**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

**x**   ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended December 31, 2005**

**OR**

**o**   TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe Transition Period from        to      **

**CommissionFile Number 000-30093**

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**Websense, Inc.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                    |   | **51-0380839**                         |
|-----------------------------------------------------------------|--------|----------------------------------------|
| (State or other jurisdiction

of incorporation or organization) |   | (I.R.S.Employer Identification Number) |

 

**10240 Sorrento Valley RoadSan Diego, California 92121858-320-8000**

(Address of principalexecutive offices, zip code and telephone number)

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Securities registeredpursuant to Section 12(b) of the Act: None

Securities registeredpursuant to Section 12(g) of the Act: Common Stock $0.01 par value (Title of class)

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.   Yes x  No o

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.   Yes o  No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.   (1) Yes x  No o   (2) Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K.   o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer (each as defined in Exchange Act Rule 12(b)-2):   Largeaccelerated filer x Accelerated filer o Non-accelerated filer o

Indicate by check markwhether the registrant is a shell company (as defined in the Rule 12b-2of the Act):   Yes o  No x

The aggregate market valueof the voting stock held by non-affiliates of the registrant, as of June 30,2005 was approximately $1,035 million (based on the closing price for shares ofthe registrant’s Common Stock as reported by the Nasdaq National Market forthat date). Shares of Common Stock held by each officer, director and holder of10% or more of the outstanding Common Stock have been excluded in that suchpersons may be deemed affiliates. Exclusion of shares held by any person shouldnot be construed to indicate that such person possesses the power, direct orindirect, to direct or cause the direction of management or policies of theregistrant, or that such person is controlled by or under common control withthe registrant.

The number of shares outstanding of the registrant’sCommon Stock, $.01 par value, as of February 15, 2006 was 24,010,998.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the definitiveProxy Statement to be delivered to stockholders in connection with the AnnualMeeting of Stockholders to be held June 6, 2006 are incorporated byreference into Part III.

Certainexhibits filed with the registrant’s prior registration statement, form 10-Kand forms 10-Q are incorporated herein by reference into Part IV ofthis Report.

 

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**Websense, Inc.Form 10-KFor the Fiscal Year Ended December 31, 2005**

**TABLE OF CONTENTS**

|               | ** ** |                                                                                             | ** ** | **Page** | ** ** |
|---------------|------------|---------------------------------------------------------------------------------------------|------------|----------|------------|
| Part I   |       |                                                                                        |       |     |       |   |   |
| Item 1.       |       | Business                                                                                    |       |     | 3          |   |   |
| Item 1A.      |       | Risk  Factors                                                                               |       |     | 18         |   |   |
| Item 1B.      |       | Unresolved Staff Comments.                                                                  |       |     | 28         |   |   |
| Item 2.       |       | Properties                                                                                  |       |     | 28         |   |   |
| Item  3.      |       | Legal  Proceedings.                                                                         |       |     | 28         |   |   |
| Item 4.       |       | Submission of Matters to a Vote of Security Holders                                         |       |     | 28         |   |   |
| Part II  |       |                                                                                        |       |     |       |   |   |
| Item 5.       |       | Market for  the Registrant’s Common Equity, Related Stockholder Matters and            |       |     |       |   |   |
|          |       | Issuer  Purchases of Equity Securities.                                                     |       |     | 29         |   |   |
| Item 6.       |       | Selected Financial Data                                                                     |       |     | 31         |   |   |
| Item 7.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |       |     | 32         |   |   |
| Item 7A.      |       | Quantitative and Qualitative Disclosures About Market  Risk.                                |       |     | 40         |   |   |
| Item 8.       |       | Financial Statements and Supplementary Data                                                 |       |     | 42         |   |   |
| Item 9.       |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure       |       |     | 65         |   |   |
| Item 9A.      |       | Controls and Procedures                                                                     |       |     | 65         |   |   |
| Item 9B.      |       | Other  Information                                                                          |       |     | 67         |   |   |
| Part III |       |                                                                                        |       |     |       |   |   |
| Item 10.      |       | Directors and Executive Officers of the Registrant                                          |       |     | 67         |   |   |
| Item 11.      |       | Executive Compensation                                                                      |       |     | 67         |   |   |
| Item 12. |       | Security  Ownership of Certain Beneficial Owners and Management and                         |       |     |       |   |   |
|          |       | Related  Stockholder Matters.                                                               |       |     | 67         |   |   |
| Item 13.      |       | Certain Relationships and Related Transactions                                              |       |     | 68         |   |   |
| Item 14.      |       | Principal Accountant Fees and Services .                                                    |       |     | 68         |   |   |
| Part IV  |       |                                                                                        |       |     |       |   |   |
| Item 15.      |       | Exhibits and Financial Statement Schedules .                                                |       |     | 69         |   |   |
|          |       | Signatures                                                                                  |       |     | 71         |   |   |

 

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**PART I**

**Forward-Looking Statements**

This report on Form 10-Kmay contain “forward-looking statements” within the meaning of the federalsecurities laws made pursuant to the safe harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. These statements, which represent ourexpectations or beliefs concerning various future events, may contain wordssuch as “may,” “will,” “expects,” “anticipates,” “intends,” “plans,” “believes,”“estimates,” or other words indicating future results. Such statements mayinclude but are not limited to statements concerning the following:

·       anticipatedtrends in revenue;

·       growthopportunities in domestic and international markets;

·       newchannels of distribution;

·       customeracceptance and satisfaction with our products;

·       expectedtrends in operating and other expenses;

·       anticipatedcash and intentions regarding usage of cash;

·       changesin effective tax rates; and

·       anticipatedproduct enhancements or releases.

These forward-looking statements are subject to risks anduncertainties that could cause actual results to differ materially from thoseanticipated as of the date of this report. We assume no obligation to updateany forward-looking statements to reflect events or circumstances arising afterthe date of this report.

