<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, 2000

                                       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)

                  Delaware                                     91-1712427
       (State or other jurisdiction of                      (I.R.S. Employer
       incorporation or organization)                      Identification No.)

              505 Fifth Avenue South, Suite 500, 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. [_]

  The aggregate market value of the voting stock held by nonaffiliates of the
registrant, based on the closing sales price of the registrant's common stock
on February 28, 2001 as reported on the Nasdaq National Market, was
approximately $224,827,879. 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 because 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 28, 2001, there were 26,680,257 shares outstanding of the
registrant's common stock.

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<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                                   FORM 10-K

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000

                               TABLE OF CONTENTS

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

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

 ITEM 2.  PROPERTIES....................................................   27

 ITEM 3.  LEGAL PROCEEDINGS.............................................   27

 ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...........   27

                                      PART II

 ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
          STOCKHOLDER MATTERS...........................................   28

 ITEM 6.  SELECTED FINANCIAL DATA.......................................   29

 ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
          AND RESULTS OF OPERATIONS.....................................   30

 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK....   45

 ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...................   46

 ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
          AND FINANCIAL DISCLOSURE......................................   69

                                     PART III

 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............   70

 ITEM 11. EXECUTIVE COMPENSATION........................................   72

 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
          MANAGEMENT....................................................   75

 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................   76

                                      PART IV

 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
          FORM 8-K......................................................   77

 SIGNATURES..............................................................  79
</TABLE>
<PAGE>

                                     PART I

Forward-Looking Statements

  Our disclosure and analysis in this annual report on Form 10-K contain
forward-looking statements, which provide our current expectations or forecasts
of future events. 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. Forward-looking statements include statements about our
plans, objectives, expectations and intentions and other statements that are
not historical facts. They are subject to known and unknown risks and
uncertainties and inaccurate assumptions that could cause our actual results to
differ materially from those expected or implied by the forward-looking
statements. 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" in Part I, Item 1 of this annual report. You should not unduly
rely on these forward-looking statements, which apply only as of the date of
this annual report.

ITEM 1. BUSINESS

Overview

  WatchGuard is a leading provider of Internet security solutions designed to
protect enterprises that use the Internet for electronic commerce and secure
communications. Thousands of large and small companies worldwide use our award-
winning products and services, which include firewalls for access control,
virtual private networks, or VPNs, for secure communications and our new
ServerLock products for server content and application security. Our core
market includes small- to medium-sized enterprises, or SMEs, large Internet-
distributed enterprises, or IDEs, with ultra-high-speed connections supporting
VPNs between the IDEs and their geographically dispersed branch offices and
telecommuters, small and home offices, or SOHOs, with broadband connections,
and telecommuters.

  Our innovative subscription-based LiveSecurity Service enables our customers
to protect their data and communications in a continuously changing environment
with minimal effort. Our LiveSecurity Service is directed by a team of security
experts that provides ongoing technical advice and alerts on emerging security
threats, delivers software updates to address these threats, when appropriate,
and provides periodic software upgrades. In addition, the LiveSecurity Service
provides various levels of technical support and Web-based training and
certification programs. The dynamic nature of our firewall and VPN solutions is
made possible through an updatable security appliance that executes software
sent from the remote management system receiving our LiveSecurity Service. Our
ServerLock product family, installed on an enterprise's existing servers, is
also updated through our LiveSecurity Service. Our comprehensive security
solutions are easily installed, configured and monitored with point-and-click
security management.

  Our recent acquisition of Qiave Technologies Corporation allowed us to expand
our product and service offerings into the emerging server content and
application security markets. Our ServerLock System, which we launched under
the WatchGuard brand in February 2001, provides content and application
security to enterprises of all sizes. ServerLock protects critical data and
services against unauthorized or unintentional changes, such as Web site
defacement and the deposit of malicious code. We sell ServerLock as an added
layer of defense to our existing customer base and as a stand-alone server
security product in new environments, including organizations deploying our
competitors' products. According to a Netcraft survey, there are currently more
than 25 million Web servers worldwide, with over 5 million running Microsoft
applications, a number that IDC projects to increase to over 13 million by
2004. ServerLock is currently available for servers running Microsoft
applications, and we expect to release additional versions designed to protect
servers using other operating systems in the near future.

  Our security solutions give enterprises a security management choice. An
enterprise can manage its own Internet security with our product offerings or
outsource its security management to an Internet service

                                       3
<PAGE>

provider, or ISP, or other managed service provider implementing our managed
security solutions. An enterprise using our security solutions can rapidly
distribute security protection from a desktop personal computer to all security
appliances or protected servers on its corporate network, while retaining
centralized control and administration. An enterprise that does not want to be
directly involved with security management may outsource the function to a
service provider. For the service provider, our technology improves the
economics of managed security services through a scalable delivery platform
that enables the service provider to remotely configure and manage thousands of
customer sites quickly and easily.

  We sell our Internet security solutions directly and indirectly to service
providers and indirectly to end-users through more than 400 distributors and
resellers covering over 60 countries, with LiveSecurity subscribers located in
approximately 100 countries. As part of this distribution network, thousands of
resellers worldwide sell our security solutions. We have established
relationships with a number of service providers to implement our security
solutions, including AlphaNet Solutions, Inc., AT&T Global Network Services
Hong Kong Limited (AGNS Ltd.), Deutsche Telekom AG, Genuity, Inc., Internet
Initiative Japan, Internet Security Systems, Inc., Interpath Communications,
Inc., KPN, Nextcom K.K., PSINet Inc., Sunrise Communications AG/Applitec AG and
UUNet, a Worldcom company. As of December 31, 2000, we had shipped over 50,000
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., our subsidiaries and our
predecessor. Our executive offices are located at 505 Fifth Avenue South, Suite
500, Seattle, Washington 98104, and our telephone number is (206) 521-8340.

Industry Background

Reliance on the Internet

  The growth in the Internet provides enterprises, regardless of size, with new
revenue opportunities through global distribution of products and services and
enables significant reductions in 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 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, alter 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 networks difficult to manage, monitor and protect from
unauthorized access. Even SOHOs and telecommuters face security threats similar
to those faced by larger enterprises connected to the Internet, with the advent
of "always-on" broadband Internet connections that leave the user's computer
much more vulnerable to security breaches than a traditional dial-up
connection. In addition, because smaller organizations are rapidly adopting
public-facing Web and application servers, they now face the types of threats
and vulnerabilities that had been previously reserved for much larger
organizations that could deploy sufficient personnel to meet that challenge.

                                       4
<PAGE>

  The annual Computer Security Institute survey conducted in 2000 highlights
the potential risks faced by organizations connected to the Internet. The CSI
survey revealed that 90% of companies responding had experienced security
breaches within the past 12 months, with 70% reporting serious breaches that
included theft of proprietary information, financial fraud and sabotage of data
or networks. 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. Those organizations in the CSI survey that were able to quantify
losses reported an average total loss of over $1 million per organization.

The Internet security challenge

  Enterprises increasingly depend on the Internet for external and internal
communications and for facilitating and conducting business, and therefore need
comprehensive Internet security solutions. Adequate Internet security is not a
response to a single challenge, but rather a response to a variety of business
requirements. For example, because businesses need to control the flow of
information between their internal networks and the Internet, they need
firewalls, an important component of a comprehensive security solution. A
firewall, a security component that varies in complexity, is designed to block
access from the Internet to a company's internal networks, as well as control
the flow of and access to information shared between the networks and the
Internet. Traditional large-enterprise firewalls, however, are often difficult
to install and expensive to maintain. They must be configured by skilled
personnel and, to maximize effectiveness, must be continually monitored and
frequently updated. A comprehensive security solution should also integrate
several other sophisticated security layers, such as VPNs, to enable encrypted
communications between two points on the Internet, and server content and
application security to protect critical data and services against unauthorized
or unintentional changes, such as Web site defacement or the deposit of
malicious code. Additionally, the technological complexity of traditional
solutions introduces a new set of risks--their many interacting components can
easily be misconfigured.

  Enterprises therefore face greater pressure to hire trained security
personnel to ensure that these 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. Traditional security solutions are also expensive to maintain
because they must be updated continually to maximize effectiveness. They 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 21,756 security
incidents in 2000, more than double the 9,859 security incidents handled in
1999 and more than five times the 3,734 security incidents handled in 1998.
Even if updates are available to allow an enterprise's traditional security
system 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. Although appliance-based
solutions have emerged as a lower-cost alternative to traditional large-
enterprise security solutions, they, like traditional solutions, too often fail
to allow customers to effectively address continuously changing security
threats and protect their data and communications with minimal effort.

The Internet security opportunity

  According to Infonetics Research, Inc., the worldwide market for firewall and
VPN hardware and software is expected to grow from $1.1 billion in 2000 to $5.4
billion by the end of 2004, representing a compounded annual growth rate of
nearly 50%. Companies are increasingly employing firewall and VPN hardware and
software solutions as they become more reliant on the Internet to connect
geographically dispersed branch offices, telecommuters and mobile workers.
According to Cahners In-Stat Group, approximately 24% of the U.S. workforce, or
approximately 30 million workers, will telecommute at some point during 2001.
In addition, the rapid deployment of public-facing Web and application servers
by less sophisticated organizations has opened these businesses to the types of
threats and vulnerabilities previously reserved for much larger organizations.
According to a Netcraft survey, there are currently more than 25 million Web
servers worldwide,

                                       5
<PAGE>

with over 5 million running Microsoft applications. IDC projects that this
number will increase to over 13 million by 2004. The need for Internet security
will only grow as millions of enterprises and consumers move from a dial-up
connection to an always-on broadband connection.

  Enterprises require an easy-to-use, robust, comprehensive Internet security
solution that has low installation and maintenance costs and 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 ISPs and other
managed service providers. Service providers face challenges, however, in
delivering affordable security services that can be rapidly and economically
deployed to thousands of customer sites and easily managed from a central
location.

The WatchGuard Solution

  WatchGuard's security products and services offer an innovative approach to
Internet security. We provide enterprises of all sizes with an easy-to-use,
robust, comprehensive and cost-effective Internet security solution that we
keep up to date through our innovative Internet-based LiveSecurity Service. Our
solution has the following key benefits:

<TABLE>
 <C>                                 <S>
 Comprehensive and scalable security For enterprises of all sizes, we offer a
                                     comprehensive security solution that
                                     includes (1) a firewall for access
                                     control, (2) VPN capability for secure,
                                     encrypted communication between remote
                                     offices, mobile employees and trading
                                     partners, (3) server security to protect
                                     against unauthorized or unintentional
                                     access to and manipulation of critical
                                     content and applications residing on a
                                     server and (4) our LiveSecurity Service.

 Dynamic protection                  Our subscription-based LiveSecurity
                                     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) expert editorials, news
                                     bulletins and Internet security-related
                                     feature articles, (4) support flashes with
                                     answers to commonly asked questions about
                                     our products and services and information
                                     on new software updates, (5) virus alerts
                                     with information from Trend Micro about
                                     the latest virus threats and access to its
                                     virus protection products, (6) Web-based
                                     customer training and technical
                                     certification and (7) Web-based and
                                     interactive technical support.

 Easy installation and use           We offer (1) a plug-in security appliance
                                     for ease of firewall and VPN deployment,
                                     (2) server security software with
                                     virtually effortless installation and
                                     configuration and (3) point-and-click
                                     centralized management of all aspects of
                                     the security solution. These features make
                                     it easy for the non-security professional
                                     to install, configure and monitor our
                                     security solutions and to receive and
                                     implement our LiveSecurity Service.

 Viable outsourcing to ISPs and      Through centralized configuration and
 other managed service providers     management capabilities, our security
                                     solution enables service providers to
                                     provide outsourced Internet security
                                     services to thousands of customers
                                     quickly, easily and at a price enterprises
                                     can afford.
</TABLE>

                                       6
<PAGE>

<TABLE>
 <C>           <S>
 Affordability We minimize the overall ownership cost of our security solution
               with easy deployment and management, which reduces the need for
               information technology personnel. Our LiveSecurity Service
               enables users of our security solutions 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 solutions to
enterprises of all sizes worldwide. Our strategy to achieve this goal is based
on the following key elements:

Continue to extend our leadership position in the market for comprehensive
security for SMEs and our established presence in the SOHO/telecommuter market
into the larger-enterprise and IDE markets

  We intend to further extend our leadership position into new markets by
expanding and enhancing our Internet security product and service offerings.
Over the past 18 months, we have expanded our traditional product line to meet
the needs of larger enterprises and IDEs. In addition, we have recently
expanded our addressable market with the introduction of ServerLock. Initially,
our marketing efforts for our ServerLock product line will be targeted at
public-facing servers connected to the Internet, such as corporate Web sites
and e-mail servers. In the future, we may expand our marketing efforts to
target internal application servers. 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 of all sizes,
particularly IDEs, to quickly and easily deploy new products and services from
a central management system, using a familiar Windows- or Web-based interface.
Our distributed architecture also facilitates the scalability necessary for
service providers 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
invest in product development and product and service enhancements.

Expand our strategic relationships with leading ISPs and other managed service
providers

  To capitalize on the large number of potential customers to which ISPs and
other managed service providers have access, we have established relationships
with industry-leading service providers to create services based on our managed
security offering, LiveSecurity for MSS, and to act as resellers of our
products and services. Service providers with which we have relationships
include AlphaNet, AT&T Global Network Services Hong Kong Limited (AGNS Ltd.),
Deutsche Telekom, Genuity, Internet Initiative Japan, Internet Security
Systems, Interpath Communications, KPN, Nextcom, Sunrise Communications and
UUNet. We intend to continue to establish relationships with service providers
to facilitate the widespread adoption of our products and services by
capitalizing on the brand recognition and customer base of the service
providers. In addition, these strategic relationships should enhance WatchGuard
brand awareness and provide a powerful endorsement of our security technology
and services.

Expand and enhance our innovative LiveSecurity Service

  Our LiveSecurity Service is an innovative, value-added security service that
delivers threat responses, software updates, expert editorials, support flashes
and virus alerts, along with training and technical support, over the Internet
directly to our subscribers and service provider partners. We plan to expand
and enhance our LiveSecurity Service, and therefore the value of our
subscription service, by expanding our internal and external team of security
experts and by adding new software and services through internal development
and partnering with third-party providers. As we expand and enhance our
LiveSecurity Service, we plan to ensure that it remains easy to implement and
use by enterprises of all sizes and service providers.


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 WatchGuard
products and services, no matter where the enterprise is located.

                                       7
<PAGE>

Our goal is to make our security solutions the easiest to purchase and deploy,
whether by the enterprise or by a service provider. We plan to expand our
distribution network of resellers, distributors and service provider partners
and continue to make our solution available for purchase through their Web
sites. We will continue to invest in Web-based training programs and regional
awareness programs that educate our resellers and subscribers all over the
world about the features and benefits of our products and services and that
assist our customers with deployment.

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 continue to invest in
marketing programs jointly executed with our distribution network around the
world. We will continue to participate in trade shows and regionally targeted
public relations activities both domestically and abroad, leverage our Web site
and links from the Web sites of our distribution network and promote the use of
the WatchGuard brand name when our service provider partners market their
managed security services.

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

Products and Services

  Our comprehensive security solutions, which include an integrated suite of
security and management software, an Internet security appliance and a dynamic
Internet-based service to keep security defenses current, provide access
control, VPN and server content and application security. Enterprises may use
our Firebox System to internally manage their Internet security or elect to
outsource security management to a service provider implementing our
LiveSecurity for MSS.

Security solutions for enterprise-managed security

  Using our security solutions for enterprise-managed security, an enterprise
can quickly and affordably deploy comprehensive security protection to all
sites on its network, while retaining centralized control and administration.
In addition, our LiveSecurity Service enables enterprises to augment their
information technology staff with our security experts, which we believe
substantially reduces personnel costs. Every new security system includes an
initial one-year subscription to our LiveSecurity Service.

  Firebox System

  For enterprises of all sizes, the Firebox System provides access control and
VPN through three key components: our security management system software with
security and management features, our security appliance and a subscription to
our Internet-based LiveSecurity Service.

  Security features. The Firebox System 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. For our SME and larger-enterprise products, our
     authentication features identify network users and define user and user-
     group security policies.

  .  Virtual private networking. Our software enables enterprises to create
     VPNs by using encryption technology to allow data to flow securely
     across the Internet between two predetermined points. Our branch office
     VPN, used in all of our Firebox System products, secures communications
     with branch offices and trading partners, and our remote-user VPN, used
     in our SME and larger-enterprise

                                       8
<PAGE>

     products, secures connections to telecommuters and traveling employees.
     Our VPN solutions implement industry standard protocols.

  .  Web surfing control. In our SME and larger-enterprise products, our Web-
     blocking feature enables enterprises to restrict site access privileges
     by user, group, time of day, site type or particular site. In our SOHO
     products, site access privileges may be restricted simply by site type.

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

  .  Integrated suite of system management tools. For our SME and larger-
     enterprise products, our security management system packages, configures
     and deploys security software, security policies and the operating
     system from the in-house manager's desktop computer to the enterprise's
     security appliances. The management system also includes logging and
     notification functions and real-time monitoring and historical reporting
     of network, service and bandwidth usage. Our SOHO products are managed
     by a Web-based interface accessed from the appliance itself or from
     remote management software. Our management tools allow management of
     multiple security appliances from a single location.

  .  Automated installation guides. Our automated installation guides enable
     enterprises to install and configure our systems in as quickly as 15 to
     30 minutes. Software updates or upgrades are also accessed through easy-
     to-use installation guides.

  Security appliance. Our security appliances for SMEs and larger enterprises
are standalone Internet security appliances that run the security functions of
the Firebox 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 hosting Web and e-mail servers. The
Firebox System encrypts communications between the security appliance and the
management software on the in-house manager's desktop.

  Our security appliances for SOHOs and telecommuters are standalone Internet
security appliances that run the security functions of the LiveSecurity System
and provide IP sharing. Our SOHO security appliances are increasingly being
used by enterprises as endpoints for VPNs. The security capabilities of the
SOHO security appliances come entirely from the operating system, security
software and security policies that reside on the appliances or that the
appliances receive from remote management software. They simply plug in and
reside between the SOHO's or telecommuter's Internet router and broadband 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.

  LiveSecurity Service. Through our subscription-based LiveSecurity Service, we
keep our family of security solutions current and allow them to continually
operate at their highest level for our customers. Our LiveSecurity Service
includes:

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

  .  Software updates. We deliver software updates that enhance the function
     of the Firebox System.

  .  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 WatchGuard
     products and information on new software updates.

  .  Virus alerts. We provide information from Trend Micro about the latest
     virus threats and offer access to its virus protection products.

                                       9
<PAGE>

  .  Training. We provide subscribers with access to interactive and Web-
     based product training and certification services.

  .  Support. We provide subscribers with access to various levels of
     interactive and Web-based technical support.

  ServerLock System

  For enterprises of all sizes, the ServerLock System provides server content
and application security that protects critical data and services against
unauthorized or unintentional access or manipulation. This protection is
offered through a combination of kernel-level software, secured remote
communications, centralized management and a simplified dual-mode
administrative model.

  System structure. The ServerLock System is comprised of the following
components:

  .  ServerLock. Our ServerLock software resides on the protected server and
     acts as a filter between operations by the user and execution by the
     operating system. This protects the system against unauthorized or
     unintentional changes by even the most privileged user, the system
     administrator.

  .  ServerLock Manager. Recognizing that users will implement ServerLock on
     multiple servers and, in large enterprises, on entire server farms, the
     ServerLock Manager is designed to maximize efficiency of control for
     tens and even hundreds of servers, all using secure, remote
     communication channels.

  .  ServerLock console. By allowing systems to be segregated into intuitive
     groupings by function, geography or any customer-selected criteria, the
     ServerLock console manages the protection state for all managed servers
     with a simple click of a mouse.

  Product features. ServerLock represents a new model for protecting data,
applications and the core of mission-critical systems by creating a new form of
protection on the server.

  .  Kernel-based protection. ServerLock's protection, from filtering user
     requests to authenticating changes in the protection state, operates
     from the kernel, the heart of the operating system. The kernel performs
     the most critical and fundamental system operations and represents the
     real core of any server. By applying ServerLock protection at this
     level, users are defended against virtually all attempts to corrupt
     systems.

  .  Simplified administration. Internet security has historically been an
     area of complexity and confusion for enterprises. The security
     appliance, pioneered by WatchGuard, represents an important and
     groundbreaking development in simplification. By using a simplified
     dual-mode model for administering the security policy, ServerLock
     extends that simplification to maintaining the integrity of server
     content and applications. Critical resources are managed in two modes,
     operational and administrative. In operational mode, designated server
     content and applications are protected from unauthorized or
     unintentional access or manipulation. In administrative mode, standard
     server protections are in force. ServerLock's simplified dual mode
     allows a technically naive user to understand the protection:
     operational mode is in place when the business is operating and
     administrative mode is in place when the server needs to be
     administered.

