<PAGE>

================================================================================

                      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, 2001

                                      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               (I.R.S.
                    jurisdiction         Employer Identification
                 of incorporation or              No.)
                    organization)

             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. [X]

   The aggregate market value of the voting stock held by nonaffiliates of the
registrant, based on the average of the high and low bid prices of the
registrant's common stock on March 25, 2002, as reported on the Nasdaq National
Market, was approximately $137,733,381. 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 March 25, 2002, there were 27,265,870 shares of the registrant's
common stock outstanding.

                      DOCUMENTS INCORPORATED BY REFERENCE

   The information required by Part III of this report, to the extent not set
forth herein, is incorporated into this report by reference to the registrant's
definitive proxy statement for the annual meeting of stockholders to be held on
May 23, 2002. The definitive proxy statement will be filed with the Securities
and Exchange Commission within 120 days after December 31, 2001, the end of the
fiscal year to which this report relates.

================================================================================

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                          ANNUAL REPORT ON FORM 10-K

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

                               TABLE OF CONTENTS

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

                                    PART I

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

 ITEM 2.  PROPERTIES.....................................................  31

 ITEM 3.  LEGAL PROCEEDINGS..............................................  31

 ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............  31

                                    PART II

 ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
          MATTERS........................................................  32

 ITEM 6.  SELECTED FINANCIAL DATA........................................  33

 ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS..........................................  34

 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.....  51

 ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................  52

 ITEM 9.  CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
          FINANCIAL DISCLOSURE...........................................  76

                                   PART III

 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.............  77

 ITEM 11. EXECUTIVE COMPENSATION.........................................  77

 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.  77

 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................  77

                                    PART IV

 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K  78
</TABLE>

                                      2

<PAGE>

                                    PART I

Forward-Looking Statements

   Our disclosure and analysis in this annual report contain forward-looking
statements, which provide our current expectations or forecasts of future
events. Forward-looking statements in this annual report include, without
limitation:

  .   information concerning possible or assumed future operating results,
      trends in financial results and business plans, including those relating
      to earnings growth and revenue growth;

  .   information about the expected closing of our acquisition of RapidStream,
      Inc. or about the benefits we may realize from that acquisition;

  .   statements about our costs and operating expenses relative to our
      revenues and about the expected composition of our revenues;

  .   statements about our future capital requirements and the sufficiency of
      our cash, cash equivalents, investments and available bank borrowings to
      meet these requirements;

  .   information about the anticipated timing of new product releases;

  .   other statements about our plans, objectives, expectations and
      intentions; and

  .   other statements that are not historical facts.

   Words such as "believes," "anticipates" and "intends" may identify
forward-looking statements, but the absence of these words does not necessarily
mean that a statement is not forward-looking. Forward-looking statements are
subject to known and unknown risks and uncertainties and are based on
potentially inaccurate assumptions that could cause 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 factors described in
the section entitled "Important Factors That May Affect Our Business, Our
Results of Operations and Our Stock Price" in this report. Other factors
besides those described in this report could also affect actual results. You
should carefully consider the factors described in the section entitled
"Important Factors That May Affect Our Business, Our Results of Operations and
Our Stock Price" in evaluating our forward-looking statements.

   You should not unduly rely on these forward-looking statements, which speak
only as of the date of this report. We undertake no obligation to publicly
revise any forward-looking statement to reflect circumstances or events after
the date of this report, or to reflect the occurrence of unanticipated events.
You should, however, review the factors and risks we describe in the reports we
file from time to time with the Securities and Exchange Commission, or SEC.

ITEM 1.  BUSINESS

Overview

   WatchGuard is a leading provider of Internet security solutions designed to
protect enterprises that use the Internet for e-commerce and secure
communications. Our mission is to provide enterprises worldwide, pro-active
Internet security solutions that protect against known and future threats in a
smart, dynamic and simple way. With threats and attacks at risk of compromising
multiple points in a corporate network, the requirements of a security solution
must now include firewalls for access control, virtual private networks, or
VPNs, for secure communications and content and application security for
servers and desktops. To be effective for enterprises of all sizes, however, a
comprehensive security solution also requires a robust and intuitive system
that simplifies the management of these point solutions. Because the security
landscape is constantly evolving, an effective security solution must also be
dynamic to allow an enterprise to keep its defenses current against the latest
threats and attacks.

                                      3

<PAGE>

   Thousands of enterprises worldwide use WatchGuard's award-winning products
and services, which include our Firebox firewall and VPN appliances for access
control and secure communications, and our ServerLock technology and anti-virus
solution for content and application security for servers and desktops. The
centralized point-and-click management of our solutions allows the non-security
professional to effectively install, configure and monitor our security
products. In addition, our innovative subscription-based LiveSecurity Service
enables our customers, with minimal effort, to protect their data and
communications in a continuously changing environment.

   On February 7, 2002, we entered into an agreement to acquire RapidStream,
Inc., a privately held provider of high-performance, ASIC-based firewall and
VPN appliances. We expect to complete the acquisition early in the second
quarter of 2002, subject to specified conditions to closing. With the
acquisition of RapidStream, we expect to be able to address a much broader
range of customer needs with small branch office to gigabit enterprise-class
products. The combination of RapidStream's appliance platform performance and
networking expertise with our award-winning product lines and security
management features, provides WatchGuard with the opportunity to offer an even
more competitive security solution.

   Our core market includes small- and medium-sized enterprises, or SMEs, and
large Internet-distributed enterprises, or IDEs, with high-speed connections
supporting VPNs between the corporate headquarters and geographically dispersed
branch offices. Our security solutions also 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
provider, or ISP, or other managed service provider implementing our managed
security solutions. 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 indirectly to end-users through
thousands of distributors and resellers, with customers located in over 125
countries. We also sell directly and indirectly to a number of service
providers who implement our managed security solution. As of December 31, 2001,
we had shipped over 90,000 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 has provided enterprises, regardless of size,
with new revenue opportunities through global distribution of products and
services and has enabled 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 e-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 business-to-consumer transactions. The accessibility
and relative

                                      4

<PAGE>

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,
terrorists, curious or disgruntled employees and 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. In addition,
because even 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.

   The need for increased Internet security has been recognized at the highest
national levels. In 2001, President George W. Bush appointed Richard Clarke as
his special advisor on cybersecurity. In response to the increased need at the
national level, President Bush included in his proposed budget a 64% increase
in spending for information security, to $4 billion. Mr. Clarke has frequently
called for corporations to increase their spending for information security. In
February 2000, he cited statistics indicating that, on average, less than
0.0025% of corporate revenue is spent on such protection.

   The annual Computer Security Institute, or CSI, survey conducted in 2001
confirms the potential risks faced by organizations connected to the Internet.
The CSI survey revealed that 85% of companies responding had experienced
security breaches within the past 12 months, with 64% acknowledging financial
loss. 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 $2 million per organization, which was approximately
double the average loss reported in the prior year.

The Internet security challenge

   Adequate Internet security is not a response to a single challenge, but
rather a response to a variety of business requirements. For example, because
enterprises need to control the flow of information between their internal
networks and the Internet, they need firewalls, which are important components
of a comprehensive security solution. A firewall, a security component that
varies in complexity, is designed to block access from the Internet to an
enterprise's internal networks, as well as control the flow of and access to
information shared between the networks and the Internet. A comprehensive
security solution should also integrate several other sophisticated security
layers, such as VPNs, to enable encrypted communications between points on the
Internet, and content and application security for servers and desktops to
protect critical data and services against unauthorized or unintentional
changes.

   Even a comprehensive solution, however, must be easy to install, configure
and manage to be truly effective. With businesses increasingly establishing
secure Internet access for branch offices, trading partners and traveling
employees, an enterprise must deploy point solutions such as firewalls and VPNs
to fully protect the corporate network, as well as protect multiple servers and
desktops in various locations. Without a robust, intuitive and easy-to-use
system to manage these point solutions, the complexity and difficulty of
successfully implementing a corporate information security solution rises
dramatically.

   To further complicate matters, the dangers against which an effective
Internet security solution must protect are dynamic rather than static, with
new types of intrusion schemes, worms, viruses and other security threats and
vulnerabilities emerging constantly. The Computer Emergency Response Team, a
federally funded research and development center, handled 52,658 security
incidents in 2001, almost two and a half times the 21,756 security incidents
handled in 2000, and more than five times the 9,859 security incidents handled
in 1999. Even if updates are available to allow an enterprise's security system
to respond to the changing security landscape, there will often be a
"vulnerability window" after the threat emerges but before it can be
neutralized. In addition, unless an enterprise can timely and easily implement
updates across the enterprise's point solutions protecting its network,

                                      5

<PAGE>

the enterprise may need dedicated, and expensive, security experts to
proactively identify, obtain and manually implement these updates quickly and
correctly.

The Internet security opportunity

   According to the "VPN and Firewall Products Quarterly Worldwide Market Share
and Forecasts for 4Q01 and CY01" report from Infonetics Research, Inc., the
"VPN and firewall markets are rapidly merging into a single market, and
hardware solutions are beginning to dominate." Infonetics reports that the
worldwide market for firewalls reached $1.7 billion in 2001, and is forecasted
to grow to $3.8 billion in 2005 at a compound annual growth rate, or CAGR, of
29%. VPN hardware revenues reached $1.3 billion in 2001, and are forecasted to
reach $2.9 billion in 2005 at a CAGR of 32%. Some VPN hardware includes
firewall capability and is therefore also reflected in the firewall market
statistics. In a separate report, International Data Corporation, or IDC,
forecasts the security software market to grow at a CAGR of 23%, from $5.1
billion in 2000 to $14.1 billion in 2005. IDC forecasts the security hardware
market to grow at a CAGR of 38%, from $2.2 billion in 2000 to $11 billion, in
2005. 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 Netcraft, there are currently more than 35 million
Web servers worldwide, with over 10 million running Microsoft applications.

   Enterprises require a robust, comprehensive Internet security solution that
secures all vulnerable points in the corporate network, that can be installed,
configured and managed easily, and that can be kept up to date quickly and
effectively, all for an economical price. In addition, many enterprises would
rather outsource the management of their Internet security 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. Our solution has the following key benefits:

Depth            For enterprises of all sizes, we offer a comprehensive
                 security solution designed to secure multiple access points to
                 the network: (1) a firewall for access control and filtering
                 of dangerous content such as worms and viruses, (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, such as Web site defacement
                 and the deposit of malicious code and (4) anti-virus
                 protection to secure the desktop.

Simplicity       We offer (1) a 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.

Vigilance        Our subscription-based LiveSecurity Service is designed to
                 keep our customers' security solutions up to date with (1)
                 information alerts that offer timely analyses of breaking
                 Internet security news combined with instructions on how
                 customers can keep their networks secure, (2) virus alerts
                 with information from McAfee.com Corporation, or McAfee, which
                 provides real-time virus alerts and specific information on
                 how customers can protect their systems, (3) security threat
                 responses that provide detailed information on security
                 vulnerabilities as they develop, including how they may affect

                                      6

<PAGE>

                 systems and what we are doing to help our customers keep their
                 networks secure, and, in the appropriate case, that provide
                 software that addresses the threat, (4) software updates, (5)
                 support flashes with tips for managing WatchGuard products,
                 (6) expert editorials that serve as continuing education about
                 Internet security, (7) Web-based and interactive technical
                 support and (8) Web-based customer training. With the aid of
                 our security experts and timely responses to changing security
                 threats, our solutions permit enterprises to more aggressively
                 manage the vulnerability window.

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 continue to expand into the IDE and larger enterprise
markets

   We intend to further extend our leadership position into new markets by
expanding and enhancing our Internet security product and service offerings.
With the acquisition of RapidStream and by integrating the RapidStream
technology with our family of products, we will enhance our network perimeter
solution with high performance, ASIC-based appliance platforms and
enterprise-level networking functionality. Over the next year, we also plan to
further integrate our server and desktop security technology with our access
control and VPN products to provide a security suite that secures all points of
vulnerability. This solution, through an enhanced management console, would
allow our customers to more effectively manage their security environments by
centralizing and automating reporting, logging and notification to provide
real-time threat analysis and attack profile correlation. Through our
LiveSecurity Service and the integration of our enhanced point solution
technologies with one another, our products will more effectively communicate
together and assist our customers in managing the "window of vulnerability,"
that period of time between the emergence of a new attack and the delivery of a
solution, allowing our customers to continue to operate their businesses
uninterrupted. With this offering of a high-performance, comprehensive and
integrated security suite, our goal is to create the next generation of
proactive security solutions.

Expand and enhance our innovative LiveSecurity Service

   Our subscription-based LiveSecurity Service is an innovative, value-added
security service that provides information and virus alerts, threat responses,
software updates, support flashes and expert editorials, 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 adding new
software and services through internal development and partnering with
third-party providers. We also plan to assist our customers in further managing
the vulnerability window through our LiveSecurity Service, which will be
designed to inform our customers of new approaches to deal with the latest
threats, as well as to further automate the process of protecting critical
processes with minimal intervention until such time as a more permanent
response to the threat can be implemented. 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 by service providers.

Continue to upgrade our distribution channel and expand and enhance our
worldwide network of resellers

   We intend to continue to upgrade our distribution channel worldwide with
direct relationships that can produce the greatest return while expanding and
enhancing the quality of our worldwide network of resellers that purchase
through distribution. With our recently announced WatchGuard Secure Partner
Program, we can reward our worldwide reseller base for technical competency and
customer support. Resellers buying our products through our distribution
partners will be provided additional discounts and benefits based on meeting
program requirements that are targeted at maximizing the ability of
participants to sell, support and promote our products. We also expect to add
key system integrators to assist our customers who are implementing large,
distributed solutions. We have also recently reorganized our worldwide sales
force to more effectively work with our

                                      7

<PAGE>

distribution partners and have focused separate sales resources on recruiting
resellers to buy through distribution and working directly with end-users to
generate demand for those resellers. We also plan to continue to invest in our
Web-based training and certification program, which we believe is becoming a
model for the industry, as well as in regional awareness programs that educate
our resellers and subscribers worldwide about the features and benefits of our
products and services.

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 jointly
execute marketing programs 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
increase our end-user demand generation activities. Through online and print
advertising, direct mail, e-mail and telemarketing campaigns, and particularly
through our Web site and sales tools, we intend to leverage our marketing
activities worldwide to uniquely position WatchGuard in the marketplace and
clearly communicate the benefits of our comprehensive solutions to our
customers and partners. We also intend to introduce innovative programs
designed to simplify the purchase of our products, and to offer end-users
product and service options that allow end-users to customize the solution to
better address their needs. We will also strengthen our focus on specific
vertical markets, such as state and local government agencies, to expand our
customer base and provide the right solutions to address the special needs of
these vertical markets.

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, and to act as resellers of our products and services.
Service providers with which we have relationships include AT&T Global Network
Services Hong Kong Limited (AGNS Ltd.), Deutsche Telekom, Genuity, Internet
Initiative Japan, Internet Security Systems, KPN, Nextcom, Sunrise
Communications, Easynet, Star Internet 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.

   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 include an integrated suite of security
and management software, an Internet security appliance and a dynamic
Internet-based service to keep security defenses current. These solutions
provide access control, VPN, and content and application security for servers
and desktops. Enterprises may use our products to internally manage their
Internet security or elect to outsource security management to a service
provider implementing our managed security solution.

Point Solutions

  Firewall and VPN

   By using our Firebox System, an enterprise can quickly and affordably deploy
comprehensive perimeter security protection and VPN capability across its
network, but still retain 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 standard Firebox system includes an initial
one-year subscription to our LiveSecurity Service.

                                      8

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   We currently offer the following Firebox models:

<TABLE>
<CAPTION>
   Firebox Model          Firebox4500           Firebox2500         Firebox1000         Firebox700      Firebox SOHO
-----------------------------------------------------------------------------------------------------------------------
<S>                 <C>                      <C>                <C>                 <C>                <C>
Recommended For     - Corporate Headquarters - Medium to Large  - Mid-Size Business - Smaller Business - Small Stand-
                     and Large Enterprises    Enterprises        or Branch Office    or Remote Office   Alone or
                    - Wire Speed VPN         - High Volume                                              Remote Office
                     Support                  Web Traffic
-----------------------------------------------------------------------------------------------------------------------

Authenticated Users 5000                     5000               1000                250                10
                                                                                                       (upgrades to 50)
-----------------------------------------------------------------------------------------------------------------------

User License        Unlimited                Unlimited          Unlimited           Unlimited          10
                                                                                                       (upgrades to 50)
-----------------------------------------------------------------------------------------------------------------------

Packet Filter       197 Mbps                 197 Mbps           185 Mbps            131 Mbps           9 Mbps
 Throughput
-----------------------------------------------------------------------------------------------------------------------

HTTP Proxy          60 Mbps                  52 Mbps            43 Mbps             43 Mbps            N/A
 Throughput
-----------------------------------------------------------------------------------------------------------------------

3DES Encryption     100 Mbps                 70 Mbps            55 Mbps             5 Mbps             1.3 Mbps
 Throughput +
 SHA1
-----------------------------------------------------------------------------------------------------------------------

Hardware            Yes                      Yes                Yes                 No                 Yes
 Encryption
 Acceleration
-----------------------------------------------------------------------------------------------------------------------

Branch Office       1000                     1000               1000                150                5*
 VPNs
-----------------------------------------------------------------------------------------------------------------------

Mobile User VPNs    1000                     1000               1000                150                5
-----------------------------------------------------------------------------------------------------------------------

Interfaces          - Three RJ-45            - Three RJ-45      - Three RJ-45       - Three RJ-45      - 5 RJ-45
                     10/100TX                 10/100TX           10/100TX            10/100TX           10BaseT
                     Ethernet                 Ethernet           Ethernet            Ethernet           Ethernet
                    - DB-9 Serial Port       - DB-9 Serial Port - DB-9 Serial Port  - DB-9 Serial Port
                    - PCI Expansion Option   - PCI Expansion    - PCI Expansion
                                              Option             Option
</TABLE>
* Requires VPN Manager

   In addition, RapidStream has developed the family of high-performance
ASIC-based Internet security appliances listed in the chart below. RapidStream
also has available versions of the RapidStream 2000, 6000 and 8000 hardware
appliances reflected in the chart below, with similar performance, as well as a
gigabit hardware appliance, that include Check Point Software Technologies Ltd.
security software instead of RapidStream-developed security software (the
RapidStream 2100, 6100, 8100 and 11000 "Secured by Check Point" models).
Subject to the consummation of the acquisition, we expect to sell the
RapidStream products under either the RapidStream or the WatchGuard brand, and
the "Secured by Check Point" models under the RapidStream brand. We also intend
to integrate technological aspects of the WatchGuard and RapidStream product
families after the acquisition to produce our next-generation line of
high-performance, ASIC-based Internet security solutions.