You should carefullyreview and consider the various disclosures in this report regarding factorsthat could cause actual results to differ materially from anticipated results,including those factors under the caption “Risk Factors” under Item 1A below,and elsewhere in this report.

**Item 1.**                        Business

**Overview**

We provide employee internet management (EIM) and websecurity software products that enable organizations to reduce the risksassociated with web-based malicious attacks, spyware, and phishing, as well asanalyze, report and manage how their employees use computing resources. At thefoundation of our product offering is the Websense Enterprise® softwareapplication, which serves as a central policy engine and management andreporting console and enables the extended functionality of our add-on products.Websense Enterprise gives organizations the ability to enhance networksecurity, improve employee productivity, mitigate potential legal liability andconserve network bandwidth by allowing organizations to identify potential riskareas and implement web access and application usage policies that reduce theserisks. Over the past 10 years, our products have evolved from software thatprevents employees from downloading unacceptable internet content (such asadult materials), to products that prevent employee access to the mostundesirable and dangerous elements on the internet—websites that contain orwill download viruses, spyware, keyloggers, phishing exploits and anever-increasing variety of malicious code.

In 1996, we released our first software product,Websense Internet Screening System. Since that time, we have focused ondeveloping and selling EIM and web security solutions. Websense Enterprise andWebsense Enterprise—Corporate EditionTM are our core web filtering solutions andserve as management platforms for related Websense add-on modules, such as ourPremium GroupsTM, Real Time Security 

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UpdatesTM, BandwidthOptimizerTM, Instant Messaging (IM) Attachment ManagerTM, Client Policy ManagerTMand Remote Filtering. We have also created suites of some of our products toaddress specific customer needs, such as the Websense Web Security SuiteTM andWebsense Web Security Suite—Lockdown EditionTM.

Our Security Premium GroupTM, for example, leverages ourlongstanding ability to identify,  categorize, and restrict employee access to undesirable websites byfurther preventing employees from accessing websites that contain spyware,worms and other mobile malicious code, even though they otherwise may be appropriatebusiness websites. By preventing access to these sites, we expanded ourtraditional employee internet management tools to offer proactive protectionagainst web-based threats.****With therecent launch of our Remote Filtering product in October 2005, webroadened our product line to protect mobile workers with the same EIM andsecurity features employees receive within the office.

In October 2005, we announced an agreement withNortel Networks to develop a web content filtering solution to protect GSM/UMTSmobile handsets from receiving and accessing unwanted content. Our solutionwill be embedded in certain Nortel Networks’ switches that are installed bywireless carriers. The wireless carriers will determine whether our solution isoffered to wireless customers. To date, our product has not been commerciallylaunched through this channel. We expect the product to be generally availablefrom Nortel Networks in mid-2006.

Our softwareapplications operate in conjunction with our proprietary databases of:

·       websiteuniversal resource locators (URLs), including sites containing spyware, virusesand other malware;

·       softwareapplications and executable files, including commonly-used productivityapplications, games, hacking tools and viruses; and

·       commonlyused network and internet protocols, such as http, instant messaging protocolsand peer-to-peer protocols.

Recently, our research efforts expanded through ourWebsense Security LabsTM to include the identification and classification ofmalicious code, malware, spyware and adware located on internet sites. Ournewest line of products that provide blocking and containment of spyware andmalware attacks from employee desktops and laptop computers, Client PolicyManager and the Lockdown Edition of our Web Security Suite, depend upon thesecontinual research efforts of Websense Security Labs.

Our products operate at four primary points of policyenforcement:  the internet gateway, thenetwork, the employee desktop and the mobile device, such as a wireless enabledlaptop computer. Our databases are updated each business day using aproprietary process of automated content assessment and classification, withmanual verification. Subscribers to our Real Time Security Updates productreceive updates of the security risk categories of the URL and applicationdatabases in real time as new malicious or high-risk URLs and executable filesare identified and categorized by our Websense Security Labs.

The Websense URL database is currently organized intomore than 90 categories and encompasses more than 15 million websites. Thesoftware application database has classified over 1.4 million softwareapplications and executable files in more than 50 categories. We also maintaina database of commonly used internet protocols.

Websense Enterprise and the add-on modules are easy todeploy and use. They integrate with a wide range of network access platforms,including market-leading firewalls, caching appliances, proxy-servers,switches, routers and other network appliances, and can scale with ourcustomers’ needs to serve a virtually unlimited number of users across multiplelocations.

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We currently derive all of our revenue fromsubscriptions to the Websense Enterprise-based solutions and expect this tocontinue in the future as more offerings are added to the Websense Enterpriseplatforms. We operate in one industry segment, as defined by generally acceptedaccounting principles.

Our business commencedoperations in 1994 as NetPartners Internet Solutions, a reseller of computersecurity products. In 1999, we changed our name to Websense, Inc. toreflect the shift in our business focus to a developer of web filteringsolutions. Our principal offices are located at 10240 Sorrento Valley Road, SanDiego, CA  92121.

**Industry Background**

As part of their overall business strategies, manyorganizations use the internet to enable critical business applications thatare accessed over their corporate networks. Many employees also use theirorganization’s computing resources for recreational “web surfing,” peer-to-peerfile sharing, downloading of high-bandwidth content, instant messaging andother personal matters. However, unmanaged use of organizational computing andnetwork resources, including internet access, can result in increased risk andcost to the organization, including increased security risks, lost employeeproductivity, increased network bandwidth consumption, and potential legalliability. In recent years, the same activities that made employees efficientand productive—doing research over the Internet, sharing files and sendinginstant messages and emails to customers and co-workers—have also made ITinfrastructures vulnerable to mobile malicious code, spyware, viruses, Trojanhorses and phishing and pharming exploits.