  .  Simplified installation. Designed to complement the manner in which
     servers are built, configured and run, ServerLock's specialized license
     keys allow straightforward installation and require little discretion on
     the part of the installer.

  .  Customizable protection. For protection of specialized resources or
     applications, ServerLock provides a utility for creating and managing
     custom rules that can be used to protect individual files, proprietary
     applications or site-specific configuration parameters. This
     customizable protection is also managed with a simple on/off,
     operational/administrative protection model.

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<PAGE>

  LiveSecurity Service. ServerLock customers also receive the benefits of our
LiveSecurity Service. This includes access to technical support, software
updates, threat responses, expert editorials, support flashes, virus alerts and
interactive training.

LiveSecurity for MSS for service providers

  To serve the needs of SMEs and larger enterprises that want to outsource
their Internet security and the needs of ISPs and other managed service
providers that want to provide this service, we created LiveSecurity for MSS.
LiveSecurity for MSS allows a service provider to centrally configure, monitor
and update the Internet security of thousands of managed customers. The service
provider can economically deliver a full range of security services while its
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 Service.

  Security features. LiveSecurity for MSS includes the same comprehensive set
of security features offered in our Firebox System.

  Management features. Centrally located at the service provider's network
operations center, our global policy manager software provides security
intelligence and configuration for all customer sites under management. Our
software allows the service provider 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
service provider customer's premises. The appliances receive and implement the
operating system, security software and security policies sent by the service
provider. All of our security appliances may be centrally managed by the
service provider.

  LiveSecurity Service. Through our LiveSecurity Service, the service
provider's network operations center receives threat responses, software
updates, expert editorials, support flashes and virus alerts. The service
provider then updates the security policy of its customers and transmits these
policy updates over its network to those customers.

  By receiving the benefits of our security solution through a service
provider, an enterprise gains a number of added advantages. The service
provider can

  .  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;

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

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

  Managed service providers, particularly those engaged in the fast-growing
area of Web hosting, continue to vie for competitive advantage in their
industry. With ServerLock, service providers can offer increased security for
hosted content with only minimal incremental cost. ServerLock's management and
deployment models enable lower cost of management and overhead through the same
intuitive design that minimizes the administrative costs for an enterprise
managing its own security.

  Customer service. We make customer service a priority. Our staff of support
representatives serves our end-users, resellers, distributors and service
provider partners by phone and e-mail from 4:00 a.m. to 7:00 p.m. Pacific time,
Monday through Friday, excluding national holidays, with expanded hours for
certain members of our distribution network. As of December 31, 2000, we had 41
customer support representatives. We also offer

                                       11
<PAGE>

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 newsgroups, vendor Web sites and hacker bulletin
boards. When the rapid response team identifies a new security threat, we send
an advisory to our LiveSecurity Service subscribers while we develop and test
software or configuration changes to neutralize the threat. We then deliver the
software updates or configuration recommendations to our subscribers. The team
also provides other information of interest relating to Internet security.

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

  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 e-mail
systems. Mr. Avolio is the co-author, with Paul Vixie, of Sendmail Theory and
Practice. 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, and consults with firms in designing and implementing
security applications. Mr. Farrow is the author of UNIX System Security and is
the co-author, with Rebecca Thomas, of UNIX Administrator's Guide to System V.
He writes a column for ;login:, the magazine of the USENIX Association, and a
network security column for Network magazine.

  David Piscitello. Mr. Piscitello is an internationally recognized expert in
internetworking and fast-packet technology. He founded Core Competence, a full-
service internetworking, broadband, security and network management consulting
firm with offices in Pennsylvania and South Carolina. He is the recipient of a
Bellcore President's Recognition Award for his contributions to SMDS, ATM and
customer network management for switched data services. Mr. Piscitello has
authored books on internetworking and remote access and publishes articles
regularly on a variety of subjects, including network security, wireless data
networking, switched internetworking, Internet security and VPNs. Mr.
Piscitello does testing, product reviews and evaluations of VPNs, firewalls,
intrusion detection and other security products for leading trade publications
and provides consultation to Fortune 100 companies on extranets and Internet
security. He is chairman of the Networld + Interop Program Committee and the
founder and program chairman of the Internet Security Conference.

Licensing and pricing

  We offer our resellers, distributors and service provider partners discounts
from current end-user list prices. In addition, we offer educational discounts
and occasional promotional pricing. All customers purchasing our Firebox and
ServerLock products receive a perpetual license for our security and management
software, which is included in the system price. Each end-user also receives a
renewable one-year subscription to our LiveSecurity Service. For LiveSecurity
for MSS, the service provider buys a license to use our network

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<PAGE>

operations center security suite management and security software and must have
an active subscription to the LiveSecurity Service for each customer security
appliance it manages.

Sales, Marketing and Distribution

  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. International sales generated 50% of our revenues in 1999 and 55% of
our revenues in 2000.

  We sell our security solutions through distributors, value-added resellers
and service providers and occasionally to end-users. We also sell our
LiveSecurity for MSS products and services directly to service providers. We
license our technology to certain original equipment manufacturers, or OEMs,
for resale as an embedded feature in their products. The OEM end-user then has
the ability to subscribe to our LiveSecurity Service. We resell our products
and services through more than 400 companies covering over 60 countries,
including

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

  .  value-added resellers, such as CDW Computer Centers, Inc., Fujitsu
     Business Systems, Ltd., Integrated Network Technologies, Network
     Computing Architects, Inc. and Solunet; and

  .  service providers, such as AlphaNet, AT&T Global Network Services Hong
     Kong Limited (AGNS Ltd.), Deutsche Telekom, Genuity, Internet Initiative
     Japan, Internet Security Systems, Interpath Communications, KPN,
     Nextcom, PSINet, Sunrise Communications and UUNet.

As part of our distribution network, thousands of resellers worldwide sell our
security solutions. Our agreements with our distribution network are
nonexclusive and provide for discounts based on the reseller's minimum purchase
targets or the volume that the reseller purchases or resells.

  We divide our sales organization regionally among the Americas, Europe/Middle
East/Africa and Asia/Pacific and have 57 sales personnel located domestically
and internationally. Assisting our distribution network within a specific
region is a central responsibility of our regional sales representatives.
Regional sales representatives manage our relationships with our distribution
network, help the distribution network sell and support key customer accounts,
and act as liaison between our distribution 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, service providers 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, regional awareness programs and
product technology conferences, sales training and marketing on our Web site.
As of December 31, 2000, we had 78 employees in our sales and marketing
organization.

  As an additional sales tool, we offer end-users, resellers and distributors
free training on our security solutions through our Web site. Our interactive
training system guides customers through the installation, setup and management
of our Firebox security solutions and provides new product information. The
ServerLock System is delivered with a set of sales and training materials for
both the reseller and the end-user, including live-action video and audio
question-and-answer segments. The ServerLock System automates the installation
process using license keys sold at the time of purchase to identify elements to
be installed and activated, which minimizes the time and skill necessary to
install the product.

                                       13
<PAGE>

  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 and, more recently, in the latter half
of the last month.

Customers

  As of December 31, 2000, we had shipped over 50,000 of our security
appliances to our distribution network, which resells our products and services
to end-users spanning a wide variety of countries and industries. The following
is a representative list of our customers:

             Service Providers           IDEs
             AlphaNet                    Bentley Systems,
             Deutsche Telekom            Incorporated
             Genuity                     Gerbig Snell/Weisheimer &
             Internet Initiative         Associates, Inc.
             Japan                       JDA Software Group, Inc.
             Nextcom                     MediaPlant
             Sunrise Communications      Old Dutch Foods
             UUNet                       Siemens AG
                                         The Staubach Company
             SMEs
             Australian Hospital Care    SOHOs
             Boullioun Aviation          Colony Homes
             Services                    GLG Group, Inc.
             Bolle Inc.                  Into Tomorrow Radio
             City of Bellingham, WA      Network
             e-DOCS.net                  Martin Staffing
             Englewood Public Schools    Resources
             Graham Steel Corporation    Pro-2000 Inc.
                                         Sensazione Studios
                                         Watershed Associates

Technology and Architecture

  Firebox System

  Our Firebox System 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 our LiveSecurity Service, which
provides new security software and operating system configurations.

  Our Firebox System encrypts communications between WatchGuard, the management
system software and the security appliance. This allows the management system
and the appliance to be separated within an enterprise's local- or wide-area
network or between a service provider 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 our LiveSecurity Service over the Internet.

  Security appliance. Our security appliances are dedicated solely to running
security functions. The security appliances have no other function and no hard
drive memory storage.

  Operating system software. Our security appliance uses a Linux or VxWorks
operating system. In the case of the Linux operating system, used in our SME
and larger-enterprise products, we use a custom-configured kernel under an open
source license, which enables us to review the source code and generate a
flexible, robust and secure operating system. We use specially designed
application programming interfaces in all of our Firebox products to facilitate
secure loading of the operating system and security software that our
management software sends to the appliance.

                                       14
<PAGE>

  Security features. The Firebox System 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 on an
extensible set of network service protocols, such as HTTP and SMTP. The Firebox
appliance applies the security policies defined by the management system to all
incoming or outgoing traffic. 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 VPN component currently
supports IPSec standards and the authentication module in our SME and larger-
enterprise products supports a variety of standard authentication methods. We
intend to adopt additional standards as they mature in the market.

  Management features. Because enterprise, distributed VPN and service provider
environments are very different, we designed separate management systems for
each. Our Firebox System management software enables quick installation and
management by an in-house manager using a standard Windows-based system. The
VPN management software in each of our security appliance types is designed
specifically for ease of configuration and visual representation of multiple
VPNs in a network. We designed our 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. All management
systems have the ability to remotely deploy new security software to the
appliances or update their security engines from the management console. Our
service provider customers can choose to separately and remotely deploy select
security features, such as VPN and Web blocking. This gives service providers
the ability to incrementally add for-fee services to their basic service
offering, without the expense of sending personnel to their customers' sites.
Our SOHO and telecommuter customers can also choose a simple Web-based
management interface, which removes the need to install management software.

  To enable service providers 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 service provider'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 Service. Our scalable LiveSecurity Service is a collection of
secured servers that registers subscribers, facilitates downloading our
software to the desktop computers of registered subscribers and delivers threat
responses, software updates, expert editorials, support 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 can replicate and distribute our LiveSecurity
servers throughout the world, which should enable us to meet the growth we
expect in demand for our LiveSecurity Service.

  ServerLock System

  The ServerLock System represents an innovative approach to securing content.
Designed to address architectural vulnerabilities in existing models of popular
multi-user operating systems, ServerLock provides content and application
security by protecting against unauthorized change activity, even when
attempted by the most privileged system users. The ServerLock System has four
key components:

  .  ServerLock. The ServerLock software runs on and protects the servers on
     which it is installed. Acting as a filter between requests for changes
     and the actual execution of those changes within the

                                       15
<PAGE>

     operating system kernel, ServerLock prevents changes to the operating
     system's static components and the configurations that implement that
     server's security policies.

  .  Kernel-based authentication and communication. Because all user-space
     processes, including authentication, are vulnerable to attack or
     accidental corruption by a privileged user or system administrator,
     ServerLock implements both its protection and its enabling
     authentication within the kernel of the operating system it protects.
     ServerLock also enables kernel-to-kernel remote communication using
     strong encryption implemented through a 239-bit elliptic curve
     cryptosystem adapted for ServerLock.

  .  Central management. To facilitate adoption by larger enterprises and
     service providers, ServerLock may be managed remotely through the
     ServerLock management software. The ServerLock Manager allows the
     administrators or service providers to control multiple servers by
     applying custom rules and turning protection on and off in much the same
     manner as those tasks are performed locally. ServerLock's remote
     communications channel simplifies setting and resetting the protection
     state of remote machines and makes aggregating systems easier, for
     simplicity of depiction in a managed environment.

  .  Remote configuration and management. The ServerLock configuration
     interface is fully portable and may be run on remote administrator
     systems and laptops, thereby connecting security functions to the
     central management server.

Research and Development

  We focus our research and development efforts on enhancing our existing
products and services, developing new products based on our innovative
distributed-appliance architecture and developing services that capitalize on
our LiveSecurity Service infrastructure. We use a modular design, which allows
us to develop new applications that plug into our existing product line. As a
result, our products can be deployed in stages, either directly by an
enterprise or by a service provider if the enterprise has outsourced its
security management. As we develop new products, our LiveSecurity end-users
and service provider partners can incorporate the new products into their
systems with minimal system interruption.

  As of December 31, 2000, we employed 130 people on our research and
development staff. Research and development expenses were $4.4 million in
1998, $7.1 million in 1999 and $13.9 million in 2000. We have product
development facilities in Seattle, Washington, Waltham, Massachusetts and
Aliso Viejo, California.

Competition

  We compete in a market that is relatively 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 service
providers. 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, customer support and distribution capability.
Currently, the primary competitors in our industry include Cisco Systems,
Inc., Check Point Software Technologies Ltd., Nokia Corporation and SonicWALL
Inc. Other competitors offering security products include hardware and
software vendors such as Netscreen 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

                                      16
<PAGE>

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 greater 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 relationship 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 some of our competitors have traditionally targeted large-enterprise
security needs, using complex products that run on general purpose operating
systems 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 our markets. If these or other of our competitors were to focus
their greater financial, technical and marketing resources in our markets, our
business could be harmed. In addition, as our security solutions are adopted by
larger enterprises, we expect to see increased competition. 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;

  .  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, and LiveSecurity(R) is a registered trademark in the
European Union and Mexico. Applications to register the WatchGuard and
LiveSecurity trademarks are pending in other jurisdictions. Firebox(TM),
ServerLock(TM), LockSolid(TM), QSecure LockSolid(TM), SpamScreen(TM) and
LiveSecurity(TM) are trademarks in use in the United States, and applications
are pending in the United States and other jurisdictions for registration of
these trademarks. We also have other trademarks in use in the United States
that do not currently have applications pending in any jurisdiction. We have no
issued patents but have 12 patents pending.

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

  .  BSAFE encryption toolkit from RSA Data Security, Inc. We use the
     encryption functions of this industry-standard product in our remote
     office VPN product.

  .  Cyber Patrol database from The Learning Company. We use this database to
     provide blocking of particular Web addresses as part of our Web-blocking
     module.

  .  Linux kernel. We use a customized version of the Linux operating system
     in our SME and larger- enterprise security appliances.

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

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

                                       17
<PAGE>

  .  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 security appliance.

  .  Intronic Semiconductor Inc. We use this 3DES software technology in our
     SOHO and telecommuter products.

  .  CertiCom Elliptic Curve Cryptosystem. We use this cryptosystem to
     authenticate protection changes and encrypt communications in our
     ServerLock products.

  .  OSR Technologies KSOCKS. We use the KSOCKS product to achieve a
     heterogeneous network signature for remote communications in our
     ServerLock products.

  .  RSA Inc. SecurID. We use SecurID's two-factor technologies to provide an
     additional level of security and accountability in our ServerLock
     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. Federal 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. The BXA has
granted retail export status to our SOHO and telecommuter security appliances,
which use encryption in branch office VPN software, and is currently reviewing
our FastVPN security appliance for retail export status. We are eligible to
export products that qualify for retail export status to all nonembargoed and
nonrestricted foreign end-users, including government entities.

Manufacturing

  We currently outsource all hardware manufacturing and assembly for our
Firebox appliances for SMEs and larger enterprises to two companies:
Washington-based Electronic Manufacturing Corporation, our primary supplier,
and California-based Force Computer Corporation. Our contract manufacturer for
our Firebox appliance for SOHOs and telecommuters is Trantronics Inc., a
California-based company. All three manufacturers are certified as meeting the
International Organization for Standardization's quality assurance standards
ISO 9001 and 9002. Other contract manufacturers are currently under review for
potential agreements as either primary or backup suppliers for current and
future products. Worldwide distribution is currently performed at our
distribution facility in Seattle, Washington.

Employees

  As of December 31, 2000, we had 287 employees. Of these, 78 were employed in
sales and marketing, 30 in finance and administration, 41 in customer support
and 138 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.


                                       18
<PAGE>

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 in the past and may not achieve or sustain consistent
profitability, which could result in a decline in the value of our common
stock.

  Since inception through the fourth quarter of 2000, we incurred net losses
and experienced negative cash flows from operations in each quarter, except for
the third quarter of 2000. As of December 31, 2000, we had an accumulated
deficit of approximately $45.6 million. 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 and we may not achieve or sustain profitability in future periods.
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;

  .  upgrading our information and internal control systems; and

  .  integrating acquisitions of businesses, products and technologies and
     pursuing additional strategic acquisitions.

  If we are unable to achieve or sustain profitability in future quarters, the
trading price of our common stock could decline.

Our operating results fluctuate and could fall below expectations of securities
analysts and investors, resulting in a decline 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 meaningful. In addition,
our limited operating history makes predicting our future performance
difficult. In the fourth quarter of 2000, our operating results fell below the
expectations of securities analysts and investors and our operating results for
a future quarter or year may again fail to meet market expectations. This could
result in a decline in our stock price.

  Beginning in the fourth quarter of 2000 and continuing into the first quarter
of 2001, we have seen a general economic downturn in the U.S. economy, which
has affected the demand for our products and services. We do not know how long
this economic downturn will last or how severe it will become. We also cannot
predict the extent and timing, if any, of the impact of the economic downturn
in the United States on economies in other countries and geographic regions in
which we conduct business. To the extent that this downturn continues or
spreads to other geographic regions, the Internet security industry and demand
for our products and services are likely to be adversely affected and could
result in a decline 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 decline in our stock price.


                                       19
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Because many potential customers remain 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 the market understands the need for Internet security and we
can 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
Internet security products and related services, including subscription fees,
and we cannot succeed if the market does not accept these products and
services. Our success depends on our ability and the ability of our
distribution network, which includes distributors, value-added resellers, ISPs
and other managed service providers and OEMs, to obtain and retain LiveSecurity
customers. Some of our LiveSecurity products and services, however, are
relatively new and unproven. The broadcast portion of our LiveSecurity solution
has been available only since February 1999, our Firebox products for SOHOs and
telecommuters have been available only since February 2000 and our ServerLock
products were launched under the WatchGuard brand only in February 2001. To
receive our LiveSecurity Service, enterprises will be required to pay an annual
subscription fee, either to us or, if they obtain the LiveSecurity Service
through one of our channel partners, to the channel partner. We are not aware
of any other Internet security product that allows enterprises to keep their
security solution current by receiving 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 LiveSecurity Service is
relatively new, we cannot accurately 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 using 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.

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 decline in our stock price.

  The growth rate of our domestic and international sales has been and may
continue 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 and, more recently, in the latter half of the 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 decline in our stock price.

The integration of Qiave and any future acquisitions may be costly, difficult
and disruptive.

  In October 2000, we acquired Qiave Technologies Corporation, a privately held
provider of digital information security products. As part of our business
strategy, we may acquire other companies, products or technologies. The Qiave
acquisition, and any future acquisitions, will subject us to numerous
operational and financial risks and difficulties, including

  .  loss of key personnel;

  .  difficulties in assimilating the acquired company's technologies,
     products, personnel and operations;

  .  disruption of our ongoing business and diversion of management
     attention;


                                       20
<PAGE>

  .  assumption of known and unknown liabilities;

  .  higher-than-expected acquisition and integration costs and charges
     against earnings;

  .  potentially dilutive issuances of equity securities; and

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

  We may be unable to successfully integrate Qiave or any future acquisition.
In addition, we may not gain any substantial benefit from the Qiave acquisition
or from any businesses, products or technologies that we acquire in the future,
notwithstanding the significant expenditure of time and financial, personnel
and other resources.

If our newly established relationships with OEMs are unsuccessful, our ability
to generate revenues from the OEM line of business will be limited.

  We have recently established relationships with several domestic and
international OEM partners to incorporate our technology into their products.
If these OEM partners are unsuccessful in marketing and implementing our
technology or the benefits realized from their implementation of our technology
are lower than expected, this line of business will be unable to generate the
levels of revenue we expect. Because our relationships with OEMs are new and
unproven, we cannot predict the degree to which the OEMs will succeed in
marketing and selling our products and services. The OEMs with which we have
established relationships have not had an opportunity to fully develop and
implement product or service offerings incorporating our technology. We cannot
predict how long our current or potential OEM partners will take to complete
this development and implementation. Until and unless this development and
implementation is achieved, our revenues from OEM partnerships will be limited.
If our OEM partners fail to provide adequate installation, deployment and
support of our products and services, end-users could choose not to purchase
OEM products that include our technology. Our OEM partners will offer our
products and services in combination with other products and services, some of
which may compete with our products and services. In addition, we may be unable
to maintain our existing relationships with OEM partners or establish new OEM
relationships in the future.

