340
       Asia...........................................    1,209    1,106   3,275
       Other..........................................      487      823   1,701
                                                        ------- -------- -------
                                                          2,836    3,978  10,316
                                                        ------- -------- -------
         Total........................................  $ 5,098 $ 11,379 $20,619
                                                        ======= ======== =======
</TABLE>

12. Acquisition of BeadleNet, LLC

  On October 19, 1999, WatchGuard acquired the assets of BeadleNet, LLC, a
California limited liability company, pursuant to an Asset Purchase Agreement
dated as of October 19, 1999, among BeadleNet,

                                       62
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)

Productivity Enhancement Products, Inc. (PEP), a member of BeadleNet, Danny M.
Beadle, the founder and a member of BeadleNet and the principal shareholder of
PEP, and WatchGuard. WatchGuard accounted for the acquisition using the
purchase method of accounting. The results of operations of BeadleNet and the
fair value of the assets acquired have been included in the financials
statements beginning on the acquisition date.

  The total BeadleNet acquisition cost of $9,556,000 is comprised of: (1)
$3,406,000 in cash paid at closing, including $1,000,000 paid to PEP in
satisfaction of BeadleNet's outstanding liabilities to PEP; (2) 335,931
unregistered shares of WatchGuard common stock issued at closing with a fair
value of $4,850,000; (3) an additional $1 million in contingent consideration,
comprised of $400,000 in cash and 20,189 unregistered shares of WatchGuard
common stock with a fair value of $600,000, which became due upon completion of
certain technology items in late December 1999 and was paid in January 2000;
and (4) estimated direct acquisition costs of $300,000.

  The aggregate purchase price was allocated, based on estimated fair values on
the acquisition date, as follows:

<TABLE>
   <S>                                                               <C>
   Inventories...................................................... $    5,000
   Equipment........................................................     69,000
   Intangibles:
     Acquired workforce.............................................    204,000
     Tradenames.....................................................    409,000
     Developed technology...........................................    503,000
     Goodwill.......................................................  4,985,000
                                                                     ----------
       Total intangibles............................................  6,101,000
   Acquired in-process research and development.....................  3,381,000
                                                                     ----------
   Total purchase price............................................. $9,556,000
                                                                     ==========
</TABLE>

  Values assigned to the acquired in-process research and development,
developed technology and tradenames were determined using a discounted cash
flow analysis. The value assigned to the workforce in place was based on
replacement cost.

  To determine the value of the in-process research and development, WatchGuard
considered, among other factors, the state of development of each project, the
time and cost needed to complete each project, expected income, and associated
risks, which included the inherent difficulties and uncertainties in completing
the project and achieving technological feasibility and risks related to the
viability of and potential changes in future target markets. This analysis
resulted in amounts assigned to in-process research and development projects
that had not yet reached technological feasibility and do not have alternative
future uses. The entire $3,381,000 allocated to acquired in-process research
and development was expensed on the date of acquisition.

  To determine the value of the developed technology, WatchGuard discounted the
expected future cash flows of the existing technology product, taking into
account risks related to the characteristics and applications of each product,
existing and future markets and assessments of the life cycle stage of each
project. Based on this analysis, WatchGuard capitalized the existing technology
that had reached technological feasibility.

  The lives assigned to the identified intangible assets ranged from two to
four years and the life assigned to goodwill was five years. Amortization
expense for these intangibles was $245,000 in the fourth quarter of 1999, and
was recorded based on the straight-line method.

                                       63
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                   NOTES TO FINANCIAL STATEMENTS--(Continued)


  The unaudited pro forma combined historical results presented as if BeadleNet
had been acquired at the beginning of each period presented and excluding the
nonrecurring one-time charge for in-process research and development are as
follows:

<TABLE>
<CAPTION>
                                                               Year Ended
                                                              December 31,
                                                            ------------------
                                                              1998      1999
                                                            --------  --------
                                                               (unaudited)
<S>                                                         <C>       <C>
Total revenues, net........................................ $ 11,379  $ 20,619
Net loss................................................... $(10,396) $(15,707)
Pro forma net loss per share............................... $ (10.21) $  (1.69)
</TABLE>