Traditionally, organizations have attempted tomitigate the legal liability, productivity and bandwidth waste risks throughwritten policies governing acceptable employee use of computing resources, andthey have sought to protect against external security risks with a combinationof firewalls, intrusion detection/prevention software and anti-virus software.With the growth in spyware, key logging applications, and phishing sites,combined with the rapid increase in employee use of instant messaging andpeer-to-peer file sharing and the proliferation of blended attacks on computingnetworks, organizations are finding that  existing security measuresleave significant time and technology gaps in their protection. Writteninternet access and software application usage policies are easily ignored,difficult to enforce and do not proactively curtail undesirable internet andsoftware application usage. Firewalls can provide protection against externalthreats such as hacking, but do little to prevent employees from hacking intotheir own organization’s data from inside the corporate firewall. Anti-virussoftware provides protection from e-mail borne viruses, but does not preventthe possible theft or corruption of corporate data by spyware, and offers onlylimited protection against viruses that proliferate via peer-to-peer networksand instant messaging. Existing anti-virus and anti-spyware software alsorequires time to identify and reverse engineer the virus or spyware applicationbefore it can be remediated and removed from infected systems.

Given the necessity of corporate internet access andthe continuing adoption of the web as a mass communication, entertainment,information and commerce medium, we believe there is a significant opportunityfor employee internet management and web security solutions that effectivelyaddress the needs of organizations to protect themselves from web-based threatsand manage employee usage of the computing environment, including internetaccess and desktop application use. Additionally, although the web and e-mailare the primary drivers of internet traffic today, the rapid emergence ofinternet-enabled applications creates the need for software that appliesmanagement policies to file types, applications, and protocols, as well as webpages, at multiple points on the information technology infrastructure.Software tools are needed to implement policy-based bandwidth management andregulation of applications such as instant messaging, peer-to-peer fileexchange tools, interactive games and desktop software applications. Thesesolutions must also be adaptable enough to manage new applications andtechnologies as they are developed.

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**Our Products and Services**

*WebsenseEnterprise.*   Websense Enterprise is thefoundation of our software offerings and includes our proprietary centralpolicy engine, central management console and multiple reporting options.Websense Enterprise gives business managers the ability to implement customizedinternet access and use policies for different users and groups within thebusiness, and supports an organization’s efforts to enhance network security,improve employee productivity, mitigate potential legal liability, and conservenetwork bandwidth. Websense Enterprise and its available add-on modules alloworganizations to manage employees’ use of corporate computing resources byfiltering access to websites, applications, protocols and bandwidth based onmanagement-defined policies.

We sell subscriptions to Websense Enterprise based onthe number of users to be managed. Websense Enterprise—Corporate Edition offersthe same functionality as Websense Enterprise with additional administrativefeatures relevant to large or distributed enterprises. Websense Enterprise andWebsense Enterprise—Corporate Edition serve as management platforms for relatedWebsense add-on modules, such as our Premium Groups, Real Time SecurityUpdates, Bandwidth Optimizer, Instant Messaging (IM) Attachment Manager, ClientPolicy Manager and Remote Filtering. Our Websense Web Security Suites includeWebsense Enterprise and a select group of add-on products and services for asingle price to address specific customer needs, such as the need for enhancednetwork security. Revenues from sales of subscriptions to Websense Enterpriseand related add-on products accounted for all of our revenues in 2005, 2004 and2003.

*Deployment Options.*   WebsenseEnterprise integrates with an organization’s network server, proxy server,switch, router or firewall and is designed to work in networks of virtually anysize and configuration. We currently offer three deployment options:

·       Integrateddeployment on a separate server that is tightly integrated with the networkgateway platform to offer pass-through filtering that maximizes stability,scalability and performance.

·       Embeddeddeployment on an appliance or gateway product to reduce hardware expense andenhance ease-of-use, particularly in remote locations.

·       Stand-alonedeployment utilizing a network agent to deliver pass-by filtering capabilitiesin any network environment.

*Web Filtering.*   WebsenseEnterprise enables employers to proactively analyze, report and manage employeeaccess to websites based on the content of the requested website. Our softwareapplication provides patented flexibility for managers when customizing,implementing and modifying internet access policies for various groups, usertypes and individuals. A graphical interface enables business managers todefine the categories of websites to which access will be managed. Thefiltering software examines each internet access request, determines thecategory of the requested website and applies the policies that have beendefined by the company. Some examples of management options include:

·       Allow:The request is allowed to proceed, because the organization has chosen not to restrictaccess to the category applicable to the website.

·       Block:The requested website is in a category that is not allowed to be accessedaccording to the policy in effect.

·       Time-basedQuotas: Users are allowed a specified amount of personal surfing time withincategories that are determined by the administrator. Once the user reaches hisor her quota time, he or she is no longer able to access sites in thosecategories.

·       Continuewith Exception Report: The user is reminded about the organization’s internetusage policy, but can choose to access the requested website.

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·       Timeof Day:  Filtering options can be managedby time of day. For example, access to shopping sites could be blocked duringbusiness hours and permitted at all other times.

The breadth and specificity of website categories wehave defined provide flexibility in selecting which types of material should beallowed, blocked or reported. We identify the types of content that we believeemployers would deem to be unacceptable, inappropriate or undesirable in a workenvironment based on input we receive from our customers, and define thecategories accordingly.

*Reporting and Analysis.**  *Websense Enterprise includesseveral reporting modules**to meetthe information needs of different management groups.

·       WebsenseReporter is a batch-based reporting application that can generate more than 80tabular and graphical reports based on an organization’s historical internetuse. It analyzes information from internet monitoring logs and builds visualcharts in a variety of pre-set or customizable formats for easy distribution toand interpretation by managers.