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

  We sell most of our products and services through our distribution network,
and we expect our success to continue to depend in large part on their
performance. Our channel partners 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.
Currently, two channel partners, Ingram Micro and Tech Data, together account
for 22% of our revenues. The loss of one of these distributors, a reduction in
their sales or a loss or reduction in sales involving one or more other channel
partners, particularly if the reduction results in increased sales of
competitive products, could harm our business.

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 primary competitors in our industry include Cisco Systems, Inc., Check
Point Software Technologies Ltd., Nokia Corporation and SonicWALL Inc. Other
competitors offering security products include hardware and software vendors
such as Netscreen 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. Many
of our competitors have longer operating histories, greater name recognition,
larger customer

                                       21
<PAGE>

bases and significantly greater financial, technical, marketing and other
resources than we do. In addition, our current and potential competitors may
establish cooperative relationships among themselves or with third parties that
may further enhance their resources. As a result, they may be able to adapt
more quickly to new 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.

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

  We provide some of our channel partners with product return rights for stock
rotation. We also provide some of our channel partners with price protection
rights for their inventories, which they may exercise 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,
for example, 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, 1998,
1999, and 2000, were $1.7 million, $1.1 million and $1.9 million, or 13%, 5%
and 3% of total revenues before returns and allowances.

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. 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 and services, 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.

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

                                       22
<PAGE>

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 channel
partners may sue us. In addition, we may face liability for breaches caused by
faulty installation and implementation of our products by end-users or channel
partners. 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 or our channel partners to lose current and potential customers
or cause us to lose potential channel 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 are a significant target of 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.

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 utilize limited 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 the LiveSecurity Service.

                                       23
<PAGE>

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 licensors 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 component
manufacturers fail to supply component parts with acceptable quantity, quality
and cost.

  We obtain the component parts for our hardware from a variety of
manufacturers. While our component vendors have produced parts for us in
acceptable quantities and with acceptable quality and cost in the past, they
may be unable to do so in the future. Companies in the electronics industry
regularly experience lower-than-required component allocations, and the
industry is subject to frequent component shortfalls. Although we believe that
we could find additional or replacement sources for our hardware components,
our operations could be disrupted if we have to add or switch to a replacement
vendor or if our component supply is interrupted for an extended period. This
could result in loss of customer orders and revenue.

We may need additional capital and our ability to secure additional funding is
uncertain.

  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. We may seek additional funding through

  .  public or private equity financings, which could result in significant
     dilution to stockholders;

  .  public or private debt financings; and

  .  capital lease transactions.

  We believe that existing cash and cash equivalent balances will be sufficient
to meet our capital required for at least the next 12 months. Our capital
requirements will depend on several factors, however, including

  .  the rate of market acceptance of our products and services;

  .  our ability to expand our customer base;

  .  the growth of our sales and marketing capabilities; and

  .  the cost of any acquisitions we may complete.

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.

  If we fail to obtain and maintain patent protection for our technology, we
may be unable to compete effectively. We have 12 patents pending, but our
patent applications may not result in issued patents. Even if

                                       24
<PAGE>

we secure a patent, the patent may not provide meaningful protection. In
addition, we rely on unpatented proprietary technology. Because this
proprietary technology does not have patent protection, we may be unable to
meaningfully protect this technology from unauthorized use or misappropriation
by a third party. In addition, our competitors may independently develop
similar or superior technologies or duplicate any unpatented technologies that
we have developed, which could significantly reduce the value of our
proprietary technology or threaten our market position.

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 or our channel partners.

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
other countries 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.

                                       25
<PAGE>

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 on 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 the United
States accounted for approximately 35% of our revenues in 1998, 50% in 1999 and
55% in 2000. The failure of our channel partners 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 has
made and may continue to make our products less competitive in international
markets.

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' earnings projections or recommendations;

  .  failure to meet analysts' revenue or earnings projections;

  .  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.

Changes in or interpretations of accounting rules may adversely impact future
and past results of operations.

  We prepare our financial statements in conformity with accounting principles
generally accepted in the United States. These principles have changed
frequently and are subject to ongoing change and interpretation by the
Financial Accounting Standards Board, the Securities and Exchange Commission
and other agencies and organizations. A change in generally accepted accounting
principles could significantly affect our reported

                                       26
<PAGE>

results of operations or the reporting of transactions completed before a
change is announced, which could require us to restate our prior published
financial statements. Accounting standards that impact the technology and
software sectors in which we operate and that are currently under review
include

  .  rules relating to revenue recognition, including rules affecting the
     recognition of revenue from the sale of software or related services;

  .  rules relating to the classification of costs related to marketing
     programs, which may impact sales discounts, cost of sales or marketing
     expenses; and

  .  accounting for stock-based compensation for employees and nonemployees.

Any changes to these accounting principles or the way they are interpreted or
applied could significantly affect our reported financial results or the way in
which we conduct business.

ITEM 2. PROPERTIES

  Our principal administrative, marketing, sales, development and operations
facility is located in Seattle, Washington. We occupy approximately 90,000
square feet in this facility (including space that is subleased) under a lease
that expires in September 2010. We also maintain a product fulfillment and
distribution warehouse in Seattle. In addition, we maintain offices in Aliso
Viejo, California and Waltham, Massachusetts.

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 2000.

                                       27
<PAGE>

                                    PART II

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

   Year Ended December 31, 2000
   First quarter...............................................  125.36   22.63
   Second quarter..............................................   90.94   27.00
   Third quarter...............................................   73.50   45.00
   Fourth quarter..............................................   60.13   17.81
</TABLE>

  The last reported sale price of our common stock on the Nasdaq National
Market on March 27, 2001 was $9.25 per share.

Holders

  As of March 15, 2001, there were approximately 160 holders of record of our
common stock. This does not include the number of persons whose stock is held
in nominee or "street name" through brokers or other fiduciaries.

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 with Silicon Valley Bank
prohibits the payment of dividends without the bank's prior written consent.

Recent Sales of Unregistered Securities

  On October 4, 2000, we issued 1,292,997 shares of our common stock in
connection with our acquisition of Qiave Technologies Corporation. 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.

  On November 9, 2000, we issued 198,446 shares of our common stock in
connection with the exercise of a warrant by a customer. 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.

Use of Proceeds

  On July 29, 1999, our registration statement on Form S-1 for our public
offering, file number 333-76587, became effective. The offering terminated as a
result of the sale of all shares offered. After accounting for underwriting
discounts and commissions and other expenses, we received net proceeds of
approximately $40.7 million.

                                       28
<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

  When you read this selected financial data, it is important that you also
read the historical consolidated financial statements and related notes
included in this annual report, as well as the section entitled "Management's
Discussion and Analysis of Financial Condition and Results of Operations." The
historical results are not necessarily indicative of future results.

<TABLE>
<CAPTION>
                            Period From
                         February 14, 1996        Year Ended December 31,
                          (Inception) to   ----------------------------------------
                         December 31, 1996   1997      1998      1999       2000
                         ----------------- --------  --------  ---------  ---------
                                  (In thousands, except per share data)
<S>                      <C>               <C>       <C>       <C>        <C>
Consolidated Statement
 of Operations Data:
 Revenues:
  Product...............      $  329       $  4,975  $ 10,678  $  17,329  $  52,010
  Service...............           2            123       701      3,290      8,693
                              ------       --------  --------  ---------  ---------
   Total revenues.......         331          5,098    11,379     20,619     60,703
 Cost of revenues:
  Product...............         104          1,529     3,653      6,954     18,932
  Service...............         --              81       272      1,010      2,987
                              ------       --------  --------  ---------  ---------
   Total cost of
    revenues............         104          1,610     3,925      7,964     21,919
                              ------       --------  --------  ---------  ---------
 Gross margin...........         227          3,488     7,454     12,655     38,784
 Operating expenses:
  Sales and marketing...         224          4,369     8,519     13,512     24,213
  Research and
   development..........         274          2,192     4,442      7,118     13,900
  General and
   administrative.......         191          1,323     2,454      3,646      6,001
  Stock-based
   compensation.........         --             --      1,039        926      8,407
  Acquired in-process
   technology and
   amortization of
   goodwill, purchased
   technology and other
   intangible assets
   acquired.............         --             --        --       3,626      8,227
                              ------       --------  --------  ---------  ---------
   Total operating
    expenses............         689          7,884    16,454     28,828     60,748
                              ------       --------  --------  ---------  ---------
 Operating loss.........        (462)        (4,396)   (9,000)   (16,173)   (21,964)
 Interest income
  (expense), net........          (6)            62      (119)       155      6,515
                              ------       --------  --------  ---------  ---------
 Loss before income
  taxes.................        (468)        (4,334)   (9,119)   (16,018)   (15,449)
 Provision for income
  taxes.................         --             --        --         --         215
                              ------       --------  --------  ---------  ---------
 Net loss...............      $ (468)      $ (4,334) $ (9,119) $ (16,018) $ (15,664)
                              ======       ========  ========  =========  =========
 Basic and diluted net
  loss per share (1)....         N/A       $ (17.17) $ (11.34) $   (1.80) $   (0.66)
                              ======       ========  ========  =========  =========
 Shares used in
  calculating basic and
  diluted net loss per
  share (1).............         N/A            252       804      8,903     23,556
                              ======       ========  ========  =========  =========
</TABLE>
--------
(1) See Notes 1 and 6 of Notes to Consolidated Financial Statements for an
    explanation of the method used to calculate basic and diluted net loss per
    share.

                                       29
<PAGE>

<TABLE>
<CAPTION>
                                                     December 31,
                                          -------------------------------------
                                          1996   1997   1998    1999     2000
                                          -----  ----- ------  ------- --------
                                                    (In thousands)
<S>                                       <C>    <C>   <C>     <C>     <C>
Consolidated Balance Sheet Data:
 Cash, cash equivalents and securities
  available for sale..................... $ 232  $ 603 $1,712  $26,401 $115,115
 Deferred revenue .......................   334    313  1,841    4,233   11,874
 Long-term debt .........................   --     --     --       --       --
 Working capital (deficit) ..............  (464)   658   (274)  24,395  117,065
 Total assets............................   597  3,303  9,032   41,311  195,930
 Total stockholders' equity (deficit)....  (318) 1,382    881   32,245  172,405
 Dividends payable ......................   --     --     --       --       --
</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 that use the Internet for electronic commerce and secure
communications. Our award-winning products and services include firewalls for
access control, virtual private networks, or VPNs, for secure communications
and our new ServerLock products for server content and application security.
Our core market includes small- to medium-sized enterprises, or SMEs, large
Internet-distributed enterprises, or IDEs, with ultra-high-speed connections
supporting VPNs between the IDEs and their geographically dispersed branch
offices and telecommuters, small and home offices, or SOHOs, with broadband
connections, and telecommuters. Our recent acquisition of Qiave Technologies
Corporation allowed us to expand our product line with a software-based
solution designed to protect server content and applications from unauthorized
and unintentional access and manipulation. Our innovative subscription-based
LiveSecurity Service delivers threat responses, software updates, expert
editorials, support flashes and virus alerts over the Internet, which enables
enterprises to protect their data and communications in a continuously changing
environment, with minimal effort.

  Since our inception, we have invested heavily in the development of our
products and services and financed our operations as follows:

  .  In September 1996, we introduced our initial Firebox security appliance
     and began selling our products both domestically and internationally.

  .  In 1997, we significantly expanded our worldwide sales and marketing
     efforts.

  .  In 1998, we launched our managed security offering for Internet service
     providers and other managed service providers and introduced our second-
     generation security appliance, which added significant functionality to
     our existing product lines.

  .  In February 1999, we launched the broadcast portion of our LiveSecurity
     Service.

  .  In July 1999, we raised net proceeds of $40.7 million in 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 broadband Internet security
     division.

  .  In January 2000, we announced the introduction of our security solutions
     for SOHOs and telecommuters, which we began shipping in the first
     quarter of 2000.

  .  In February 2000, we raised net proceeds of $90.4 million in a follow-on
     public offering of our common stock.

                                       30
<PAGE>

  .  In October 2000, we acquired Qiave, a developer of digital information
     security systems, which allowed us to expand our product line with
     ServerLock, which protects server content and applications against
     unauthorized or unintentional changes.

Sources of Revenues and Revenue Recognition Policy

  We generate revenues through

  .  sales of products and service subscriptions indirectly through our
     distribution network at a discount from list price;

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

  .  sales of service subscription renewals directly to our end-users.

  Product revenues include

  .  the perpetual software license fees for our Firebox System and the sale
     of our security appliance as part of our security solutions;

  .  the sales of software options, such as VPN;

  .  the sales of our network operations center, or NOC, security suite
     software license and our security appliance as part of LiveSecurity for
     MSS. Future product revenues will also include sales from our new
     ServerLock product line.

  Service revenues include the annual fee for our LiveSecurity Service, which
is sold as part of our security solution, and for LiveSecurity subscription
renewals from our enterprise customers and end-users. These services provide
access to our LiveSecurity Service for product updates, security threat
responses, general security information and technical support. These services
also provide our service provider customers access to the LiveSecurity Service
and the ability to manage and update a specific number of their customers'
security appliances.

  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. While we generally recognize product revenues upon
shipment, we defer revenues on product sales for two of our major distributors
until these distributors have sold the product to their customers. Service
subscription revenues are recognized ratably on a monthly basis, generally over
a one-year period.

                                       31
<PAGE>

Recent Acquisition

  In October 2000, we acquired Qiave. The total consideration paid for Qiave
was approximately $70.0 million, including approximately $400,000 in direct
acquisition costs, and was comprised of 1,292,997 shares of WatchGuard common
stock, including 299,495 shares that are subject to repurchase as described
below. Total consideration for Qiave included $19.3 million in deferred stock-
based compensation charges, of which $15.0 million related to the issuance of
common stock subject to repurchase and $4.3 million related to options we
assumed to purchase 100,856 shares of our common stock at a weighted average
exercise price of $0.46 per share. The aggregate purchase price was allocated
based on estimated fair values on the acquisition date, as determined by an
independent appraisal, and excludes $19.3 million in consideration related to
deferred stock-based compensation for common stock subject to restriction and
unvested options we assumed (in thousands):

<TABLE>
   <S>                                                                 <C>
   Fair value of Qiave tangible assets, net of current liabilities.... $    654
   Intangible assets:
     Acquired workforce...............................................      592
     Current technology...............................................   13,351
     Goodwill.........................................................   31,707
                                                                       --------
   Total intangibles..................................................   46,304
   Acquired in-process research and development.......................    4,399
                                                                       --------
                                                                         50,703
   Deferred stock-based compensation..................................   19,342
                                                                       --------
   Total consideration, including deferred stock-based compensation... $ 70,045
                                                                       ========
</TABLE>

  Acquired workforce. The value assigned to the workforce in place was
determined using the avoided cost approach. Under this approach, the workforce
is valued according to the costs WatchGuard avoided by obtaining a pre-
existing, trained and fully efficient team rather than assembling a workforce.

  Developed technology. Values assigned to the developed technology were
determined using the income approach. Under the income approach, fair value
reflects the present value of the projected earnings that are expected to be
generated by the current technology. To determine the value of the developed
technology, WatchGuard discounted the expected future cash flows of the
existing technology products at a rate of 25%, 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 projected revenues used in the income
approach are based on the future revenues that we believe will most likely be
generated by the commercial sales of the technology.

  Stock-based compensation. In connection with the employment agreements and
related stock retention agreements with four of Qiave's key employees, a
portion of the shares of common stock otherwise issuable to these employees
pursuant to the merger agreement are subject to repurchase by us in the event
that the employee's employment is terminated under specified circumstances.
These shares will be released from the repurchase restriction over a two-year
vesting period. We recorded the value of this stock as deferred stock-based
compensation, based on the fair value of our common stock on the closing date
of the merger. We also recorded deferred stock-based compensation in connection
with the assumption of unvested options to purchase Qiave common stock, based
on the intrinsic value of the unvested options at the closing date of the
merger.

  Acquired in-process research and development. Values assigned to acquired in-
process research and development, or IPR&D, were determined using an income
approach. To determine the value of IPR&D, 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 include 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
IPR&D projects that had not yet

                                       32
<PAGE>

reached technological feasibility and do not have alternative future uses. We
expensed the entire $4,399,000 allocated to acquired IPR&D on the date of
acquisition.

  At the time of the acquisition, we identified six IPR&D projects as being
related to future products for which technological or commercial feasibility
had not yet been established and that did not have an alternative future use.
We analyzed each project, using estimated percentage completion factors ranging
from 10% to 85%. Revenues attributable to Qiave's IPR&D were assumed to
increase after each of the first three years of a five-year projection period
after the year of introduction, at annual rates ranging from 60% to 216%,
decreasing to a 27% growth rate in revenues after the fourth year in the
projection. Projected annual revenues related to in-process technology ranged
from approximately $1.1 million to $14.8 million over the term of the
projections. These projections were based on aggregate revenue growth rates for
the business as a whole, anticipated growth rates for the Internet security
market, anticipated product development and product introduction cycles and the
estimated life of the underlying technology.

  Gross profit was assumed to remain at 93% of revenues for each of the five
years of the projection period. Operating expenses, including sales and
marketing, research and development and general and administrative costs, were
assumed to be 48% of revenues in the initial year of the projection, declining
to 44% for each of the four remaining years.

  We used a 35% discount rate for valuing the acquired IPR&D. In arriving at
the discount rate, we considered the implied rate of the transaction and the
weighted average cost of capital. We also took into account risks related to
the characteristics and applications of each project, existing future markets
and estimated life cycles of each project.

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,
                                                        ---------------------
                                                        1998    1999    2000
                                                        -----   -----   -----
   <S>                                                  <C>     <C>     <C>
   Revenues:
    Product............................................  93.8 %  84.0 %  85.7 %
    Service............................................   6.2    16.0    14.3
                                                        -----   -----   -----
      Total revenues................................... 100.0   100.0   100.0
   Cost of revenues:
    Product............................................  32.1    33.7    31.2
    Service............................................   2.4     4.9     4.9
                                                        -----   -----   -----
      Total cost of revenues...........................  34.5    38.6    36.1
   Gross margin........................................  65.5    61.4    63.9
   Operating expenses:
    Sales and marketing................................  74.9    65.5    39.9
    Research and development...........................  39.0    34.5    22.9
    General and administrative.........................  21.6    17.7     9.9
    Stock-based compensation...........................   9.1     4.5    13.8
    Acquired in-process technology and amortization of
     goodwill, purchased technology and other
     intangible assets acquired........................   --     17.6    13.6
                                                        -----   -----   -----
      Total operating expenses......................... 144.6   139.8   100.1
                                                        -----   -----   -----
   Operating loss...................................... (79.1)  (78.4)  (36.2)
   Interest income (expense), net......................  (1.0)    0.7    10.7
                                                        -----   -----   -----
   Loss before income taxes............................ (80.1)  (77.7)  (25.5)
   Provision for income taxes..........................   --      --      0.4
                                                        -----   -----   -----
   Net loss............................................ (80.1)% (77.7)% (25.8)%
                                                        =====   =====   =====
</TABLE>

                                       33
<PAGE>

Years Ended December 31, 1999 and 2000

Revenues

  Total revenues, which consist of product revenues and service revenues,
increased from $20.6 million in 1999 to $60.7 million in 2000, an increase of
194%. 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 50% of
total revenues in 1999 and 55% in 2000. In 1999, no one customer accounted for
more than 10% of total revenues. In 2000, however, worldwide revenues from one
of our distributors, Ingram Micro, were $7.3 million or 12% of total revenues,
and revenues from another distributor, Tech Data, were $6.4 million, or 10% of
total revenues.

  Product revenues include

  .  the perpetual software license fees for our Firebox System and the sale
     of our security appliance as part of our security solutions;

  .  the sales of software options, such as VPN; and

  .  the sales of our NOC security suite software license and our security
     appliance as part of LiveSecurity for MSS.

Future product revenues will also include sales from our new ServerLock product
line. Product revenues increased from $17.3 million in 1999 to $52.0 million in
2000, an increase of 200%. As a percentage of total revenues, product revenues
increased from 84% in 1999 to 86% in 2000. We do not believe that the
historical percentage growth rates of product revenues will be sustainable as
our revenue base increases.