                                      9

<PAGE>

   RapidStream currently offers the following models:

<TABLE>
<CAPTION>
 RapidStream  RapidStream        RapidStream             RapidStream       RapidStream            RapidStream
    Model        8000               6000                    2000              1000                    500
----------------------------------------------------------------------------------------------------------------
<S>           <C>               <C>                   <C>               <C>                     <C>
Recommended   VPN concentrator, High-speed VPN tunnel VPN concentrator, Branch office firewall, Small standalone
 For           Data center       connecting data       Fast Ethernet     branch office site-     or branch
               firewall, Multi-  centers, Data center  firewall, HQ for  to-site VPN, and        office firewall
               tenant security,  firewall, Fast        small to          intranet firewall and   and VPN
               OC/3 firewall     Ethernet firewall,    medium-sized      VPN
                                 Multiple T3 firewall  enterprises
----------------------------------------------------------------------------------------------------------------

Concurrent    128,000           64,000                8,000             2,000                   1,000
 Sessions
----------------------------------------------------------------------------------------------------------------

User License  Unlimited         Unlimited             Unlimited         Unlimited               Unlimited
----------------------------------------------------------------------------------------------------------------

Packet Filter 620 Mbps          270 Mbps              240 Mbps          200 Mbps                20 Mbps
 Throughput
----------------------------------------------------------------------------------------------------------------

3DES          300 Mbps          155 Mbps              70 Mbps           35 Mbps                 15 Mbps
 Encryption
 Throughput +
 SHA1
----------------------------------------------------------------------------------------------------------------

Hardware      Yes               Yes                   Yes               Yes                     Yes
 Encryption   Proprietary ASIC  Proprietary ASIC      Proprietary ASIC  Proprietary ASIC        Proprietary ASIC
 Acceleration
----------------------------------------------------------------------------------------------------------------

Branch Office 20,000            8,000                 400               30                      10
 VPNs
----------------------------------------------------------------------------------------------------------------

Mobile User   20,000            8,000                 400               30                      10
 VPNs
----------------------------------------------------------------------------------------------------------------

Interfaces    2 x 1000BaseSX    3 x 10/100 Ethernet,  3 x 1000BaseSX    2 x 1000BaseSX          2 x 1000BaseSX
               GigaBit, 2 High   2 High Availability   GigaBit,          GigaBit, 1 High         GigaBit,
               Availability      (Ethernet) ports      1 UPS Port        Availability            1 x RS232
               (Ethernet) ports  1 UPS port            1 x RS232         (Ethernet) port         console port
               1 UPS port        1 x RS232 console     console port      1 x RS232 console
               1 x RS232         port                                    port
               console port
</TABLE>

  Server Security

   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, such as Web site
defacement and the deposit of malicious code. This protection is offered
through a combination of kernel-level software, secured remote communications,
centralized management and a simplified dual-mode administrative model. We also
offer an application-specific version of our server security software for Web
sites residing on a Windows NT or Windows 2000 server using Microsoft IIS.
Every standard ServerLock System product includes an initial one-year
subscription to our LiveSecurity Service. We currently offer the following
server security products:

  .   ServerLock for NT/2000

  .   ServerLock for Solaris

  .   AppLock/Web

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  Desktop Security

   Through our relationship with Network Associates, Inc., we currently offer
desktop virus protection with the McAfee Virus Scan ASaP product for Microsoft
Windows 98, NT and 2000 operating systems. Every standard Firebox system
includes either one annual Virus Scan ASaP license for our SOHO class Firebox
products or five annual Virus Scan ASaP licenses for all of our other Firebox
products. Additional licenses may also be purchased separately.

Point Solution Management

   We offer robust and intuitive management of our comprehensive Internet
security point solutions that reduces the complexity and difficulty of
successful implementation. Our management systems include:

  .   Control Center.  Our easy-to-use Control Center management tool serves as
      the operational headquarters for the Firebox System. The Control Center
      is designed to enable the end-user to quickly and easily configure the
      Firebox System, implement security policies and monitor the status of
      installed network services.

  .   VPN Manager.  VPN Manager automates the creation of VPN tunnels between
      an enterprise's headquarters, branch offices and remote users, and is
      designed to dramatically reduce the complexity of creating and managing
      multi-site VPNs. With VPN Manager, VPN tunnels can be created with a
      revolutionary quick and simple point-and-click user interface.

  .   Global Policy Manager.  Centrally located at a managed security service
      provider's network operations center, our Global Policy Manager provides
      security intelligence and configuration for all customer sites under
      management. Global Policy Manager allows the service provider to create
      and store various security policy configurations for different customer
      groups or service plans.

  .   Firebox Monitors.  Integrated monitoring and reporting tools for the
      Firebox System provide real-time and historical data about network
      traffic. At a glance, the end-user can view user, host, service and
      bandwidth use, and use this information to optimize the network's
      security performance. Logging and notification features allow customers
      to detect and interrupt suspicious activity.

  .   Logging and Notification.  The Firebox System supports multiple levels of
      logging and notification. Separate rules may be set for incoming and
      outgoing communication for each service (such as HTTP and SMTP) that is
      configured. Secure, centralized logging permits customers to monitor
      traffic over their entire network. Logs from multiple sites can be
      securely distributed to a central location using 3DES encryption.

  .   HostWatch.  HostWatch displays real-time monitoring of network usage
      mapped to authenticated users and host computers. Color-coded connection
      types (Allowed, Denied, Proxied or Masqueraded) between internal/external
      hosts are identified by IP address, DNS name or user name.

  .   Historical Reporting.  Our flexible HTML-based historical reporting tool
      enables end-users to summarize network activity through custom and
      standardized reporting options.

  .   ServerLock Manager.  The ServerLock Manager is designed to maximize
      efficiency of control for tens and even hundreds of servers, all using
      secure, remote communication channels. The ServerLock Manager allows
      administrators or service providers to control multiple servers by
      applying custom rules and turning protection on and off in much the same
      manner as if those tasks are performed locally. ServerLock's remote
      communications channel is designed to simplify setting and resetting the
      protection state of remote machines and to make aggregating systems
      easier, which provides simplicity of depiction in a managed environment.

LiveSecurity Service

   Our subscription-based LiveSecurity Service for both enterprises and managed
security providers and their customers includes (1) information alerts that
offer timely analyses of breaking Internet security news combined

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<PAGE>

with instructions on how customers can protect their systems, (2) virus alerts
with information from McAfee that provides real-time virus alerts and specific
information on how customers can protect their systems, (3) security threat
responses that provide detailed information on security vulnerabilities as they
develop, including how they may affect systems and what WatchGuard is doing to
help its customers keep their networks secure, and, when appropriate, software
updates to address specific threats, (4) software updates, (5) support flashes
with tips for managing WatchGuard products, (6) expert editorials that serve as
continuing education about Internet security, (7) interactive and Web-based
technical support and (8) interactive and Web-based customer training. We
currently offer standard and upgrade versions of our LiveSecurity Service, each
of which provides end-users differing levels of interactive technical support:

   Standard Technical Support Service

  .   Access to a moderated online user forum;

  .   Technical support 15 hours a day, five days a week;

  .   Target four-hour maximum response time for customer service; and

  .   Access to technical support team limited to three incidents per year.

   Gold Technical Support Service Upgrade

  .   Access to a moderated online user forum;

  .   Technical support 24 hours a day, seven days a week;

  .   Target one-hour maximum response time for customer service; and

  .   Unlimited access to technical support team.

Other Products

   We offer additional products and options, including mobile-user VPN for
telecommuting or traveling employees, SOHO Web-Blocker to restrict Web site
access for our small or branch office and home office, or SOHO, class Firebox
products, SpamScreen to filter or identify e-mail spam, High Availability for
failover protection for our SME and larger enterprise products, and user
upgrades for our SOHO products.

Customer Service

   We make customer service a priority and consider it a product differentiator
for WatchGuard. Our staff of technical support representatives serves our
end-users and our reseller, distributor and service provider partners by phone
and e-mail. Support is available to our partners that have representatives that
have passed required WatchGuard technical training 24 hours a day, seven days a
week, and our average response time to these partners' technical requests is
measured in minutes, not hours. For our end-users, we offer the two technical
support programs described above, our Standard Technical Support Service and
our Gold Technical Support Service Upgrade. In addition to the WatchGuard
technical support staff, we offer all authorized WatchGuard customers access to
our Web-based technical support self-help toolset 24 hours a day, seven days a
week. These tools include comprehensive frequently asked questions, a listing
of all known issues with our current software version (and any available
work-arounds or fixes), and an interactive Web forum that allows customers to
post WatchGuard-related technical questions to other customers and the
WatchGuard technical moderator.

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 monitors a wide variety of Internet sources related to network
security, including newsgroups, vendor Web sites and security-related bulletin
boards. When the rapid response

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<PAGE>

team identifies a new security threat, we send an advisory to our LiveSecurity
Service subscribers informing them of what they need to do to keep their system
secure and, if appropriate, provide software updates that address the threat.
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 contributes to the efforts of our rapid response
team. Currently, the LiveSecuity Advisory Council is composed of 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 consults for 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 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 purchaser of our
standard products also receives a renewable one-year subscription to our
standard LiveSecurity Service. For our managed security solution, the service
provider buys a license to use our network operations center security suite
management and security software. In addition, the service provider must have
an active subscription to the LiveSecurity Service for each end-user 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 55% of our revenues in 2000 and 56% of
our revenues in 2001.

                                      13

<PAGE>

   We sell our security solutions through distributors and service providers.
We also sell our managed security solution products and services directly to
service providers. We resell our products and services directly and indirectly
through distributors, resellers and service providers, including

  .   distributors, such as Ingram Micro, Otsuka Shokai Co., Tech Data, Wick
      Hill Group, Westcon, Alternative Technologies and Compushack;

  .   value-added resellers, or VARs, such as Comark, Compucom, XO
      Communications, Secure Networks Ltd., Century Computing Ltd., Siemens
      Business Services, Taskarena IT-Solutions GmbH, Nextcom, Softbank,
      Fujitsu Business Systems, Ltd. and Network Computing Architects, Inc.;

  .   direct marketers, such as CDW Computer Centers, Insight Enterprises,
      Dell, Microwarehouse, PC Connection and PC Mall; and

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

   As part of our distribution network, thousands of resellers worldwide sell
our security solutions. Our agreements with our distribution network are
nonexclusive. As of December 31, 2001, we had shipped over 90,000 of our
security appliances to our distribution network, which resells our products and
services to end-users spanning a wide variety of industries and more than 125
countries.

   We divide our sales organization geographically and by channel partner
focus. We have sales teams specifically responsible for the Americas,
Europe/Middle East/Africa and Asia Pacific. Our sales professionals are
typically local nationals who live and work in their designated geographic
regions. We also assign sales resources to specific channel categories,
including: distribution, resellers and managed security providers. The National
Account Managers are responsible for our relationships with our distribution
network, helping them sell and support key reseller accounts and acting as a
liaison to our marketing and product development organizations. The Enterprise
Sales team works directly with resellers who purchase through distribution. The
Enterprise Sales team recruits new resellers, provides training on WatchGuard
products and assists in selling to end-user customers.

   We have a dedicated channel marketing team responsible for delivering
programs, sales tools and communication to the different categories of channel
partners. The team supporting national accounts works closely with distributors
to market our products to their resellers through advertising, e-mail, training
opportunities and seminars. The team supporting enterprise accounts promotes
the WatchGuard Secure Partner Program, organizes training seminars and assists
with co-marketing opportunities presented by our resellers. WatchGuard actively
participates in public forums to inform existing and potential end-user
customers, distributors, resellers and service providers about the capabilities
and benefits of our products. These include industry trade shows in every major
geographic region, product technology conferences, regional awareness programs,
trade publications and journals. WatchGuard uses the Web extensively to deliver
information to both end-users and our channel partners, with a dedicated,
secure Web site that provides extensive information to partners. We offer
resellers access to white papers, competitive information, graphics to assist
their advertising efforts, product and sales training modules and the
opportunity to post their events on-line.

   WatchGuard offers comprehensive on-line training on our security solutions
through our Web site. Our interactive training system guides both end-user
customers and resellers through the installation, setup and management of our
Firebox security solutions and provides new product information. Training
modules cover firewalling basics, VPN, server security and sales training (for
resellers only) and include live-action video and audio question-and-answer
segments. On-line certification testing is offered for both end-user customers
and resellers to confirm their product knowledge.

   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

                                      14

<PAGE>

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.

Technology and Architecture

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.  In our SME and larger-enterprise products, our
      authentication features identify network users and define user and
      user-group security policies.

  .   Virtual private networking.  Using encryption technology, our software
      enables enterprises to create VPNs to allow data to flow securely across
      the Internet between two predetermined points. Our branch office VPN,
      included in all of our Firebox System products, secures communications
      with branch offices and trading partners. Our remote-user VPN, included
      in our SME and larger-enterprise products, secures connections to
      telecommuters and traveling employees. Our VPN solutions implement
      industry standard protocols such as IPSec, IKE and PPTP.

  .   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.
      With our products for SOHOs, Web site access privileges may be restricted
      simply by site type.

  .   Security appliance.  Our security appliances are dedicated solely to
      running security functions and IP sharing and have no other function and
      no hard drive memory storage. 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 security appliances 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 are standalone
      Internet security appliances that run security functions 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 security appliances have two independent, separately monitored
      connections: one to the SOHO's or telecommuter's network and one to the
      Internet.

   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. This technology allows us to
keep our customers' security up to date with our LiveSecurity Service, which
provides new security software and operating system configurations while still
enabling us to take advantage of hardware acceleration for key functions.

                                      15

<PAGE>

   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, thereby eliminating the need for someone to be physically
present at each location.

   Operating system software.  Our SME and larger enterprise products use a
Linux operating system and our SOHO products use a VxWorks operating system. In
the case of the Linux operating system, 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 System products to
facilitate secure loading of the operating system and security software that
our management software sends to the appliance.

   Security feature implementation.  The Firebox System implements our security
features through 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, and differ from other appliance firewalls in that we
provide two different levels of protection, stateful packet filtering, which
has become the de-facto standard in the industry, plus transparent application
proxying that allows us to examine the content of a data stream in detail and
provide enhanced protection against specific threats that stateful packet
filters cannot detect. This is particularly important for the four key business
protocols HTTP (Web traffic), SMTP (e-mail), FTP (file transfer) and DNS
(Internet name services). 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 and IKE 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.  Our management software allows a customer to manage
and monitor the enterprise's Internet security with an intuitive,
point-and-click user interface.

   Integrated suite of system management tools.  Our SME and larger enterprise
products use a Windows-based security management system that 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 the management of multiple
security appliances from a single location.

   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 managed security solution management software, on the other
hand, for a trained operator using a dedicated management console to configure
and manage the security of a

                                      16

<PAGE>

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 SOHO and telecommuter customers can also
choose a simple Web-based management interface, which removes the need to
install management software.

   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.

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. 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.

   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. Acting as a filter between requests for changes and the
      actual execution of those changes within the operating system kernel,
      ServerLock prevents changes to the operating system's static components
      and the configurations that implement that server's security policies.

  .   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. The ServerLock Manager allows 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 is designed
      to simplify setting and resetting the protection state of remote machines
      and to make aggregating systems easier, which provides simplicity of
      depiction in a managed environment.

  .   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. 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.

  .   Kernel-based protection.  Because all user-space processes, including
      authentication, are vulnerable to attack or accidental corruption by a
      privileged user or system administrator, ServerLock's protection, from
      filtering user requests to authenticating changes in the protection
      state, operates from the kernel. The kernel, which is the heart of the
      operating system, 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. ServerLock also enables kernel-to-kernel
      remote communication using strong encryption implemented through a
      239-bit elliptic curve cryptosystem adapted for ServerLock.

  .   Simplified administration.  Internet security has historically been an
      area of complexity and confusion for enterprises. The security appliance,
      which was 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

                                      17

<PAGE>

      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,
      existing server protections are in force. ServerLock's simplified dual
      mode allows even 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.

   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.

AppLock/Web

   Based on WatchGuard's ServerLock kernel protection, AppLock/Web specifically
protects Microsoft NT/2000 IIS Web servers from both malicious and
unintentional damage. This protection applies to the server operating system,
the IIS application, and over 200 types of common content. This protection is
offered through a combination of kernel-level software and a simplified
dual-mode administrative model. Content protection is managed through a simple
point-and-click customization interface.

   System structure.  AppLock/Web is comprised of the following components:

  .   AppLock/Web.  Our AppLock/Web 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. Acting as a filter between requests for changes and the
      actual execution of those changes within the operating system kernel,
      AppLock/Web prevents changes to the operating system's static components
      and the configurations that implement that server's security policies.
      This protection is applied, and the content to be protected is
      discovered, automatically during the installation of the product.

  .   AppLock/Web console.  Our AppLock/Web protections are managed with a
      local console that provides a simple interface to enable and disable
      protection, discover new content to protect, and provide protection to
      apply to new types of content not protected by default. The management of
      this protection is driven from a simple point-and-click system that
      allows users to select and sort at varying levels of granularity, from
      individual files to directories of files to specified file types.

   LiveSecurity Service.  AppLock/Web 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 Service

   Our subscription-based LiveSecurity Service includes:

  .   Information alerts.  Timely analyses of breaking Internet security news
      combined with instructions on how our customers can protect their systems.

  .   Virus alerts.  Our strategic alliance with Network Associates, Inc. gives
      our customers real-time virus alerts from McAfee and specific information
      on how to protect their systems.

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<PAGE>

  .   Threat responses.  Detailed information on security vulnerabilities as
      they develop, including how they may affect our customers' systems and
      what WatchGuard is doing to help its customers keep their networks
      secure, and, when appropriate, software updates to address specific
      threats.

  .   Software updates.  Customers receive on-going functional enhancements for
      their Firebox System or ServerLock/AppLock software.

  .   Support flashes.  Interactive technical tutorials provide our customers
      with answers to frequently asked questions about managing WatchGuard
      products, in addition to information on new software updates.

  .   Expert editorials.  The WatchGuard LiveSecurity Advisory Council, a
      network of top security consultants, offers their views on Internet
      security and provides a source of continuing education.

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

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

   Our scalable LiveSecurity Service, which runs on a collection of secured
servers, registers subscribers, facilitates downloading our software to the
desktop computers of registered subscribers and delivers LiveSecurity content
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.

  Managed Security Solution

   WatchGuard's managed security solution for service providers has three main
components: our network operations center, or NOC, security suite software with
security and management features, our security appliances and our LiveSecurity
Service.

   Security features.  Our managed security solution includes the same
comprehensive set of security features offered in our Firebox System.

   Management features.  We designed our managed security solution management
software for a trained operator using a dedicated management console to
configure and manage the security of a large subscriber base. Centrally located
at the service provider's NOC, 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. For example, 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. To enable service providers to configure, monitor and manage
the Internet security of thousands of customers, our managed security solution
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 NOC.

   Security appliances.  One or more of our security appliances reside on the
premises of each managed customer of the service provider. 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 NOC receives information and virus alerts, threat responses,
software updates, support flashes and expert editorials, as well as access to
training and service provider-specific technical support. The service provider
then updates the security policies of its customers and transmits these policy
updates over its network to the customers.

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<PAGE>

   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, seven days a week;

  .   define and implement professional, customized Internet security policies;

  .   easily install software updates across their installed base;

  .   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.

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 Service
end-users and service provider partners can incorporate the new products and
services into their systems with minimal system interruption.

   As of December 31, 2001, we employed 120 people on our research and
development staff. Research and development expenses were $7.1 million in 1999,
$13.9 million in 2000 and $18.9 million in 2001. We have product development
facilities in Seattle, Washington, and Waltham, Massachusetts.

Competition

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

   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, performance, updatability,
scalability, brand recognition, price, customer support and distribution
capability. Currently, the primary competitors in our industry include Check
Point Software Technologies Ltd., Cisco Systems, Inc., Netscreen Technologies,
Inc., Nokia Corporation, SonicWALL, Inc. and Symantec Corporation. Other
competitors offering security products include hardware and software vendors
such as Lucent Technologies, Inc. and Network Associates, Inc., operating
system vendors such as Microsoft Corporation, Novell, Inc. and Sun
Microsystems, Inc., and a number of smaller companies.

   Our competitors may be able to respond more quickly to new or emerging
technologies and changes in customer requirements than we can. In addition, our
current and future competitors may bundle their products with other software or
hardware, including operating systems and browsers, in a manner that may
discourage users from purchasing the products and services we offer. Many of
our current and potential competitors have greater name recognition, larger
customer bases to leverage and greater access to proprietary technology, and
could therefore gain market share to our detriment. In addition, our current
and potential competitors may

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<PAGE>

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 on 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, Canada,
Norway, Australia, New Zealand and Japan, LiveSecurity(R) is a registered
trademark in the United States, the European Union and Mexico, Firebox(R) is a
registered trademark in the United States, LockSolid(TM) is a registered
trademark in Australia, Japan, New Zealand and Norway, and SpamScreen(R) is a
registered trademark in the United States. Applications to register the
WatchGuard, LiveSecurity and LockSolid trademarks are pending in other
jurisdictions. ServerLock(TM), AppLock(TM), Designing Peace of Mind(TM),
FireChip(TM), and our current logo 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:

   SurfControl, Inc.  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.

   Network Associates, Inc. McAfee Virus Scan ASaP virus protection.  We bundle
this virus protection product with our Firebox security products.

   Hifn Inc. encryption acceleration hardware and software.  We include a
hardware chip and compression software in our Firebox 1000 and 2500.

   SafeNet, Inc. hardware acceleration and software VPN client.  We include
SafeNet's hardware encryption acceleration in our Firebox 4500 and its software
VPN client in all of our products.

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<PAGE>

   Cylan Technologies, Inc. Internet Key Exchange (IKE).  We use a customized
version of this Internet Key Exchange software in all of our Firebox security
appliances that have IPSec support.

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

   WindRiver VxWorks Real Time operating system.  We use this operating system
in our SOHO security appliance.