  In connection with the acquisition, WatchGuard entered into an employment
agreement and a stock vesting agreement with Mr. Beadle. Pursuant to the
employment agreement, WatchGuard granted Mr. Beadle an option, vesting over a
period of four years, to purchase 250,000 shares of WatchGuard common stock at
an exercise price of $14.44 per share, the fair value of the stock on the date
the option was granted. In consideration of certain of Mr. Beadle's obligations
in the employment agreement, including his agreement not to compete with
WatchGuard for a period of three years after his employment terminates,
WatchGuard also issued to Mr. Beadle 51,948 unregistered shares of WatchGuard
common stock, valued at $750,000 on the closing date of the acquisition. The
value of this stock has been recorded as deferred stock compensation expense
and is being amortized on a straight-line basis over the two-year employment
agreement period. Amortization of this deferred stock compensation was $73,000
in the fourth quarter of 1999. Under the stock vesting agreement, 34,632 of
these shares will be subject to forfeiture if Mr. Beadle's employment is
terminated for cause or if he resigns. One half of these shares will no longer
be subject to forfeiture on October 19, 2000 and the remainder will no longer
be subject to forfeiture on October 19, 2001.

13. Related-Party Transactions

  The vice president and general manager of WatchGuard's broadband Internet
security division is also the founder and principal shareholder of PEP, the
former parent of BeadleNet. Since the acquisition date, PEP has provided, and
continues to provide, various products and services to WatchGuard. Primarily,
PEP supplies products for sale (including purchasing, producing and assembling
products), provides office space and facilities services and provides
engineering and consulting services during the development of some of
WatchGuard's new broadband product offerings. Total expenditures for PEP
products and services during 1999 were $448,000 and total amounts due PEP at
December 31, 1999 were $361,000. WatchGuard expects that PEP will continue to
provide products and services during the first half of 2000 until WatchGuard
relocates to a new facility, contracts with new manufacturing sources and fills
its open staffing positions, all of which are believed to be reasonably
attainable during that time frame.

                                       64
<PAGE>

                                  SCHEDULE II

                       VALUATION AND QUALIFYING ACCOUNTS
                                 (In thousands)

<TABLE>
<CAPTION>
        Column A           Column B         Column C          Column D      Column E
------------------------ ------------ --------------------- ------------   ----------
                                            Additions
                                      ---------------------
                                      Charged to Charged to
                          Balance at   Revenue,    Other                   Balance at
                         Beginning of  Costs or  Accounts-- Deductions--     End of
      Description           Period     Expenses   Describe    Describe       Period
------------------------ ------------ ---------- ---------- ------------   ----------
<S>                      <C>          <C>        <C>        <C>            <C>
Year ended December 31,
 1997
  Allowance for
   uncollectible
   accounts.............    $   8      $   122     $  --      $     6        $ 124
  Sales return reserve..    $ --       $   --      $  --      $   --         $ --
Year ended December 31,
 1998
  Allowance for
   uncollectible
   accounts.............    $ 124      $   418     $  --      $    93 (A)    $ 449
  Sales return reserve..    $ --       $ 1,655     $  --      $ 1,040 (B)    $ 615
Year ended December 31,
 1999
  Allowance for
   uncollectible
   accounts.............    $ 449      $   129     $  --      $   401 (A)    $ 177
  Sales return reserve..    $ 615      $ 1,083     $  --      $ 1,148 (B)    $ 550
</TABLE>
--------
(A)  Deductions consist of write-offs of uncollectible accounts, net of
     recoveries.

(B)  Deductions consist of product returns.

                                       65
<PAGE>

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE

  None.

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

  Information called for by Part III, Item 10, regarding our directors and
executive officers is included in our proxy statement relating to our 2000
annual meeting of stockholders, and is incorporated by reference. The
information appears in the proxy statement under the captions "Election of
Directors" and "Executive Officers." We will file the proxy statement within
120 days of December 31, 1999, our fiscal year end.