  Service revenues include the annual fee for our LiveSecurity Service, which
is sold as part of the Firebox System and LiveSecurity for MSS. Service
revenues increased from $3.3 million in 1999 to $8.7 million in 2000, an
increase of 164%. As a percentage of total revenues, service revenues decreased
from 16% in 1999 to 14% in 2000, which reflects the significant growth in
product revenues, offsetting the impact of growth in service revenue from the
increased base of customers renewing their LiveSecurity subscriptions.

  We have established a returns and allowances reserve to address the return
rights and pricing protection rights of some of our customers. The provision
for sales returns and allowances was $1.1 million, or 5% of total revenues
before returns and allowances, in 1999 and $1.9 million, or 3% of total
revenues before returns and allowances, in 2000. The decrease in the provision
as a percentage of total revenues reflects a reduction in the returns and
pricing protection allowances based on historical trends, no recent
introduction of major replacement products and no significant changes in our
product and service pricing over the course of the year. We expect to continue
to introduce new products each year, which may impact our reserve for sales
returns and allowances.

Cost of Revenues and Gross Margin

  Total cost of revenues, which includes product and service costs, increased
from $8.0 million in 1999 to $21.9 million in 2000, an increase of 175%. As a
percentage of total revenues, cost of revenues decreased from 39% in 1999 to
36% in 2000. Gross margins are impacted by various factors, including the
volume discount rates contained in our customer agreements, the cost of
manufacturing our Firebox appliances, the mix of product and service sales,
which may include hardware and software products or service subscriptions or
both, the cost of royalties associated with our products and the costs of our
technical support organization and LiveSecurity Service.

  Cost of product revenues, which includes the cost of manufacturing our
security appliance, product packaging and third-party product licensing fees,
increased from $7.0 million in 1999 to $18.9 million in 2000, an increase of
172%, primarily due to greater sales volume. As a percentage of total revenues,
cost of product revenues decreased from 34% in 1999 to 31% in 2000. The
decrease as a percentage of total revenues primarily

                                       34
<PAGE>

reflects a decrease in the cost of manufacturing our Firebox security
appliances during 2000 and, to a lesser extent, an increase in revenues from
software options that generally have higher gross margins than our Firebox
appliances. Over time, as volume levels increase, we expect the unit costs to
manufacture our security appliances to continue to decrease. Competitive
pressures in the future may lead to a negative impact on the gross margins of
our existing product line. However, we expect that product mix changes in the
future, with the addition of software products such as our ServerLock product
line, will have a positive impact on gross margins.

  Cost of service revenues, which includes the costs of our technical support
organization and costs associated with our LiveSecurity Service, increased from
$1.0 million in 1999 to $3.0 million in 2000, an increase of 200%. This
increase reflects an investment in our customer support organization to assist
the growing number of customers who are implementing VPNs in a more complex
environment, in addition to a broader customer base. As a percentage of total
revenues, cost of service revenues was 5% for both 1999 and 2000. We expect
service costs to increase in total dollar amount as our user base expands. In
the longer term, as revenues from LiveSecurity subscriptions increase and
account for a greater percentage of total revenues, we expect our service
margins to increase.

Operating Expenses

  Sales and Marketing. Sales and marketing expenses include salaries,
commissions and employee-related expenses and select variable marketing
expenses, including distributor promotional costs, public relations costs,
marketing collateral and trade show expenses. Total sales and marketing
expenses increased from $13.5 million in 1999 to $24.2 million in 2000, an
increase of 79%. As a percentage of total revenues, sales and marketing
expenses decreased from 66% in 1999 to 40% in 2000. The dollar increase in
sales and marketing expenses was primarily due to recruiting and selling to a
greater number of our current and prospective resellers and distributors and,
to a lesser extent, to increased efforts in establishing brand recognition of
our products and services. Specifically, major components of the increase
included

  .  an increase in salaries, commissions, recruiting and related expenses
     from $6.6 million to $10.6 million;

  .  an increase in variable marketing costs from $3.4 million to $7.8
     million; and

  .  an increase in travel and related expenses from $2.5 million to $3.2
     million.

  The decrease in sales and marketing expenses as a percentage of total
revenues reflects both increased productivity of and efficiencies in managing
our distribution network and realization of our previous investments to expand
distribution, capture market share and establish brand recognition of our
products. We will continue to invest in sales and marketing programs designed
to increase distribution.

  Because we expect our sales and marketing expenses, as well as the other
expenses we describe below, to increase at a slower rate than revenues, we
expect to see over time a gradual reduction in each of these types of expenses
as a percentage of total revenues.

  Research and Development. Research and development expenses include salaries,
noncapitalized equipment and software tools, depreciation from capital
equipment and software, nonrecurring costs associated with our security
appliance prototypes and payments to designers and contractors. Research and
development expenses increased from $7.1 million in 1999 to $13.9 million in
2000, an increase of 95%. As a percentage of total revenues, research and
development expenses decreased from 35% in 1999 to 23% in 2000. The dollar
increase in research and development expenses reflects the growth of our
research and development organization to expand and enhance our Firebox System
and LiveSecurity for MSS product lines, including our SOHO and ServerLock
products, and our efforts to respond to new and emerging threats through our
LiveSecurity Service. Specifically, major components of the increase included

  .  an increase in payroll and related expenses from $4.9 million to $8.8
     million, a portion of which is related to the acquisition of Qiave in
     the fourth quarter of 2000 and resulting costs related to development
     personnel within our server products organization; and

                                       35
<PAGE>

  .  an increase in security appliance prototype engineering costs from
     $562,000 to $1.5 million, reflecting increased expenses related to our
     SOHO products, enhancement of our Firebox security appliance and costs
     related to planned expansion of our product offerings in 2001.

  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, which analyzes and addresses
Internet security threats, and our advisory council, which provides continuing
education and editorials on Internet security.

  General and Administrative. General and administrative expenses include costs
of executive, human resource, finance and administrative support functions,
provision for uncollectible accounts and costs of legal and accounting
professional services. General and administrative expenses increased from $3.6
million in 1999 to $6.0 million in 2000, an increase of 65%. As a percentage of
total revenues, general and administrative expenses decreased from 18% in 1999
to 10% in 2000. The dollar increase in general and administrative expenses
reflects the expansion of our infrastructure to manage the growth of our
operations, costs associated with being a public company, an increase in
payroll and related expenses and increases in other general and administrative
areas such as bad debt. Specifically, major components of the increase included

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

  .  an increase in bad debt expense from $109,000 to $486,000. As a
     percentage of total revenues, bad debt expenses increased from 0.5% in
     1999 to 0.8% in 2000, reflecting increased risk associated with
     increased revenues from a broader customer base.

  Stock-Based Compensation. Stock-based compensation arises from amortization
of deferred stock-based compensation over the vesting periods of common stock
subject to repurchase and assumed stock options. Stock-based compensation
expenses were $926,000 in 1999 and $8.4 million in 2000. The allocation of the
stock-based compensation expenses associated with the functional operating
expense categories of sales and marketing, research and development, and
general and administrative were $307,000, $491,000 and $128,000 in 1999 and
$824,000, $7.5 million and $103,000 in 2000.

  Deferred stock-based compensation is recorded as a component of stockholders'
equity as the difference between the exercise price of options and the fair
value of our common stock on the date of grant, and for the value of common
stock subject to repurchase that we issued and unvested options that we assumed
in connection with our 1999 acquisition of BeadleNet and our October 2000
acquisition of Qiave. We recorded $19.3 million of deferred stock-based
compensation in 2000 in connection with the Qiave acquisition, which included
charges related to the issuance of common stock subject to repurchase and the
assumption of unvested Qiave employee stock options outstanding at the time of
the merger. We recorded $912,000 in deferred stock-based compensation in 1999,
which included charges related to the BeadleNet acquisition.

  Acquired in-process technology and amortization of goodwill, purchased
technology and other intangible assets acquired. Acquired in-process technology
and amortization of goodwill, purchased technology and other intangibles
consists of IPR&D expense and amortization of goodwill and other intangibles
related to our acquisitions of BeadleNet in 1999 and Qiave in 2000. We recorded
IPR&D expense of $3.4 million in 1999 and $4.4 million in 2000. The intangible
assets are being amortized on a straight-line basis over useful lives ranging
from two to five years. We recorded amortization charges of $259,000 in 1999
and $3.8 million in 2000 related to these assets. The increase in amortization
in 2000 resulted primarily from recording a full year's amortization of
intangibles associated with the 1999 acquisition of BeadleNet and the
amortization of intangibles associated with our acquisition of Qiave in the
fourth quarter of 2000.

                                       36
<PAGE>

Interest Income (Expense)

  Interest income of $6.6 million in 2000 resulted from our investment of
proceeds from our public offerings, and was offset by $50,000 of interest
expense resulting from borrowings on our term loan with a bank, which has since
been paid in full. Interest expense of $485,000 in 1999 resulted from
borrowings on our bank line of credit, notes payable and our equipment term
loan, and was offset by $640,000 of interest income generated from our
investment of proceeds from our initial public offering in July 1999.

Income Taxes

  Income tax expense of $215,000 in 2000 primarily relates to the provision for
foreign income taxes associated with our international operations. We have
experienced losses since inception, resulting in a net operating loss
carryforward position for federal income tax purposes of approximately $124.7
million as of December 31, 2000. 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, 1998 and 1999

Revenues

  Total 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 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, reflecting the increase in the
deferred service component of billings, as well as an increase in LiveSecurity
subscription renewals. Service revenues include the annual fee for our
LiveSecurity Service, which is sold as a part of the Firebox 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.

  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. The decrease in
the provision as a percentage of total revenues reflects a reduction in the
expected returns and pricing protection allowances based on historical results
and no introduction of major replacement products during 1999.

Cost of Revenues and Gross Margin

  Total cost of revenues increased from $3.9 million in 1998 to $8.0 million in
1999, an increase of 103%. As a percentage of total revenues, cost of revenues
increased from 35% in 1998 to 39% in 1999.

  Cost of product revenues increased from $3.7 million in 1998 to $7.0 million
in 1999, an increase of 90%, primarily due to greater sales volume. As a
percentage of total revenues, cost of product revenues increased from 32% in
1998 to 34% in 1999. The increase in cost of product revenues as a percentage
of total revenues reflects an increase in the cost of manufacturing our Firebox
II security appliance. In the third quarter of 1998, we released an enhanced
version of our security appliance, the Firebox II, which incorporated
additional

                                       37
<PAGE>

features required to support LiveSecurity for MSS. The Firebox II is more
expensive to manufacture than the previous version of our security appliance,
which increased our cost of revenues.

  Cost of service revenues increased from $272,000 in 1998 to $1.0 million in
1999, an increase of 271%. This increase reflects investments in our customer
support organization and our LiveSecurity Service to assist our growing
customer base. As a percentage of total revenues, cost of service revenues
increased from 2% in 1998 to 5% in 1999, reflecting our investment in our
customer support organization.

Operating Expenses

  Sales and Marketing. 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 and selling to a greater number of prospective and current resellers
and distributors and, to a lesser extent, to greater efforts in 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;

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

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

  The decrease in sales and marketing expenses as a percentage of total
revenues, as well as the decreases as a percentage of total revenues in the
other expenses we discuss below, reflects both increased productivity of and
efficiencies in managing our distribution network and realization of our
previous investments to expand distribution, capture market share and establish
brand recognition of our products.

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

  Research and Development. 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
LiveSecurity for MSS and our efforts in researching and responding to new and
emerging security threats through our LiveSecurity 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 the completion of our SOHO and
     telecommuter products originating from the acquisition of BeadleNet.

  General and Administrative. 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 and costs associated with being a public company.
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 connection with the
     revision and implementation of our employee benefit plans, the expansion
     of our international operations and costs associated with being a public
     company.

                                       38
<PAGE>

  Stock-Based Compensation. Amortization of deferred stock-based compensation
was $1.0 million in 1998 and $926,000 in 1999. The allocation of the stock-
based compensation expenses associated with the functional operating expense
categories of sales and marketing, research and development and general and
administrative were $148,000, $829,000 and $62,000 for 1998. We recorded
$912,000 of deferred stock-based compensation in 1999 and $2.5 million of
deferred stock-based compensation in 1998, which included $628,000 in charges
related to options granted to a former employee in exchange for services.

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.

                                       39
<PAGE>

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 eight-quarter period ended December 31, 2000. In our opinion,
this unaudited information has been prepared on the same basis as our audited
consolidated 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 consolidated financial statements and the notes to the
consolidated financial statements. The results of operations for any quarter
are not necessarily indicative of our future results.

<TABLE>
<CAPTION>
                                                     Three Months Ended
                          ------------------------------------------------------------------------------
                          Mar. 31,  June 30,  Sept. 30, Dec. 31,  Mar. 31,  June 30,  Sept. 30, Dec. 31,
                            1999      1999      1999      1999      2000      2000      2000      2000
                          --------  --------  --------- --------  --------  --------  --------- --------
                                                       (In thousands)
<S>                       <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>
Consolidated Statement of
 Operations
 Data:
Revenues:
  Product...............  $ 3,387   $ 3,831    $ 4,614  $ 5,497   $ 8,494   $12,000    $14,782  $ 16,734
  Service...............      551       806        907    1,026     1,308     1,740      2,453     3,192
                          -------   -------    -------  -------   -------   -------    -------  --------
   Total revenues.......    3,938     4,637      5,521    6,523     9,802    13,740     17,235    19,926
Cost of revenues:
  Product...............    1,476     1,680      1,768    2,030     3,091     4,341      5,363     6,137
  Service...............      159       166        317      368       432       557        824     1,174
                          -------   -------    -------  -------   -------   -------    -------  --------
   Total cost of
    revenues............    1,635     1,846      2,085    2,398     3,523     4,898      6,187     7,311
Gross margin............    2,303     2,791      3,436    4,125     6,279     8,842     11,048    12,615
Operating expenses:
  Sales and marketing...    2,841     3,242      3,612    3,817     5,559     5,967      5,849     6,838
  Research and
   development..........    1,426     1,614      1,700    2,378     2,521     3,262      3,413     4,704
  General and
   administrative.......      912       862        842    1,030     1,154     1,249      1,703     1,895
  Stock-based
   compensation.........      253       258        186      229       236       228        193     7,750
  Acquired in-process
   technology and
   amortization of
   goodwill, purchased
   technology and other
   intangible assets
   acquired.............      --        --         --     3,626       368       368        368     7,123
                          -------   -------    -------  -------   -------   -------    -------  --------
   Total operating
    expenses............    5,432     5,976      6,340   11,080     9,838    11,074     11,526    28,310
                          -------   -------    -------  -------   -------   -------    -------  --------
Operating loss..........   (3,129)   (3,185)    (2,904)  (6,955)   (3,559)   (2,232)      (478)  (15,695)
Interest income
 (expense), net.........      (84)     (263)       118      384       863     1,854      1,812     1,986
                          -------   -------    -------  -------   -------   -------    -------  --------
Income (loss) before
 income taxes...........   (3,213)   (3,448)    (2,786)  (6,571)   (2,696)     (378)     1,334   (13,709)
Provision for income
 taxes..................       --        --         --       --        --        --         --       215
                          -------   -------    -------  -------   -------   -------    -------  --------
Net income (loss).......  $(3,213)  $(3,448)   $(2,786) $(6,571)  $(2,696)  $  (378)   $ 1,334  $(13,924)
                          =======   =======    =======  =======   =======   =======    =======  ========
</TABLE>

                                       40
<PAGE>

<TABLE>
<CAPTION>
                                                     Three Months Ended
                          ------------------------------------------------------------------------------
                          Mar. 31,  June 30,  Sept. 30, Dec. 31,  Mar. 31,  June 30,  Sept. 30, Dec. 31,
                            1999      1999      1999      1999      2000      2000      2000      2000
                          --------  --------  --------- --------  --------  --------  --------- --------
<S>                       <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>
Consolidated Statement
 of Operations Data:
Revenues:
  Product...............    86.0 %    82.6 %     83.6 %    84.3 %   86.7 %    87.3 %     85.8 %   84.0 %
  Service...............    14.0      17.4       16.4      15.7     13.3      12.7       14.2     16.0
                           -----     -----      -----    ------    -----     -----      -----    -----
   Total revenues.......   100.0     100.0      100.0     100.0    100.0     100.0      100.0    100.0
Cost of revenues:
  Product...............    37.5      36.2       32.0      31.1     31.5      31.6       31.1     30.8
  Service...............     4.0       3.6        5.7       5.6      4.4       4.1        4.8      5.9
                           -----     -----      -----    ------    -----     -----      -----    -----
   Total cost of
    revenues............    41.5      39.8       37.8      36.8     35.9      35.6       35.9     36.7
                           -----     -----      -----    ------    -----     -----      -----    -----
Gross margin............    58.5      60.2       62.2      63.2     64.1      64.4       64.1     63.3
Operating expenses:
  Sales and marketing...    72.1      69.9       65.4      58.5     56.7      43.4       33.9     34.3
  Research and
   development..........    36.2      34.8       30.8      36.5     25.7      23.7       19.8     23.6
  General and
   administrative.......    23.2      18.6       15.3      15.8     11.8       9.1        9.9      9.5
  Stock-based
   compensation.........     6.4       5.6        3.4       3.5      2.4       1.7        1.1     38.9
  Acquired in-process
   technology and
   amortization of
   goodwill, purchased
   technology and other
   intangible assets
   acquired.............     0.0       0.0        0.0      55.6      3.8       2.7        2.1     35.7
                           -----     -----      -----    ------    -----     -----      -----    -----
   Total operating
    expenses............   137.9     128.9      114.8     169.9    100.4      80.6       66.9    142.1
                           -----     -----      -----    ------    -----     -----      -----    -----
Operating loss..........   (79.9)    (68.7)     (52.6)   (106.6)   (36.3)    (16.2)      (2.8)   (78.8)
Interest income
 (expense), net.........    (2.1)     (5.7)       2.1       5.9      8.8      13.5       10.5     10.0
                           -----     -----      -----    ------    -----     -----      -----    -----
Income (loss) before
 income taxes...........   (81.6)    (74.4)     (50.5)   (100.7)   (27.5)     (2.8)       7.7    (68.8)
Provision for income
 taxes..................     0.0       0.0        0.0       0.0      0.0       0.0        0.0      1.1
                           -----     -----      -----    ------    -----     -----      -----    -----
Net income (loss).......   (81.6)%   (74.4)%    (50.5)%  (100.7)%  (27.5)%    (2.8)%      7.7 %  (69.9)%
                           =====     =====      =====    ======    =====     =====      =====    =====
</TABLE>

  The trends discussed in the annual comparison of operating results for the
years ended December 31, 1999 and 2000 generally apply to the comparison of
results of operations for each of the quarters in the eight-quarter period
ended December 31, 2000. We have, in general, continued to improve our gross
margins over time as we gained efficiencies in the production of our security
appliances and introduced product options that carry higher gross margins.
However, gross margins in the third and fourth quarters of 2000 were negatively
impacted by our product mix, in which lower-margin products comprised a greater
percentage of overall revenues than we expected. During the third and fourth
quarters of 2000, we also made significant investments in our customer support
organization, leading to an overall increase in the cost of service revenues.
While these investments had a negative short-term impact on our gross margins
during the quarter, we believe they were required to meet the needs of our
expanding customer base.

  We also made large investments in our sales and marketing organization during
the fourth quarter of 2000, leading to an overall increase in costs. Other
significant increases in operating expenses during the quarter, including
research and development costs, stock-based compensation charges, acquired
IPR&D expenses and amortization of intangibles, were primarily related to our
acquisition of Qiave in October 2000. While our operating expenses continued to
increase during 2000 in dollar amount, expenses continued to decrease as a
percentage of total revenues. Our quarterly operating results have fluctuated
significantly in the past and will probably continue to fluctuate.

  Beginning in the fourth quarter of 2000 and continuing into the first quarter
of 2001, we have seen a general economic downturn in the U.S. economy, which
has affected the demand for our products and services. To the extent that this
downturn continues or spreads to other geographic regions in which we conduct
business, our future revenues are likely to be adversely affected.

                                       41
<PAGE>

Liquidity and Capital Resources

  We have financed our operations primarily through proceeds from private
placements of preferred stock and, more recently, proceeds from our initial
public offering in July 1999 and our follow-on public offering in February
2000. To date, net proceeds from our private placements and public offerings
have totaled approximately $144.0 million.

  We have a working capital revolving line of credit with a bank, secured by
our accounts receivable. The line of credit provides for borrowings not greater
than $5.0 million or the amount of the borrowing base. For purposes of this
loan, the borrowing base is the sum of 80% of our eligible domestic accounts
receivable and 50% of our eligible foreign accounts receivable. As of December
31, 2000, we had no borrowings on this line of credit, which expires in April
2001 and bears interest at the prime rate plus 0.5% per year. At December 31,
2000, our borrowing limit of $5.0 million was reduced by a $3.0 million
unconditional letter of credit we issued to our landlord in conjunction with
our new facilities lease. In February 2000, we repaid our two term-loan
facilities with the same bank, which had a combined balance of $383,000 as of
December 31, 1999.