   Interconnect System Solutions.  We use this 3DES software technology in our
SOHO 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 KSOCKS in our ServerLock products to
achieve a heterogeneous network signature for remote communications.

   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 U.S. governmental regulations governing the
export of encryption commodities and software. In recent years, however, U.S.
legislation has relaxed export controls on encryption. U.S. law now allows the
export of encryption commodities and software of any strength to
nongovernmental end-users located in any country except those designated as
embargoed or otherwise restricted by the U.S. government, subject to
streamlined reporting requirements. To satisfy these encryption export
reporting requirements, we use data gathered from end-users during product
registration. WatchGuard's encryption commodities and software have been
approved for export by the U.S. Department of Commerce, Bureau of Export
Administration, or BXA, under an Export License Exception granted after
previous technical reviews by the BXA. The approved commodities and software
include our branch office and remote user VPN software and our Firebox II and
Firebox III families of security appliances. The BXA has granted retail export
status to our Firebox 700 and Firebox SOHO security appliances, which use
encryption in branch office VPN software. 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
security appliances for SMEs and larger enterprises to two Washington-based
companies: Electronic Manufacturing Corporation, our primary supplier, and
Integrex Computer Corporation, our back up supplier. Our contract manufacturers
for our SOHO security appliances are Trantronics Inc., a California-based
company, and Accton Technology Corporation for board assembly, a Taiwan,
R.O.C-based corporation. All three manufacturers are certified as meeting the
International Organization for Standardization's quality assurance standards
ISO 9001 and 9002. We are currently reviewing other contract manufacturers for
potential engagement 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, 2001, we had 298 employees. Of these, 92 were employed in
sales and marketing, 33 in finance and administration, 53 in customer support
and operations and 120 in research and development. We are not a party 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.

Important Factors That May Affect 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.

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<PAGE>

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 end of 2001, we have incurred net losses and
experienced negative cash flows from operations in each quarter, except that we
had net income and a positive cash flow in the third quarter of 2000 and a
positive cash flow in the third quarter of 2001. As of December 31, 2001, we
had an accumulated deficit of approximately $82.6 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. Although we introduced certain cost-saving measures in the
second quarter of 2001 in response to the current economic downturn, we expect
that over time we will have to increase our operating expenses in connection
with

  .   continuing to develop our technology;

  .   integrating RapidStream's business, products and technologies with our
      own and pursuing additional strategic acquisitions in the future;

  .   expanding into new product markets;

  .   expanding into new geographic markets;

  .   hiring additional personnel; and

  .   upgrading our information and internal control systems.

   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 may not be meaningful. In
addition, our limited operating history makes predicting our future performance
difficult. In the fourth quarter of 2000, the first quarter of 2001 and the
fourth quarter of 2001, 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 late in the fourth quarter of 2000 and continuing past the end of
2001, we saw a general economic downturn in the U.S. economy and, more
recently, the worldwide economy. The events of September 11, 2001 and their
aftermath have exacerbated this downturn. These factors have 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 of the effect 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.

In attempting to integrate the business and technology of RapidStream and any
future acquisition, we will incur significant costs that may not be outweighed
by any benefits of the acquisition.

   We expect to incur costs and commit significant management time integrating
the operations, technology, products, customers, suppliers and personnel of
RapidStream. As part of our business strategy, we may acquire

                                      23

<PAGE>

other companies, products or technologies, and these acquisitions may also
result in substantial costs. The costs of the RapidStream acquisition and any
future acquisitions may include costs for:

  .   integration of operations, including combining teams and processes in
      various functional areas;

  .   reorganization or closure of operations and facilities;

  .   integration of new technology into our products;

  .   fees and expenses of professionals involved in completing the integration
      process; and

  .   potential existing liabilities of RapidStream or any future acquisition.

   Successful integration of the operations, technology, products, customers,
suppliers and personnel of RapidStream or any future acquisition will place a
significant burden on our management and internal resources. The diversion of
the attention of our management and any difficulties encountered in the
transition and integration process could disrupt our business and have an
adverse effect on our business and operating results. In addition, as a result
of the RapidStream acquisition, we expect that our gross margins will
temporarily decrease slightly in the first few quarters after the acquisition
is completed as we sell the RapidStream inventory we acquire in the
acquisition, because this inventory will be valued at fair market value, which
is significantly higher than RapidStream's cost for the inventory. If our gross
margins fall below the expectations of securities analysts and investors, the
price of our common stock may decline.

If we do not successfully integrate the business, technology and operations of
RapidStream and any future acquisition, our business and our ability to achieve
profitability will be adversely affected.

   If we complete the RapidStream acquisition, we plan to integrate the
RapidStream technology with our products. We may be unable to successfully
integrate RapidStream's ASIC-based technology into our products in a timely and
efficient manner. Even if we are successful in integrating RapidStream's
technology with our own, our sales force, consultants and development staff may
not effectively adapt the new product line and the new product line may not
achieve market acceptance.

   Upon completing the acquisition, we also will commence the integration of
RapidStream's customers, suppliers, operations and personnel. Although we will
strive to maintain RapidStream's relationships with customers and suppliers,
including our competitor Check Point, we may be unable to do so and, as a
result, we may not realize the benefits of these relationships and may incur
significant costs in establishing new relationships. Integration of
RapidStream's personnel may be difficult and unpredictable because of
differences between corporate cultures and different opinions on strategic
plans, personnel and other decisions.

   If we cannot successfully integrate RapidStream's technology, products,
operations and personnel and maintain its relationships with third-party
customers and suppliers, we may not realize any benefit from the acquisition,
notwithstanding our significant expenditure of time and resources. As part of
our business strategy, we may acquire other companies, products or
technologies. These acquisitions entail numerous operational and financial
risks and difficulties, including those described above with respect to the
RapidStream acquisition.

We may not be able to complete the acquisition of RapidStream, which could
negatively affect our business and the market price of our common stock.

   Although we have entered into an agreement to acquire RapidStream and expect
the acquisition to close early in the second quarter of 2002, the completion of
the acquisition is subject to several risks and contingencies, including
shareholder approval by the shareholders of RapidStream. Although the directors
and officers of RapidStream have agreed to vote their shares in favor of the
acquisition, and these shareholders hold sufficient votes to ensure shareholder
approval, there is no guarantee that these shareholders will not breach their
agreement. In addition, although we have an option to purchase the shares of
any shareholder who breaches his, her or its obligation to vote in favor of the
acquisition, we might be unable to quickly acquire and direct the

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<PAGE>

voting of the shares subject to this option in order to ensure the timely and
efficient closing of the acquisition, if at all. The number of shares of
WatchGuard common stock issuable in the acquisition will be based on our
average stock price for the 20-trading-day period ending two trading days prior
to the closing of the transaction. Based on the number of our shares of common
stock outstanding on March 25, 2002, if this 20-trading-day average fell to and
remained below $4.42 through June 30, 2002, the acquisition would not close
unless either RapidStream agreed to reduce the merger consideration or we
agreed to pay additional cash consideration to complete the transaction.

   If the merger is not completed for any reason, we will be subject to a
number of risks and difficulties, including:

  .   the market price of our common stock may decline to the extent it
      currently reflects a market assumption that the merger will be completed;

  .   we will have to pay costs related to the merger, such as legal and
      accounting fees, even if the merger is not completed;

  .   the benefits that we expect to realize from the merger, including the
      integration of RapidStream's technology into our products, would not be
      realized; and

  .   we may be required to pay a termination fee of $1.5 million if the
      termination results from our breach of the representations, warranties or
      covenants we made in the RapidStream merger agreement.

Because many potential customers do not fully understand or remain unaware of
the need for comprehensive 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, do not fully
understand or are not aware of the need for comprehensive Internet security
products and services, particularly those products designed for server content
and application security. Historically, only enterprises having substantial
resources have developed or purchased comprehensive Internet security
solutions. Also, there is a perception that comprehensive Internet security is
costly and difficult to implement. We will therefore not succeed unless the
market understands the need for comprehensive 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 comprehensive Internet security and the benefits
of our products and services, our efforts may be unsuccessful.

If potential customers do not accept our Firebox and ServerLock products and
the related LiveSecurity Service, our business will not succeed.

   We currently expect all future revenues to be generated through sales of our
Firebox and ServerLock products and the related LiveSecurity Service, 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, VARs and ISPs and other
managed service providers, to obtain and retain customers. Some of our Firebox
products and the related LiveSecurity Service, and all of our ServerLock
products, however, are relatively new and unproven. The broadcast portion of
our LiveSecurity solution has been available only since February 1999 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 customers, 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
comprehensive security information over the Internet. Enterprises may be
unwilling to pay a subscription fee to keep their Internet security up to date
and to receive Internet security-related information. 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.

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<PAGE>

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 Check Point Software
Technologies Ltd., Cisco Systems, Inc., Netscreen Technologies, Inc., Nokia
Corporation, SonicWALL, Inc. and Symantec Corporation. Other competitors
offering security products include hardware and software vendors such as 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 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.

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 received a substantial portion of a quarter's sales orders
and 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.

If our third-party channel customers 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 the
performance of this network. Our channel customers 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. Two channel customers, Ingram Micro and Tech Data, together
accounted for 24% of our revenues for the year ended December 31, 2001. The
loss of one of these distributors, a reduction in their sales, a reduction in
our share of their sales of Internet security products, or a loss or reduction
in sales involving one or more other channel customers, particularly if the
reduction results in increased sales of competitive products, could harm our
business. In addition, we are in the process of consolidating our channel by
reducing the number of direct partners while expanding our programs for our
indirect partners to improve overall performance and efficiencies. If this
consolidation causes disruption, we could experience a loss or reduction in
sales involving one or more of our channel customers.

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

   We provide some of our channel customers with product return rights for
stock rotation, and price protection rights for their inventories, which they
may exercise if we lower our prices for those products. We also provide
promotional rebates to some of our channel customers. We may experience
significant returns, price adjustments and rebate costs for which we may not
have adequate allowances. The short life cycles of our

                                      26

<PAGE>

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. When we introduced
the Firebox II, and then later the Firebox III, security appliances, we
experienced an increase in returns of previous products and product versions.
Provisions for returns and allowances were $1.1 million in 1999, $1.9 million
in 2000 and $6.9 million in 2001, or 5%, 3% and 10% of total revenues before
returns and allowances. The increase in the provision for the year ended
December 31, 2001 reflects promotional rebates that were introduced during
2001, the actual returns of current products and the future expected returns of
current products that may originate from the introduction of our new Firebox
III family of products during 2001. While we increased our provision for
returns and allowances during 2001 to reflect the potential for promotional
rebate costs, increased returns and pricing adjustments associated with new
products introduced during 2001 and products we expect to introduce in 2002,
including new products resulting from our acquisition of RapidStream, the
provision may still be inadequate.

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. These performance
difficulties 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 products and services is a complex
and uncertain process that requires 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
customers 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
customers. Although we attempt to reduce the risk of losses from claims through
contractual warranty disclaimers and liability limitations, these

                                      27

<PAGE>

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 the license. 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 customers to lose current and potential customers
or cause us to lose potential channel customers. 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 our LiveSecurity Service.

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

                                      28

<PAGE>

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.

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.

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 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

                                      29

<PAGE>

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 customers.

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 50% of our revenues in 1999, 55% in
2000 and 56% in 2001. The failure of our channel customers 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 or those requiring local content;

  .   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.

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;

                                      30

<PAGE>

  .   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.

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.

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 have the option to extend the lease for an
additional five-year term. We also maintain a product fulfillment and
distribution warehouse in Seattle. In addition, we maintain an office in
Waltham, Massachusetts and are subject to lease obligations for space in Aliso
Viejo, California and Waltham.

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 2001.

                                      31

<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

   Year Ended December 31, 2001
   First quarter..............................................   32.00   6.00
   Second quarter.............................................   10.50   5.00
   Third quarter..............................................   13.90   6.72
   Fourth quarter.............................................   12.99   6.02
</TABLE>

   The last reported sale price of our common stock on the Nasdaq National
Market on March 25, 2002 was $6.26 per share.

Holders

   As of March 21, 2002, there were approximately 146 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.

Recent Sales of Unregistered Securities

   None.

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.

                                      32

<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>
                                                                      Year Ended December 31,
                                                          ----------------------------------------------
                                                           1997     1998      1999      2000      2001
                                                          -------  -------  --------  --------  --------
                                                               (In thousands, except per share data)
<S>                                                       <C>      <C>      <C>       <C>       <C>
Consolidated Statement of Operations Data:
 Revenues:
   Product............................................... $ 4,975  $10,678  $ 17,329  $ 52,010  $ 46,893
   Service...............................................     123      701     3,290     8,693    17,390
                                                          -------  -------  --------  --------  --------
     Total revenues......................................   5,098   11,379    20,619    60,703    64,283
 Cost of revenues:
   Product...............................................   1,529    3,653     6,954    18,932    20,658
   Service...............................................      81      272     1,010     2,987     5,824
                                                          -------  -------  --------  --------  --------
     Total cost of revenues..............................   1,610    3,925     7,964    21,919    26,482
 Gross margin............................................   3,488    7,454    12,655    38,784    37,801
 Operating expenses:
   Sales and marketing...................................   4,369    8,519    13,512    24,213    29,717
   Research and development..............................   2,192    4,442     7,118    13,900    18,854
   General and administrative............................   1,323    2,454     3,646     6,001     7,726
   Stock-based compensation..............................      --    1,039       926     8,407     9,433
   Amortization of goodwill, purchased technology and
     other intangible assets acquired....................      --       --       245     3,828    10,942
   Acquired in-process technology........................      --       --     3,381     4,399        --
                                                          -------  -------  --------  --------  --------
   Restructuring charges.................................      --       --        --        --     3,720
                                                          -------  -------  --------  --------  --------
     Total operating expenses............................   7,884   16,454    28,828    60,748    80,392
                                                          -------  -------  --------  --------  --------
 Operating loss..........................................  (4,396)  (9,000)  (16,173)  (21,964)  (42,591)
 Interest income (expense), net..........................      62     (119)      155     6,515     5,771
                                                          -------  -------  --------  --------  --------
 Loss before income taxes................................  (4,334)  (9,119)  (16,018)  (15,449)  (36,820)
 Provision for income taxes..............................      --       --        --       215       157
                                                          -------  -------  --------  --------  --------
 Net loss................................................ $(4,334) $(9,119) $(16,018) $(15,664) $(36,977)
                                                          =======  =======  ========  ========  ========
 Basic and diluted net loss per share (1)................ $(17.17) $(11.34) $  (1.80) $  (0.66) $  (1.38)
                                                          =======  =======  ========  ========  ========
 Shares used in calculation of basic and diluted net loss
   per share (1).........................................     252      804     8,903    23,556    26,723
                                                          =======  =======  ========  ========  ========
</TABLE>
--------
(1) See Notes 1 and 5 of our consolidated financial statements for an
    explanation of the method used to calculate basic and diluted net loss per
    share.

                                      33

<PAGE>

<TABLE>
<CAPTION>
                                                                 December 31,
                                                   ----------------------------------------
                                                    1997   1998    1999     2000     2001
                                                   ------ ------  ------- -------- --------
                                                                (In thousands)
<S>                                                <C>    <C>     <C>     <C>      <C>
Consolidated Balance Sheet Data:
 Cash, cash equivalents and short-term investments $  603 $1,712  $26,401 $115,115 $113,743
 Deferred revenues ...............................    313  1,841    4,233   11,874   15,709
 Long-term debt ..................................     --     --       --       --       --
 Working capital .................................    658   (274)  24,395  117,065  103,792
 Total assets.....................................  3,303  9,032   41,311  195,930  173,031
 Total stockholders' equity.......................  1,382    881   32,245  172,405  148,304
 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 e-commerce and secure
communications. Our award-winning products and services include our Firebox
firewall and VPN appliances for access control and secure communications and
our ServerLock technology and anti-virus solution for content and application
security for servers and desktops. Our innovative subscription-based
LiveSecurity Service provides information and virus alerts, threat responses,
software updates, support flashes and expert editorials over the Internet,
which enables enterprises to protect their data and communications in a
continuously changing environment, with minimal effort, and also provides
end-users with access to training and technical support. Our core market
includes SMEs and IDEs, with high-speed connections supporting VPNs between the
corporate headquarters and their geographically dispersed branch offices.

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

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

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

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

  .   In October 1999, we acquired BeadleNet, LLC, a developer of Internet
      security solutions for SOHOs.

  .   In the first quarter of 2000, we began shipping our security solutions
      for SOHOs and telecommuters.

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

  .   In February 2001, we announced the introduction of our ServerLock for NT
      products, which we began shipping in the first quarter of 2001.

  .   During the second and third quarters of 2001, we introduced a product
      line based on a higher-performance, third-generation security appliance,
      our Firebox III, including products targeted at larger enterprises, the
      IDE markets and small businesses and branch offices.

  .   In July 2001, we announced the introduction of our ServerLock for Solaris
      product and our AppLock/Web product for securing Web sites.

  .   In February 2002, we signed an agreement to acquire RapidStream, Inc., a
      privately held provider of high-performance, ASIC-based firewall and VPN
      appliances. The closing of the transaction is subject to several
      specified conditions and is expected to occur early in the second quarter
      of 2002.

                                      34

<PAGE>

Critical Accounting Policies

   Our discussion and analysis of financial condition and results of operations
is based on our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
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. On an on-going basis, we evaluate significant estimates
used in preparing our financial statements, including sales returns and
allowances, bad debt, inventory reserves, restructuring reserves relating to
abandoned facilities, intangible assets and deferred taxes. We base our
estimates on historical experience and on various other assumptions that we
believe to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ
from these estimates under different assumptions or conditions.

   We believe the following critical accounting policies affect the more
significant judgments and estimates used in preparing our consolidated
financial statements:

Revenue Recognition

   Revenue recognition rules for software companies are very complex. We follow
very specific and detailed guidelines in measuring revenue; however, certain
judgments affect the application of our revenue policy. The discretion involved
in this process makes revenue results difficult to predict, and any shortfall
in revenue or delay in recognizing revenue could cause our operating results to
vary significantly from quarter to quarter and could result in future operating
losses.

   We generate revenues through:

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

  .   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.

   Product revenues include:

  .   the perpetual software license fees for our Firebox System that are
      bundled with the sale of our security appliance as part of our security
      solutions;

  .   revenues from sales of software options, such as user expansion and VPN
      software management modules;

  .   revenues from sales of our NOC security suite software license as part of
      our managed security solution; and

  .   sales of our ServerLock products for server content and application
      security.

   Service revenues primarily include the annual fees for our LiveSecurity
Service, which is sold as part of our security solutions, and for LiveSecurity
Service subscription renewals from our enterprise customers and end-users.
These service fees provide our customers access to our LiveSecurity Service for
product updates, security threat responses, general security information and
technical support. These service fees also enable 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, revenues on product sales for some of our major distributors are
recorded when these distributors have sold the product to their customers.
Service subscription revenues are recognized ratably on a monthly basis,
generally over periods ranging from one to two years.

                                      35

<PAGE>

   We have established a sales returns and allowances reserve to address the
return rights, pricing protection rights, and promotional rebates that may be
earned by some of our customers. We estimate these reserves and adjust them
periodically based on historical rates of returns and allowances, as well as
the expected effect of current promotional programs and new product
introductions. If new or expanded promotional programs are introduced, or new
products are announced, additional allowances may be required.

Bad Debts

   We maintain allowances for doubtful accounts for estimated losses resulting
from the inability of our customers to make required payments. Significant
judgment is required when we assess the ultimate realization of receivables,
including the probability of collection and the creditworthiness of each
customer. If the financial condition of our customers were to deteriorate,
resulting in an impairment of their ability to make payments, additional
allowances might be required.

Inventory Valuation

   Our inventories are stated at the lower of cost or market, with cost being
determined on a first-in, first-out basis. We write our inventories down to
estimated market value based on assumptions about future demand and market
conditions. Variation in market trends, customer preferences, introduction of
new products (replacing existing products) or technological advances could,
however, significantly affect these estimates and result in additional
inventory write-downs.

Restructuring

   In 2001, we recorded significant accruals related to our restructuring plan.
These accruals included an estimate related to the abandonment of excess
facilities. Although we do not anticipate significant changes, the actual costs
related to the abandonment of the excess facilities may differ from the
estimate if it takes us longer than expected to find suitable tenants, or if we
are unable to negotiate affordable termination fees. Any changes in these
factors could have a material effect on our financial position and operating
results.