·       WebsenseReal-Time AnalyzerTM utilizes the network agent in Websense Enterprise tomonitor and analyze network traffic on-the-fly. This allows IT managers toidentify potential risks and bandwidth bottlenecks associated with differenttypes of network traffic.

·       WebsenseExplorer is a browser-based forensics and analytics reporting tool fornon-technical business managers that enables them to drill down on internet usedata by risk class, user group, or individual.

*Add-OnModules.**  *Thereare three primary types of add-on products that extend and enhance the policyenforcement capabilities of Websense Enterprise:  additional database categories; products thatextend the management capabilities of Websense Enterprise at the gateway and onthe network; and products that enforce policies at the desktop and on mobiledevices, such as laptop computers. These add-on products rely on theapplication framework of the Websense Enterprise platform and our proprietarydatabases of software applications and protocols. We plan to continue todevelop and market new products and services based on our Websense Enterpriseplatform and our proprietary search and categorization technologies.  For example, in October 2005, weintroduced Remote Filtering to extend the web filtering features of WebsenseEnterprise to laptop computers and other mobile devices when they aredisconnected from the corporate network.

The three PremiumGroup add-on products include specialized database categories that augment thecategories included with Websense Enterprise and provide additional policyenforcement options at the internet gateway.

·       *Security Premium Group.*TM The Security Premium Group allowsmanagement of access to sites associated with spyware, phishing, and maliciousmobile code.

·       *Bandwidth Premium Group.*TM The Bandwidth Premium Group allowsmanagement of access to bandwidth intensive sites, including streaming media,internet radio and television, personal network storage/backup, internettelephony, and peer-to-peer file sharing.

·       *Productivity Premium Group.*TM The Productivity Premium Groupallows management of access to advertisements, message boards,freeware/software downloads, online brokerage & trading, instantmessaging, and pay-to-surf sites.

Add-on productsthat extend the management capabilities of Websense Enterprise at the gatewayand on the network include:

·       *Bandwidth Optimizer.* The BandwidthOptimizer module allows customers to dynamically manage network usage byprioritizing business and non-business related traffic flows and disablingnon-business related traffic when available network bandwidth drops belowpre-determined levels. Our 

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customers can applymanagement policies based on content category, protocols, user group,individual, or network segment. Bandwidth Optimizer relies on the centralpolicy engine in the Websense Enterprise platform, a network agent thatmonitors network traffic and a database of protocols, file types and contentcategories to automatically monitor network bandwidth levels and dynamicallyallow or deny network application requests.

·       *Instant Messaging (IM) Attachment Manager.*TheIM Attachment Manager module enhances the built-in management capabilities ofWebsense Enterprise by allowing organizations to control the transmission andreceipt of files via IM clients. The IM Attachment Manager module allowscustomers to apply policies to file attachments over the most popular IMapplications, define custom file attachment policies by user, by group, or byworkstation, using popular management options such as warn/continue screens,and provide real-time and historical views of employee use of IM fileattachments. Used in conjunction with Bandwidth Optimizer, the IM AttachmentManager can manage the transmission of attachments by bandwidth availability.

Our desktop policymanagement add-on products are:

·       *Client Policy Manager*. The Client PolicyManager (CPM) product allows our customers to implement management policies,such as block, allow or defer, for usage of software applications and otherexecutables on desktop computers, by application type, by user type, or byindividual user. CPM can be used to inventory desktop software, provide acategorized view of applications in the desktop environment, and identifypotential security threats from hacking and spyware applications. It can alsobe used to create lists of allowable applications and block the launch ofothers, enhancing security by preventing the launch of certain categories ofexecutables such as hacking tools or spyware.

CPM utilizes theapplication framework of Websense Enterprise and references our Client PolicyManager database of over 1.4 million software applications and executablefiles. We are expanding this database as well as adapting the database toactual employee computing patterns through the use of AppCatcher, apatent-pending feature by which customers anonymously send uncategorizedapplications and other executables launched by their employees to us for reviewand categorization into our database. CPM includes two reporting modules, CPMReporter, which provides Web-based reports based on historical applicationusage, and Explorer for CPM, a click-through browser-based interface thatprovides immediate access to application usage information by user, group,category, machine, or risk class.

·       *Remote Filtering.*Remote Filtering utilizes the CPM desktopagent to extend the corporate web filtering policies to laptop computers andother mobile devices when they are disconnected from the corporate network. Byusing remote filtering, IT administrators can enforce security policies, suchas blocking access to sites containing spyware, even when a laptop computer isaccessing the internet from an unmanaged server. This enables the networkmanager to reduce the risk that mobile devices will infect the network withmalicious code when the device again connects to the network.

Additional productsor services include:

·       *Real Time Security Updates.*Real TimeSecurity Updates allow subscribing organizations to receive database updatesfor web-based and application-based threats in real time as they are identifiedand categorized by the Websense Security Labs.

·       *Websense Web Protection Services*TM*:  SiteWatcher*TM,*BrandWatcher*TM** *and ThreatWatcher*****TM  *Services*. TheSiteWatcher and BrandWatcher services monitor our customer’s web sites andbrands for malicious code or illegal use in a phishing attack and notify thecustomer if either occurs. The ThreatWatcher service helps customers to preventmalicious attacks on their web servers by 

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identifyingvulnerabilities. These products are available only as part of the Websense WebSecurity Suite or Websense Web Security Suite—Lockdown Edition.

·       *Priority One 24x7 Support.*Priority Onesupport gives customers access to a dedicated team of senior technical supportspecialists 24 hours a day via a toll-free support hotline.

·       *Content Filtering for Mobile Devices.*In October 2005,we announced an agreement with Nortel Networks to develop a web contentfiltering solution to protect GSM/UMTS mobile handsets from receiving andaccessing unwanted content. Our solution will be embedded in certain NortelNetworks’ switches that are installed by wireless carriers. The wirelesscarriers will determine whether our solution is offered to wireless customers. Todate, our product has not been commercially launched through this channel. Weexpect the product to be generally available from Nortel Networks in mid-2006.