  In March 2000, we signed a facilities lease agreement for approximately
90,000 square feet of office space for a new corporate headquarters located in
Seattle, Washington. This lease has a 10-year term, with an option to extend
for an additional five years. This lease commenced in September 2000 and
includes base rent of approximately $200,000 per month during the first year of
the lease, increasing to $280,000 per month during the final year of the lease.
We are also responsible for our pro-rata share of the building operating costs,
which we estimate to be $60,000 per month during the first year of the lease.
We have exercised an option to lease approximately 14,000 square feet of
additional space in the same building, which should commence in August 2001. We
have subleased approximately 30,000 square feet of the space in our building,
which will again become available to us over various periods beginning January
2002 through October 2002.

  As of December 31, 2000, we had $115.1 million in cash, cash equivalents and
securities available for sale, invested primarily in high-quality money market
accounts and marketable securities. We believe that the market risk arising
from our holdings of these financial instruments is not material. Our working
capital as of December 31, 2000 was $117.1 million.

  Operating activities. Our operating activities resulted in net cash outflows
of $8.0 million in 1999 and $2.4 million in 2000. The operating cash outflows
in 1999 and 2000 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 $6.6
million in 1999 and $20.5 million in 2000. These noncash charges were primarily
associated with depreciation and amortization of capital assets, amortization
of goodwill, provisions for bad debts and sales returns and allowances,
acquisition-related charges such as acquired IPR&D expenses, and compensation
charges resulting from the issuance of stock options and warrants. Cash
provided by working capital components for operating activities was $1.5
million in 1999, and cash utilized in working capital components for operating
activities was $7.3 million in 2000. In 2000, there were large fluctuations
within some major working capital components, as described below:

  (a)  Receivables increased from $3.8 million at December 31, 1999 to $15.3
       million at December 31, 2000, originating primarily from revenue
       generated in the fourth quarter of each year. The increased receivable
       balance primarily reflects the increase in revenues from $6.5 million
       in the three months ended December 31, 1999 to $19.9 million in the
       three months ended December 31, 2000. Days sales outstanding, or DSOs,
       were 52 days and 69 days at December 31, 1999 and 2000. DSOs are
       impacted by the payment terms contained in our customer contracts,
       linearity in revenues in any particular quarter, and the amount of
       deferred revenue contained in the receivable balance that has not been
       recognized as revenue. The increase in DSOs for the fourth quarter of
       2000 compared to the fourth quarter of 1999 primarily reflects changes
       in our customer sales mix during the fourth quarter. Our largest
       domestic customers and international customers receive longer payment
       terms, and the sales volume from these customers in the fourth quarter
       of 2000 was greater than in prior quarters and the comparable period
       in 1999. Based on the current sales mix, the resulting timing
       differences arising

                                       42
<PAGE>

       from varying payment terms in our customer agreements, the linearity of
       revenues in any particular quarter and the growth of deferred revenue, we
       expect our DSOs to generally range from 55 days to 70 days.

       Reserves for uncollectible accounts were $177,000 at December 31, 1999
       and $633,000 at December 31, 2000, reflecting an increased accounts
       receivable balance related to increased sales to a broader customer base.
       Our returns and allowance reserves were $550,000 at December 31, 1999 and
       $965,000 at December 31, 2000, reflecting 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 on the timing of product introductions and pricing program
       changes.

  (b)  Inventories increased from $2.0 million at December 31, 1999 to $7.0
       million at December 31, 2000. The increase reflects build-up of
       inventory levels as a result of continued anticipated increases in
       product shipments, as well as inventory purchases related to our
       expanded product line. In addition, inventory levels for those
       distributors for whom we recognize revenue on a sell-through basis has
       increased due to our significant revenue growth associated with those
       distributors. Also contributing to the increase was the purchase of
       component parts on allocation or purchases of parts and components
       with long lead times. We maintain a reserve for inventory obsolescence
       and will continue to review inventory on a periodic basis to ensure
       our reserves are adequate.

  (c)  Prepaid expenses and other receivables increased from $1.3 million at
       December 31, 1999 to $3.2 million at December 31, 2000. This increase
       is primarily due to a $1.1 million increase in the interest receivable
       originating from the investment of proceeds from our public offerings.

  (d)  Accounts payable, accrued expenses and accrued payroll-related
       expenses increased from $4.4 million at December 31, 1999 to $11.7
       million at December 31, 2000, related to increased purchases of
       inventory and inventory components, increased headcount and increased
       operating expenses.

  (e)  Deferred revenue increased from $4.2 million at December 31, 1999 to
       $11.9 million at December 31, 2000, reflecting the deferral of revenue
       from bundled LiveSecurity subscriptions included in increased new
       product revenues and renewals of LiveSecurity subscriptions.

  Investing activities. Cash used in investing activities totaled $30.0
million in 1999 and $82.5 million in 2000, reflecting short-term investing
activity and capital expenditures. During 1999 and 2000, investing activities
also included capital expenditures for furniture and leasehold improvements in
our new corporate headquarters. In addition, in 1999 we funded the acquisition
of BeadleNet through cash payments of $4.1 million.

  Financing activities. Cash provided by financing activities totaled $38.2
million in 1999 and $96.9 million in 2000. These activities primarily relate
to borrowings on our line of credit and through bridge financing during 1999,
proceeds from public offerings in the third quarter of 1999 and in the first
quarter of 2000, and, to a lesser extent, the exercise of employee stock
options during 2000. Cash provided from the exercise of employee stock options
and the purchase of common stock through our employee stock purchase plan was
$219,000 in 1999, increasing to $5.6 million in 2000.

  We believe that existing cash and cash equivalents balances and our line of
credit will be sufficient to meet our anticipated cash needs for working
capital, capital expenditures and potential acquisitions or technology
investments for at least the next 12 months. However, if the underlying
assumed levels of spending for the potential acquisition of or investment in
complementary businesses or technologies prove to be inaccurate, we may need
to seek additional funding before that time through public or private
financings or other arrangements.

                                      43
<PAGE>

Unaudited Pro Forma Operating Results

  Our management reviews our operating results on a pro forma basis in making
operating decisions, and we believe pro forma results provide additional
meaningful information. The following table provides our pro forma results for
the years ended December 31, 1998, 1999 and 2000 (in thousands):

<TABLE>
<CAPTION>
                                                 Year Ended December 31,
                                               ------------------------------
                                                 1998      1999       2000
                                               --------  ---------  ---------
<S>                                            <C>       <C>        <C>
Net loss...................................... $ (9,119) $ (16,018) $ (15,664)
Adjustments to reconcile net loss in the
 financial statements to pro forma net
 income/loss:
  Stock-based compensation....................    1,039        926      8,407
  Amortization of goodwill, purchased
   technology and other intangibles...........      --         259      3,828
  Acquired in-process technology..............      --       3,381      4,399
                                               --------  ---------  ---------
Pro forma net income (loss)................... $ (8,080) $ (11,452) $     970
                                               ========  =========  =========
Pro forma net income (loss) per share:
  Basic....................................... $  (0.60) $   (0.69) $    0.04
                                               ========  =========  =========
  Diluted..................................... $  (0.60) $   (0.69) $    0.03
                                               ========  =========  =========
Shares used in calculating pro forma net
 income (loss) per share:
  Basic.......................................   13,366     16,664     23,556
                                               ========  =========  =========
  Diluted.....................................   13,366     16,664     27,779
                                               ========  =========  =========
</TABLE>
--------
Note: Pro forma information is presented for informational purposes only and is
not prepared in accordance with generally accepted accounting principles. Pro
forma results:

  .  assume the conversion of all preferred stock to common stock at the time
     of issuance;

  .  exclude acquired IPR&D expenses, and the amortization of goodwill and
     other intangibles arising from WatchGuard's acquisition of BeadleNet in
     October 1999 and Qiave in October 2000;

  .  exclude noncash stock-based compensation expenses originating from
     employee stock options granted at less than fair value and restricted
     common stock issued in connection with the BeadleNet and Qiave
     acquisitions; and

  .  reflect the dilutive effect on earnings per share of outstanding options
     and warrants, calculated using the treasury stock method.

                                       44
<PAGE>

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
and debt securities available for sale 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. The fair value of our investment portfolio or related income would
not be significantly impacted by either a 100 basis point increase or decrease
in interest rates due primarily to the short-term nature of the major portion
of our investment portfolio, which is summarized in Note 3 to our consolidated
financial statements.

  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 2000 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.

                                       45
<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 consolidated balance sheets of WatchGuard
Technologies, Inc. as of December 31, 1999 and 2000 and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 2000. 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 consolidated financial position of WatchGuard
Technologies, Inc. at December 31, 1999 and 2000, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended December 31, 2000, 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
January 26, 2001

                                       46
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                          CONSOLIDATED BALANCE SHEETS
                (In thousands, except share and per share data)

<TABLE>
<CAPTION>
                                                              December 31,
                                                           -------------------
                                                             1999      2000
                                                           --------  ---------
<S>                                                        <C>       <C>
ASSETS
Current assets:
  Cash and cash equivalents............................... $  1,903  $  13,837
  Securities available for sale...........................   24,498    101,278
  Trade accounts receivable, net..........................    3,772     15,271
  Inventories.............................................    2,013      7,026
  Prepaid expenses and other receivables..................    1,275      3,178
                                                           --------  ---------
Total current assets......................................   33,461    140,590
Property and equipment, net...............................    1,927      7,341
Goodwill..................................................    4,830     33,947
Other intangibles and other assets........................    1,093     14,052
                                                           --------  ---------
Total assets.............................................. $ 41,311  $ 195,930
                                                           ========  =========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable........................................ $  2,088  $   7,256
  Accrued expenses........................................    2,362      4,395
  Deferred revenue........................................    4,233     11,874
  Equipment term loan.....................................      383        --
                                                           --------  ---------
Total current liabilities.................................    9,066     23,525
Commitments
Stockholders' equity:
  Preferred stock, $0.001 par value:
    Authorized shares: 10,000,000                               --         --
    No shares issued and outstanding......................      --         --
  Common stock, $0.001 par value:
    Authorized shares: 80,000,000
    Shares issued and outstanding: 19,511,752 at December
     31, 1999 and 26,287,072 at December 31, 2000.........       19         26
  Additional paid-in capital..............................   63,694    230,591
  Deferred stock-based compensation.......................   (1,452)   (12,387)
  Accumulated other comprehensive loss....................      (77)      (222)
  Accumulated deficit.....................................  (29,939)   (45,603)
                                                           --------  ---------
    Total stockholders' equity............................   32,245    172,405
                                                           --------  ---------
    Total liabilities and stockholders' equity............ $ 41,311  $ 195,930
                                                           ========  =========
</TABLE>

                            See accompanying notes.

                                       47
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

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

<TABLE>
<CAPTION>
                                                    Year Ended December 31,
                                                   ---------------------------
                                                    1998      1999      2000
                                                   -------  --------  --------
<S>                                                <C>      <C>       <C>
Revenues:
  Product......................................... $10,678  $ 17,329  $ 52,010
  Service.........................................     701     3,290     8,693
                                                   -------  --------  --------
    Total revenues................................  11,379    20,619    60,703
Cost of revenues:
  Product.........................................   3,653     6,954    18,932
  Service.........................................     272     1,010     2,987
                                                   -------  --------  --------
    Total cost of revenues........................   3,925     7,964    21,919
                                                   -------  --------  --------
Gross margin......................................   7,454    12,655    38,784
Operating expenses:
  Sales and marketing(1)..........................   8,519    13,512    24,213
  Research and development(2).....................   4,442     7,118    13,900
  General and administrative(3)...................   2,454     3,646     6,001
  Stock-based compensation........................   1,039       926     8,407
  Acquired in-process technology and amortization
   of goodwill, purchased technology and other
   intangible assets acquired.....................     --      3,626     8,227
                                                   -------  --------  --------
    Total operating expenses......................  16,454    28,828    60,748
                                                   -------  --------  --------
Operating loss....................................  (9,000)  (16,173)  (21,964)
Interest income...................................      84       640     6,565
Interest expense..................................    (203)     (485)      (50)
                                                   -------  --------  --------
Loss before income taxes..........................  (9,119)  (16,018)  (15,449)
Provision for income taxes........................     --        --        215
                                                   -------  --------  --------
Net loss.......................................... $(9,119) $(16,018) $(15,664)
                                                   =======  ========  ========
Basic and diluted net loss per share.............. $(11.34) $  (1.80) $  (0.66)
                                                   =======  ========  ========
Shares used in calculating basic and diluted net
 loss per share...................................     804     8,903    23,556
                                                   =======  ========  ========
</TABLE>
--------
(1)  Sales and marketing expenses exclude amortization of stock-based
     compensation of $148,000, $307,000 and $824,000 for the years ended
     December 31, 1998, 1999 and 2000, respectively.

(2)  Research and development expenses exclude amortization of stock-based
     compensation of $829,000, $491,000 and $7,480,000 for the years ended
     December 31, 1998, 1999 and 2000, respectively.

(3)  General and administrative expenses exclude amortization of stock-based
     compensation of $62,000, $128,000 and $103,000 for the years ended
     December 31, 1998, 1999 and 2000, respectively.


                            See accompanying notes.

                                       48
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

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

<TABLE>
<CAPTION>
                                                                                     Accumulated
                      Preferred Stock      Common Stock    Additional    Deferred       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,
1998...............   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
 Deferred 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 in
 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)         --          --             --           --
 Deferred 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
 BeadleNet
 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
 Proceeds from
 issuance of
 common stock in
 public offering,
 net of offering
 costs.............         --     --     1,780,000     2     90,425          --          --             --        90,427
 Deferred stock-
 based
 compensation......         --     --           --    --      19,342      (19,342)        --             --           --
 Amortization of
 stock-based
 compensation......         --     --           --    --         --         8,407         --             --         8,407
 Issuance of
 common stock in
 connection with
 BeadleNet
 acquisition.......         --     --        20,189   --         --           --          --             --           --
 Issuance of
 common stock in
 connection with
 Qiave
 acquisition.......         --     --     1,292,997     1     50,302          --          --             --        50,303
 Exercise of
 common stock
 options and
 warrants..........         --     --     3,597,202     3      5,690          --          --             --         5,693
 Issuance of
 common stock in
 conjunction with
 the employee
 stock purchase
 program...........         --     --        84,932     1      1,138          --          --             --         1,139
 Comprehensive
 loss:
   Net unrealized
   loss on
   securities
   available for
   sale............         --     --           --    --         --           --         (145)           --          (145)
   Net loss........         --     --           --    --         --           --          --         (15,664)     (15,664)
                                                                                                                ---------
   Comprehensive
   loss............                                                                                               (15,809)
                     ----------  -----   ---------- -----  ---------    ---------      ------      ---------    ---------
Balance, December
31, 2000...........         --   $ --    26,287,072 $  26  $ 230,591    $ (12,387)     $ (222)     $ (45,603)   $ 172,405
                     ==========  =====   ========== =====  =========    =========      ======      =========    =========
</TABLE>

                            See accompanying notes.

                                       49
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (In thousands)

<TABLE>
<CAPTION>
                                                 Year Ended December 31,
                                               ------------------------------
                                                 1998      1999       2000
                                               --------  ---------  ---------
<S>                                            <C>       <C>        <C>
Operating activities:
Net loss...................................... $ (9,119) $ (16,018) $ (15,664)
Adjustments to reconcile net loss to net cash
 used in operating activities:
  Depreciation and amortization of property
   and equipment..............................      235        602      1,400
  Amortization of intangible assets...........       86        259      3,828
  Amortization of stock-based compensation....    1,039        926      8,407
  Warrant issued in exchange for services.....      470        --         --
  Acquired in-process research and
   development................................      --       3,381      4,399
  Provision for sales returns and allowances..    1,655      1,083      1,932
  Provision for bad debt expense..............      418        129        486
  Noncash interest expense....................      --         195        --
  Changes in operating assets and liabilities:
    (Increase) in accounts receivable.........   (3,968)    (1,526)   (13,914)
    (Increase) decrease in inventories........   (1,938)       148     (5,013)
    (Increase) in prepaid expenses and other
     receivables..............................     (288)      (792)    (1,903)
    (Increase) decrease in other assets.......      183         12        (43)
    Increase in accounts payable and accrued
     expenses.................................    2,093      1,249      6,034
    Increase in deferred revenue..............    1,528      2,392      7,641
                                               --------  ---------  ---------
Net cash used in operating activities.........   (7,606)    (7,960)    (2,410)

Investing activities:
Purchases of property and equipment and
 other........................................   (1,003)    (1,330)    (6,369)
Proceeds from sale and maturities of
 marketable securities........................      --       1,000     85,474
Purchases of marketable securities............      --     (25,575)  (162,399)
Net cash (paid) received in connection with
 acquisitions.................................      --      (4,106)       762
                                               --------  ---------  ---------
Net cash used in investing activities.........   (1,003)   (30,011)   (82,532)

Financing activities:
Borrowings on line of credit, long-term debt
 and notes payable............................    2,663      7,280        --
Issuance of warrants..........................      --         195        --
Principal repayments on line of credit, long-
 term debt and notes payable..................      (54)   (10,201)      (383)
Proceeds from sale of preferred stock.........    7,075        --         --
Proceeds from sale of common stock, net of
 expenses.....................................      --      40,669     90,427
Proceeds from the exercise of common stock
 options and warrants.........................       34        219      5,693
Proceeds from sale of common stock through
 employee stock purchase plan.................      --         --       1,139
                                               --------  ---------  ---------
Net cash provided by financing activities.....    9,718     38,162     96,876
                                               --------  ---------  ---------
Net increase in cash and cash equivalents.....    1,109        191     11,934
Cash and cash equivalents at beginning of
 period.......................................      603      1,712      1,903
                                               --------  ---------  ---------
Cash and cash equivalents at end of period.... $  1,712  $   1,903  $  13,837
                                               ========  =========  =========
Supplemental disclosure of cash flow
 information:
Cash paid for interest........................ $    179  $     508  $      51
                                               ========  =========  =========
</TABLE>

                            See accompanying notes.

                                       50
<PAGE>

                          WATCHGUARD TECHNOLGIES, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Accounting Policies

Description of Business

  WatchGuard Technologies, Inc. is a provider of Internet security solutions
designed to protect enterprises that use the Internet for electronic commerce
and secure communications.

Revenue Recognition

  WatchGuard recognizes revenue in accordance with accounting standards for
software companies, including Statement of Position (SOP) 97-2, "Software
Revenue Recognition," as amended by SOP 98-9, and related interpretations,
including Technical Practice Aids.

  WatchGuard generates revenues through sales of its Firebox products,
including related software licenses and subscriptions for its LiveSecurity
Service, which includes threat responses, 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) and other managed service providers that
utilize WatchGuard's products to provide managed security services to the
service providers' customers.

  Revenues from software license agreements are generally recognized upon
delivery of software if persuasive evidence of an arrangement exists,
collection is probable, the fee is fixed or determinable, and vendor-specific
objective evidence exists to allocate the total fee to undelivered elements of
the arrangement. Payment terms typically range from 30 to 60 days. A limited
number of WatchGuard's distributors have unlimited stock return and rotation
rights. Revenues from these arrangements are not recognized until sale to the
end-user occurs. 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.
Revenues from LiveSecurity Service subscriptions are recognized ratably over
the term of the contract, typically one year.

  In December 1999, the SEC issued Staff Accounting Bulletin No. 101, "Revenue
Recognition in Financial Statements" (SAB 101). SAB 101 summarizes certain of
the SEC's views in applying generally accepted accounting principles to revenue
recognition in financial statements. The SEC continues to issue further
guidance with respect to adoption of specific issues addressed by SAB 101.
WatchGuard believes its current revenue recognition policies and practices are
consistent with the current accounts standards and guidance from SAB 101.

Principles of Consolidation

  The consolidated financial statements include the accounts of WatchGuard and
its wholly owned subsidiaries. All significant intercompany accounts and
transactions are eliminated in consolidation.

                                       51
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



Fair Values of Financial Instruments

  At December 31, 2000, WatchGuard had the following financial instruments:
cash and cash equivalents, securities available for sale, accounts receivable,
accounts payable and accrued liabilities. 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.