Asset Impairment

   Our business acquisitions have resulted in, and future acquisitions
typically will result in, the recording of goodwill and other intangibles,
which represent the excess of the purchase price over the fair value of net
tangible assets acquired. The goodwill and other intangible assets associated
with acquisitions are periodically reviewed for potential impairment
indicators. Our judgments regarding the existence of impairment indicators are
based on legal factors, market conditions and operational performance of the
acquired business. Future events could cause us to conclude that impairment
indicators exist and that goodwill associated with our acquired businesses is
impaired. Any resulting impairment loss could have a material adverse effect on
our financial position and operating results.

   Before 2002, in accordance with Statement of Financial Accounting Standards,
or SFAS, No. 121, "Accounting for the Impairment of Long-Lived Assets to be
Disposed of," we reviewed long-lived assets and certain identifiable
intangibles for impairment whenever events or changes in circumstances
indicated that the carrying amount of an asset might not be recoverable. Under
SFAS No. 121, measurement of such an impairment was based on the fair value of
the asset in comparison to an estimate of the future cash flows expected to
result from the use of the asset and its eventual disposition. If the sum of
the expected future cash flows (undiscounted and without interest charges) was
less than the carrying amount of the asset, an impairment loss was recognized.
Otherwise, an impairment loss was not recognized.

   Goodwill and other intangibles, including purchased technology, represent
the excess of the purchase price over the fair value of net tangible assets
acquired. Before 2002, we amortized goodwill and other intangibles on a
straight-line basis over lives ranging from two to five years. With the
required adoption of SFAS No. 142,

                                      36

<PAGE>

"Goodwill and Other Intangible Assets," beginning January 1, 2002, we will no
longer amortize goodwill and other intangibles with indefinite lives to
earnings. Instead, we will review them for impairment under a two-step approach
required by SFAS No. 142. The first step of the two-step approach requires the
identification of reporting units and a comparison of the fair value of the
reporting unit versus the book value of the reporting unit, while the second
step measures the amount of goodwill impairment, if any. Any measured
impairment realized from the two-step approach is written down as a charge to
earnings.

Deferred Taxes

   We provide a valuation allowance for deferred tax assets that cannot be
currently recognized due to our cumulative losses and the uncertainty as to
future recoverability. While we have considered future taxable income and
ongoing prudent and feasible tax planning strategies in assessing the need for
the valuation allowance, in the event we were to determine that we would be
able to realize the deferred tax assets in the future, an adjustment to the
deferred tax asset would increase income in the period that determination was
made.

Agreement to Acquire RapidStream, Inc.

   In February 2002, we signed an agreement to acquire RapidStream, Inc., a
privately held provider of high performance ASIC-based firewall and VPN
appliances, for approximately $48.0 million. Under the terms of the agreement,
we expect to acquire RapidStream for a consideration of approximately $17.0
million in cash and approximately $31.0 million in common stock. In addition,
we will assume all outstanding options to purchase common stock of RapidStream,
with the exercise price and number of shares subject to each assumed option to
be adjusted according to the exchange ratio for the merger. The number of
shares of WatchGuard common stock issuable in the transaction will be based on
our average stock price for the 20-day-trading period ending two trading days
before the closing of the transaction. The cash portion of the consideration
may be increased up to a maximum of $24.0 million, with a proportionate
decrease in the stock portion of the consideration, should the amount of stock
required to be issued in the transaction exceed 19.9% of the total number of
shares of our common stock outstanding on the business day immediately
preceding the closing date of the merger. The acquisition is subject to
RapidStream shareholder approval and other customary conditions to closing. The
transaction is expected to close early in the second quarter of 2002. Each of
WatchGuard and RapidStream has agreed to pay a termination fee of $1.5 million
under certain customary circumstances.

   We expect the acquisition of RapidStream, if completed, to have a
significant effect on our financial position and operating results in 2002.
Specifically, we expect that:

  .   product revenues will increase in 2002 due to sales of RapidStream
      ASIC-based products;

  .   gross margins will temporarily decrease slightly in the first few
      quarters after the acquisition is completed as we sell the inventory
      acquired in the acquisition, because this inventory will be valued at
      fair market value, which is significantly higher than RapidStream's cost
      for the inventory;

  .   product returns may increase in 2002 due to sales of a new product
      resulting from the acquisition;

  .   operating expenses will increase in all areas due to the additional
      employee-related and other costs associated with the acquisition,
      especially during the first two quarters of operations as we integrate
      RapidStream with our operations;

  .   we will incur a restructuring charge due to the proper integration of
      operations;

  .   stock-based compensation will increase due to deferred stock compensation
      associated with the acquisition;

  .   we will record additional charges to expense for goodwill and other
      intangibles and amortization expense on definite lived intangibles will
      increase; and

  .   we will expend $17.0 million to $24.0 million in cash to complete the
      acquisition.

                                      37

<PAGE>

Results of Operations

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

<TABLE>
<CAPTION>
                                                                     Year Ended December 31,
                                                                     ---------------------
                                                                     1999    2000    2001
                                                                     -----   -----   -----
<S>                                                                  <C>     <C>     <C>
Revenues:
 Product............................................................  84.0%   85.7%   72.9%
 Service............................................................  16.0    14.3    27.1
                                                                     -----   -----   -----
   Total revenues................................................... 100.0   100.0   100.0
Cost of revenues:
 Product............................................................  33.7    31.2    32.1
 Service............................................................   4.9     4.9     9.1
                                                                     -----   -----   -----
   Total cost of revenues...........................................  38.6    36.1    41.2
Gross margin........................................................  61.4    63.9    58.8
Operating expenses:
 Sales and marketing................................................  65.5    39.9    46.2
 Research and development...........................................  34.5    22.9    29.3
 General and administrative.........................................  17.7     9.9    12.0
 Stock-based compensation...........................................   4.5    13.8    14.7
 Amortization of goodwill, purchased technology and other intangible
   assets acquired..................................................   1.2     6.3    17.0
 Acquired in-process technology.....................................  16.4     7.2      --
 Restructuring charges..............................................    --      --     5.8
                                                                     -----   -----   -----
   Total operating expenses......................................... 139.8   100.1   125.1
                                                                     -----   -----   -----
Operating loss...................................................... (78.4)  (36.2)  (66.3)
Interest income, net................................................   0.7    10.7     9.0
                                                                     -----   -----   -----
Loss before income taxes............................................ (77.7)  (25.5)  (57.3)
Provision for income taxes..........................................    --     0.4     0.2
                                                                     -----   -----   -----
Net loss............................................................ (77.7)% (25.8)% (57.5)%
                                                                     =====   =====   =====
</TABLE>

Years Ended December 31, 2000 and 2001

Revenues

   Total revenues, which consist of product revenues and service revenues,
increased from $60.7 million in 2000 to $64.3 million in 2001, an increase of
6%. The 6% increase represents an increase in service revenues, which offset a
decrease in product revenues. We believe the decrease in product revenues can
be attributed to slowing economic conditions that resulted in a delay or
deferral in customer spending, changes in our sales and marketing organizations
and a realignment of our distribution and channel partner strategy.
Specifically, we hired a Senior Vice President, Worldwide Sales and a Senior
Vice President, Marketing, and subsequently upgraded our sales force and
established strategies emphasizing closer ties to our VARs and end-users. The
increase in service revenues resulted from previous deferrals attributable to
bundled product revenues and the renewals of LiveSecurity Service subscriptions
by our existing customer base.

   We categorize our revenues into three geographic regions: the Americas,
Europe/Middle East/Africa, or EMEA, and Asia Pacific, or APAC. Revenues from
the Americas, EMEA and APAC as a percentage of total revenues were
approximately 49%, 32% and 19% in 2000 and 47%, 33%, and 20% in 2001,
respectively. Total international revenues, which are revenues from customers
located outside of the United States, represented approximately 55% of total
revenues in 2000 and 56% of total revenues in 2001. In 2000, no foreign country
represented in excess of 10% of revenues. In 2001, revenues from Japan were 12%
of total revenues. In 2000, worldwide revenues from one of our distributors,
Ingram Micro, were $7.3 million, or 12% of total revenues, and

                                      38

<PAGE>

revenues from another distributor, Tech Data, were $6.4 million, or 10% of
total revenues. In 2001, worldwide revenues from Ingram Micro were $8.7
million, or 14% of total revenues, and revenues from Tech Data were $6.6
million, or 10% of total revenues.

   Product revenues include (1) perpetual software license fees for our Firebox
System that are bundled with the sale of our security appliance as part of our
security solutions; (2) sales of software options, such as user expansion and
VPN software management modules; (3) sales of our NOC security suite software
license as part of our managed security solution; and (4) sales from our
ServerLock product line, which is based on technology acquired in conjunction
with our purchase of Qiave in October 2000. Product revenues decreased from
$52 million in 2000 to $46.9 million 2001, a decrease of 10%. Product revenues
as a percentage of total revenues decreased from 86% in 2000 to 73% in 2001 due
to a lower growth rate associated with slowing economic conditions, as well as
the events of September 11, 2001 and their aftermath and an increase in service
revenues from an increased base of customers renewing their LiveSecurity
Service subscriptions. The decrease in product revenues was also influenced by
changes in our sales and marketing organizations, and a realignment of our
distribution and channel partner strategy. Given the current economic
uncertainty and slowdown in capital spending, it is difficult to predict
revenue levels in future quarters, which may remain depressed or fluctuate more
than they have historically.

   Service revenues primarily include the annual fee for our LiveSecurity
Service, which is sold as part of the Firebox System and managed security
solution. Service revenues increased from $8.7 million in 2000 to $17.4 million
in 2001, an increase of 100%. The increase in service revenues is due to a
greater number of installed products in 2001 and from an increase in
LiveSecurity Service renewals. We expect the decreased product sale growth rate
for 2001, which is also reflected in the deferred revenue decrease mentioned
below, to result in a lower service revenue growth rate in 2002 than in 2001.
As a percentage of total revenues, service revenues increased from 14% in 2000
to 27% in 2001, which reflects an increased base of customers renewing their
LiveSecurity Service subscriptions and a reduced growth rate for product sales.

   We have established a returns and allowances reserve to address the return
rights, pricing protection rights, and promotional rebates that may be earned
by some of our customers. These reserves are estimated and adjusted
periodically based on historical rates of returns and allowances and the
expected effect of current promotional programs and new product introductions.
The provision for sales returns and allowances was $1.9 million, or 3% of total
revenues before returns and allowances, in 2000 and $6.9 million, or 10% of
total revenues before returns and allowances, in 2001. The 2001 increase in the
provision as a percentage of revenue reflects the major product replacement of
the Firebox II with the Firebox III, promotional rebates associated with
selling residual inventories of Firebox II products and the introduction of our
Firebox III related products. We expect to continue to introduce new products
each year, which may affect 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 $21.9 million in 2000 to $26.5 million in 2001, an increase of 21%. As a
percentage of total revenues, cost of revenues increased from 36% in 2000 to
41% in 2001. Gross margins are affected by various factors, including the
volume discount levels contained in our channel customer agreements, the cost
of our Firebox appliances, expense associated with a provision for inventory
reserves, lower of cost or market assessment of inventory carrying value, fixed
manufacturing overhead, the mix of product and service sales, which may include
hardware and software products and service subscriptions or both, the cost of
royalties associated with our products, promotional programs and the costs of
our technical support organization and LiveSecurity Service.

   Cost of product revenues, which includes the cost of manufacturing our
products, product packaging and third-party product licensing fees, increased
from $18.9 million in 2000 to $20.7 million in 2001, an increase of 9%. The
dollar increase was primarily due to an $861,000 expense increase relating to
our provision for inventory reserves, a $464,000 write-down of existing Firebox
II-related inventory and higher fixed manufacturing overhead. Cost of product
revenues as a percentage of total product revenues increased from 36% in 2000
to 44% in 2001. The increase in cost of product revenues as a percentage of
product revenues reflects

                                      39

<PAGE>

increases from the items noted above, as well as the revenue effect of
promotional programs on certain existing and new Firebox products established
to facilitate the introduction of several new products during 2001. The
increase also reflects a change in product mix, in which the sales volume of
some of our lower-margin products increased on a relative basis from 2000 to
2001. We expect product mix changes, which would result from increased sales of
higher-margin enterprise-class Firebox products and software products such as
ServerLock, to have a positive effect on gross margins. We therefore expect
that gross margins will gradually improve during 2002, primarily as a result of
reductions in hardware manufacturing costs. These improvements may be offset,
in part, by the lower margin on sales of the RapidStream inventory acquired at
the time of the RapidStream acquisition.

   Cost of service revenues, which includes the costs of our technical support
organization and costs associated with our LiveSecurity Service, increased from
$3.0 million in 2000 to $5.8 million in 2001, an increase of 95%. As a
percentage of total service revenues, cost of service revenues was 34% in both
2000 and 2001. Cost of service revenues as a percentage of total service
revenues remained level, reflecting an increase in the investment in our
customer support organization that coincides with a increasingly growing number
of customers who are implementing VPNs in a more complex environment, as well
as a broader customer base. We expect service costs to continue to increase in
total dollar amount as our user base expands. In the longer term, as revenues
from LiveSecurity Service 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 certain variable marketing
expenses, including distributor promotional costs, public relations costs,
marketing collateral and trade show expenses. Sales and marketing expenses
increased from $24.2 million in 2000 to $29.7 million in 2001, an increase of
23%. As a percentage of total revenues, sales and marketing expenses increased
from 40% in 2000 to 46% in 2001. The dollar increase in sales and marketing
expenses was primarily due to recruiting and supporting a greater number of
current and prospective resellers and distributors and to increased efforts to
establish brand recognition of our products and services. Specifically, major
components of the increase included:

  .   an increase in salaries, commissions, recruiting, consulting and related
      expenses from $10.7 million to $12.5 million; and

  .   an increase in variable marketing costs from $7.8 million to $10.6
      million related to specific marketing activities designed to increase
      brand awareness.

   As mentioned above we expect that sales and marketing expenses will increase
in 2002 due to the proposed acquisition of RapidStream, and in connection with
our continued investment in sales and marketing programs designed to increase
distribution through our reseller network.

   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 $13.9 million in 2000 to $18.9 million in
2001, an increase of 36%. As a percentage of total revenues, research and
development expenses increased from 23% in 2000 to 29% in 2001. 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 managed security solution product lines and ServerLock products, and our
efforts to respond to new and emerging worldwide Internet security threats
through our LiveSecurity Service. Specifically, major components of the
increase included:

  .   an increase in payroll and related expenses from $8.8 million to $11.6
      million, a portion of which is related to the research and development
      costs of our ServerLock products originating from our acquisition of
      Qiave;

  .   an increase in facilities expenses from $688,000 to $1.9 million, which
      reflects both a combination of the costs associated with our new
      corporate headquarters and the costs of facilities originating from our
      acquisition of Qiave; and

                                      40

<PAGE>

  .   an increase in designer, contractor and security appliance prototype
      engineering costs from $2.6 million to $3.0 million related to expanded
      product offerings in 2001, including Firebox III and future products.

   As mentioned above, we expect the proposed acquisition of RapidStream to
cause research and development expenses to increase in 2002. We also expect to
continue to increase our research and development expenses in total dollar
amounts to enhance and expand our current product offerings and integrate the
new RapidStream product offerings, develop new products and enhance our rapid
response team, which analyzes and addresses Internet security threats.

   General and Administrative.  General and administrative expenses include
costs of executive, human resource, finance and administrative support
functions, provisions for uncollectible accounts and legal and accounting
professional services. General and administrative expenses increased from $6.0
million in 2000 to $7.7 million in 2001, an increase of 29%. As a percentage of
total revenues, general and administrative expenses increased from 10% in 2000
to 12% in 2001. The dollar increase in general and administrative expenses
reflects the expansion of our infrastructure to manage the growth of our
operations, including an increase in payroll and related expenses and increases
in other general and administrative areas, such as professional service fees
and bad debt.

   Stock-Based Compensation.  Stock-based compensation expenses arise from
amortization of previously deferred stock-based compensation over the vesting
periods of common stock subject to repurchase and stock options. Amortization
of deferred stock-based compensation expenses was $8.4 million in 2000 and $9.4
million in 2001. In 2000, the allocation of the stock-based compensation
expenses associated with the functional operating expense categories was
$824,000 for sales and marketing, $7.5 million for research and development,
and $103,000 for general and administrative. In 2001, the allocation of
stock-based compensation expense was $220,000 for sales and marketing, $9.2
million for research and development and $35,000 for general and administrative.

   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 in connection with our
October 1999 acquisition of BeadleNet and our October 2000 acquisition of
Qiave. In addition, deferred stock-based compensation is recorded for the fair
value of stock options granted to consultants. 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. In 2001, we recorded $213,000 in
deferred stock-based compensation related to options issued to consultants.

   Acquired In-Process Technology.  Acquired in-process technology expenses
consists of in-process research and development, or IPR&D, expense related to
our acquisitions of BeadleNet in October 1999 and Qiave in October 2000. We
recorded IPR&D expense related to the acquisition of Qiave of $4.4 million in
2000. The projects associated with the majority of this IPR&D were completed
and included in our 2001 product offerings of ServerLock for NT, ServerLock for
Solaris and AppLock/Web.

   Amortization of Goodwill, Purchased Technology and Other Intangible Assets
Acquired.  Amortization of goodwill, purchased technology and other intangible
assets acquired consists of amortization of goodwill and other intangibles
related to our acquisitions of BeadleNet and Qiave. We are amortizing the
intangible assets acquired in connection with the Qiave and BeadleNet
acquisitions, including goodwill and purchased technology, on a straight-line
basis over useful lives ranging from two to five years. We recorded
amortization charges related to these intangible assets of $3.8 million in 2000
and $10.9 million in 2001. The increase in amortization in 2001 resulted
primarily from recording amortization of intangibles associated with our
acquisition of Qiave. With the required adoption of SFAS No. 142, "Goodwill and
Other Intangible Assets," beginning January 1, 2002, we will no longer amortize
goodwill to earnings, but instead we will review goodwill for impairment on an
annual basis or on an interim basis if circumstances change or if events occur
that would reduce the fair value of

                                      41

<PAGE>

a reporting unit below its carrying value. We will charge impairment losses to
earnings in the period they are determined. We will apply the provisions of
SFAS No. 141 and SFAS No. 142 in the first quarter of 2002. Application of the
new standards is expected to result in a reclassification of the unamortized
balance of an assembled workforce in the amount of $390,000 to goodwill on
January 1, 2002. This will result in a net goodwill balance of $27.0 million
(which will no longer be subject to amortization but will be subject to
evaluation for impairment) and a net balance of other intangibles of $9.8
million (which will continue to be amortized over their estimated useful lives
of three to five years). Amortization of goodwill will decrease by $7.5 million
in 2002 as a result of the adoption of the new standards. During the first six
months of 2002, we will perform the required transitional impairment tests of
goodwill as of January 1, 2002. We have not yet determined the effect of these
tests on our earnings and financial position.

   Restructuring Charges.  In April 2001, we announced a restructuring plan
designed to streamline our operations and reduce operating costs. This
restructuring plan included a reduction in workforce and a consolidation of
excess facilities, in addition to other cost-saving strategies. As part of the
restructuring plan, we exited the consumer security market and terminated
various OEM agreements to develop products and services for that market, and
streamlined operations in support of new products and services aimed at
business customers. As a result of this restructuring, we recorded a $3.7
million restructuring charge in 2001. The components of the restructuring
charge for 2001 included the following:

<TABLE>
<CAPTION>
                                                                December 31,
                                          Restructuring Amounts 2001 Accrued
                                           Charges in   Paid or Restructuring
                                              2001      Charged    Balance
                                          ------------- ------- -------------
                                                    (In thousands)
  <S>                                     <C>           <C>     <C>
  Severance and termination benefits.....    $1,015     $1,015     $   --
  Stock-based compensation...............       579        579         --
  Abandoned facilities and other.........     2,126        640      1,486
                                             ------     ------     ------
     Total...............................    $3,720     $2,234     $1,486
                                             ======     ======     ======
</TABLE>

   As part of the reorganization, we implemented a workforce reduction of 50
employees, which represented approximately 16% of our employee base at that
time and included employees from all of our functional areas. All of these
employees were terminated prior to June 30, 2001. All restructuring charges
have been paid as of December 31, 2001, except for accrued amounts related to
losses for the lease buyout or sublease of abandoned facilities of
approximately $1.5 million at December 31, 2001 which are expected to be
realized through September 2006. Operating expenses, exclusive of restructuring
charges, amortization of goodwill, intangibles and stock-based compensation
decreased by $1.0 million in the second quarter of 2001, $700,000 in the third
quarter of 2001 and $400,000 in the fourth quarter of 2001, in each case as
compared to the prior quarter primarily due to this restructuring. We expect
modest decreases in operating expenses during 2002 related to the restructuring
to be offset by the changes in our sales and marketing organization and the
realignment of our distribution and channel partner strategy, which is designed
to upgrade our sales force, and established strategies emphasizing closer ties
to our VARs and end-users.