ITEM 11. EXECUTIVE COMPENSATION

  Information called for by Part III, Item 11, regarding executive compensation
is included in our proxy statement relating to our 2000 annual meeting of
stockholders, and is incorporated by reference. The information appears in the
proxy statement under the caption "Executive Compensation." We will file the
proxy statement within 120 days of December 31, 1999, our fiscal year end.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

  Information called for by Part III, Item 12, regarding beneficial ownership
of our stock is included in our proxy statement relating to our 2000 annual
meeting of stockholders, and is incorporated by reference. The information in
the proxy statement under the caption "Beneficial Ownership of Shares." We will
file the proxy statement within 120 days of December 31, 1999, our fiscal year
end.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  Information regarding related-party transactions is included in our proxy
statement relating to our 2000 annual meeting of stockholders, and is
incorporated by reference. The information in the proxy statement under the
caption "Certain Transactions." We will file the proxy statement within 120
days of December 31, 1999, our fiscal year end.

                                       66
<PAGE>

                                    PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

  (a) Financial Statements and Financial Statement Schedules

(1) INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                            Page
                                                                            ----
<S>                                                                         <C>
  Report of Ernst & Young LLP, Independent Auditors........................  45
  Balance Sheets...........................................................  46
  Statements of Operations.................................................  47
  Statements of Stockholders' Equity.......................................  48
  Statements of Cash Flows.................................................  49
  Notes to Financial Statements............................................  50
</TABLE>

(2) INDEX TO FINANCIAL STATEMENT SCHEDULES

  Schedule II--Valuation and Qualifying Accounts for each of the three years
ended December 31, 1999, 1998 and 1997

  Schedules not listed above have been omitted because they are not applicable
or are not required or the information required to be set forth in the
schedules is included in the financial statements or related notes.

(3) EXHIBITS

<TABLE>
<CAPTION>
 Number                               Description
 ------                               -----------
 <C>    <S>
  3.1*  Restated Certificate of Incorporation of the registrant.
  3.2*  Restated Bylaws of the registrant.
 10.1*  Lease Agreement, dated as of March 15, 1996, between COM Realty, Inc.
         and the registrant.
 10.2*  Lease Agreement, dated as of October 10, 1997, between Burke-State
         Bldg. LLC and the registrant.
 10.3*  Lease Agreement, dated as of August 17, 1998, between Cederstrand
         Rentals and the registrant.
 10.4*  Amended and Restated Loan and Security Agreement, dated as of March 20,
         1998, between Silicon Valley Bank and the registrant.
 10.5*  Loan Modification Agreement, dated as of September 18, 1998, between
         Silicon Valley Bank and the registrant.
 10.6*  1996 Stock Incentive Compensation Plan.
 10.7*  Standardized Adoption Agreement Prototype Cash or Deferred Profit-
         Sharing Plan and Trust (401(k) plan), effective as of September 1,
         1998.
 10.8+* Development and Supply Agreement, dated as of March 25, 1998, between
         SMART Modular Technologies, Inc. and the registrant.
 10.9+* OEM Master License Agreement, dated as of August 14, 1997, between RSA
         Data Security, Inc. and the registrant.
 10.10W Asset Purchase Agreement dated as of October 19, 1999, by and among
         BeadleNet, LLC, Productivity Enhancement Products, Inc., Danny M.
         Beadle and WatchGuard Technologies, Inc.
 10.11W Employment Agreement dated as of October 19, 1999, by and between Danny
         M. Beadle and WatchGuard Technologies, Inc.
 10.12W Stock Vesting Agreement dated as of October 19, 1999, by and between
         Danny M. Beadle and WatchGuard Technologies, Inc.
 23.1   Consent of Ernst & Young LLP, independent auditors.
 27.1   Financial Data Schedule
</TABLE>
--------
+  Portions of these exhibits have been omitted based on a grant of
   confidential treatment by the Securities and Exchange Commission. The
   omitted portions of the exhibits have been filed separately with the SEC.

                                       67
<PAGE>

*  Incorporated by reference to the Registration Statement on Form S-1 (No.
   333-76587) filed by WatchGuard on April 20, 1999, as amended.
W  Incorporated by reference to the Current Report on Form 8-K (File No. 000-
   26819) filed by WatchGuard on November 2, 1999, as amended.