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, with unrealized gains and losses included as a component of
stockholders' equity. The amortized cost of investments is adjusted for
amortization of premiums and accretion of discounts to maturity. The
amortizations and accretions are included in interest income. Realized gains
and losses, declines in value of securities judged to be other than temporary,
and interest and all dividends earned on securities are also 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 or market, with cost being
determined on a first-in, first-out basis. WatchGuard's inventory costs include
the freight and handling costs incurred to transport goods from its suppliers.
WatchGuard receives certain of its components from sole suppliers and relies on
a limited number of hardware manufacturers. The inability of any supplier or
manufacturer to fulfill supply requirements of WatchGuard could materially
impact future operating results. Inventories located at distributors who have
unlimited return rights are included in finished goods.

Property and Equipment

  Property and equipment is stated at cost, less accumulated depreciation and
amortization. Equipment and furniture is depreciated using the straight-line
method over estimated useful lives ranging from three to five years. Leasehold
improvements are amortized over the shorter of the lease term or the estimated
useful life.

Goodwill and Other Intangibles

  Goodwill and other intangibles, including purchased technology, 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

                                       52
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


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
discounted 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, which consist primarily of software
development costs, are expensed as incurred. Financial accounting standards
provide for 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
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 consolidated statements of operations.

Internal-Use Software

  Costs of software developed internally by WatchGuard for use in its
operations are accounted for under the SOP 98-1, "Accounting for Costs of
Corporate Software Developed or Obtained for Internal Use." Under SOP 98-1,
WatchGuard expenses costs of research, including predevelopment efforts prior
to establishing technological feasibility, and costs incurred for training and
maintenance. Software development efforts are capitalized when technological
feasibility has been established, it is probable that the project will be
completed, and the software will be used as intended. Because costs incurred
during the application development stage were insignificant, no costs related
to internal-use software have been capitalized through December 31, 2000.

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 because their effect is antidilutive.

Advertising Costs

  WatchGuard expenses advertising costs as incurred. Total advertising expenses
were $60,000, $234,000 and $711,000 in 1998, 1999 and 2000, 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 a diverse portfolio of high-quality money market
instruments and debt securities available for sale. In addition, substantially
all of WatchGuard's accounts receivable are due from WatchGuard's resellers,
distributors and service providers located throughout the world. Sales to
customers outside the United States were $4.0 million, $10.3 million and
$33.2 million, or 35%, 50% and 55% of total revenues, for 1998, 1999 and 2000,
respectively. No single customer or foreign country accounted for more than 10%
of revenues in 1998 or 1999. During 2000, two customers accounted for 22% of
total revenues. Foreign geographic regions accounting for 10% or more of
revenues were Europe, with 18%, 26% and 31% of total revenues, and Asia, with
10%, 16% and 16% of total revenues, for 1998, 1999 and 2000, respectively.
WatchGuard does not require collateral or other security to support credit
sales, but provides an allowance for bad debts based on historical experience
and specifically identified risks.

                                       53
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



Stock-Based Compensation

  WatchGuard has elected to apply the disclosure-only provisions of SFAS 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. Pro forma
information required by SFAS 123 is included in Note 5.

  Stock compensation expense for options or warrants granted to nonemployees
has been determined in accordance with SFAS 123 and EITF 96-18 as the fair
value of the consideration received or the fair value of the equity instruments
issued, whichever is more reliably measured. The fair value of options granted
to nonemployees is periodically remeasured as the underlying options vest.

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 cumulative losses and the uncertainty as to future
recoverability.

Comprehensive Loss

  WatchGuard complies with SFAS 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 consolidated
statement of stockholders' equity.

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 consolidated financial statements and
accompanying notes. Actual results could differ from those estimates.

Segment Information

  SFAS 131, "Disclosures About Segments of an Enterprise and Related
Information," establishes standards for reporting information about operating
segments in annual financial statements. It also establishes standards for
related disclosures about products, services, geographical areas and major
customers. WatchGuard operates in a single business segment related to Internet
and computer security and provides hardware, software and services as a
complete security solution. See Note 10 for revenue reported by geographic
area.

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 133, "Accounting for Derivatives and
Hedging Activities," subsequently amended by SFAS 137, which establishes
accounting and reporting standards for derivative

                                       54
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


instruments, including certain derivative instruments embedded in other
contracts (collectively referred to as "derivatives"), and for hedging
activities. WatchGuard has never used derivatives. Therefore, the pronouncement
will not affect WatchGuard's financial results unless it enters into
transactions that involve the use of derivatives in the future.

2. Balance Sheet Account Detail (in thousands)

Trade Accounts Receivable, Net

  Trade accounts receivable, net consisted of the following:

<TABLE>
<CAPTION>
                                                                December 31,
                                                              -----------------
                                                               1999      2000
                                                              -------  --------
     <S>                                                      <C>      <C>
     Trade accounts receivable............................... $ 4,499  $ 16,869
     Reserve for returns and allowances......................    (550)     (965)
     Allowance for uncollectible accounts....................    (177)     (633)
                                                              -------  --------
                                                              $ 3,772  $ 15,271
                                                              =======  ========
</TABLE>

Inventories

  Inventories consisted of the following:

<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1999     2000
                                                               -------  -------
     <S>                                                       <C>      <C>
     Finished goods........................................... $ 1,162  $ 4,077
     Components...............................................     920    3,394
                                                               -------  -------
                                                                 2,082    7,471
     Inventory reserves.......................................     (69)    (445)
                                                               -------  -------
                                                               $ 2,013  $ 7,026
                                                               =======  =======
</TABLE>

Property and Equipment, Net

  Property and equipment, net consisted of the following:

<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1999     2000
                                                               -------  -------
     <S>                                                       <C>      <C>
     Computer equipment....................................... $ 1,615  $ 3,274
     Leasehold improvements...................................     138    2,894
     Furniture................................................     438    2,246
     Software.................................................     638      963
                                                               -------  -------
                                                                 2,829    9,377
     Less accumulated depreciation and amortization...........    (902)  (2,036)
                                                               -------  -------
                                                               $ 1,927  $ 7,341
                                                               =======  =======
</TABLE>


                                       55
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Goodwill

  Goodwill consisted of the following:

<TABLE>
<CAPTION>
                                                                December 31,
                                                              -----------------
                                                               1999      2000
                                                              -------  --------
     <S>                                                      <C>      <C>
     Goodwill................................................ $ 4,985  $ 36,692
     Less accumulated amortization...........................    (155)   (2,745)
                                                              -------  --------
                                                              $ 4,830  $ 33,947
                                                              =======  ========
</TABLE>

Other Intangibles and Other Assets

  Other intangibles and other assets consisted of the following:

<TABLE>
<CAPTION>
                                                                December 31,
                                                              -----------------
                                                               1999      2000
                                                              -------  --------
     <S>                                                      <C>      <C>
     Other intangibles....................................... $ 1,289  $ 15,256
     Less accumulated amortization...........................    (263)   (1,505)
                                                              -------  --------
     Other intangibles, net..................................   1,026    13,751
     Other assets............................................      67       301
                                                              -------  --------
                                                              $ 1,093  $ 14,052
                                                              =======  ========
</TABLE>

Accrued Expenses

  Accrued expenses consisted of the following:

<TABLE>
<CAPTION>
                                                                 December 31,
                                                               ----------------
                                                                1999     2000
                                                               ------- --------
     <S>                                                       <C>     <C>
     Accrued payroll-related expenses......................... $ 1,323 $  2,235
     Acquisition-related liabilities..........................     531       54
     Other....................................................     508    2,106
                                                               ------- --------
                                                               $ 2,362 $  4,395
                                                               ======= ========
</TABLE>

3. Securities Available for Sale (in thousands)

  Securities available for sale consist of the following:

<TABLE>
<CAPTION>
                                                 Gross      Gross
                                      Market   Unrealized Unrealized Amortized
                                       Value     Gains      Losses     Cost
                                     --------- ---------- ---------- ---------
   <S>                               <C>       <C>        <C>        <C>
   Balance at 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
                                     =========   =====      ======   =========
   Balance at December 31 2000:
     Commercial paper............... $  11,608   $   4      $   (4)  $  11,608
     Corporate debt securities......    73,923     196        (476)     74,203
     U.S. Government and agency
      obligations...................    15,747      61          (3)     15,689
                                     ---------   -----      ------   ---------
                                     $ 101,278   $ 261      $ (483)  $ 101,500
                                     =========   =====      ======   =========
</TABLE>

                                       56
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



  WatchGuard's gross realized gains or losses in 1999 and 2000 on sales of
securities available for sale were immaterial. The contractual maturities of
WatchGuard's securities available for sale are shown below:


<TABLE>
<CAPTION>
                                                       Estimated Fair Amortized
                                                        Market Value    Cost
                                                       -------------- ---------
   <S>                                                 <C>            <C>
   December 31, 2000:
     Due in one year or less..........................   $  69,427    $  70,126
     Due in one year through two years................      31,851       31,374
                                                         ---------    ---------
                                                         $ 101,278    $ 101,500
                                                         =========    =========
</TABLE>

4. Borrowing Agreements

Line of Credit and Term Loans

  WatchGuard has a revolving line of credit agreement with a commercial bank,
which may be used for operating needs and is collateralized by substantially
all of WatchGuard's assets. Principal and interest on the line of credit are
due at maturity. The line of credit, which expires in April 2001, provides for
borrowings not greater than $5.0 million or the amount of the borrowing base.
The borrowing base for the line of credit consists of the sum of up to 80% of
eligible domestic and 50% of eligible foreign accounts receivable. Borrowings
under the line of credit bear interest at the bank's prime interest rate plus
0.5%, which was 10% at December 31, 2000. As of December 31, 2000, there were
no outstanding borrowings on the line of credit. However, WatchGuard's
available line of credit borrowings of $5.0 million at December 31, 2000 were
reduced by a $3.0 million unconditional letter of credit issued to its landlord
in conjunction with a new facilities lease. WatchGuard was in compliance with
all financial covenants of the credit facility as of December 31, 2000.

  At December 31, 1999, WatchGuard had borrowings outstanding from a bank under
a $95,000 equipment term loan and a $288,000 equipment term loan, both of which
were collateralized by equipment. The term loans were repaid in February 2000.

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 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 $155,000
calculated using the Black-Scholes pricing model. 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. WatchGuard assigned the warrants a fair value of
$40,000, calculated using the Black-Scholes pricing model, and amortized the
resulting discount over the term of the loan. The loan was repaid with proceeds
from the initial public offering and the warrants had either been exercised or
cancelled as of December 31, 2000.

                                       57
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



5. Stockholders' Equity

Preferred Stock

  In March 1998, WatchGuard completed its Series B offering by issuing 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. 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>

Public Offerings

  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.

  On February 15, 2000, WatchGuard issued 1,780,000 shares of its common stock
at a public offering price of $54.125 per share. The offering also included an
additional 2,314,000 shares of common stock sold by selling stockholders,
including those sold pursuant to the exercise of the underwriters' over-
allotment option. The proceeds to WatchGuard from the offering were
approximately $90.4 million, net of $5.9 million in offering expenses,
underwriting discounts and commissions.

Stock Options

  WatchGuard's 1996 Stock Incentive Compensation Plan (the 1996 Plan) 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 1996
Plan that provide for a 900,000-share increase in the authorized number of
shares to be granted under the 1996 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 lesser 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, 2000, WatchGuard had authorized 8,902,073 shares of common
stock for grant under the 1996 Plan.

  In July 2000, WatchGuard adopted the 2000 Stock Option Plan (the 2000 Plan),
which provides for the granting of nonqualified stock options to employees,
agents, consultants, advisors and independent contractors. As of December 31,
2000, WatchGuard had authorized 3,000,000 shares of common stock for grant
under the 2000 Plan.

  Options under both the 1996 Plan and the 2000 Plan generally are granted at
fair market value on the date of grant. The shares of common stock covered by
the options granted on the date of hire generally vest at the

                                       58
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


rate of 25% on the first anniversary of the date of grant, and an additional
2.08% every month thereafter, with all shares becoming fully vested on the
fourth anniversary date of the date of grant. Options granted other than on the
date of hire generally vest at the rate of 2.08% every month from the date of
grant. Stock options under both the 1996 Plan and the 2000 Plan have a term of
ten years unless modified by the plan administrator.

  In October 2000, WatchGuard acquired Qiave Technologies Corporation. Under
the terms and conditions of the acquisition, all options to purchase shares of
Qiave common stock outstanding at the effective time of the acquisition were
assumed by WatchGuard and converted into options to purchase 100,856 shares of
WatchGuard common stock (see Note 11) under the 2000 Qiave Technologies
Corporation Stock Option Plan.

  The following table summarizes WatchGuard's stock option activity for all
stock option plans during 1998, 1999 and 2000:

<TABLE>
<CAPTION>
                         December 31, 1998   December 31, 1999    December 31, 2000
                         ------------------- ------------------- --------------------
                                    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................. 5,227,580   $ 0.08  5,145,268   $ 0.16   6,502,680  $  4.60
Granted................. 1,212,500     0.44  2,248,314    13.26   3,506,656    46.24
Exercised...............  (819,828)    0.04   (774,563)    0.09  (3,375,551)    1.69
Canceled................  (474,984)    0.09   (116,339)    5.67    (641,366)   17.15
                         ---------           ---------           ----------
Balance at end of
 period................. 5,145,268   $ 0.16  6,502,680   $ 4.60   5,992,419  $ 29.27
                         =========           =========           ==========
Exercisable at end of
 period................. 1,618,038           2,359,707            1,071,510
Shares of common stock
 available for grant....                                          1,027,881
Weighted average fair
 value of options
 granted during the
 period:
  Granted at fair
   value................   308,000   $ 0.01  2,086,314   $ 9.59   3,405,800  $ 42.32
  Granted below fair
   value................   904,500   $ 2.08    162,000   $ 5.75     100,856  $ 49.54
</TABLE>

  The weighted average remaining contractual life and weighted average exercise
price of options outstanding and options exercisable at December 31, 2000 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>
     $  0.13 -   0.55... 1,156,685       6.47       $  0.24    467,021 $  0.23
     $  1.13 -  13.00... 1,004,563       8.35         11.28    285,308   10.83
     $ 14.30 -  32.72... 1,108,308       8.69         22.25    186,509   17.30
     $ 33.01 -  49.58... 1,004,000       9.73         44.74     10,010   42.68
     $ 50.55 -  53.06... 1,025,963       9.62         53.02     83,479   53.06
     $ 53.34 - 100.19...   692,900       9.55         57.43     39,183   54.13
                         ---------                           ---------
                         5,992,419       8.64       $ 29.27  1,071,510 $ 12.51
                         =========                           =========
</TABLE>

  WatchGuard uses the intrinsic value-based method to account for all of its
employee stock-based compensation arrangements. Therefore, compensation costs
are not recognized in the accompanying

                                       59
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


consolidated financial statements, unless the underlying fair value of
WatchGuard's common stock exceeds the exercise price of the stock options at
the date of grant.

  WatchGuard recorded deferred stock-based compensation of $2.5 million
relating to options granted during the year ended December 31, 1998. This
includes deferred stock-based compensation of $628,000 related to 48,000 option
shares granted in 1997 to a consultant, in connection with a one-year
consulting agreement. WatchGuard recorded compensation expense of approximately
$628,000 based on the fair value of the options at the termination of the
consulting agreement. Deferred stock-based compensation of $162,000 related to
stock option grants was recorded in 1999.

  In 1999, WatchGuard issued 51,948 unregistered shares of its common stock to
an employee in connection with the BeadleNet acquisition. WatchGuard recorded
$750,000 in deferred stock-based compensation based on the fair value of this
transaction. Based on the terms of the stock vesting agreement, 17,316 of these
shares remain unvested at December 31, 2000.

  In 2000, WatchGuard recorded $19.3 million in deferred stock-based
compensation in connection with the acquisition of Qiave (see Note 11), $4.3
million of which related to WatchGuard's assumption of unvested options to
purchase Qiave common stock. In addition, 299,495 shares of WatchGuard common
stock otherwise issuable to certain key employees of Qiave based on the terms
of the acquisition agreement are subject to repurchase by WatchGuard in the
event that the employee's employment is terminated under specified
circumstances. The shares subject to repurchase are being released from the
repurchase restriction over a two-year vesting period. WatchGuard recorded
$15.0 million in deferred stock-based compensation based on the fair value of
the shares subject to repurchase (see Note 11). At December 31, 2000, 250,079
of these shares remained subject to repurchase.

  Amounts recorded as deferred stock-based compensation related to stock
options are generally being amortized over the vesting period of the options
(generally three to four years), using the graded vesting approach.
Amortization of deferred stock-based compensation related to shares subject to
repurchase is generally recognized over the two-year term of the related
employment agreements. Amortization of deferred stock-based compensation of
$1.0 million, $926,000 and $8.4 million was recognized for the years ended
December 31, 1998, 1999 and 2000, respectively. Amortization of deferred stock-
based compensation will be $10.3 million in 2001, $1.8 million in 2002,
$316,000 in 2003 and $27,000 in 2004.

  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 4.9% to 6.0% from 1998 through 2000; a dividend yield rate of 0% for all
periods; an expected life ranging from two to five years; and volatility of
0.85 in 1999 during the period after the initial public offering and volatility
of 1.36 during 2000.

  For purposes of pro forma disclosures, the estimated fair value of the
options is amortized over the options' vesting periods. WatchGuard's pro forma
information is as follows (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                  Year Ended December 31,
                                                ------------------------------
                                                  1998      1999       2000
                                                --------  ---------  ---------
     <S>                                        <C>       <C>        <C>
     Net loss--as reported..................... $ (9,119) $ (16,018) $ (15,664)
     Net loss--pro forma.......................   (9,166)   (19,837)   (55,120)
     Net loss per share--as reported...........   (11.34)     (1.80)     (0.66)
     Net loss per share--pro forma.............   (11.42)     (2.23)     (2.34)
</TABLE>


                                       60
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Common Stock Warrants

  During 1998, 1999 and 2000, certain warrants granted in 1996 were exercised
for the purchase of 10,000, 20,000 and 15,000 shares of common stock,
respectively, at an exercise price of $0.03 per share.

  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. This warrant was exercised in 1999. The fair value of
the warrant 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 included provisions for termination by either party
for nonperformance, with the return of all product and promotional material as
the only recourse for nonperformance. 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 was 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 the customer. The warrant is not tied to any
performance commitments under the license and sales agreement. The customer
exercised the warrant on a net basis in November 2000.

  WatchGuard also granted warrants in connection with the bridge loan and
convertible notes discussed in Note 4. At December 31, 2000, WatchGuard had no
warrants outstanding.

1999 Employee Stock Purchase Plan

  In May 1999, WatchGuard's board of directors and stockholders approved the
1999 Employee Stock Purchase Plan (the 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. The
price of the common stock purchased under the ESPP will be the lesser of 85% of
the fair market value on the first day of an offering period and 85% of the
fair market value on the last day of an offering period. 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 lesser 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.

  During the year ended December 31, 2000, a total of 84,932 shares of common
stock were purchased under the ESPP. At December 31, 2000, WatchGuard had a
total of 648,068 shares of common stock reserved for future issuance under the
ESPP.

Common Shares Reserved

  At December 31, 2000, common stock reserved for future issuance was as
follows:

<TABLE>
     <S>                                                               <C>
     Outstanding stock options........................................ 5,992,419
     Stock options available for grant................................ 1,027,881
     ESPP.............................................................   648,068
                                                                       ---------
                                                                       7,668,368
                                                                       =========
</TABLE>


                                       61
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


6. 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. For the years
ended December 31, 1998, 1999 and 2000, options to purchase 5,145,268,
6,502,680 and 5,992,419 shares of common stock, respectively, and warrants to
purchase 45,000 and 225,000 shares of common stock for 1998 and 1999,
respectively, and 250,079 shares of common stock subject to repurchase for 2000
were excluded from the computation of basic and diluted net loss per common
share, as their effect is antidilutive.

7. Income Taxes

  At December 31, 2000, WatchGuard had a net operating loss carryforward for
federal tax purposes of approximately $124.7 million and research and
development tax credit carryforwards of $1.2 million. These carryforwards begin
to expire after the 2011 tax year. Utilization of net operating loss
carryforwards may be subject to certain limitations under Section 382 of the
Internal Revenue Code. Additionally, approximately $102.0 million of the net
operating losses generated for federal income tax purposes are not available to
reduce income tax expense for financial reporting purposes because the tax
effects of tax deductions for employee stock options in excess of the related
financial reporting compensation expense are recognized through equity. A
valuation allowance has been established to reflect the uncertainty of
generating future taxable income necessary to utilize available tax loss
carryforwards.