Interest Income

   Interest income is generated from the investment of proceeds from the sale
of common stock in our initial public offering in 1999 and our follow-on public
offering in February 2000. Interest income decreased from $6.5 million in 2000
to $5.8 million in 2001. This decrease resulted from a decrease in the average
rates of return.

Income Taxes

   Income tax expense of $215,000 in 2000 and $157,000 in 2001 primarily
relates to our provision for foreign income taxes associated with our
international operations. We have experienced losses since inception,

                                      42

<PAGE>

resulting in a net operating loss carryforward position for federal income tax
purposes of approximately $145.9 million as of December 31, 2001. 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, 1999 and 2000

Revenues

   Total 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,
APAC and North American markets. Revenues from the Americas, EMEA and APAC as a
percentage of total revenues were approximately 54%, 26% and 20% in 1999 and
49%, 32% and 19% in 2000, respectively. Total international revenues
represented approximately 50% of total revenues in 1999 and 55% in 2000. In
1999 and 2000, no foreign country represented in excess of 10% of revenues. In
1999, no one customer accounted for more than 10% of total revenues. In 2000,
however, worldwide revenues from Ingram Micro were $7.3 million, or 12% of
total revenues, and revenues from Tech Data were $6.4 million, or 10% of total
revenues.

   Product revenues increased from $17.3 million in 1999 to $52 million in
2000, an increase of 200%. This increase reflects favorable market conditions
for our products, and the first full year of product sales from our BeadleNet
acquisition. As a percentage of total revenues, product revenues increased from
84% in 1999 to 86% in 2000.

   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 that a significant
growth in product revenues offset the effect of growth in service revenue from
the increased base of customers renewing their LiveSecurity Service
subscriptions.

   Our returns and allowances reserve addresses 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 introduction of major replacement products
during 2000 and no significant changes in our product and service pricing over
the course of the year.

Cost of Revenues and Gross Margin

   Total cost of revenues 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.

   Cost of product revenues increased from $7.0 million in 1999 to $18.9
million in 2000, an increase of 172%, which increase primarily reflects greater
sales volume. As a percentage of total revenues, cost of product revenues
decreased from 34% in 1999 to 31% in 2000. Cost of product revenues as a
percentage of total product revenues decreased from 40% in 1999 to 36% in 2000.
Both decreases reflect 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, which generally have higher gross margins than
our Firebox appliances.

   Cost of service revenues increased from $1.0 million in 1999 to $3.0 million
in 2000, an increase of 200%. As a percentage of total revenues, cost of
service revenues was 5% for both 1999 and 2000. As a percentage of total
service revenues, cost of service revenues increased from 31% in 1999 to 34% in
2000. The increase in cost of service revenues in both dollar amounts and as a
percentage of total service revenues reflects an increased 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.

                                      43

<PAGE>

Operating Expenses

   Sales and Marketing.  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 supporting a greater number of 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.

   Research and Development.  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 managed security solution product
lines, including our SOHO and ServerLock products, and our efforts to respond
to new and emerging Internet security 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

  .   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.

   General and Administrative.  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.  Amortization of deferred stock-based compensation
expenses was $926,000 in 1999 and $8.4 million in 2000. The increase in
deferred stock-based compensation amortization in 2000 was primarily due to
amortization associated with the acquisition of Qiave in the fourth quarter of
2000. In 1999, the allocation of the stock-based compensation expenses
associated with the functional operating expense categories was $307,000 for
sales and marketing, $491,000 for research and development and $128,000 for
general and administrative. In 2000, the allocation of stock-based compensation
expenses was $824,000 for sales and marketing, $7.5 million for research and
development and $103,000 for general and administrative.

                                      44

<PAGE>

   Acquired In-Process Technology.  Acquired in-process technology consists of
IPR&D expense related to our acquisitions of BeadleNet and Qiave. We recorded
IPR&D expense of $3.4 million in 1999 related to the BeadleNet acquisition and
$4.4 million in 2000 related to the Qiave acquisition. In the first half of
2000, we completed IPR&D project expenditures that were associated with the
1999 BeadleNet acquisition.

   Amortization of Goodwill, Purchased Technology and Other Intangible Assets
Acquired.  Amortization of goodwill, purchased technology and other intangible
assets acquired consists of amortization of goodwill and other intangibles
related to our acquisitions of BeadleNet and Qiave. The intangible assets are
being amortized on a straight-line basis over useful lives ranging from two to
five years. We recorded amortization charges related to these intangible assets
of $259,000 in 1999 and $3.8 million in 2000. 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 October 2000 acquisition of
Qiave.

Interest Income

   Interest income of $6.6 million in 2000 resulted from our investment of
proceeds from our public offerings in July 1999 and February 2000, 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 related 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.

                                      45

<PAGE>

Quarterly Results of Operations

   The following tables provide our unaudited results of operations, both in
dollar amounts and as a percentage of total revenues, for each quarter in the
eight-quarter period ended December 31, 2001. 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 our 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,
                                             2000     2000     2000      2000      2001      2001      2001      2001
                                           -------- -------- --------- --------  --------  --------  --------- --------
                                                               (In thousands, except per share data)
<S>                                        <C>      <C>      <C>       <C>       <C>       <C>       <C>       <C>
Consolidated Statement of Operations
 Data:
Revenues:
  Product................................. $ 8,494  $12,000   $14,782  $ 16,734  $ 13,284  $ 13,255   $12,806  $  7,548
  Service.................................   1,308    1,740     2,453     3,192     3,818     4,253     4,462     4,857
                                           -------  -------   -------  --------  --------  --------   -------  --------
    Total revenues........................   9,802   13,740    17,235    19,926    17,102    17,508    17,268    12,405

Cost of revenues:
  Product.................................   3,091    4,341     5,363     6,137     5,267     5,425     5,214     4,752
  Service.................................     432      557       824     1,174     1,376     1,558     1,450     1,440
                                           -------  -------   -------  --------  --------  --------   -------  --------
    Total cost of revenues................   3,523    4,898     6,187     7,311     6,643     6,983     6,664     6,192
                                           -------  -------   -------  --------  --------  --------   -------  --------
Gross margin..............................   6,279    8,842    11,048    12,615    10,459    10,525    10,604     6,213

Operating expenses:
  Sales and marketing.....................   5,559    5,967     5,849     6,838     8,171     7,690     7,380     6,476
  Research and development................   2,521    3,262     3,413     4,704     5,271     4,740     4,129     4,714
  General and administrative..............   1,154    1,249     1,703     1,895     1,870     1,865     2,060     1,931
  Stock-based compensation................     236      228       193     7,750     4,520     2,546     1,468       899
  Amortization of goodwill, purchased
   technology and other intangible assets
   acquired...............................     368      368       368     2,724     2,724     2,724     2,724     2,770
  Acquired in-process technology..........      --       --        --     4,399        --        --        --        --
  Restructuring charges...................      --       --        --        --        --     2,900        --       820
                                           -------  -------   -------  --------  --------  --------   -------  --------
    Total operating expenses..............   9,838   11,074    11,526    28,310    22,556    22,465    17,761    17,610
                                           -------  -------   -------  --------  --------  --------   -------  --------
Operating loss............................  (3,559)  (2,232)     (478)  (15,695)  (12,097)  (11,940)   (7,157)  (11,397)
Interest income, net......................     863    1,854     1,812     1,986     1,701     1,622     1,292     1,156
                                           -------  -------   -------  --------  --------  --------   -------  --------
Income (loss) before income taxes.........  (2,696)    (378)    1,334   (13,709)  (10,396)  (10,318)   (5,865)  (10,241)
Provision for income taxes................      --       --        --       215        84        84        28       (39)
                                           -------  -------   -------  --------  --------  --------   -------  --------
Net income (loss)......................... $(2,696) $  (378)  $ 1,334  $(13,924) $(10,480) $(10,402)  $(5,893) $(10,202)
                                           =======  =======   =======  ========  ========  ========   =======  ========
Net income (loss) per share(1):
    Basic................................. $ (0.13) $ (0.02)  $  0.06  $  (0.54) $  (0.40) $  (0.39)  $ (0.22) $  (0.38)
                                           =======  =======   =======  ========  ========  ========   =======  ========
    Diluted............................... $ (0.13) $ (0.02)  $  0.05  $  (0.54) $  (0.40) $  (0.39)  $ (0.22) $  (0.38)
                                           =======  =======   =======  ========  ========  ========   =======  ========
Shares used in computation of net income
 (loss) per share(1):
    Basic.................................  21,243   23,160    24,147    25,741    26,348    26,673    26,839    27,011
                                           =======  =======   =======  ========  ========  ========   =======  ========
    Diluted...............................  21,243   23,160    27,809    25,741    26,348    26,673    26,839    27,011
                                           =======  =======   =======  ========  ========  ========   =======  ========
</TABLE>
--------
(1) See Notes 1 and 5 of our consolidated financial statements for an
    explanation of the method used to calculate basic and diluted net loss per
    share.

                                      46

<PAGE>

<TABLE>
<CAPTION>
                                                                      Three Months Ended
                                           -----------------------------------------------------------------------
                                           Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31,
                                             2000     2000     2000      2000     2001     2001     2001      2001
                                           -------- -------- --------- -------- -------- -------- --------- --------
<S>                                        <C>      <C>      <C>       <C>      <C>      <C>      <C>       <C>
Consolidated Statement of Operations Data:
Revenues:
  Product.................................   86.7%    87.3%     85.8%    84.0%    77.7%    75.7%     74.2%    60.8%
  Service.................................   13.3     12.7      14.2     16.0     22.3     24.3      25.8     39.2
                                            -----    -----     -----    -----    -----    -----     -----    -----
    Total revenues........................  100.0    100.0     100.0    100.0    100.0    100.0     100.0    100.0
Cost of revenues:
  Product.................................   31.5     31.6      31.1     30.8     30.8     31.0      30.2     38.3
  Service.................................    4.4      4.1       4.8      5.9      8.0      8.9       8.4     11.6
                                            -----    -----     -----    -----    -----    -----     -----    -----
    Total cost of revenues................   35.9     35.6      35.9     36.7     38.8     39.9      38.6     49.9
                                            -----    -----     -----    -----    -----    -----     -----    -----
Gross margin..............................   64.1     64.4      64.1     63.3     61.2     60.1      61.4     50.1

Operating expenses:
  Sales and marketing.....................   56.7     43.4      33.9     34.3     47.8     43.9      42.7     52.2
  Research and development................   25.7     23.7      19.8     23.6     30.8     27.1      23.9     38.0
  General and administrative..............   11.8      9.1       9.9      9.5     10.9     10.7      11.9     15.6
  Stock-based compensation................    2.4      1.7       1.1     38.9     26.5     14.5       8.5      7.2
  Amortization of goodwill, purchased
   technology and other intangible assets
   acquired...............................    3.8      2.7       2.1     13.7     15.9     15.6      15.8     22.3
  Acquired in-process technology..........    0.0      0.0       0.0     22.1      0.0      0.0       0.0      0.0
  Restructuring charges...................    0.0      0.0       0.0      0.0      0.0     16.6       0.0      6.6
                                            -----    -----     -----    -----    -----    -----     -----    -----
    Total operating expenses..............  100.4     80.6      66.9    142.1    131.9    128.3     102.9    142.0
                                            -----    -----     -----    -----    -----    -----     -----    -----
Operating loss............................  (36.3)   (16.2)     (2.8)   (78.8)   (70.7)   (68.2)    (41.4)   (91.9)
Interest income, net......................    8.8     13.5      10.5     10.0      9.9      9.3       7.5      9.3
                                            -----    -----     -----    -----    -----    -----     -----    -----
Income (loss) before income taxes.........  (27.5)    (2.8)      7.7    (68.8)   (60.8)   (58.9)    (34.0)   (82.6)
Provision for income taxes................    0.0      0.0       0.0      1.1      0.5      0.5       0.2     (0.3)
                                            -----    -----     -----    -----    -----    -----     -----    -----
Net loss..................................  (27.5)%   (2.8)%     7.7%   (69.9)%  (61.3)%  (59.4)%   (34.1)%  (82.2)%
                                            =====    =====     =====    =====    =====    =====     =====    =====
</TABLE>

   During 2000, we experienced revenue growth due to increased sales volume
caused by increased distribution in the EMEA and APAC markets. During 2001,
global economic, political and other uncertainties, as well as constrained
corporate information technology spending, slowed the demand for our products
and services. Like most companies in the technology sector, we experienced a
downturn in revenues from the fourth quarter of 2000 through the fourth quarter
of 2001. Revenues for the four quarters ended December 31, 2001 were $17.1
million, $17.5 million, $17.3 million and $12.4 million and were significantly
lower than revenues of $19.9 million recorded for the fourth quarter of 2000.
Both revenues and our operating results for 2001 were negatively affected by
the economic slowdown worldwide and an overall reduction in capital spending.
We expect our negative 2001 product sales growth rate will result in a lower
2002 service revenue growth rate than that for 2001. Additionally, revenues and
operating results for the fourth quarter of 2001 were negatively affected by
changes in our sales and marketing organizations and a realignment of our
distribution and channel partner strategy, as well as the economic issues
mentioned above. Specifically, we hired a Senior Vice President, Worldwide
Sales and a Senior Vice President, Marketing, and subsequently upgraded our
sales force and established strategies emphasizing closer ties to our VARs and
end-users. While the changes in our sales and marketing organizations and the
realignment of our distribution and channel partner strategy negatively
affected revenues and operating results during 2001, we believe they were
required to compete in the global Internet security market.

   In general, through December 2000, we improved our gross margins, both in
dollars and as a percentage of revenues, as we gained efficiencies in the
production of our security appliances and introduced product options that
carried higher gross margins. Beginning in 2001, however, our gross margins, in
dollars and as a percentage of revenues, remained relatively flat until the
fourth quarter of 2001, when we experienced a sharp decline in gross margins.
Gross margins in the fourth quarter of 2001 were affected by the factors
described above as well

                                      47

<PAGE>

as by a change in product mix that resulted in a higher concentration of
lower-priced, lower-margin products being sold, fixed manufacturing overhead
and customer support costs spread over a smaller revenue base, and the
write-down of existing Firebox II products and related assets. Gross margins
during 2001 were also negatively affected by promotional programs on certain
existing Firebox II products established to facilitate the introduction of the
new Firebox III product line. We have also continued to make significant
investments in our customer support organization as our LiveSecurity Service
subscription base has expanded. Competitive selling pressures in future
quarters could adversely affect our gross margins.

   We also have continued to make investments in our sales and marketing
organization, as reflected in the increased sales and marketing expenses
recorded for 2001. In addition, our second quarter and fourth quarter 2001
operating expenses included significant restructuring charges associated with
our April 2001 restructuring plan. Other significant increases in operating
expenses during 2001, including research and development expenses, stock-based
compensation expenses, and the amortization of intangibles, were primarily
related to our acquisition of Qiave in October 2000. Although our operating
expenses, excluding amortization of goodwill, intangibles and stock-based
compensation, and restructuring charges continued to increase in dollar amounts
through the first quarter of 2001, we reduced these expenses by approximately
$1.0 million in the second quarter, $700,000 in the third quarter and $400,000
in the fourth quarter of 2001, as compared to the respective prior quarter.
Increased operating expenses as a percentage of total revenues during 2001
primarily resulted from the lower revenues discussed above.

   To the extent that the economic and political uncertainties discussed above
continue to occur, spread to other geographic regions in which we conduct
business or both, our future operating results are likely to be adversely
affected. As noted above, we would also expect the proposed RapidStream
acquisition to have a significant effect on future operating results.

Liquidity and Capital Resources

   As of December 31, 2001, we had $113.7 million in cash, cash equivalents and
short-term investments, 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. We currently
have outstanding a $3.0 million unconditional letter of credit that we issued
in September 2000 to our landlord in conjunction with the building lease for
our corporate headquarters. Currently, our letter of credit is collateralized
by short-term investments with our bank. Our working capital as of December 31,
2001 was $103.8 million.

   Operating Activities.  Our operating activities resulted in net cash
outflows of $2.4 million in 2000 and $2.0 million in 2001. The operating cash
outflows during these periods resulted primarily from significant investments
in sales and marketing and research and development, all of which led to
operating losses. Net losses for 2000 and 2001 exceeded cash used in operating
activities primarily as a result of non-cash charges included in net losses
totaling $18.6 million during 2000 and $24.0 million during 2001. These
non-cash charges were primarily associated with the amortization of goodwill
and other intangibles, depreciation and amortization of capital assets,
provisions for bad debts, and compensation charges resulting from the issuance
of stock options and common stock subject to repurchase by WatchGuard. Cash
utilized by working capital components for operating activities was $5.3
million during 2000 and cash provided by working capital components for
operating activities was $11.0 million during 2001. During 2001, there were
large fluctuations within some of our major working capital components, as
described below:

   (a) Net Receivables decreased from $15.3 million at December 31, 2000 to
       $6.4 million at December 31, 2001, primarily reflecting the decrease in
       revenues from $19.9 million for the three months ended December 31, 2000
       to $12.4 million for the three months ended December 31, 2001. Days
       sales outstanding, or DSOs, were 69 days at December 31, 2000 and 46
       days at December 31, 2001, calculated on a quarterly basis. The decrease
       in DSOs reflects both lower product sales and improved collection
       results, and we expect future DSOs to be in the range mentioned below.
       DSOs are affected by the payment terms contained in our customer
       contracts, risks associated with the uncertain

                                      48

<PAGE>

       economy, linearity in revenues for a particular quarter and the amount
       of deferred revenue contained in the receivable balance that has not
       been recognized as revenue. Based on our current sales mix, the
       resulting timing differences arising from the varying payment terms in
       our customer agreements, the linearity of revenues in past quarters and
       the growth of deferred revenue, we expect our DSOs to generally range
       from 55 to 70 days in the future. Any change in these factors, however,
       could negatively affect expected DSO results.

       Reserves for uncollectible accounts were $633,000 at December 31, 2000
       and $793,000 at December 31, 2001, reflecting sales to a broader
       customer base and a slowing economy. Sales reserves for returns and
       allowances were $965,000 at December 31, 2000 and $2.0 million at
       December 31, 2001, reflecting our estimate of returns and allowances
       associated with the return rights, price protection rights, and
       promotional rebates of some of our customers. We increased the sales
       reserve during 2001 to reflect the potential for increased returns and
       pricing adjustments associated with new products and promotional rebates
       introduced during 2001, restocking and price protection rights. The
       reserve will continue to fluctuate from time to time depending on the
       timing of product introductions and pricing program changes.

   (b) Net Inventories decreased from $7.0 million at December 31, 2000 to $4.4
       million at December 31, 2001. The overall decrease reflects consumption
       of Firebox component inventory in the manufacture of finished goods
       inventory and a lower of cost or market write-down of the remaining
       Firebox II products. 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 $3.2 million at
       December 31, 2000 to $4.0 million at December 31, 2001, primarily due to
       an increase in prepaid product royalty costs, prepaid insurance and
       prepaid rents.

   (d) Accounts Payable and Accrued Expenses decreased from $11.7 million at
       December 31, 2000 to $9.0 million at December 31, 2001. This decrease
       resulted primarily from the timing of inventory purchases and other
       expenditures during 2000 compared to 2001, offset by an increase of
       $1.5 million in restructuring liability.

   (e) Deferred Revenue increased from $11.9 million at December 31, 2000 to
       $15.7 million at December 31, 2001, an increase of 32%. This increase
       reflects the deferral of revenue from bundled LiveSecurity Service
       subscriptions included in new product revenues and renewals of
       LiveSecurity Service subscriptions from a growing customer base.
       Deferred revenue decreased from $16.9 million at September 30, 2001 to
       $15.7 million at December 31, 2001, a decrease of 7%. This decrease will
       have the effect of reducing the growth rate of our service revenues
       during 2002.