The principal benefits of our products include:

*EnhancedNetwork and Data Security.**  *The WebsenseWeb Security Suites, Websense Enterprise, the Security Premium Group andother add-on products, provide an additional layer of protection to anorganization’s network and data security by blocking employee access to sitesthat pose security risks. These sites include phishing sites and sitescontaining malicious code, spyware, hacking tools, and other high risk software.Websense Enterprise also prevents “back channel” communication with serverscollecting data from spyware applications. This allows an organization toreduce the risk of malicious code attacks - such as Web-based worms, viruses,Visual Basic scripts and more—and prevent back-channel communication ofimportant corporate or personal data by spyware and key logging programs. Additionally,Client Policy Manager can be used to prevent the launch of viruses, hackingtools, peer-to-peer file sharing programs and other malicious executable filesor otherwise unauthorized applications at the employee’s desktop or laptopcomputer, including when disconnected from the network. This helps prevent thespread of viruses throughout the network and reduces the risk of unauthorizeddata access by employees. To further enhance security and reduce the window ofexposure to viruses and other malware, Real Time Security Updates can bedownloaded in real time as new threats are identified and categorized. InstantMessaging Attachment Manager also increases the built-in instant messagingmanagement capabilities of Websense Enterprise by allowing managers to controlthe sending and receiving of file attachments.

*IncreasedEmployee Productivity.*   Our software givesbusinesses the ability to more effectively manage employees’ use of corporatecomputing resources, including internet access, application use at the desktopand network bandwidth, thereby reducing non-productive use of these assets by employees.Websense Enterprise enables organizations to identify the pattern and scope ofemployees’ internet use, and to manage access to potentially non-businessrelated content and applications such as instant messaging and peer-to-peerfile sharing. In addition, our software allows managers to permit or denyinternet access based on the employee, type of user, time of day, amount ofpersonal surfing time, and type of content being accessed. Websense Enterprisemay also be configured to set time-based quotas for each employee, allowing forlimited personal surfing during the workday, limiting workplace distractionsbut allowing appropriate use of the organization’s high-speed internetconnection. Our Client Policy Manager add-on module allows managers to applysimilar policies to employees’ use of non-business related applications ontheir desktop or laptop computers, such as games and hacking tools.

*ReducedExposure to Potential Legal Liabilities.*   WebsenseEnterprise supports organizations’ efforts to reduce exposure to legalliability resulting from the improper use of the internet in the workplace. Byimplementing our products in conjunction with an overall corporate internetusage policy, organizations can proactively curtail access to objectionableinternet content such as adult entertainment, illegal activities, hate andracism. Websense Enterprise can also manage the use of peer-to-peer filesharing, 

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reducing the risk thatunauthorized copyrighted material or other inappropriate content is beingdownloaded and stored on company servers.

*Conservationof Information Technology Resources.*   We believeWebsense Enterprise allows organizations to reduce bandwidth consumption bymanaging personal internet use and access to websites, in particular thosewhich may contain bandwidth-intensive content, such as streaming audio andvideo, MP3 music files, multi-player games and other new media. The BandwidthOptimizer add-on module, used in conjunction with Websense Enterprise, furtherenhances bandwidth management capabilities by monitoring network usage inreal-time and by allowing employee access management based on availablebandwidth thresholds. For example, Bandwidth Optimizer can temporarily disablenon-business network traffic when available bandwidth drops belowpre-determined thresholds. Reducing the bandwidth consumed bynon-business-related internet traffic allows an organization to use its networkmore efficiently and effectively, and helps ensure that bandwidth is availablefor mission-critical business applications such as voice-over-IP. In addition,by limiting access to bandwidth-intensive content, organizations are able tosave valuable network storage from being cluttered with MP3s, images or othernon-business files.

In addition to the benefits above, our productsprovide these key features:

*Accessto Comprehensive Databases of URLs, Software Applications and NetworkProtocols.*   We provide access to proprietarydatabases that categorize website URLs, software applications and executablesand commonly used network and internet protocols. We have categorized more than15 million websites in our URL database, and more than three million dead linkshave been purged from the database. These website URLs have been classifiedinto more than 90 different categories to enable organizations flexibility indetermining the types of internet content that are appropriate for theirworkplace culture. In the software application database, we have categorizedover 1.4 million software applications and executable files in more than 50categories, such as instant messaging, spyware, hacking and games.  We add approximately 22,000 newly categorizedwebsites and applications each business day to our databases and make theseupdates available to our customers for daily differential downloads.Subscribers to Real Time Security Updates are able to update the securitycategories of the databases in real time as new threats are identified andcategorized by the Websense Security Labs.

*Abilityto Easily Configure and Manage Employee Internet and Application Usage Policiesfrom a Single Management Console.*   WebsenseEnterprise allows organizations to configure specific internet and applicationusage policies for various groups, user types or individuals from a singlemanagement console. Through our intuitive interface, we allow managers toimplement internet and application use policies with limited investment ofinformation technology resources and personnel. Organizations may chooseinternet use options which include blocking websites, setting time periods foraccess, allowing access but generating an exception report, allowing users aspecified amount of personal surfing or deferring access until additionalnetwork bandwidth is available. Organizations can apply similar policies to theuse of applications at the desktop, specifying permissions based on applicationcategory, user group, workstation, or IP address.

*MultipleOptions for Identifying, Analyzing and Reporting on Employee Internet andApplication Use.**  *WebsenseEnterprise includes several analysis and reporting modules to provide managersand information technology (IT) administrators with multiple options foridentifying, analyzing and reporting on internet and desktop applicationactivity and the risks associated with employee computing. These optionsinclude a reporting engine with pre-defined and customizable report templates,a real-time analyzer that provides a current view of network activity andbrowser-based reporting tools that allow non-technical managers to viewinternet and application use data.