  (b) Reports on Form 8-K

  On November 2, 1999, we filed with the Securities and Exchange Commission a
Current Report on Form 8-K, as amended by Form 8-K/A filed on January 3, 2000,
reporting our acquisition of BeadleNet, LLC.

                                       68
<PAGE>

                                   SIGNATURES

  Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of
1934, as amended, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                          WatchGuard Technologies, Inc.

                                              /s/ Christopher G. Slatt
                                          _____________________________________
                                               Name: Christopher G. Slatt
                                          Title: President and Chief Executive
                                                         Officer

                                          Date: February 11, 2000

  Pursuant to the requirements of the Securities Act of 1934, as amended, this
report has been signed by the following persons, on behalf of the registrant,
in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
              Signature                          Title                   Date
              ---------                          -----                   ----

<S>                                    <C>                        <C>
     /s/ Christopher G. Slatt          President, Chief Executive  February 11, 2000
______________________________________  Officer and Chairman of
         Christopher G. Slatt           the Board (Principal
                                        Executive Officer)

       /s/ Steven N. Moore             Executive Vice President    February 11, 2000
______________________________________  of Finance, Chief
           Steven N. Moore              Financial Officer,
                                        Secretary, Treasurer and
                                        Director (Principal
                                        Financial and Accounting
                                        Officer)

       /s/ Stuart J. Ellman            Director                    February 11, 2000
______________________________________
           Stuart J. Ellman

      /s/ Andrew W. Verhalen           Director                    February 11, 2000
______________________________________
          Andrew W. Verhalen

    /s/ Charles P. Waite, Jr.          Director                    February 11, 2000
______________________________________
        Charles P. Waite, Jr.
</TABLE>

                                       69
<PAGE>

                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
 Number                               Description
 ------                               -----------
 <C>    <S>
  3.1*  Restated Certificate of Incorporation of the registrant.

  3.2*  Restated Bylaws of the registrant.

        Lease Agreement, dated as of March 15, 1996, between COM Realty, Inc.
 10.1*  and the registrant.

        Lease Agreement, dated as of October 10, 1997, between Burke-State
 10.2*  Bldg. LLC and the registrant.

        Lease Agreement, dated as of August 17, 1998, between Cederstrand
 10.3*  Rentals and the registrant.

 10.4*  Amended and Restated Loan and Security Agreement, dated as of March 20,
        1998, between Silicon Valley Bank and the registrant.

 10.5*  Loan Modification Agreement, dated as of September 18, 1998, between
        Silicon Valley Bank and the registrant.

 10.6*  1996 Stock Incentive Compensation Plan.

 10.7*  Standardized Adoption Agreement Prototype Cash or Deferred Profit-
        Sharing Plan and Trust (401(k) plan), effective as of September 1,
        1998.

 10.8+* Development and Supply Agreement, dated as of March 25, 1998, between
        SMART Modular Technologies, Inc. and the registrant.

 10.9+* OEM Master License Agreement, dated as of August 14, 1997, between RSA
        Data Security, Inc. and the registrant.

 10.10W Asset Purchase Agreement dated as of October 19, 1999, by and among
        BeadleNet, LLC, Productivity Enhancement Products, Inc., Danny M.
        Beadle and WatchGuard Technologies, Inc.

 10.11W Employment Agreement dated as of October 19, 1999, by and between Danny
        M. Beadle and WatchGuard Technologies, Inc.

 10.12W Stock Vesting Agreement dated as of October 19, 1999, by and between
        Danny M. Beadle and WatchGuard Technologies, Inc.

 23.1   Consent of Ernst & Young LLP, independent auditors.

 27.1   Financial Data Schedule
</TABLE>

--------
+  Portions of these exhibits have been omitted based on a grant of
   confidential treatment by the Securities and Exchange Commission. The
   omitted portions of the exhibits have been filed separately with the SEC.
*  Incorporated by reference to the Registration Statement on Form S-1 (No.
   333-76587) filed by the registrant on April 20, 1999, as amended.
W  Incorporated by reference to the Current Report on Form 8-K (File No. 000-
   26819) filed by the registrant on November 2, 1999, as amended.