   Investing Activities.  Cash used in investing activities was $82.5 million
in 2000 and cash provided by investing activities was $121,000 in 2001. These
activities primarily relate to short-term investing activity of the proceeds
received from our public offerings, and capital expenditures for equipment and
furniture.

   Financing Activities.  Cash provided by financing activities totaled $96.9
million in 2000 and $2.0 million in 2001. We received $90.4 million in proceeds
from our follow-on public offering of common stock in the first quarter of
2000. We received cash in both 2000 and 2001 from the exercise of employee
stock options and the purchase of common stock through our employee stock
purchase plan.

   We believe that existing cash and securities balances will be sufficient to
meet our anticipated cash needs for working capital, capital expenditures,
higher than usual cash requirements during the first quarter of 2002 due to
lower than usual revenues during the fourth quarter of 2001, the proposed
acquisition of RapidStream, and other potential acquisitions or technology
investments for at least the next 12 months. We may need to seek additional
funding before that time through public or private financings or other
arrangements, however, if the underlying assumed levels of spending for other
potential acquisitions of or investments in complementary businesses or
technologies prove to be inaccurate.

                                      49

<PAGE>

Other Commitments

   We lease office space and some equipment under noncancelable operating
leases. Our facilities commitments include a lease for our corporate
headquarters in Seattle, Washington, which expires in September 2010. We have
the option to extend this lease for an additional five-year term. We also lease
facilities in Aliso Viejo, California and Waltham, Massachusetts under
operating leases that expire in 2005, in addition to leases for other sales
offices under operating leases or other lease obligations that expire over
various terms. Aggregate future commitments under these leases were $28.1
million at December 31, 2001.

   WatchGuard is also a party to a product royalty agreement with a total
commitment of $1.1 million at December 31, 2001 and several
noncancelable/nonrefundable agreements to purchase inventory with a total
commitment of $2.2 million at December 31, 2001.

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, 1999, 2000 and 2001:

<TABLE>
<CAPTION>
                                                                        Year Ended December 31,
                                                                     ----------------------------
                                                                       1999      2000      2001
                                                                     --------  --------  --------
                                                                            (In thousands)
<S>                                                                  <C>       <C>       <C>
Net loss--as reported............................................... $(16,018) $(15,664) $(36,977)
Adjustments to reconcile net loss in the financial statements to pro
  forma net income/ loss:
   Stock-based compensation.........................................      926     8,407     9,433
   Amortization of goodwill, purchased technology and other
     intangible assets acquired.....................................      245     3,828    10,942
   Acquired in-process technology...................................    3,381     4,399        --
Restructuring charges...............................................       --        --     3,720
                                                                     --------  --------  --------
Pro forma net income (loss)......................................... $(11,466) $    970  $(12,882)
                                                                     ========  ========  ========
Pro forma net income (loss) per share:
   Basic............................................................ $  (0.69) $   0.04  $  (0.48)
                                                                     ========  ========  ========
   Diluted.......................................................... $  (0.69) $   0.03  $  (0.48)
                                                                     ========  ========  ========
Shares used in computation of pro forma net income (loss) per share:
   Basic............................................................   16,664    23,556    26,723
                                                                     ========  ========  ========
   Diluted..........................................................   16,664    27,779    26,723
                                                                     ========  ========  ========
</TABLE>

   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 our acquisition of BeadleNet in October
      1999 and Qiave in October 2000;

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

  .   exclude restructuring charges; and

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

                                      50

<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 short-term investments 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 at the time of purchase, with the exception of United
States treasury and agency 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 affected 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 incurred some expenses
in foreign currencies during 2001 and 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 us. Although we have not engaged in foreign currency hedging to
date, we may do so in the future.

                                      51

<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, 2000 and 2001 and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 2001. 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, 2000 and 2001, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended December 31, 2001, in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.

                                                    ERNST & YOUNG LLP

Seattle, Washington
February 4, 2002

                                      52

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

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

<TABLE>
<CAPTION>
                                                                                  December 31,
                                                                               ------------------
                                                                                 2000      2001
                                                                               --------  --------
<S>                                                                            <C>       <C>

                                           ASSETS

Current assets:
   Cash and cash equivalents.................................................. $ 13,837  $ 13,958
   Short-term investments.....................................................  101,278    99,785
   Trade accounts receivable, net.............................................   15,271     6,363
   Inventories, net...........................................................    7,026     4,413
   Prepaid expenses and other.................................................    3,178     4,000
                                                                               --------  --------
Total current assets..........................................................  140,590   128,519
Property and equipment, net...................................................    7,341     7,383
Goodwill, net.................................................................   33,947    26,601
Other intangibles, net and other assets.......................................   14,052    10,528
                                                                               --------  --------
Total assets.................................................................. $195,930  $173,031
                                                                               ========  ========

                            LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Accounts payable........................................................... $  7,256  $  4,032
   Accrued expenses...........................................................    4,395     4,986
   Deferred revenues..........................................................   11,874    15,709
                                                                               --------  --------
Total current liabilities.....................................................   23,525    24,727
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: 26,287,072 at December 31, 2000 and
         27,123,260 at December 31, 2001......................................       26        27
   Additional paid-in capital.................................................  230,591   231,533
   Deferred stock-based compensation..........................................  (12,387)   (1,357)
   Accumulated other comprehensive income (loss)..............................     (222)      681
   Accumulated deficit........................................................  (45,603)  (82,580)
                                                                               --------  --------
       Total stockholders' equity.............................................  172,405   148,304
                                                                               --------  --------
       Total liabilities and stockholders' equity............................. $195,930  $173,031
                                                                               ========  ========
</TABLE>

                            See accompanying notes.

                                      53

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

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

<TABLE>
<CAPTION>
                                                                           Year Ended December 31,
                                                                        ----------------------------
                                                                          1999      2000      2001
                                                                        --------  --------  --------
<S>                                                                     <C>       <C>       <C>
Revenues:
   Product............................................................. $ 17,329  $ 52,010  $ 46,893
   Service.............................................................    3,290     8,693    17,390
                                                                        --------  --------  --------
       Total revenues..................................................   20,619    60,703    64,283
Cost of revenues:
   Product.............................................................    6,954    18,932    20,658
   Service.............................................................    1,010     2,987     5,824
                                                                        --------  --------  --------
       Total cost of revenues..........................................    7,964    21,919    26,482
                                                                        --------  --------  --------
Gross margin...........................................................   12,655    38,784    37,801
Operating expenses:
   Sales and marketing (1).............................................   13,512    24,213    29,717
   Research and development (2)........................................    7,118    13,900    18,854
   General and administrative (3)......................................    3,646     6,001     7,726
   Stock-based compensation............................................      926     8,407     9,433
   Amortization of goodwill, purchased technology and other intangible
     assets acquired...................................................      245     3,828    10,942
   Acquired in-process technology......................................    3,381     4,399        --
   Restructuring charges...............................................       --        --     3,720
                                                                        --------  --------  --------
       Total operating expenses........................................   28,828    60,748    80,392
                                                                        --------  --------  --------
Operating loss.........................................................  (16,173)  (21,964)  (42,591)
Interest income, net...................................................      155     6,515     5,771
                                                                        --------  --------  --------
Loss before income taxes...............................................  (16,018)  (15,449)  (36,820)
Provision for income taxes.............................................       --       215       157
                                                                        --------  --------  --------
Net loss............................................................... $(16,018) $(15,664) $(36,977)
                                                                        ========  ========  ========
Basic and diluted net loss per share................................... $  (1.80) $  (0.66) $  (1.38)
                                                                        ========  ========  ========
Shares used in calculation of basic and diluted net loss per share.....    8,903    23,556    26,723
                                                                        ========  ========  ========
</TABLE>
--------
(1) Sales and marketing expenses exclude amortization of stock-based
    compensation of $307,000, $824,000 and $220,000 for 1999, 2000 and 2001,
    respectively.

(2) Research and development expenses exclude amortization of stock-based
    compensation of $491,000, $7,480,000 and $9,178,000 for 1999, 2000 and
    2001, respectively.

(3) General and administrative expenses exclude amortization of stock-based
    compensation of $128,000, $103,000 and $35,000 for 1999, 2000 and 2001,
    respectively.

                            See accompanying notes.

                                      54

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                       (In thousands, except share data)
<TABLE>
<CAPTION>


                                                                               Preferred Stock     Common Stock    Additional
                                                                              -----------------  -----------------  Paid-In
                                                                                Shares    Amount   Shares   Amount  Capital
                                                                              ----------  ------ ---------- ------ ----------
<S>                                                                           <C>         <C>    <C>        <C>    <C>
Balance, January 1, 1999.....................................................  6,712,658   $  6   1,362,744  $  1   $ 16,261
   Proceeds from issuance of common stock from initial public offering, net
    of offering costs........................................................         --     --   3,500,000     3     40,666
   Conversion of preferred stock into common stock........................... (6,712,658)    (6) 13,425,316    13         (7)
   Deferred stock-based compensation.........................................         --     --          --    --        162
   Issuance of common stock to an employee...................................         --     --      51,948    --        750
   Amortization of stock-based compensation..................................         --     --          --    --         --
   Issuance of common stock in connection with the BeadleNet acquisition.....         --     --     335,931    --      5,450
   Issuance of stock warrants................................................         --     --          --    --        195
   Exercise of common stock options and warrants.............................         --     --     835,813     2        217
   Comprehensive loss:
      Net unrealized loss on securities available for sale...................         --     --          --    --         --
      Net loss...............................................................         --     --          --    --         --

      Comprehensive loss.....................................................
                                                                              ----------   ----  ----------  ----   --------
Balance, December 31, 1999...................................................         --     --  19,511,752    19     63,694
   Proceeds from issuance of common stock from public offering, net of
    offering costs...........................................................         --     --   1,780,000     2     90,425
   Deferred stock-based compensation.........................................         --     --          --    --     19,342
   Amortization of stock-based compensation..................................         --     --          --    --         --
   Issuance of common stock in connection with the BeadleNet acquisition.....         --     --      20,189    --         --
   Issuance of common stock in connection with the Qiave acquisition.........         --     --   1,292,997     1     50,302
   Exercise of common stock options and warrants.............................         --     --   3,597,202     3      5,690
   Issuance of common stock in conjunction with the employee stock
    purchase program.........................................................         --     --      84,932     1      1,138
   Comprehensive loss:
      Net unrealized loss on securities available for sale...................         --     --          --    --         --
      Net loss...............................................................         --     --          --    --         --

      Comprehensive loss.....................................................
                                                                              ----------   ----  ----------  ----   --------
Balance, December 31, 2000...................................................         --     --  26,287,072    26    230,591
   Deferred stock-based compensation.........................................         --     --          --    --        213
   Stock compensation related to acceleration of option vesting..............         --     --          --    --        161
   Amortization of stock-based compensation..................................         --     --          --    --         --
   Adjustment to deferred stock-based compensation for options cancelled
    upon employee terminations...............................................         --     --          --    --     (1,392)
   Exercise of common stock options and warrants.............................         --     --     722,566     1        894
   Issuance of common stock in conjunction with the employee stock
    purchase program.........................................................         --     --     113,622    --      1,066
   Comprehensive loss:
      Net unrealized gain on securities available for sale...................         --     --          --    --         --
      Net loss...............................................................         --     --          --    --         --

      Comprehensive loss.....................................................
                                                                              ----------   ----  ----------  ----   --------
Balance, December 31, 2001...................................................         --   $ --  27,123,260  $ 27   $231,533
                                                                              ==========   ====  ==========  ====   ========
</TABLE>
<TABLE>
<CAPTION>

                                                                                            Accumulated
                                                                                Deferred       Other
                                                                              Stock-Based  Comprehensive Accumulated
                                                                              Compensation     Loss        Deficit
                                                                              ------------ ------------- -----------
<S>                                                                           <C>          <C>           <C>
Balance, January 1, 1999.....................................................   $ (1,466)      $  --      $(13,921)
   Proceeds from issuance of common stock from initial public offering, net
    of offering costs........................................................         --          --            --
   Conversion of preferred stock into common stock...........................         --          --            --
   Deferred stock-based compensation.........................................       (162)         --            --
   Issuance of common stock to an employee...................................       (750)         --            --
   Amortization of stock-based compensation..................................        926          --            --
   Issuance of common stock in connection with the BeadleNet acquisition.....         --          --            --
   Issuance of stock warrants................................................         --          --            --
   Exercise of common stock options and warrants.............................         --          --            --
   Comprehensive loss:
      Net unrealized loss on securities available for sale...................         --         (77)           --
      Net loss...............................................................         --          --       (16,018)

      Comprehensive loss.....................................................
                                                                                --------       -----      --------
Balance, December 31, 1999...................................................     (1,452)        (77)      (29,939)
   Proceeds from issuance of common stock from public offering, net of
    offering costs...........................................................         --          --            --
   Deferred stock-based compensation.........................................    (19,342)         --            --
   Amortization of stock-based compensation..................................      8,407          --            --
   Issuance of common stock in connection with the BeadleNet acquisition.....         --          --            --
   Issuance of common stock in connection with the Qiave acquisition.........         --          --            --
   Exercise of common stock options and warrants.............................         --          --            --
   Issuance of common stock in conjunction with the employee stock
    purchase program.........................................................         --          --            --
   Comprehensive loss:
      Net unrealized loss on securities available for sale...................         --        (145)           --
      Net loss...............................................................         --          --       (15,664)

      Comprehensive loss.....................................................
                                                                                --------       -----      --------
Balance, December 31, 2000...................................................    (12,387)       (222)      (45,603)
   Deferred stock-based compensation.........................................       (213)         --            --
   Stock compensation related to acceleration of option vesting..............                     --            --
   Amortization of stock-based compensation..................................      9,851          --            --
   Adjustment to deferred stock-based compensation for options cancelled
    upon employee terminations...............................................      1,392          --            --
   Exercise of common stock options and warrants.............................         --          --            --
   Issuance of common stock in conjunction with the employee stock
    purchase program.........................................................         --          --            --
   Comprehensive loss:
      Net unrealized gain on securities available for sale...................         --         903            --
      Net loss...............................................................         --          --       (36,977)

      Comprehensive loss.....................................................
                                                                                --------       -----      --------
Balance, December 31, 2001...................................................   $ (1,357)      $ 681      $ 82,580)
                                                                                ========       =====      ========
</TABLE>
<TABLE>
<CAPTION>


                                                                                  Total
                                                                              Stockholders'
                                                                                 Equity
                                                                              -------------
<S>                                                                           <C>
Balance, January 1, 1999.....................................................   $    881
   Proceeds from issuance of common stock from initial public offering, net
    of offering costs........................................................     40,669
   Conversion of preferred stock into common stock...........................         --
   Deferred stock-based compensation.........................................         --
   Issuance of common stock to an employee...................................         --
   Amortization of stock-based compensation..................................        926
   Issuance of common stock in connection with the BeadleNet acquisition.....      5,450
   Issuance of stock warrants................................................        195
   Exercise of common stock options and warrants.............................        219
   Comprehensive loss:
      Net unrealized loss on securities available for sale...................        (77)
      Net loss...............................................................    (16,018)
                                                                                --------
      Comprehensive loss.....................................................    (16,095)
                                                                                --------
Balance, December 31, 1999...................................................     32,245
   Proceeds from issuance of common stock from public offering, net of
    offering costs...........................................................     90,427
   Deferred stock-based compensation.........................................         --
   Amortization of stock-based compensation..................................      8,407
   Issuance of common stock in connection with the BeadleNet acquisition.....         --
   Issuance of common stock in connection with the Qiave acquisition.........     50,303
   Exercise of common stock options and warrants.............................      5,693
   Issuance of common stock in conjunction with the employee stock
    purchase program.........................................................      1,139
   Comprehensive loss:
      Net unrealized loss on securities available for sale...................       (145)
      Net loss...............................................................    (15,664)
                                                                                --------
      Comprehensive loss.....................................................    (15,809)
                                                                                --------
Balance, December 31, 2000...................................................    172,405
   Deferred stock-based compensation.........................................         --
   Stock compensation related to acceleration of option vesting..............        161
   Amortization of stock-based compensation..................................      9,851
   Adjustment to deferred stock-based compensation for options cancelled
    upon employee terminations...............................................         --
   Exercise of common stock options and warrants.............................        895
   Issuance of common stock in conjunction with the employee stock
    purchase program.........................................................      1,066
   Comprehensive loss:
      Net unrealized gain on securities available for sale...................        903
      Net loss...............................................................    (36,977)
                                                                                --------
      Comprehensive loss.....................................................    (36,074)
                                                                                --------
Balance, December 31, 2001...................................................   $148,304
                                                                                ========
</TABLE>

                            See accompanying notes.


                                      55

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (In thousands)

<TABLE>
<CAPTION>
                                                                                Year Ended December 31,
                                                                            ------------------------------
                                                                              1999      2000       2001
                                                                            --------  ---------  ---------
<S>                                                                         <C>       <C>        <C>
Operating activities:
Net loss................................................................... $(16,018) $ (15,664) $ (36,977)
Adjustments to reconcile net loss to net cash used in operating activities:
   Depreciation and amortization of property and equipment.................      602      1,400      2,233
   Amortization of goodwill and other intangible assets....................      259      3,828     10,945
   Amortization of stock-based compensation................................      926      8,407     10,012
   Acquired in-process technology..........................................    3,381      4,399         --
   Provision for bad debt expense..........................................      129        546        831
   Non-cash interest expense...............................................      195         --         --
   Changes in operating assets and liabilities:
       (Increase) decrease in accounts receivable..........................     (443)   (12,042)     8,077
       (Increase) decrease in inventories..................................      148     (5,013)     2,613
       (Increase) in prepaid expenses and other............................     (792)    (1,903)      (822)
       (Increase) decrease in other assets.................................       12        (43)       (75)
       Increase (decrease) in accounts payable and accrued expenses........    1,249      6,034     (2,633)
       Increase in deferred revenue........................................    2,392      7,641      3,835
Net cash used in operating activities......................................   (7,960)    (2,410)    (1,961)

Investing activities:
Purchases of equipment, furniture and other................................   (1,330)    (6,369)    (2,275)
Proceeds from sales of marketable securities...............................       --         --     61,907
Proceeds from maturities of marketable securities..........................    1,000     85,474    124,112
Purchases of marketable securities.........................................  (25,575)  (162,399)  (183,623)
Net cash (paid) acquired in connection with acquisitions...................   (4,106)       762         --
Net cash (used in) provided by investing activities........................  (30,011)   (82,532)       121

Financing activities:
Borrowings on line of credit, long-term debt and notes payable.............    7,280         --         --
Issuance of warrants.......................................................      195         --         --
Principal repayments on line of credit, long-term debt and notes payable...  (10,201)      (383)        --
Proceeds from sale of common stock, net of expenses........................   40,669     90,427         --
Proceeds from the exercise of common stock options and warrants and the
  sale of common stock through the employee stock purchase plan............      219      6,832      1,961
Net cash provided by financing activities..................................   38,162     96,876      1,961
Net increase in cash and cash equivalents..................................      191     11,934        121
Cash and cash equivalents at beginning of period...........................    1,712      1,903     13,837
Cash and cash equivalents at end of period................................. $  1,903  $  13,837  $  13,958
                                                                            ========  =========  =========

Supplemental disclosure of cash flow information:
Cash paid for interest..................................................... $    508  $      51  $      --
                                                                            ========  =========  =========
Adjustment to deferred stock-based compensation for options cancelled
  upon employee termination................................................ $     --  $      --  $   1,392
                                                                            ========  =========  =========
</TABLE>

                            See accompanying notes.

                                      56

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  Accounting Policies

Description of Business

   WatchGuard Technologies, Inc. (WatchGuard) is a leading provider of Internet
security solutions designed to protect enterprises that use the Internet for
e-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. In December 1999, the Securities and
Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) 101, "Revenue
Recognition in Financial Statements." SAB 101 summarizes certain of the SEC's
views in applying generally accepted accounting principles to revenue
recognition in financial statements. WatchGuard believes its current revenue
recognition policies and practices are consistent with the current accounting
standards.