  WatchGuard provides for deferred taxes based on the differences between the
basis of assets and liabilities for financial reporting purposes and the basis
for income tax purposes, calculated using enacted rates that will be in effect
when the differences are expected to reverse. Significant components of
WatchGuard's deferred tax assets and liabilities are as follows (in thousands):

<TABLE>
<CAPTION>
                                                               December 31,
                                                             ------------------
                                                               1999      2000
                                                             --------  --------
     <S>                                                     <C>       <C>
     Deferred tax assets:
       Net operating loss carryforwards..................... $  8,160  $ 42,867
       Acquisition intangibles..............................    1,179     1,484
       Research and development tax credit..................      569     1,171
       Sales reserve and allowance for bad debts............      313       858
       Accrued expenses and other...........................       17       527
                                                             --------  --------
     Total deferred tax assets..............................   10,238    46,907
     Valuation allowance....................................  (10,238)  (46,907)
                                                             --------  --------
     Net deferred taxes..................................... $    --   $    --
                                                             ========  ========
</TABLE>

  WatchGuard's valuation allowance increased by $6.2 million and $36.7 million
in 1999 and 2000, respectively.

                                       62
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



  The reconciliation of the income tax provision (benefit) calculated using the
federal statutory rates to the recorded income tax provision are as follows (in
thousands):

<TABLE>
<CAPTION>
                                          December 31,
                          ---------------------------------------------------
                             1998 Tax          1999 Tax          2000 Tax
                             Effected          Effected          Effected
                          ---------------   ---------------   ---------------
                           Amount   Rate     Amount   Rate     Amount   Rate
                          --------  -----   --------  -----   --------  -----
<S>                       <C>       <C>     <C>       <C>     <C>       <C>
Net loss before taxes...  $ (9,119)         $(16,018)         $(15,449)
                          ========          ========          ========
Expected tax benefit at
 federal statutory
 rate...................    (3,100)  34.0 %   (5,446)  34.0 %   (5,253)  34.0 %
Research and development
 credit.................      (103)   1.1       (359)   2.2       (602)   3.9
Permanent differences,
 including nondeductible
 acquisition costs......        33   (0.4)        48   (0.3)     5,160  (33.4)
Tax benefit not
 recognized due to
 valuation allowance....     3,170  (34.7)     5,757  (35.9)       695   (4.5)
Alternative minimum
 tax....................       --     --         --     --          36   (0.2)
Foreign tax expense.....       --     --         --     --         179   (1.2)
                          --------  -----   --------  -----   --------  -----
Total tax expense.......  $    --     0.0 % $    --     0.0 % $    215   (1.4)%
                          ========  =====   ========  =====   ========  =====
</TABLE>

8. 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.

9. Commitments

  WatchGuard leases office space and some equipment under noncancelable
operating leases. Facilities commitments include a 10-year lease for its
corporate headquarters in Seattle, Washington, which expires in March 2010.
WatchGuard has the option to extend this lease for an additional five-year
term. WatchGuard also leases facilities in Aliso Viejo, California and Waltham,
Massachusetts under operating leases that expire in 2005 through 2006, in
addition to leases for other sales offices under operating leases that expire
over various terms. Future minimum payments at December 31, 2000 under these
leases, net of future minimum rentals of $1.1 million to be received under
subleases, are as follows (in thousands):

<TABLE>
     <S>                                                                 <C>
     2001............................................................... $ 1,981
     2002...............................................................   2,723
     2003...............................................................   3,250
     2004...............................................................   3,380
     2005...............................................................   3,330
     Thereafter.........................................................  14,775
                                                                         -------
                                                                         $29,439
                                                                         =======
</TABLE>

  Rent expenses for 1998, 1999 and 2000 were $273,000, $512,000 and $1,547,000,
respectively.

                                       63
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



10. Geographic 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 as follows (in
thousands):

<TABLE>
<CAPTION>
                                              Year Ended December 31,
                                       ----------------------------------------
                                           1998          1999          2000
                                       ------------  ------------  ------------
     <S>                               <C>      <C>  <C>      <C>  <C>      <C>
     United States.................... $  7,401  65% $ 10,303  50% $ 27,503  45%
     Rest of World:
       Europe.........................    2,049  18     5,340  26    18,912  31
       Asia...........................    1,106  10     3,275  16     9,845  16
       Other..........................      823   7     1,701   8     4,443   8
                                       -------- ---  -------- ---  -------- ---
                                          3,978  35    10,316  50    33,200  55
                                       -------- ---  -------- ---  -------- ---
         Total........................ $ 11,379 100% $ 20,619 100% $ 60,703 100%
                                       ======== ===  ======== ===  ======== ===
</TABLE>

11. Acquisitions

Qiave Technologies Corporation

  In October 2000, WatchGuard acquired Qiave Technologies Corporation. The
total consideration paid for Qiave was approximately $70.0 million, including
approximately $400,000 in direct acquisition costs, and was comprised of
1,292,997 shares of WatchGuard common stock valued at $64.6 million, including
299,495 shares that were subject to repurchase by WatchGuard, and the
assumption of options to purchase 100,856 shares of WatchGuard common stock,
valued at $5.0 million. WatchGuard accounted for the acquisition using the
purchase method of accounting. The results of operations of Qiave and the fair
value of assets acquired have been included in the consolidated financial
statements beginning on the acquisition date.

  The aggregate purchase price was allocated based on estimated fair values on
the acquisition date, as determined by an independent appraisal, and excludes
$19.3 million in consideration related to deferred stock-based compensation for
common stock subject to repurchase and assumption of unvested options to
purchase common stock (in thousands):

<TABLE>
   <S>                                                                <C>
   Fair value of Qiave tangible assets, net of current liabilities... $    654
   Intangible assets:
     Acquired workforce..............................................      592
     Current technology..............................................   13,351
     Goodwill........................................................   31,707
                                                                      --------
       Total intangibles.............................................   46,304
   Acquired in-process research and development......................    4,399
                                                                      --------
                                                                        50,703
   Deferred stock-based compensation.................................   19,342
                                                                      --------
       Total consideration, including deferred stock-based
        compensation................................................. $ 70,045
                                                                      ========
</TABLE>

  Acquired workforce. The value assigned to the workforce in place was
determined using the avoided cost approach. Under this approach, the workforce
is valued according to the costs WatchGuard avoided by obtaining a pre-
existing, trained and fully efficient team rather than assembling a workforce.

                                       64
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



  Current technology. Values assigned to the developed technology were
determined using the income approach. Under the income approach, fair value
reflects the present value of the projected earnings that are expected to be
generated by the current technology. To determine the value of the developed
technology, WatchGuard discounted the expected future cash flows of the
existing technology products at a rate of 25%, 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 projected revenues used in the income
approach are based on the future revenues that WatchGuard believes will most
likely be generated by the commercial sales of the technology.

  The lives assigned to the identified intangible assets described above ranged
from three to five years and the life assigned to goodwill was five years.
Amortization expense for these intangibles was $2.4 million in the fourth
quarter of 2000, and was recorded based on the straight-line method.

  Deferred stock-based compensation. In connection with the employment
agreements and related stock retention agreements with four of Qiave's key
employees, 299,495 shares of WatchGuard common stock otherwise issuable to
these employees pursuant to the merger agreement are subject to repurchase, and
are being released from the repurchase restriction over a two-year vesting
period. At December 31, 2000, 250,079 shares are subject to repurchase. The
value of this stock has been recorded as $15.0 million in deferred stock-based
compensation, based on the fair value of WatchGuard common stock on the closing
date of the Qiave acquisition, and is being amortized over a two-year vesting
period using a graded vesting approach. Amortization of the deferred stock-
based compensation originating from the issuance during the fourth quarter of
2000 of stock subject to repurchase was $6.5 million. In addition, options to
purchase shares of Qiave common stock that were outstanding at the time of the
merger were assumed by WatchGuard and converted into options to purchase
100,856 shares of WatchGuard common stock, at a weighted average exercise price
of $0.46 per share. Deferred stock-based compensation originating from the
assumption of Qiave stock options was $4.3 million. Amortization of deferred
stock-based compensation arising from the stock options was $1.1 million in
2000.

  Acquired in-process research and development. Values assigned to the acquired
in-process research and development (IPR&D) were determined using an income
approach. To determine the value of the IPR&D, 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 IPR&D projects that had not yet reached technological
feasibility and do not have alternative future uses. The entire $4,399,000
allocated to acquired IPR&D was expensed on the date of acquisition.

  At the time of the acquisition, six IPR&D projects were identified as being
related to future products for which technological or commercial feasibility
had not yet been established and that did not have an alternative future use.
WatchGuard analyzed each project, using estimated percentage completion factors
ranging from 10% to 85%. Revenue attributable to Qiave's IPR&D was assumed to
increase after each of the first three years of a five-year projection period
after the year of introduction, at annual rates ranging from 60% to 216%,
decreasing to a 27% growth rate in revenues after the fourth year in the
projection. Projected annual revenues related to in-process technology ranged
from approximately $1.1 million to $14.8 million over the term of the
projections. These projections were based on aggregate revenue growth rates for
the business as a whole, anticipated growth rates for the Internet security
market, anticipated product development and product introduction cycles and the
estimated life of the underlying technology.

                                       65
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



  Gross profit was assumed to remain at 93% of revenues for each of the five
years of the projection period. Operating expenses, including sales and
marketing, research and development and general and administrative costs, were
assumed to be 48% of revenues in the initial year of the projection, declining
to 44% for each of the four remaining years.

  WatchGuard used a 35% discount rate for valuing the acquired IPR&D. In
arriving at the discount rate, WatchGuard considered the implied rate of the
transaction and the weighted average cost of capital. WatchGuard also took into
account risks related to the characteristics and applications of each project,
existing future markets, and assessments of the life cycles of each project.

  The unaudited pro forma combined historical results, presented as if Qiave
had been acquired on January 1, 2000 and excluding the nonrecurring one-time
charge for IPR&D in 2000, are presented below. Pro forma results for 1999 are
not presented because Qiave had no significant operations in 1999.

<TABLE>
   <S>                                                               <C>
   Total revenues, net.............................................. $  60,703
   Net loss......................................................... $ (29,536)
   Pro forma net loss per share..................................... $   (1.21)
</TABLE>

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, 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.
BeadleNet was a developer of Internet security solutions for small and home
offices. 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 consolidated financial statements
beginning on the acquisition date.

  The total BeadleNet acquisition cost of $9.6 million was comprised of (1)
$3.4 million in cash paid at closing, including $1.0 million paid to PEP in
satisfaction of BeadleNet's outstanding liabilities to PEP; (2) 335,931
unregistered shares of WatchGuard common stock with a fair value of $4.9
million, issued at closing; (3) 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 upon
completion of specified technology items in late December 1999 and was paid in
January 2000; and (4) estimated direct acquisition costs of $300,000. The lives
assigned to the identified intangible assets ranged from two to four years and
the life assigned to goodwill was five years.

  The aggregate purchase price for BeadleNet was allocated, based on estimated
fair values on the acquisition date, as follows (in thousands):

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


                                       66
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Acquired workforce. The value assigned to the workforce in place was
determined using the avoided cost approach. Under this approach, the workforce
is valued according to the costs WatchGuard avoided by obtaining a pre-
existing, trained and fully efficient team rather than assembling a workforce.

  Trade names. Values assigned to the trade names also were determined using an
avoided cost approach. The discount rate used to determine the value of the
trade names was 20% and took into account the uncompensated use of trade names
in marketing and distributing BeadleNet's products.

  Developed technology. Values assigned to the developed technology were
determined using the income approach. Under the income approach, fair value
reflects the present value of the projected earnings that are expected to be
generated by the current technology. To determine the value of the developed
technology, WatchGuard discounted, at a 15% rate, 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 projected revenues used in the income approach
are based on the future revenues that WatchGuard believes will most likely be
generated by the commercial sales of the technology.

  Acquired in-process research and development. Values assigned to the acquired
IPR&D were determined using an income approach. To determine the value of the
IPR&D, 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 IPR&D projects that had
not yet reached technological feasibility and do not have alternative future
uses. The entire $3.4 million allocated to acquired IPR&D was expensed on the
date of acquisition.

  At the time of the acquisition, BeadleNet's engineers had spent approximately
$1.2 million in fully burdened research and development expenses to develop the
project. WatchGuard anticipated that an additional $260,000 would be spent
developing the technology to complete the project. Based on this information,
WatchGuard used a percentage completion factor of 80%. WatchGuard completed
production-ready prototypes in late December 1999 and introduced the new
products in January 2000 for delivery during February 2000, the time that
WatchGuard projected to begin receiving benefit from the acquired IPR&D. The
total costs to complete the production-ready prototypes and to prepare for
market introduction after the acquisition date were approximately $635,000.

  Revenue attributable to BeadleNet's IPR&D was assumed to increase at annual
rates ranging from 72% to 21% after each of the first three years of a five-
year projection period following the year of introduction, decreasing at a rate
of 9% after the fourth year in the projection. Projected annual revenue ranged
from approximately $6 million to over $18 million over the term of the
projections. These projections were based on aggregate revenue growth rates for
the business as a whole, anticipated growth rates for the Internet security
market, anticipated product development and product introduction cycles and the
estimated life of the underlying technology. Projected revenues from the IPR&D
were assumed to peak in 2003 and begin declining in 2004 as other new products
enter the market.

  Gross profit was assumed to increase after each of the first three years of
the projection period at annual rates ranging from 72% to 21%, decreasing at a
rate of 8% after the fourth year of the projection. The profit growth
projections assumed the profit growth rate to be approximately the same as the
revenue growth rate.

                                       67
<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



  Operating expenses, including selling and marketing, research and development
and general and administrative costs, were assumed to be 57% of revenues in the
initial year of the projection, declining in subsequent years to approximately
20% of revenues in the last three years of the projection. Initial operating
costs to develop the infrastructure to support and market the new product
offerings accounts for the higher range of costs in the first two years of the
projections.

  WatchGuard used a 30% discount rate for valuing the acquired IPR&D. In
arriving at the discount rate, WatchGuard considered the implied rate of the
transaction and its weighted average cost of capital. WatchGuard also took into
account risks related to the characteristics and applications of each project,
existing future markets and assessments of the life cycles of each project.

  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.

  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 IPR&D, are as follows (in
thousands):

<TABLE>
<CAPTION>
                                                             December 31,
                                                          --------------------
                                                            1998       1999
                                                          ---------  ---------
   <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, WatchGuard 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 over the two-year
employment agreement period. Under the stock vesting agreement, 34,632 of these
shares were subject to forfeiture if Mr. Beadle's employment is terminated for
cause or if he resigns. At December 31, 2000, 17,316 shares remain subject to
forfeiture until October 19, 2001.

12. Related-Party Transactions

  Danny M. Beadle, WatchGuard's senior vice president of home security, was
also the founder of PEP, the former parent of BeadleNet, and its principal
shareholder through the latter part of 2000. Since the acquisition of
BeadleNet, 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) and provides engineering and
consulting services in connection with the development of some of WatchGuard's
broadband product offerings. Total expenditures for PEP products and services
during 1999 and 2000 were $448,000 and $457,000, respectively, and total
amounts due PEP at December 31, 1999 and 2000 were $361,000 and $44,000,
respectively.

13. Subsequent Events

  In January 2001, WatchGuard's board of directors approved an increase of an
additional 5,000,000 shares of common stock authorized for grant under the 2000
Stock Option Plan.

                                       68
<PAGE>

                                  SCHEDULE II

                       VALUATION AND QUALIFYING ACCOUNTS
                                 (In thousands)

<TABLE>
<CAPTION>
        Column A           Column B    Column C   Column D    Column E      Column F
------------------------ ------------ ---------- ---------- ------------   ----------
                                      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,
 1998
  Allowance for
   uncollectible
   accounts.............    $ 124      $   418      $ --      $    93 (A)    $ 449
  Sales return reserve..    $ --       $ 1,655      $ --      $ 1,040 (B)    $ 615
  Inventory reserve.....    $ --       $    80      $ --      $    80 (C)    $ --

Year ended December 31,
 1999
  Allowance for
   uncollectible
   accounts.............    $ 449      $   129      $ --      $   401 (A)    $ 177
  Sales return reserve..    $ 615      $ 1,083      $ --      $ 1,148 (B)    $ 550
  Inventory reserve.....    $ --       $   200      $ --      $   131 (C)    $  69

Year ended December 31,
 2000
  Allowance for
   uncollectible
   accounts.............    $ 177      $   486      $ --      $    30 (A)    $ 633
  Sales return reserve..    $ 550      $ 1,932      $ --      $ 1,517 (B)    $ 965
  Inventory reserve.....    $  69      $   430      $ --      $    54 (C)    $ 445
</TABLE>
--------
(A) Deductions consist of write-offs of uncollectible accounts, net of
    recoveries.

(B) Deductions consist of product returns.

(C) Deductions consist of write-offs of obsolete or excess quantities of
    inventory.

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

  None.

                                       69
<PAGE>

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Directors

  Our restated bylaws provide that our board of directors shall be composed of
not less than five nor more than nine directors, and that the board shall be
divided into three classes, as nearly equal in number as possible. At present
we have six directors. At each annual meeting, our stockholders will elect one
class, with each director in that class elected to serve a term of three years
or until his or her successor is elected and qualified. If a director resigns
from the board before the expiration of his or her term, however, the director
elected or appointed to fill the resulting vacancy will be elected to a term
equal in time to the resigning director's remaining term or until his or her
successor is elected and qualified.

 Class 1 - Term Expires 2001

  Stuart J. Ellman, 34, has served as a director of WatchGuard since April
1998. Mr. Ellman cofounded RRE Ventures LLC, a venture capital firm, and since
August 1994 has served as general partner of RRE Ventures LLC and its
affiliates and predecessors. He also serves as managing director of RRE
Investors, LLC and as a member of RRE Investors II, LLC. He is also a director
of Loudeye Technologies, Inc. Mr. Ellman holds a B.A. in economics from
Wesleyan University and an M.B.A. from Harvard University.

  Michael R. Hallman, 55, has served as a director of WatchGuard since November
2000. Mr. Hallman founded The Hallman Group, a management consulting firm, in
October 1992 and has served as its president since October 1992. From February
1990 to March 1992, he was president and chief operating officer of Microsoft
Corporation. Mr. Hallman is also a director of In Focus Corporation, Intuit,
Inc. and Network Appliance, Inc., as well as a director of two subsidiaries of
Fujitsu Ltd., and is a trustee of the Seattle Museum of Flight. He also serves
on the executive advisory boards of the business schools of Seattle Pacific
University and the University of Washington and on the visiting committee to
the University of Michigan Business School. Mr. Hallman holds a B.B.A. and an
M.B.A. from the University of Michigan.

 Class 2 - Term Expires 2002

  Andrew W. Verhalen, 44, has served as a director of WatchGuard since May
1997. Since April 1992, Mr. Verhalen has served as a partner of Matrix
Partners, a venture capital firm. Before 1992, Mr. Verhalen held senior
management positions at 3Com Corporation and Intel Corporation. He is also a
director of Blue Martini Software, Inc., Copper Mountain Networks, Inc., Open
Wave Systems, Turnstone Systems, Inc. and several private technology companies.
Mr. Verhalen holds a B.S.E.E., an M.E. and an M.B.A. from Cornell University.

  Charles P. Waite, Jr., 45, has served as a director of WatchGuard since May
1997. Since December 1987, Mr. Waite has served as a general partner of OVP
Ventures (formerly Olympic Venture Partners), a venture capital firm. He is
also a director of Loudeye, Inc., Rosetta Inpharmetics, Inc., Seattle Genetics,
Inc., SignalSoft Corporation, Verity, Inc. and several private companies. Mr.
Waite holds an A.B. in history from Kenyon College and an M.B.A. from Harvard
University.

 Class 3 - Term Expires 2003

  Christopher G. Slatt, 42, cofounded WatchGuard in February 1996. Mr. Slatt
has served as president, chief executive officer and a director of WatchGuard
since its inception, and as chairman of the board since April 1999. From
September 1993 to October 1995, he served as a vice president and a general
manager of Legent Corporation, a computer software company, which was acquired
by Computer Associates International, Inc., a computer software company, in
August 1995. Mr. Slatt holds a B.S.E.E. from the University of Notre Dame.

                                       70
<PAGE>

  Steven N. Moore, 43, cofounded WatchGuard in February 1996. Mr. Moore has
served as executive vice president of strategic financial operations since
October 2000 and as secretary and director of WatchGuard since inception. Mr.
Moore served as chief financial officer and treasurer from inception to October
2000. He served as executive vice president of finance from March 1999 to
October 2000, and as vice president of finance and operations from inception to
March 1999. From September 1993 to September 1995, he served as director of
finance of Legent Corporation. Mr. Moore holds a B.S. in finance from Central
Washington University.

Executive Officers

  The following table lists the executive officers of WatchGuard as of March
15, 2001.