*Abilityto Adapt to our Customers’ Employee Computing Patterns.*   Weutilize our relationship with our customers to help our software adapt toevolving employee computing and internet access patterns. We 

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accomplish this withWebCatcherTM, a patent-pending feature by which customers anonymously send uncategorizedwebsites visited by their employees to us for review and categorization intothe Websense URL database. AppCatcherTM, another patent-pending feature, createsthe same feedback mechanism for software applications and network protocols. Asnew websites, protocols and applications are categorized, the updated databasesare available for daily download by the entire customer base. Updates to thesecurity categories are available in real time to subscribing customers.

*Abilityto Scale and Operate on a Variety of Network Platforms.*   Oursoftware is designed to have minimal impact on network performance. WebsenseEnterprise is available on a broad range of network platforms, and can supportup to 50,000 users on a single server. Our software works with popular proxyservers, firewalls, cache engines, switches and routers offered by internetinfrastructure providers such as Blue Coat Systems, Check Point Software, CiscoSystems, Juniper Networks/NetScreen, Microsoft, Network Appliance, and Nokia.

*Ability to Integrate withExisting Security Software Infrastructures.**  *Websense Enterprise—Corporate Edition can beintegrated with several industry leading identity management, security alertingand network access control systems to increase the functionality of thesesystems. Data collected through the monitoring and reporting features ofWebsense Enterprise can be fed into these systems to create a comprehensiveview of network activity and help managers more easily identify security risks.

**Technology Integrations**

In 2005, we implemented the Websense Web SecurityEcosystemTM—a comprehensive ecosystem of world class security and networkingtechnology providers that enable easy deployment and integration of Websensesolutions in enterprise environments. The Websense Web Security Ecosystemincorporates vendors from leading security and networking markets,including:  network access control,internet gateways, certified appliance platforms, security event management andidentity management. The Websense Web Security Ecosystem providesinteroperability of joint solutions for seamless integration in enterpriseenvironments.

Thetable below lists many of the platforms included in the Websense Web SecurityEcosystem:

| Firewall Solutions:                |   | Cache/Proxy Solutions:                                   |
|------------------------------------|--------|----------------------------------------------------------|
| ·3Com                         |   | ·  Blue Coat Systems                           |
| ·Check Point Software         |   | ·  Cisco Content Engine                        |
| ·Cisco PIX                    |   | ·  IMimic DataReactor                          |
| ·CyberGuard                   |   | ·  Inktomi Traffic Server                      |
| ·Juniper Networks/NetScreen   |   | ·  Microsoft Proxy Server                      |
| ·Microsoft ISA Server         |   | ·  Network Appliance NetCache                  |
| ·ServGate                     |   | ·  Squid Proxy                                 |
| ·SonicWall                    |   | ·  Stratacache Flyer                           |
|                               |   | ·  Sun ONE Web Proxy Server (formerly iPlanet) |
| Appliance  Solutions:              |   | ·  3Com Webcache                               |
| ·Blue Coat Systems            |   |                                                     |
| ·Cisco Systems Content Engine |   | Switch/Router Solutions:                                 |
| ·Crossbeam Systems C-Series   |   | ·  Cisco Catalyst Switches                     |
| ·Crossbeam Systems X-Series   |   | ·  Cisco Routers                               |
| ·Network Appliance NetCache   |   |                                                     |
| ·Network Engines NS           |   |                                                     |
| ·Stratacache Flyer            |   |                                                     |

 

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| Identity Management Solutions:                                                          |   | Security Event Management Solutions:                                              |
|-----------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------|
| ·HP  Open View                                                                     |   | ·        Arcsight                         |
| ·IBM  Tivoli                                                                       |   | ·        Network  Intelligence            |
| ·        Novell  Nsure                          |   |                                                                              |
| ·        Novell  Nsure                          |   | Network Access  Control Solutions:                                                |
| ·        Microsoft  Identity Integration Server |   | ·        Cisco  Network Admission Control |

 

**Customers**

Our more than 24,000 customers range from companieswith as few as 50 employees to members of the Global 1000 and to governmentagencies and educational institutions. In total, these customers havesubscribed to approximately 23.9 million seats as of December 31, 2005. Nocustomer accounted for more than 10% of our total revenues in 2005, 2004 or2003.

**Sales, Marketing and Distribution**

*Sales.*   Wesell our products and services through both indirect and direct channels. For2005, indirect channel sales comprised over 80% of total revenues. In theUnited States, we typically sell our products through a network ofapproximately 1,000 value added resellers. Internationally, we sell ourproducts through a multi-tiered distribution network of more than 200distributors and resellers in over 80 countries, who sell to customers locatedin over 150 countries.

Our channel sales efforts are coordinated worldwidethrough a sales team of approximately 200 individuals. Customers that buydirect from us are typically large organizations that prefer a directrelationship.

In 2005, we generated 33% of our total revenue fromcustomers outside of the United States. Revenue generated in the United Kingdomrepresented 10% of our total revenues. See Note 4 of Notes to the ConsolidatedFinancial Statements for further explanation of our revenue based on geography.Our current international efforts are focused on expanding our indirect saleschannels in Europe, Latin America, Asia/Pacific, and Australia. Our continuingreliance on sales in international markets exposes us to risks attendant toforeign sales. See “Item 1A. Risk Factors—Sales to customers outside the UnitedStates have accounted for a significant portion of our revenue, and we expectthis trend to continue, which exposes us to risks inherent in internationalsales.”

*Marketing.*   Ourmarketing strategy is to raise awareness of the potential risks associated withunmanaged use of corporate computing resources, generate qualified sales leadsfor our channel partners, and increase recognition of Websense as a provider ofweb security and employee internet management solutions.