   WatchGuard generates revenues primarily through sales of its Firebox and
ServerLock products, including related software licenses, and subscriptions for
its LiveSecurity Service, which includes access to technical support, software
updates, threat responses, expert editorials, support flashes, virus alerts and
interactive training. Software license revenues are generated from licensing
the rights to use WatchGuard's products directly to end-users, from sublicense
fees from resellers and distributors and from sales of its managed security
solution products to Internet service providers and other service providers
that utilize WatchGuard's products to provide managed security services to
their 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 and determinable, and vendor-specific
objective evidence of fair value for undelivered elements of the arrangement
has been established. Vendor-specific objective evidence is typically based on
the price charged when an element is sold separately or, if an element is 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 an estimated returns and allowances reserve for return
rights, pricing protection rights and promotional rebates for some of its
customers. A customer's return rights are generally limited to a percentage of
the customer's purchases for the previous quarter. Pricing protection rights,
if offered to customers, are generally limited to 60 to 90 days after
notification of a price change. The promotional rebates vary by type and term
and are earned by customers in accordance with various conditions. Revenues are
reduced by the provision for estimated returns and allowances at the time the
sales are made. Some of WatchGuard's distributors have unlimited stock return
and rotation rights. Revenues from these distribution arrangements are not
recognized until the distributors sell the products to their customer. Revenues
from LiveSecurity Service subscriptions are recognized ratably over the term of
the contract, typically one to two years. WatchGuard's payment terms typically
range from 30 to 60 days.

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.

                                      57

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Fair Values of Financial Instruments

   At December 31, 2001, WatchGuard had the following financial instruments:
cash and cash equivalents, short-term investments, accounts receivable,
accounts payable and accrued expenses. The carrying value of cash and cash
equivalents, accounts receivable, accounts payable and accrued expenses
approximates their fair value based on the liquidity of these financial
instruments or their short-term nature.

Cash Equivalents

   WatchGuard considers all highly liquid investments purchased with maturities
of three months or less at the date of purchase to be cash equivalents. Cash
equivalents are carried at fair market value. Cash equivalents consist of money
market funds.

Short-Term Investments

   WatchGuard's investments, consisting entirely of commercial paper and
corporate and government debt securities, 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 WatchGuard's
suppliers. WatchGuard receives some of its components from single-source
suppliers and relies on a limited number of hardware manufacturers. 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, Intangibles and Long-Lived Assets

   In accordance with Statement of Financial Accounting Standards (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 indicate that the assets
are impaired. To date, no such impairment with respect to WatchGuard's
intangible or other long-lived assets has been indicated. Should an impairment
occur, WatchGuard would measure the amount of the impairment based on
discounted future cash flows expected to result from the use and eventual
disposition of the impaired assets.

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

                                      58

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

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 WatchGuard's consolidated statements of operations.

Internal-Use Software

   Costs of software developed internally by WatchGuard for use in its
operations are accounted for under SOP 98-1, "Accounting for Costs of Corporate
Software Developed or Obtained for Internal Use." Under SOP 98-1, WatchGuard
expenses its costs of research and development of internal-use software,
including costs related to predevelopment efforts prior to establishing
technological feasibility and costs incurred for training and maintenance.
Software development costs 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
development stage were insignificant, no costs related to internal-use software
have been capitalized through December 31, 2001.

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 $234,000, $711,000 and $885,000 in 1999, 2000 and 2001,
respectively.

Concentration of Credit Risk

   WatchGuard is subject to concentrations of credit risk primarily from cash
investments and accounts receivable. WatchGuard's manages its credit risk by
investing its excess cash in a diverse portfolio of high-quality money market
instruments and short-term investments. 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 $10.3 million, $33.2 million and $35.8
million, or 50%, 55% and 56% of total revenues, for 1999, 2000 and 2001,
respectively. No foreign country accounted for more than 10% of revenues in
1990 or 2000. However, revenues from Japan accounted for 12% of total revenues
during 2001. No single customer accounted for more than 10% of revenues during
1999. During 2000 and 2001, two customers accounted for 22% and 24% of total
revenues, respectively. Geographic regions accounting for 10% or more of
revenues were the Americas with 54%, 49% and 47% of total revenues,
Europe/Middle East/Africa (EMEA) with 26%, 32% and 33% of total revenues, and
Asia Pacific (APAC) with 20%, 19% and 20% of total revenues, for 1999, 2000 and
2001, 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.

Stock-Based Compensation

   WatchGuard has elected to apply the disclosure-only provisions of SFAS No.
123, "Accounting for Stock-Based Compensation." Accordingly, WatchGuard
accounts for stock-based compensation using the intrinsic value method
prescribed in Accounting Principle Board (APB) Opinion No. 25, "Accounting for
Stock Issued to

                                      59

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

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 No. 123 is included in Note 4.

   Stock compensation expense for options or warrants granted to non-employees
has been determined in accordance with SFAS No. 123 and Emerging Issues Task
Force Issue No. 96-18, "Accounting for Equity Instruments with Variable Terms
that are Issued for Consideration other than Employee Services under FASB
statement No. 123, Accounting for Stock-Based Compensation," based on the fair
value of the equity instruments issued. The fair value of options granted to
non-employees is periodically measured 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 of future
recoverability.

Comprehensive Income (Loss)

   WatchGuard complies with SFAS No. 130, "Reporting Comprehensive Income,"
which establishes standards for reporting and displaying comprehensive income
and its components (revenues, expenses, gains and losses) in a full set of
general-purpose financial statements. WatchGuard's comprehensive loss includes
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. Significant estimates used in preparing the attached financial
statements relate to sales returns and allowances, provision for bad debt,
inventory reserves, restructuring reserves relating to abandoned facilities,
the useful lives of property and equipment and intangible assets, and deferred
tax valuation allowance.

Segment Information

   SFAS No. 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 9 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 July 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other
Intangible Assets." SFAS No. 141 requires business

                                      60

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

combinations completed after June 30, 2001 to be accounted for using the
purchase method of accounting, and broadens the criteria for recording
intangible assets separate from goodwill. Recorded goodwill and intangibles
will be evaluated against this new criteria and may result in certain
intangibles being subsumed into goodwill or, alternatively, amounts initially
recorded as goodwill may be separately identified and recognized apart from
goodwill. SFAS No. 142 requires that goodwill and other indefinite lived
intangibles no longer be amortized to earnings, but instead be reviewed for
impairment on an annual basis or on an interim basis if circumstances change or
if events occur that would reduce the fair value of a reporting unit below its
carrying value. Impairment losses will be charged to earnings in the period
they are determined. Separable intangible assets that do not have indefinite
lives will continue to be amortized over their useful lives. WatchGuard will
apply the provisions of SFAS No. 141 and SFAS No. 142 in the first quarter of
2002. Application of the new standards is expected to result in a
reclassification of the unamortized balance of an assembled workforce in the
amount of $390,000 to goodwill on January 1, 2002. This will result in a net
goodwill balance of $27.0 million (which will no longer be subject to
amortization but will be subject to evaluation for impairment) and a net
balance of other intangibles of $9.8 million (which will continue to be
amortized over their estimated useful lives of three to five years).
Amortization of goodwill will decrease as a result of the adoption of the
standards by $7.5 million in 2002. During the first six months of 2002,
WatchGuard will perform the required transitional impairment tests of goodwill
as of January 1, 2002. WatchGuard has not yet determined the effect of these
tests on its earnings and financial position.

   In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment
or Disposal of Long-Lived Assets," which is effective January 1, 2002. SFAS No.
144 supercedes SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets to be Disposed Of," and the accounting and reporting provisions relating
to the disposal of a segment of a business in APB Opinion No. 30. In accordance
with SFAS No. 144, the carrying value of intangible assets and other long-lived
assets is reviewed on a regular basis for the existence of facts or
circumstances, both internal and external, that may suggest impairment. To
date, no such impairment has been indicated. Should there be an impairment in
the future, WatchGuard will measure the amount of the impairment based on
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. WatchGuard
does not expect that the adoption of SFAS No. 144 will have a material effect
on its operating results or financial condition.

2.  Balance Sheet Account Detail

Trade Accounts Receivable, Net

   Trade accounts receivable, net consisted of the following (in thousands):


<TABLE>
<CAPTION>
                                                           December 31,
                                                        -----------------
                                                         2000      2001
                                                        -------  --------
      <S>                                               <C>      <C>
      Trade accounts receivable........................ $16,869  $  9,202
      Reserve for returns and allowances...............    (965)   (2,046)
      Allowance for uncollectible accounts.............    (633)     (793)
                                                        -------  --------
                                                        $15,271  $  6,363
                                                        =======  ========
</TABLE>

                                      61

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Inventories, Net

   Inventories, net consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                           December 31,
                                                        -----------------
                                                         2000      2001
                                                        -------  --------
      <S>                                               <C>      <C>
      Finished goods................................... $ 4,077  $  4,015
      Components.......................................   3,394       746
                                                        -------  --------
                                                          7,471     4,761
      Inventory reserves...............................    (445)     (348)
                                                        $ 7,026  $  4,413
                                                        =======  ========
</TABLE>

Property and Equipment, Net

   Property and equipment, net consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                         December 31,
                                                      -----------------
                                                       2000      2001
                                                      -------  --------
       <S>                                            <C>      <C>
       Computer equipment............................ $ 3,274  $  4,403
       Leasehold improvements........................   2,682     2,587
       Furniture and equipment.......................   2,458     2,721
       Software......................................     963     1,894
                                                      -------  --------
                                                        9,377    11,605
       Less accumulated depreciation and amortization  (2,036)   (4,222)
                                                      $ 7,341  $  7,383
                                                      =======  ========
</TABLE>

Goodwill, Net

   Goodwill, net, consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                        December 31,
                                                     -----------------
                                                      2000      2001
                                                     -------  --------
        <S>                                          <C>      <C>
        Goodwill.................................... $36,692  $ 36,692
        Less accumulated amortization...............  (2,745)  (10,091)
                                                     -------  --------
                                                     $33,947  $ 26,601
                                                     =======  ========
</TABLE>

Other Intangibles, Net and Other Assets

   Other intangibles, net and other assets consisted of the following (in
thousands):

<TABLE>
<CAPTION>
                                                          December 31,
                                                        ----------------
                                                         2000     2001
                                                        -------  -------
      <S>                                               <C>      <C>
      Other intangibles................................ $15,256  $15,084
      Less accumulated amortization....................  (1,505)  (4,932)
                                                        -------  -------
      Other intangibles, net...........................  13,751   10,152
      Other assets.....................................     301      376
                                                        -------  -------
                                                        $14,052  $10,528
                                                        =======  =======
</TABLE>

                                      62

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Accrued Expenses

   Accrued expenses consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                          December 31,
                                                          -------------
                                                           2000   2001
                                                          ------ ------
        <S>                                               <C>    <C>
        Accrued payroll-related expenses................. $2,235 $1,395
        Accrued restructuring costs......................     --  1,486
        Other............................................  2,160  2,105
                                                          ------ ------
                                                          $4,395 $4,986
                                                          ====== ======
</TABLE>

3.  Short-Term Investments

   Short-term investments consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                      Gross      Gross
                                            Market  Unrealized Unrealized Amortized
                                            Value     Gains      Losses     Cost
                                           -------- ---------- ---------- ---------
<S>                                        <C>      <C>        <C>        <C>
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
                                           ========    ====      =====    ========

Balance at December 31, 2001:
   Commercial paper....................... $  3,000    $ --      $  --    $  3,000
   Corporate debt securities..............   47,772     442        (22)     47,352
   U.S. government and agency obligations.   49,013     293        (32)     48,752
                                           --------    ----      -----    --------
                                           $ 99,785    $735      $ (54)   $ 99,104
                                           ========    ====      =====    ========
</TABLE>

   The contractual maturities of WatchGuard's available-for-sale securities as
of December 31, 2001 are as follows (in thousands):

<TABLE>
<CAPTION>
                                                       Estimated
                                                         Fair
                                                        Market   Amortized
                                                         Value     Cost
                                                       --------- ---------
     <S>                                               <C>       <C>
     Due in one year or less..........................  $48,137   $47,974
     Due in one year through two years................   51,648    51,130
                                                        -------   -------
                                                        $99,785   $99,104
                                                        =======   =======
</TABLE>

   At December 31, 2001, short-term investments were restricted by a $3.0
million unconditional letter of credit issued to WatchGuard's landlord in
conjunction with a facilities lease.

                                      63

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


4.  Stockholders' Equity

Preferred Stock

   All of WatchGuard's outstanding preferred stock was converted to common
stock at the close of WatchGuard's initial public offering in July 1999. The
following is a summary of terms and conditions for each series of preferred
stock before its conversion:

<TABLE>
<CAPTION>
                                                       Approximate
                                                        Aggregate      Annual
                           Shares     Shares    Stated Liquidation Dividend 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 in
its initial public offering, at a 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 outstanding 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 grant 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 provided for a 900,000-share increase in the number of shares
authorized for grant 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 least of (a) 750,000 shares, (b) 3% of the
average number of common shares outstanding used to calculate fully diluted
earnings per share as reported in WatchGuard's annual financial statements for
the preceding year and (c) an amount determined by the board of directors. As
of December 31, 2001, WatchGuard had reserved 9,608,766 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,
2001, WatchGuard had reserved 8,000,000 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
options granted on the date of hire generally vest at the 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

                                      64

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

of hire generally vest at the rate of 2.08% every month, commencing one month
from the date of grant. Stock options granted under both the 1996 Plan and the
2000 Plan have a term of ten years.

   In October 2000, WatchGuard acquired Qiave Technologies Corporation. Under
the terms and conditions of the acquisition, the Qiave Technologies Corporation
2000 Stock Option Plan (the Qiave Plan) was assumed by WatchGuard and all
options to purchase shares of Qiave common stock outstanding at the effective
time of the acquisition converted into options to purchase an aggregate of
100,856 shares of WatchGuard common stock (see Note 10) granted under the Qiave
Plan.

   The following table summarizes WatchGuard's stock option activity for all of
its stock option plans during 1999, 2000 and 2001:

<TABLE>
<CAPTION>
                                              1999                 2000                 2001
                                       ------------------- -------------------- --------------------
                                                  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........ 5,145,268   $ 0.16   6,502,680   $ 4.60   5,992,419   $29.27
Granted............................... 2,248,314    13.26   3,506,656    46.24   4,367,750    11.82
Exercised.............................  (774,563)    0.09  (3,375,551)    1.69    (722,566)    1.23
Canceled..............................  (116,339)    5.67    (641,366)   17.15  (4,637,661)   35.01
                                       ---------           ----------           ----------
Balance at end of period.............. 6,502,680     4.60   5,992,419    29.27   4,999,942    12.75
                                       =========           ==========           ==========
Exercisable at end of period.......... 2,359,707            1,071,510            1,339,509
Shares of common stock available for
  grant...............................                                           7,004,485
Weighted average fair value of options
  granted during the period
Granted at fair value................. 2,086,314     9.59   3,405,800    42.32   4,367,750    10.53
Granted below fair value..............   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,
2001 under all of WatchGuard's stock option plans for selected exercise price
ranges is as follows:

<TABLE>
<CAPTION>
                                 Options Outstanding  Options Exercisable
                                 -------------------- -------------------
                                  Weighted
                                   Average
                                  Remaining  Weighted            Weighted
                                 Contractual Average             Average
                                  Life (in   Exercise            Exercise
       Exercise Prices  Shares     years)     Price     Shares    Price
       --------------- --------- ----------- -------- ---------  --------
       <S>             <C>       <C>         <C>      <C>        <C>
       $ 0.03 -  0.55    357,182    4.31      $ 0.24    305,376   $ 0.21
       $ 1.13 -  7.41    361,457    8.63        5.57    101,732     3.77
       $ 7.48 - 12.21  1,880,500    9.61        9.92      6,413    10.50
       $12.53 - 18.53  2,046,485    8.37       13.93    780,631    13.73
       $19.53 - 29.18     71,860    8.11       27.61     31,482    27.85
       $29.81 - 40.09    117,250    8.89       32.36     39,032    32.47
       $44.81 - 53.34    165,208    8.62       52.75     74,843    52.90
                       ---------                      ---------
                       4,999,942    8.58      $12.75  1,339,509   $12.94
                       =========                      =========
</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 WatchGuard's consolidated

                                      65

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

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.

   Deferred stock-based compensation of $162,000 related to stock option grants
was recorded in 1999. Also, 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.

   In 2000, WatchGuard recorded $19.3 million in deferred stock-based
compensation in connection with the acquisition of Qiave (see Note 10), $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 under 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 10). At December 31, 2001, 74,186 of these shares remained
subject to repurchase.

   In 2001, WatchGuard recorded $213,000 of deferred stock-based compensation
related to 20,000 option shares granted to one consultant and 12,000 option
shares granted to other consultants. Final measurement of the fair value of
these options will not occur until the options are fully vested in 2002 and
2005, respectively. Also, in 2001, WatchGuard recognized stock compensation of
$161,000 when it accelerated vesting provisions of an employee's stock option
on his termination of employment in connection with the April 2001
restructuring.

   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 term of the related employment
agreements. Amortization of deferred stock-based compensation of $926,000 and
$8.4 million was recognized for the years ended December 31, 1999 and 2000,
respectively. Amortization of deferred stock-based compensation was $9.9
million in 2001, including $418,000 charged to restructuring related to the
acceleration of the vesting of options and the release of restricted shares on
termination of individuals in connection with the restructuring and $166,000
for the amortization of deferred stock-based compensation on options issued to
consultants during 2001. In addition, approximately $1.4 million of deferred
stock compensation was reversed in 2001 due to cancellation of options prior to
vesting. Amortization of deferred stock-based compensation to employees will be
$1.2 million in 2002, $91,000 in 2003 and $7,000 in 2004.

Stock Option Exchange Program

   On August 1, 2001, WatchGuard cancelled options to purchase 2,106,347 shares
of WatchGuard common stock with exercise prices ranging from $14.47 to $100.19
per share. In exchange, in February 2002, WatchGuard granted options to
purchase 1,833,303 shares of WatchGuard common stock with exercise prices equal
to $6.1255 per share, the then fair market value of the underlying common
stock. Each replacement option vested and was exercisable substantially to the
same degree as the original option.

Common Stock Warrants

   During 1999 and 2000, certain warrants were exercised for the purchase of
30,000 and 15,000 shares of common stock, respectively, at exercise prices
ranging from $0.03 per share to $0.13 per share. In 2000, a warrant holder
exercised a warrant to purchase 200,000 shares of common stock at an exercise
price of $0.39 per share on a net exercise basis, resulting in the issuance of
198,446 shares of common stock.

   At December 31, 2001, WatchGuard had no warrants outstanding.

                                      66

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


1999 Employee Stock Purchase Plan

   The 1999 Employee Stock Purchase Plan (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 equal to the least of (a) 400,000 shares, (b)
1.5% of the average number of common shares outstanding used to calculate fully
diluted earnings per share as reported in WatchGuard's annual financial
statements for the preceding year and (c) an amount determined by the board of
directors.

   A total of 84,932 and 113,622 shares of common stock were purchased by
WatchGuard employees under the ESPP during 2000 and 2001, respectively. At
December 31, 2001, WatchGuard had a total of 888,337 shares of common stock
reserved for future issuance under the ESPP.

Pro Forma Disclosures Under SFAS 123

   The following pro forma information regarding stock-based compensation has
been determined as if WatchGuard had accounted for its employee stock options
and ESPP under the fair market value method of SFAS No. 123. The fair value of
the employee stock 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 of 4.9%, 6% and 4% in 1999, 2000 and 2001,
respectively; 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, volatility of 1.36 during 2000 and
volatility of 1.14 during 2001. For purposes of pro forma disclosures, the
estimated fair value of the options is amortized over the options' vesting
periods.

   Pro forma disclosures are not representative of future results. WatchGuard's
pro forma information is as follows (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                     Year Ended December 31,
                                                  ----------------------------
                                                    1999      2000      2001
                                                  --------  --------  --------
<S>                                               <C>       <C>       <C>
Net loss--as reported............................ $(16,018) $(15,664) $(36,977)
Net loss--pro forma..............................  (19,837)  (55,120)  (49,506)
Net loss per share--as reported..................    (1.80)    (0.66)    (1.38)
Net loss per share--pro forma....................    (2.23)    (2.34)    (1.85)
</TABLE>

Common Shares Reserved

   At December 31, 2001, common stock reserved for future issuance was as
follows:

<TABLE>
              <S>                                      <C>
              Outstanding stock options...............  4,999,942
              Stock options available for future grant  7,004,485
              ESPP....................................    888,337
                                                       ----------
                                                       12,892,764
                                                       ==========
</TABLE>

5.  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. Options to
purchase 6,502,680, 5,992,419 and 4,999,942 shares of common stock in 1999,
2000 and 2001, respectively, warrants to purchase 225,000 shares of common
stock in

                                      67

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

1999, and common stock subject to repurchase of 250,079 shares and 74,186
shares in 2000 and 2001, respectively, were excluded from the computation of
basic and diluted net loss per common share, as their effect is antidilutive.