<TABLE>
<CAPTION>
            Name          Age                     Position
            ----          ---                     --------
   <C>                    <C> <S>
   Christopher G. Slatt..  42 President, Chief Executive Officer and Chairman
                              of the Board
   Steven N. Moore.......  43 Executive Vice President of Strategic Financial
                              Operations, Secretary and Director
   Michael E. McConnell..  50 Vice President, Chief Financial Officer and
                              Treasurer
</TABLE>

  Christopher G. Slatt's and Steven N. Moore's biographies are contained in the
section entitled "Directors-- Class 3--Term Expires 2003" in Part III, Item 10
of this annual report.

  Michael E. McConnell has served as vice president, chief financial officer
and treasurer of WatchGuard since October 2000. From May 1999 to October 2000,
he served as vice president of finance. From January 1992 to May 1999, he
served as chief financial officer of Cellular Technical Services Company, Inc.,
a wireless telecom technologies company. Mr. McConnell holds a B.A. from
California Polytechnic State University--San Luis Obispo.

Section 16(a) Beneficial Ownership Reporting Compliance

  Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
our executive officers, directors and holders of 10% or more of a registered
class of our equity securities to file reports of ownership and changes in
ownership with the SEC. SEC regulations require executive officers, directors
and 10%-or-greater stockholders to give us copies of all Section 16(a) forms
they file with the SEC.

  Based solely on our review of these forms, or written representations from
reporting persons that no such forms were required for those persons, we
believe that during 2000 our executive officers, directors and 10%-or-greater
stockholders complied with all applicable filing requirements, other than one
late filing related to a Form 4 filed by each of Andrew W. Verhalen and Charles
P. Waite, Jr., who are directors of WatchGuard.

                                       71
<PAGE>

ITEM 11. EXECUTIVE COMPENSATION

Compensation Summary

  The following table lists all compensation earned during 2000, 1999 and 1998
by our chief executive officer and our other executive officers whose
compensation exceeded $100,000 in 2000.

                           Summary Compensation Table

<TABLE>
<CAPTION>
                                                                     Long-Term
                                                                    Compensation
                                                                       Awards
                                                                    ------------
                                            Annual Compensation      Securities
                                            ---------------------    Underlying
Name and Principal Position            Year Salary ($)    Bonus ($)  Options (#)
---------------------------            ---- ------------  ---------  -----------
<S>                                    <C>  <C>         <C>          <C>
Christopher G. Slatt.................. 2000  $  216,667 $  42,451         --
 Chief Executive Officer and President 1999     190,000    67,203      40,000
                                       1998     155,000       --       70,000

Steven N. Moore (1)................... 2000     191,667    42,451         --
 Executive Vice President of Strategic
  Financial Operations and             1999     174,250    67,203      40,000
 Secretary                             1998     155,000       --       70,000

Michael E. McConnell (2).............. 2000     141,942    33,925      60,000
 Vice President, Chief Financial
  Officer and Treasurer

R. Michael Peronto (3)................ 2000     187,311    34,063         --
 Former Vice President and Chief
  Operating Officer                    1999     142,019    49,538     440,364
</TABLE>
--------
(1)  Mr. Moore resigned as executive vice president of finance, chief financial
     officer and treasurer effective October 24, 2000, at which time he became
     executive vice president of strategic financial operations.
(2)  Mr. McConnell became vice president, chief financial officer and treasurer
     effective October 24, 2000.
(3)  Mr. Peronto joined WatchGuard in March 1999. His annual salary for 1999
     was $175,000. Mr. Peronto resigned as vice president and chief operating
     officer effective August 21, 2000.

 Option Grants in 2000

  The following table provides information regarding options granted during
2000 to our chief executive officer and our other executive officers whose
compensation exceeded $100,000 in 2000. The table includes the potential
realizable value over the 10-year term of the options, based on assumed rates
of stock appreciation of 5% and 10%, compounded annually. The assumed rates of
appreciation are prescribed by the SEC for illustrative purposes only and are
not intended to forecast or predict future stock prices. Any actual gains on
option exercises will depend on the future performance of our stock.

                       Option Grants in Last Fiscal Year

<TABLE>
<CAPTION>
                                        Individual Grants
                         -------------------------------------------------
                                                                            Potential Realizable
                                                                           Value at Assumed Annual
                         Number of                                          Rates of Stock Price
                         Securities  Percent of Total                      Appreciation for Option
                         Underlying  Options Granted  Exercise                      Term
                          Options    to Employees in    Price   Expiration -----------------------
          Name           Granted (#) Last Fiscal Year ($/Share)    Date      5% ($)      10% ($)
          ----           ----------  ---------------- --------  ---------- ----------- -----------
<S>                      <C>         <C>              <C>       <C>        <C>         <C>
Christopher G. Slatt....      --            --            --          --           --          --
Steven N. Moore.........      --            --            --          --           --          --
Michael E. McConnell
 (1)....................   50,000          1.49%      $ 53.34     8/15/10  $ 1,677,381 $ 4,250,814
                           10,000          0.30         37.25    10/17/10      234,263     593,669
R. Michael Peronto......      --            --            --          --           --          --
</TABLE>
--------
(1)  Approximately 2% of Mr. McConnell's options vest and become exercisable
     each month, commencing on September 15, 2000 for the first option grant
     and commencing on November 17, 2000 for the second option grant.

                                       72
<PAGE>

  In 2000, we granted options to purchase an aggregate of 3,345,031 shares to
employees. We granted all options under our stock option plan at exercise
prices that equal or, in the case of holders of 10% or more of our outstanding
stock, exceed the fair market value of our common stock on the date of grant.

 Options Exercised in 2000 and Unexercised Options Held as of December 31, 2000

  The following table provides information regarding options exercised in 2000
and unexercised options held as of December 31, 2000 by our chief executive
officer and our other executive officers whose compensation exceeded $100,000
in 2000. The value of unexercised options is calculated on the basis of the
closing sales price of our common stock on the Nasdaq National Market on
December 31, 2000, which was $31.625 per share.

          Options Exercised in 2000 and Fiscal Year-End Option Values

<TABLE>
<CAPTION>
                                                   Number of Securities
                                                        Underlying           Value of Unexercised
                           Shares                 Unexercised Options at    In-the-Money Options at
                         Acquired on    Value       Fiscal Year-End (#)       Fiscal Year-End ($)
                          Exercise    Realized   ------------------------- -------------------------
          Name               (#)         ($)     Exercisable Unexercisable Exercisable Unexercisable
          ----           ----------- ----------- ----------- ------------- ----------- -------------
<S>                      <C>         <C>         <C>         <C>           <C>         <C>
Christopher G. Slatt....       --            --    66,041        43,959    $ 1,869,976  $ 1,036,240
Steven N. Moore.........       --            --    66,041        43,959      1,869,976    1,036,240
Michael E. McConnell....    39,962   $ 1,607,278   24,350       146,688        368,160    1,699,922
R. Michael Peronto......   137,600     5,441,113   36,705           --         683,631          --
</TABLE>

Compensation Committee Report on Executive Compensation

  The compensation committee of the board of directors has furnished the
following report on compensation. The compensation committee, which is
comprised of three nonemployee directors, reviews and approves the compensation
and benefits for our executive officers, grants stock options to officers and
nonemployees under our stock option plan and makes recommendations to the board
of directors regarding these matters. The compensation committee applies a
similar compensation policy to executives and employees and considers internal
and external information in determining compensation.

 Compensation Philosophy

  Our compensation policies are based on the belief that the interests of
employees should be closely aligned with those of our stockholders. The
compensation policies are designed to achieve the following objectives:

  .  Offer compensation opportunities that attract highly qualified
     employees, reward outstanding initiative and achievement, and retain the
     leadership and skills necessary to build long-term stockholder value.

  .  Maintain a market-competitive compensation structure in line with
     corporate business objectives. The focus is weighted on incentive
     programs and based on results as measured by both the quarterly and
     long-term financial performance of WatchGuard.

  .  Further our short- and long-term strategic goals and values by aligning
     compensation with business objectives and individual performance.

 Compensation Program

  Our compensation program has three major integrated components: base salary,
quarterly bonus awards and long-term incentives. We emphasize the award of
stock options as long-term incentives to executive officers.

  Base salary. Base salary levels are determined annually by reviewing the
skills, performance level and contribution to the business of individual
employees.

                                       73
<PAGE>

  Quarterly bonus awards. Quarterly bonus awards are based on individual
employee goals and the attainments of quarterly corporate objectives, which are
set on a quarterly basis.

  Long-term incentives. The compensation committee views stock options as an
important part of its long-term, performance-based compensation program. The
committee believes that stock ownership is an excellent vehicle for
compensating its officers and employees. We provide long-term incentives
through our Amended and Restated 1996 Stock Incentive Compensation Plan, or the
1996 plan, our 2000 Stock Option Plan and our 1999 Employee Stock Purchase
Plan, the purpose of which is to create a direct link between executive
compensation and increases in stockholder value. Stock options are granted at
fair market value and vest in installments generally over four years. Thus, the
value of the stockholders' investment must appreciate before the optionee
receives any financial benefit. Additionally, the employee must remain in our
employ for the period required for the stock option to be exercisable, thus
providing an incentive to remain in our employ. When determining option awards
for an executive officer, the committee considers the executive's current
contribution to WatchGuard's performance, the anticipated contribution to
meeting our long-term strategic performance goals, and industry practices and
norms. Long-term incentives granted in prior years and existing levels of stock
ownership are also taken into consideration. Because the receipt of value by an
executive officer under a stock option depends on an increase in the price of
our common stock, this portion of the executive's compensation is directly
aligned with an increase in stockholder value. The committee believes that such
stock plans align the interests of the employees with the long-term interests
of the stockholders.

 Chief Executive Officer Compensation

  Mr. Slatt's annual salary for 2000 was $216,667 and his bonus was $42,451.
Mr. Slatt was not granted any stock options in 2000. Mr. Slatt's base salary
and bonus for 2000 was determined based on the same factors employed by the
committee for executive officers generally.

  Section 162(m) of the Internal Revenue Code limits the tax deductibility by a
corporation of compensation in excess of $1 million paid to its chief executive
officer and any other of its four most highly compensated executive officers.
Compensation that qualifies as "performance-based," however, is excluded from
the $1 million limit. The committee does not presently expect total cash
compensation payable for salaries to exceed the $1 million limit for any
individual executive. In addition, our 1996 plan is designed to qualify as
performance-based compensation that is fully deductible by us for income tax
purposes. The committee will continue to monitor the compensation levels
potentially payable under our other compensation programs, but intends to
retain the flexibility necessary to provide total compensation in line with
competitive practice, our compensation philosophy and the best interests of
WatchGuard.

                                          Compensation Committee

                                          Stuart J. Ellman
                                          Andrew W. Verhalen
                                          Charles P. Waite, Jr.

                                       74
<PAGE>

Performance Graph

  The following graph shows a comparison of cumulative total stockholder return
for WatchGuard, the Nasdaq Stock Market Index and the Nasdaq Computer and Data
Processing Index. The graph shows the value, as of December 31, 2000, of $100
invested on July 30, 1999, the date of our initial public offering, in
WatchGuard common stock, the Nasdaq Stock Market Index (U.S. companies) and the
Nasdaq Computer and Data Processing Index.

 Comparison of Cumulative Total Return Among WatchGuard Technologies, Inc., the
  Nasdaq Stock Market Index and the Nasdaq Computer and Data Processing Index

                             [GRAPH APPEARS HERE]

<TABLE>
<CAPTION>
                                                     July 30, Dec. 31, Dec. 31,
                                                       1999     1999     2000
                                                     -------- -------- --------
     <S>                                             <C>      <C>      <C>
     WatchGuard..................................... $ 100.00 $ 226.70 $ 261.80
     Nasdaq Stock Market Index (U.S. companies).....   100.00   149.80    92.70
     Nasdaq Computer and Data Processing Index......   100.00   178.50    85.80
</TABLE>

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

  The following table provides information regarding the beneficial ownership
of our common stock outstanding as of February 28, 2001 by

  .  each person or group that we know beneficially owns 5% or more of our
     common stock;

  .  each of our directors;

  .  our chief executive officer and the other executive officers whose
     compensation exceeded $100,000 in 2000; and

  .  all of our directors and executive officers as a group.

  The percentage ownership data is based on 26,680,257 shares of WatchGuard
common stock outstanding as of February 28, 2001. Under the rules of the SEC,
beneficial ownership includes shares over which the indicated beneficial owner
exercises voting and/or investment power. Shares of common stock subject to
options that are currently exercisable or will become exercisable within 60
days of February 28, 2001 are deemed outstanding for computing the percentage
ownership of the person holding the option, but are not deemed outstanding for
purposes of computing the percentage ownership of any other person. Unless
otherwise

                                       75
<PAGE>

indicated in the footnotes below, we believe that the persons and entities
named in the table have sole voting and investment power with respect to all
shares beneficially owned, subject to applicable community property laws.
Unless otherwise indicated, the following beneficial owners can be reached at
our principal offices.

<TABLE>
<CAPTION>
                                    Number of Shares  Percentage of Shares of
              Name                 Beneficially Owned Common Stock Outstanding
              ----                 ------------------ ------------------------
<S>                                <C>                <C>
Scudder Kemper Investments, Inc.
 (1)..............................     2,404,800                9.01%
  345 Park Avenue
  New York, NY 10154..............
Stuart J. Ellman (2)..............        10,460                   *
Michael R. Hallman (3)............         8,755                   *
Andrew W. Verhalen (4)............       930,813                3.49
Charles P. Waite, Jr. (5).........        53,596                   *
Christopher G. Slatt (6)..........     2,252,637                8.42
Steven N. Moore (7)...............     2,257,137                8.44
Michael E. McConnell (8)..........        45,809                   *
R. Michael Peronto (9)............         1,522                   *
Directors and executive officers
 as a group (7 persons) (10)......     5,559,207               20.67
</TABLE>
--------
  *   Less than 1%
 (1)  In a filing with the SEC on Schedule 13G, dated February 14, 2001,
      Scudder Kemper Investments, Inc. reported sole voting power with respect
      to 2,001,100 shares and sole dispositive power with respect to 2,211,800
      shares, and shared voting power with respect to 206,800 shares and shared
      dispositive power with respect to 193,000 shares.

 (2)  Includes 5,555 shares subject to options exercisable on or within 60 days
      of February 28, 2001.

 (3)  Represents 3,200 shares held by a trust for the benefit of Mr. Hallman
      and his spouse, of which they are trustees, and 5,555 shares subject to
      options exercisable on or within 60 days of February 28, 2001.

 (4)  Includes 858,291 shares held by entities affiliated with Matrix IV
      Management Co., L.P. Mr. Verhalen is a general partner of Matrix IV
      Management Co., L.P., which the general partner of each of the entities
      affiliated with it. Mr. Verhalen disclaims beneficial ownership of the
      shares held by the entities affiliated with Matrix IV Management Co.,
      L.P., except to the extent of his pecuniary interest arising from his
      interest in Matrix IV Management Co., L.P. Also includes 66,967 shares
      held by trusts of which Mr. Verhalen is trustee and 5,555 shares subject
      to options exercisable on or within 60 days of February 28, 2001.

 (5)  Includes 1,508 shares held by trusts of which Mr. Waite is trustee and
      5,555 shares subject to options exercisable on or within 60 days of
      February 28, 2001.

 (6)  Includes 300,000 shares held by Venus Capital LLC and 75,207 shares
      subject to options exercisable on or within 60 days of February 28, 2001.

 (7)  Includes 300,000 shares held by Baja Investment Co. LLC and 75,207 shares
      subject to options exercisable on or within 60 days of February 28, 2001.

 (8)  Includes 43,990 shares subject to options exercisable on or within 60
      days of February 28, 2001.

 (9)  Mr. Peronto resigned as vice president and chief operating officer
      effective August 21, 2000. Mr. Peronto's share information reflects the
      number of shares he reported as owned on a Form 4 for September 2000, the
      last beneficial ownership report he was required to file with the SEC.

(10)  Includes 216,624 shares subject to options exercisable on or within 60
      days of February 28, 2001.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  None.

                                       76
<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........................  46
  Consolidated Balance Sheets..............................................  47
  Consolidated Statements of Operations....................................  48
  Consolidated Statements of Stockholders' Equity..........................  49
  Consolidated Statements of Cash Flows....................................  50
  Notes to Consolidated Financial Statements...............................  51
</TABLE>

(2) INDEX TO FINANCIAL STATEMENT SCHEDULES

  Schedule II--Valuation and Qualifying Accounts for each of the three years
ended December 31, 2000, 1999 and 1998.

  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 consolidated financial statements or related
notes.

(3) EXHIBITS

<TABLE>
<CAPTION>
 Number                               Description
 ------                               -----------
 <C>    <S>
  2.1   Agreement and Plan of Merger dated as of October 4, 2000, among Logan
        Acquisition Corporation, Qiave Technologies Corporation, certain common
        stockholders of Qiave Technologies Corporation and the registrant
        (Exhibit 2.1) (A)

  3.1   Restated Certificate of Incorporation of the registrant (Exhibit 3.1)
        (B)

  3.2   Restated Bylaws of the registrant (Exhibit 3.2) (B)

 10.1   Lease Agreement, dated as of March 1, 2000, between 505 Union Station
        and the registrant (Exhibit 10.1) (C)

 10.2   Amended and Restated Loan and Security Agreement, dated as of March 20,
        1998, between Silicon Valley Bank and the registrant (Exhibit 10.4) (B)

 10.3   Loan Modification Agreement, dated as of March 1, 2000, between Silicon
        Valley Bank and the registrant (Exhibit 10.13) (D)

 10.4   1996 Stock Incentive Compensation Plan (Exhibit 10.6) (B)

 10.5   2000 Stock Option Plan

 10.6   Qiave Technologies Corporation 2000 Stock Option Plan (Exhibit 99.1)
        (E)

 10.7   1999 Employee Stock Purchase Plan (Exhibit 10.10) (B)

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

 10.9+  Development and Supply Agreement, dated as of March 25, 1998, between
        SMART Modular Technologies, Inc. and the registrant (Exhibit 10.8) (B)

 10.10+ OEM Master License Agreement, dated as of August 14, 1997, between RSA
        Data Security, Inc. and the registrant (Exhibit 10.9) (B)
</TABLE>

                                       77
<PAGE>

<TABLE>
<CAPTION>
 Number                     Description
 ------                     -----------
 <C>    <S>
 21.1   Subsidiaries of the registrant

 23.1   Consent of Ernst & Young LLP, independent auditors
</TABLE>
--------
 +  Portions of these exhibits have been omitted based on a grant of
    confidential treatment by the SEC. The omitted portions of the exhibits
    have been filed separately with the SEC.

(A) Incorporated by reference to the Current Report on Form 8-K (File No. 000-
    26819), filed with the SEC on October 19, 2000, as amended.

(B) Incorporated by reference to the Registration Statement on Form S-1 (File
    No. 333-76587), filed with the SEC on April 20, 1999, as amended.

(C) Incorporated by reference to the Quarterly Report on Form 10-Q (File No.
    000-26819), filed with the SEC on May 15, 2000.

(D) Incorporated by reference to the Annual Report on Form 10-K/A (File No.
    000-26819), filed with the SEC on May 1, 2000.

(E) Incorporated by reference to the Registration Statement on Form S-8 (File
    No. 333-51196), filed with the SEC on December 4, 2000.

  (b) Reports on Form 8-K

  On October 19, 2000, we filed a current report on Form 8-K to report our
October 4, 2000 acquisition of Qiave Technologies Corporation.

  On December 1, 2000, we filed an amended current report on Form 8-K to
provide the financial statements of Qiave Technologies Corporation required by
Item 7(a) of Form 8-K and the pro forma financial statements required by Item
7(b) of Form 8-K.

                                       78
<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
                                              President and Chief Executive
                                                         Officer

                                          Date: March 27, 2001

  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   March 27, 2001
______________________________________  Officer and Chairman of
         Christopher G. Slatt           the Board (Principal
                                        Executive Officer)

     /s/ Michael E. McConnell          Vice President, Chief        March 27, 2001
______________________________________  Financial Officer and
         Michael E. McConnell           Treasurer (Principal
                                        Financial and Accounting
                                        Officer)

       /s/ Stuart J. Ellman            Director                     March 24, 2001
______________________________________
           Stuart J. Ellman

      /s/ Michael R. Hallman           Director                     March 27, 2001
______________________________________
          Michael R. Hallman

       /s/ Steven N. Moore             Director                     March 27, 2001
______________________________________
           Steven N. Moore

      /s/ Andrew W. Verhalen           Director                     March 27, 2001
______________________________________
          Andrew W. Verhalen

    /s/ Charles P. Waite, Jr.          Director                     March 27, 2001
______________________________________
        Charles P. Waite, Jr.
</TABLE>

                                       79