Our marketingefforts are targeted toward business executives, including informationtechnology professionals, chief executives, upper level management and humanresource personnel. We actively manage our public relations programs,communicating directly with technology professionals and the media, in aneffort to promote greater awareness of the growing problems caused by viruses,spyware, phishing sites, and key logging, as well as employee misuse of theinternet and other computing resources at work. We also provide potentialcustomers and channel partners with free trials of Websense Enterprise and theadd-on modules, typically for 30-day periods. Our additional marketinginitiatives include:

·       advertisingonline and in high-technology trade magazines, management journals and otherbusiness oriented periodicals;

·       participationin and sponsorship of trade shows and industry events;

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·       providingfree subscriptions to security alerts from Websense Security Labs, which informsubscribers of newly identified security threats, such as phishing sites andsites infected with spyware and malicious code;

·       hostingregional and international seminars, webinars, and training sessions for oursales organization and reseller partners, as well as customers and prospects;

·       cooperativemarketing efforts with our internet infrastructure partners including Web linkexchanges, joint press announcements, joint trade show activities, channelmarketing campaigns, road shows and seminars;

·       conductingspeaking engagements on topics of interest to our customers and prospects;

·       useof our website to communicate with our indirect sales channels, and provideproduct and company information to interested parties; and

·       providing and distributingsoft and hard-copy collateral on our company, products, solutions, technologies,partnerships and benefits.

**CustomerService, Training and Support**

We believe that superiorcustomer support is critical to retaining and expanding our customer base. Ourtechnical support group provides dependable and timely resolution of customertechnical inquiries and is available to customers by telephone, e-mail and overthe Web. Our training services group delivers education, training and pre-salessupport to our customers. We also offer online training to our customers andresellers to provide them with the knowledge and skills to successfully deploy,use and maintain our products. Our customer service team is responsible forhandling general customer inquiries, answering questions about the orderingprocess, updating and maintaining customer account information, investigatingthe status of orders and payments, as well as processing customer orders. Inaddition, our customer service team proactively updates customers on a varietyof topics, including release dates of new products and updates to existingproducts.

**Research and Development**

We have investedsignificant time and resources in creating a structured process for undertakingproduct and database development projects. Our research and developmentdepartment is divided into several groups, which include database production,software development, quality and assurance, documentation and research.Individuals are grouped along product lines and work as part ofcross-disciplined teams designed to provide a framework for defining andaddressing the activities required to bring product concepts and developmentprojects to market successfully. The Websense Security Labs focus exclusivelyon identifying and categorizing malicious web sites and applications,augmenting the capabilities of the database production teams. Research anddevelopment expenses totaled $16.3 million in 2005, $14.5 million in 2004 and$12.8 million in 2003. Research and development expenses as a percentage ofrevenue were 11% in 2005, 13% in 2004, and 16% in 2003.

**Technology**

*SoftwareArchitecture.*   Websense Enterprise is aserver-based system designed to function in networks of virtually any size andconfiguration. Websense Enterprise is composed of a system of analyzing,reporting and management applications integrated in a proprietary centralpolicy engine. It is designed to accommodate network growth without impairingperformance or requiring major infrastructure modifications and can scale tosupport networks of nearly any size. Websense Enterprise integrates with majorfirewalls, proxy servers, caching engines, network switches and routers. Wehave designed our products to run on multiple network platforms and in multiplelocations. Websense 

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Enterprise can alsoinclude agents at the desktop and on the network that allow customers to manageapplications, protocols, and network bandwidth through its Client PolicyManager product as well as other add-on application modules.

*Database Content Analysisand Updating.*   We use a process of automatedcontent assessment and classification with manual verification to gather andclassify new websites and applications for our databases. Our automated searchtechnology uses Java-based tools and proprietary algorithmic classificationsystems to automatically search the internet to identify and catalog websitesinto one of our more than 90 database categories. Additionally, the optionalWebCatcher and AppCatcher features of Websense Enterprise collect unrecognizedsites, software applications and protocols from customers and return them to usfor review and categorization.

**Competition**

The market for ourproducts is fragmented, highly and increasingly competitive, quickly evolvingand subject to rapid technological change. Increased competition may result inreduced market acceptance of our products, pricing pressure and reduced grossmargins, any of which could seriously harm our business. Competitors vary insize and in the scope and breadth of the products and services they offer. Ourcurrent principal competitors include:

·       companiesoffering web filtering products, such as SurfControl, Secure Computing,  Computer Associates, Microsoft, St. BernardSoftware and Trend Micro;

·       companiesintegrating web filtering into specialized security appliances, such as 8e6Technologies, Blue Coat Systems, Cisco Systems, McAfee and SonicWALL;

·       companiesoffering web security solutions, such as McAfee, Microsoft, Symantec and TrendMicro; and

·       companiesoffering desktop security solutions such as Cisco Systems, Check PointSoftware, McAfee, Microsoft and Symantec.

We also face current and potential competition fromvendors of internet servers, operating systems and networking hardware, many ofwhich now, or may in the future, develop and/or bundle web security, employeeinternet management or other competitive products with their offerings. Wecompete against and expect increased competition from anti-virus softwaredevelopers, traditional network management software developers and Webmanagement service providers. Many of our current and potential competitors havelonger operating histories and significantly greater financial, technical,marketing or other resources. They may have significantly greater namerecognition, established marketing relationships and access to a largerinstalled base of customers. In addition, current and potential competitorshave established or may establish cooperative relationships among themselves orwith third parties to increase the functionality of their products to addresscustomer needs. Accordingly, new competitors or alliances among competitors mayemerge and rapidly acquire significant market share.