6.  Income Taxes

   At December 31, 2001, WatchGuard had a net operating loss carryforward for
federal tax purposes of approximately $145.9 million and research and
development tax credit carryforwards of $1.8 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 $105.3 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,
                                                       ------------------
                                                         2000      2001
                                                       --------  --------
     <S>                                               <C>       <C>
     Deferred tax assets:
        Net operating loss carryforwards.............. $ 42,867  $ 51,138
        Acquisition intangibles.......................    1,484     1,818
        Research and development tax credit...........    1,171     1,822
        Sales reserve and allowance for bad debts.....      858     1,102
        Accrued expenses and other....................      527       641
     Total deferred tax assets........................   46,907    56,521
     Valuation allowance..............................  (46,907)  (56,521)
                                                       --------  --------
     Net deferred taxes............................... $     --  $     --
                                                       ========  ========
</TABLE>

   WatchGuard's valuation allowance increased by $36.7 million in 2000 and $9.6
million in 2001.

                                      68

<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
(dollars in thousands):


<TABLE>
<CAPTION>
                                                                   December 31,
-                                              ---------------------------------------------------
                                               1999 Tax Effected 2000 Tax Effected 2001 Tax Effected
                                               ---------------   ---------------   ---------------
                                                Amount   Rate     Amount   Rate     Amount   Rate
                                               --------  -----   --------  -----   --------  -----
<S>                                            <C>       <C>     <C>       <C>     <C>       <C>
Net loss before taxes......................... $(16,018)         $(15,449)         $(36,820)
                                               ========          ========          ========
Expected tax benefit at federal statutory rate   (5,446)  34.0 %   (5,253)  34.0 %  (12,519)  34.0 %
Research and development credit...............     (359)   2.2       (602)   3.9       (602)   1.7
Permanent differences, including non-
  deductible acquisition costs................       48   (0.3)     5,160  (33.4)     5,990  (16.9)
Tax benefit not recognized due to valuation
  allowance...................................    5,757  (35.9)       695   (4.5)     7,131  (18.8)
Alternative minimum tax.......................       --     --         36   (0.2)        --     --
Foreign tax expense...........................       --     --        179   (1.2)       157   (0.4)
                                               --------  -----   --------  -----   --------  -----
Total tax expense............................. $     --    0.0 % $    215   (1.4)% $    157   (0.4)%
                                               ========  =====   ========  =====   ========  =====
</TABLE>

7.  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.

8.  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 September 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, in addition to leases
for other sales offices under operating leases or other lease obligations that
expire over various terms. Future minimum payments at December 31, 2001 under
these leases, net of future minimum rentals of $388,000 to be received under
subleases in 2002, are as follows (in thousands):

<TABLE>
                     <S>                           <C>
                     2002......................... $ 2,966
                     2003.........................   3,457
                     2004.........................   3,465
                     2005.........................   3,415
                     2006.........................   3,052
                     Thereafter...................  11,747
                                                   -------
                                                   $28,102
                                                   =======
</TABLE>

   Rent expense for 1999, 2000 and 2001 was $512,000, $1.5 million and $2.8
million, respectively.

   In addition to the foregoing lease commitments, WatchGuard is a party to
several noncancelable/non-refundable agreements to purchase inventory in 2002.
The total of these commitments was $2.2 million at December 31, 2001.
WatchGuard is also a party to a product royalty agreement with a total
commitment of $1.1 million at December 31, 2001.

                                      69

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


9.  Geographical 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. WatchGuard categorizes revenues into three geographic regions, as
shown in the table below. Revenue information by geographic region is as
follows (dollars in thousands):

<TABLE>
<CAPTION>
                                           Year Ended December 31,
      -                             -------------------------------------
                                        1999         2000         2001
                                    -----------  -----------  -----------
      <S>                           <C>     <C>  <C>     <C>  <C>     <C>
      Americas..................... $11,192  54% $29,710  49% $30,171  47%
      EMEA.........................   5,406  26   19,267  32   21,414  33
      APAC.........................   4,021  20   11,726  19   12,698  20
                                    ------- ---  ------- ---  ------- ---
      Total........................ $20,619 100% $60,703 100% $64,283 100%
                                    ======= ===  ======= ===  ======= ===
</TABLE>

   Revenue information for countries representing more than 10% of total
revenues is as follows (dollars in thousands):

<TABLE>
               <S>           <C>     <C> <C>     <C> <C>     <C>
                                   Year Ended December 31,
               -             ----------------------------------
                                1999        2000        2001
                             ----------  ----------  ----------
               United States $10,303 50% $27,503 45% $28,473 44%
               Japan........          *           *    7,572 12
</TABLE>
--------
* Less than 10%

10.  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
with a fair value of $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 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 as follows (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....................................................  45,650
Acquired in-process research and development................................   4,399
                                                                             -------
       Total purchase price.................................................  50,703
Deferred stock-based compensation...........................................  19,342
                                                                             -------
       Total consideration, including deferred stock-based compensation..... $70,045
                                                                             =======
</TABLE>

                                      70

<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.

   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.

   Acquired in-process research and development.  Values assigned to 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 $4.4 million
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 global 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.

   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 (in
thousands):

<TABLE>
<CAPTION>
                                                           December 31,
                                                               2000
                                                           ------------
         <S>                                               <C>
         Total revenues, net..............................   $ 60,703
         Net loss.........................................   $(29,536)
         Pro forma net loss per share.....................   $  (1.21)
</TABLE>

                                      71

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   Deferred stock-based compensation.  In connection with 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 acquisition agreement are subject to repurchase and are being
released from the repurchase restriction over a two-year vesting period. The
value of these shares 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. 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. Deferred stock-based compensation
originating from the assumption of Qiave stock options was $4.3 million.

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, 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 (a)
$3.4 million in cash paid at closing, including $1.0 million paid to PEP in
satisfaction of BeadleNet's outstanding liabilities to PEP; (b) 335,931
unregistered shares of WatchGuard common stock with a fair value of $4.9
million, issued at closing; (c) 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 payable
upon completion of specified technology items in late December 1999 and was
paid in January 2000; and (4) direct acquisition costs of $300,000.

   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>

   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.

                                      72

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   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 and 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 IPR&D. WatchGuard anticipated that an additional $260,000 would
be spent developing the technology to complete the IPR&D. 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 of the projection. Projected annual revenue
ranged from approximately $6.0 million to over $18.0 million over the term of
the projection. These projections were based on aggregate revenue growth rates
for the business as a whole, anticipated growth rates for the global 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.

   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.

                                      73

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   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 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, except per share amount):

<TABLE>
<CAPTION>
                                                      December 31,
                                                          1999
                                                      ------------
              <S>                                     <C>
              Total revenues, net....................   $ 20,619
              Net loss...............................   $(15,707)
              Pro forma net loss per share...........   $  (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 a share of WatchGuard
common 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 was
recorded as deferred stock compensation expense and was being amortized over
the two-year employment agreement period. Under the stock vesting agreement, up
to 34,632 of these shares were subject to forfeiture if Mr. Beadle's employment
was terminated for cause or if he resigned before October 19, 2001. In
connection with the April 2001 restructuring, Mr. Beadle's employment was
terminated and the restriction on the remaining shares was lifted. As a result,
the remaining deferred stock compensation in the amount of $208,000 was
recognized as a restructuring cost.

11.  Business Restructuring

   In April 2001, WatchGuard announced a restructuring plan designed to
streamline operations and reduce operating costs. This restructuring plan
included a reduction in workforce and a consolidation of excess facilities, in
addition to other cost-saving strategies. As part of the restructuring plan,
WatchGuard exited the consumer security market and terminated various original
equipment manufacturer agreements to develop product and services for that
market, and streamlined operations in support of new products and services
aimed at business customers. As a result of this restructuring, WatchGuard
recorded a $2.9 million restructuring charge during the second quarter of 2001
and an $820,000 restructuring charge during the fourth quarter of 2001. The
additional restructuring costs recorded in the fourth quarter of 2001 relate to
revised estimates of the costs associated with the consolidation and sublease
of excess facilities. The total restructuring charge of $3.7 million for 2001
included the following (in thousands):

<TABLE>
<CAPTION>
                                                                   December 31,
                                        Restructuring              2001 Accrued
                                           Charges    Amounts Paid Restructuring
                                           in 2001     or Charged     Balance
                                        ------------- ------------ -------------
<S>                                     <C>           <C>          <C>
Severance and termination benefits.....    $1,015        $1,015       $   --
Stock-based compensation...............       579           579           --
Abandoned facilities and other.........     2,126           640        1,486
                                           ------        ------       ------
   Total...............................    $3,720        $2,234       $1,486
                                           ======        ======       ======
</TABLE>

                                      74

<PAGE>

                         WATCHGUARD TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   As part of the reorganization, WatchGuard implemented a workforce reduction
of 50 employees, which represented approximately 16% of WatchGuard's employee
base at that time and included employees from all of WatchGuard's functional
areas. All such employees were terminated prior to June 30, 2001. Other
expenses associated with the reorganization consisted of stock-based
compensation expense associated with the acceleration of vesting stock subject
to repurchase and stock options held by terminated employees, the
discontinuation of the consumer security market products and the abandonment of
facilities and equipment. Costs that related to ongoing operations are not
included as restructuring charges. All restructuring charges have been paid as
of December 31, 2001, except for accrued amounts related to losses for the
lease buyout or sublease of abandoned facilities of approximately $1.5 million
at December 31, 2001, which are expected to be realized through September 2006.
Revenues recorded from the consumer security market were insignificant prior to
the restructuring.

12.  Related-Party Transactions

   Danny M. Beadle, WatchGuard's former 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. After the acquisition of
BeadleNet, PEP provided various products and services to WatchGuard through the
first quarter of 2001. Primarily, PEP supplied products for sale (including
purchasing, producing and assembling products) and provided 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, 2000 and 2001 were $448,000, $457,000 and $4,000, respectively,
and total amounts due PEP at December 31, 2000 and 2001 were $44,000 and $0,
respectively.

13.  Subsequent Event (unaudited)

Agreement to Acquire RapidStream, Inc.

   In February 2002, WatchGuard signed an agreement to acquire RapidStream,
Inc., a privately held provider of high performance, ASIC-based firewall and
virtual private network appliances, for approximately $48.0 million. Under the
terms of the agreement, WatchGuard expects to acquire RapidStream for a
consideration of approximately $17.0 million in cash and approximately $31.0
million in stock. In addition, WatchGuard will assume all outstanding options
to purchase common stock of RapidStream, with the exercise price and number of
shares subject to each assumed option to be adjusted according to the exchange
ratio for the merger. The number of shares of WatchGuard common stock issuable
in the transaction would be based on the 20-trading-day average of WatchGuard's
stock price ending two trading days before the closing of the transaction. The
cash portion of the consideration may be increased up to a maximum of $24.0
million, with a proportionate decrease in the stock portion of the
consideration, should the amount of stock required to be issued in the
transaction exceed 19.9% of the total number of shares of WatchGuard common
stock outstanding on the business day immediately preceding the closing date of
the merger. The acquisition is subject to RapidStream shareholder approval and
other customary conditions to closing. The transaction is expected to close
early in the second quarter of 2002. Each of WatchGuard and RapidStream has
agreed to pay a termination fee of $1.5 million under certain customary
circumstances.

                                      75

<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   Costs or   Accounts  Deductions    End of
              Description                of Period   Expenses  --Describe --Describe    Period
---------------------------------------  ---------- ---------- ---------- ----------  ----------
<S>                                      <C>        <C>        <C>        <C>         <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      $  546     $  --      $   90(A)   $  633
   Sales return reserve.................   $ 550      $1,932     $  --      $1,517(B)   $  965
   Inventory reserve....................   $  69      $  430     $  --      $   54(C)   $  445

Year ended December 31, 2001
   Allowance for uncollectible accounts.   $ 633      $  831     $  --      $  671(A)   $  793
   Sales return reserve.................   $ 965      $6,924     $  --      $5,845(B)   $2,046
   Inventory reserve....................   $ 445      $1,291     $  --      $1,388(C)   $  348
</TABLE>
--------
(A) Deductions consist of write-offs of uncollectible accounts.

(B) Deductions consist of product returns and price protection allowances.

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

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

   None.

                                      76

<PAGE>

                                   PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

   (a) The information regarding our directors required by this item is
incorporated into this annual report by reference to the section entitled
"Election of Directors" in the proxy statement for our annual meeting of
stockholders to be held on May 23, 2002.

   (b) The information regarding our executive officers required by this item
is incorporated into this annual report by reference to the section entitled
"Executive Officers" in the proxy statement for our annual meeting of
stockholders to be held on May 23, 2002.

   We will file the proxy statement for our 2002 annual meeting of stockholders
within 120 days of December 31, 2001, our fiscal year end.

ITEM 11.  EXECUTIVE COMPENSATION

   The information regarding executive compensation required by this item is
incorporated into this annual report by reference to the section entitled
"Executive Compensation" in the proxy statement for our annual meeting of
stockholders to be held on May 23, 2002. We will file the proxy statement for
our 2002 annual meeting of stockholders within 120 days of December 31, 2001,
our fiscal year end.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

   The information regarding beneficial ownership of our common stock required
by this item is incorporated into this annual report by reference to the
section entitled "Principal Stockholders" in the proxy statement for our annual
meeting of stockholders to be held on May 23, 2002. We will file the proxy
statement within 120 days of December 31, 2001, our fiscal year end.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   The information regarding certain relationships and related transactions
required by this item is incorporated into this annual report by reference to
the section entitled "Certain Relationships and Related Transactions" in the
proxy statement for our annual meeting of stockholders to be held on May 23,
2002. We will file the proxy statement within 120 days of December 31, 2001,
our fiscal year-end.

                                      77

<PAGE>

                                    PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM-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....................  52
   Consolidated Balance Sheets..........................................  53
   Consolidated Statements of Operations................................  54
   Consolidated Statements of Stockholders' Equity......................  55
   Consolidated Statements of Cash Flows................................  56
   Notes to Consolidated Financial Statements...........................  57
</TABLE>

(2) Index to Financial Statement Schedules

   Schedule II--Valuation and Qualifying Accounts for each of the three years
ended December 31, 2001, 2000 and 1999.

   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 February 6, 2002, among River Acquisition Corp.,
       RapidStream, Inc., the registrant, and for purposes of Section 6.16 only, certain management
       shareholders of RapidStream, Inc. (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   1996 Stock Incentive Compensation Plan (Exhibit 10.6) (B)

10.3   2000 Stock Option Plan (Exhibit 10.1) (D)

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

10.5   1999 Employee Stock Purchase Plan (Exhibit 10.10) (B)

10.6   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)

10.7   Shareholders Agreement, dated as of February 6, 2002, by and among River Acquisition Corp.,
       RapidStream, Inc., certain shareholders of RapidStream, Inc. and the registrant (Exhibit 10.1) (A)

10.8   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) (F)

10.9   Employment Agreement between Jim Cady and WatchGuard Technologies, Inc. dated July 1, 2001
       (Exhibit 10.1) (G)

21.1   Subsidiaries of the registrant

23.1   Consent of Ernst & Young LLP, independent auditors
</TABLE>

                                      78

<PAGE>

--------
 +  Portions of this exhibit have been omitted based on a request for
    confidential treatment filed with the SEC. The omitted portions of the
    exhibits have been filed separately with the SEC.

(A) Incorporated by reference to the specified exhibit to the registrant's
    Current Report on Form 8-K (File No. 000-26819), filed with the SEC on
    February 15, 2002.

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

(D) Incorporated by reference to the specified exhibit to the registrant's
    Quarterly Report on Form 10-Q for the quarter ended March 31, 2001 (File
    No. 000-26819), filed with the SEC on May 15, 2001.

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

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

(G) Incorporated by reference to the specified exhibit to the registrant's
    Quarterly Report on Form 10-Q for the quarter ended June 30, 2001 (File No.
    000-26819), filed with the SEC on August 13, 2001.

(b) Reports on Form 8-K

   None.

                                      79

<PAGE>

                                  SIGNATURES

   Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized, in the
city of Seattle, state of Washington, on March 28, 2002.

                                               WATCHGUARD TECHNOLOGIES, INC.

                                               By:      /S/  JAMES A. CADY
                                                   -----------------------------
                                                           James A. Cady
                                                   President and Chief Executive
                                                              Officer

                               POWER OF ATTORNEY

   Each person whose individual signature appears below hereby authorizes and
appoints James A. Cady and Steven N. Moore, and each of them, with full power
of substitution and resubstitution and full power to act without the other, as
his true and lawful attorney-in-fact and agent to act in his name, place and
stead and to execute in the name and on behalf of each person, individually and
in each capacity stated below, and to file, any and all amendments to this
report, and to file the same, with all exhibits thereto, and other documents in
connection therewith, with the Securities and Exchange Commission, granting
unto said attorneys-in-fact and agents, and each of them, full power and
authority to do and perform each and every act and thing, ratifying and
confirming all that said attorneys-in-fact and agents or any of them or their
or his substitute or substitutes may lawfully do or cause to be done by virtue
thereof.

   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.

          Signature                       Title                  Date
          ---------                       -----                  ----

     /S/  JAMES A. CADY       President, Chief Executive    March 28, 2002
-----------------------------   Officer and Director
        James A. Cady           (Principal Executive
                                Officer)

  /S/  MICHAEL E. MCCONNELL   Senior Vice President, Chief  March 28, 2002
-----------------------------   Financial Officer and
    Michael E. McConnell        Treasurer (Principal
                                Financial and Accounting
                                Officer)

   /S/  MICHAEL R. HALLMAN    Director                      March 28, 2002
-----------------------------
     Michael R. Hallman

    /S/  STEVEN N. MOORE      Director                      March 28, 2002
-----------------------------
       Steven N. Moore

  /S/  CHRISTOPHER G. SLATT   Chairman of the Board         March 28, 2002
-----------------------------
    Christopher G. Slatt

   /S/  ANDREW W. VERHALEN    Director                      March 28, 2002
-----------------------------
     Andrew W. Verhalen

 /S/  CHARLES P. WAITE, JR.   Director                      March 28, 2002
-----------------------------
    Charles P. Waite, Jr.


                                      80

<PAGE>

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
Number                                            Description
------                                            -----------
<C>    <S>
 2.1+  Agreement and Plan of Merger dated as of February 6, 2002, among River Acquisition Corp.,
       RapidStream, Inc., the registrant, and for purposes of Section 6.16 only, certain management
       shareholders of RapidStream, Inc. (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   1996 Stock Incentive Compensation Plan (Exhibit 10.6) (B)

10.3   2000 Stock Option Plan (Exhibit 10.1) (D)

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

10.5   1999 Employee Stock Purchase Plan (Exhibit 10.10) (B)

10.6   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)

10.7   Shareholders Agreement, dated as of February 6, 2002, by and among River Acquisition Corp.,
       RapidStream, Inc., certain shareholders of RapidStream, Inc. and the registrant (Exhibit 10.1) (A)

10.8   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) (F)

10.9   Employment Agreement between Jim Cady and WatchGuard Technologies, Inc. dated July 1, 2001
       (Exhibit 10.1) (G)

21.1   Subsidiaries of the registrant

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

(A) Incorporated by reference to the specified exhibit to the registrant's
    Current Report on Form 8-K (File No. 000-26819), filed with the SEC on
    February 15, 2002.

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

(D) Incorporated by reference to the specified exhibit to the registrant's
    Quarterly Report on Form 10-Q for the quarter ended March 31, 2001 (File
    No. 000-26819), filed with the SEC on May 15, 2001.

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

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

(G) Incorporated by reference to the specified exhibit to the registrant's
    Quarterly Report on Form 10-Q for the quarter ended June 30, 2001 (File No.
    000-26819), filed with the SEC on August 13, 2001.