We believe that theprincipal competitive factors in the market for our products include:

·       aproduct’s ability to scale and support the requirements of complex networks;

·       therobustness of the solution, allowing management of emerging software andinternet applications, protocols and URLs;

·       qualityof a large and professionally maintained category databases;

·       availabilityof real time updates for security risk categories, such as spyware, keylogging, phishing and viruses;

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·       breadthof product line, giving customers a number of implementation choices;

·       easeof implementation, reducing overall cost of ownership;

·       depthof monitoring, reporting and analysis capabilities;

·       capacityto integrate with key network providers and security infrastructure software;

·       qualityof customer support; and

·       price.

**Intellectual Property Rights**

Our intellectual property rights are important to ourbusiness. We rely on a combination of trademark, copyright, patent and tradesecret laws in the United States and other jurisdictions as well asconfidentiality procedures and contractual provisions to protect ourproprietary technology and Websense brand. We have registered our Websense®trademark in the United States, Japan, the European Union, Canada, Australia,China, Switzerland, Norway, Mexico, Colombia, Argentina, Singapore, Taiwan andTurkey. We have also registered the Websense Enterprise® trademark in theUnited States, Japan, Canada, Australia and China. In addition, we haveregistrations for the Websense trademark pending in several other countries.Effective trademark protection may not be available in every country where ourproducts are available.

We currently have three patents issued in the UnitedStates, one patent issued in an international market, eight patent applicationspending in the United States and sixteen pending international patentapplications that seek to protect our proprietary database and filteringtechnologies, including issued and pending patents relating to our flexiblefiltering management options, and pending patents relating to our WebCatcher,AppCatcher and Network Lockdown product features. No assurance can be giventhat our pending patent applications will result in issued patents.

Our policy is to enterinto confidentiality and invention assignment agreements with all employees andconsultants, and nondisclosure agreements with all other parties to whom wedisclose confidential information. These protections, however, may not beadequate to protect our intellectual property rights.

**Employees**

As of February 15,2006, we had 635 employees. None of our employees are represented by a laborunion, and we have never experienced a work stoppage. We believe that ourrelations with our employees are good.

**Website Access to SEC Filings**

**Wemaintain an internet website at *www.websense.com*.The content of our website is not part of this report. We make available, freeof charge, through our internet website our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K,and amendments to those reports filed or furnished pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934, as amended, or the ExchangeAct, as soon as reasonably practicable after we electronically file suchmaterial with, or furnish it to, the SEC.**

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**Executive Officers**

Ourexecutive officers and their ages as of February 15, 2006 are as follows:

| ** **         | **Name** | ** ** | ** ** | **Age**                                          | ** ** | ** ** | **Position(s)** | ** ** |
|--------------------|----------|------------|------------|--------------------------------------------------|------------|------------|-----------------|------------|
| John B. Carrington |     | 61         |       | Executive Chairman of  the Board                 |
| Gene Hodges.       |     | 54         |       | President and Chief  Executive Officer           |
| Douglas C. Wride   |     | 52         |       | Chief Financial Officer                          |
| Leo Cole.          |     | 48         |       | Vice President of  Marketing                     |
| Karen V. Goodrum   |     | 48         |       | Vice President of  Finance & Accounting |
| Michael A. Newman. |     | 36         |       | Vice President &  General Counsel       |
| Kian Saneii        |     | 41         |       | Vice President of Business Development           |

 

John B. Carrington has served as a Director and ourChairman of the Board since June 1999. Mr. Carrington also served asour Chief Executive Officer from May 1999 to January 2006, as well asour President from May 1999 to January 2003 and from August 2005to January 2006. Prior to joining Websense, Mr. Carrington wasChairman, President and Chief Executive Officer of Artios, Inc., aprovider of hardware and software design solutions to companies in thepackaging industry, from August 1996 until it was acquired by BARCO n.a.in December 1998. He received his B.S. in Business Administration from theUniversity of Texas.

Gene Hodges has served as our President and Chief ExecutiveOfficer, and as a Director, since January 2006. From 1995 to January 2006,Mr. Hodges held various management positions at McAfee, Inc., apublicly-held security software company, most recently as its President. Priorto joining McAfee, Mr. Hodges was Vice-President of Marketing forMobileware, a wireless data startup, and managed the Office Automation businessunit for Digital Equipment Corporation. Mr. Hodges received a B.A. inAstronomy from Haverford College and completed the Harvard Advanced ManagementProgram for business executives.

Douglas C. Wride has served as our Chief FinancialOfficer since June 1999. From March 1997 to December 1998, Mr. Wrideserved as Chief Financial Officer of Artios, Inc. Mr. Wride alsoserved as Chief Operating Officer of Artios from July 1997 to December 1998.From April 1996 to March 1997, Mr. Wride served as ChiefOperating Officer and Chief Financial Officer of NetCount, LLC, a provider ofinternet measurement and research services. Mr. Wride is a C.P.A. andreceived his B.S. in Business/Accounting from the University of SouthernCalifornia.

Leo Cole has served as our Vice President ofMarketing since June 2004. Prior to joining Websense, Mr. Cole workedfor IBM for 25 years where he held various management and executivepositions. He joined the Tivoli division of IBM in 1992, where heheld executive roles in the areas of Product Development, Marketing, andBusiness Development, including serving as the Director of ProductManagement and Strategy for the Security Business Unit. Mr. Colereceived his B.S. in Computer Science from Syracuse Universityand his M.B.A. from the University of Tennessee, Knoxville.

Karen V. Goodrum has served as our Vice President ofFinance & Accounting since October 2003, and prior to that, asVice President of Finance & Administration from August 2000. FromJanuary 1997 to February 2000, Ms. Goodrum served as ChiefFinancial Officer for COMPS.Com, Inc., a provider of commercial realestate information services. Ms. Goodrum received her B.A. in Educationfrom the University of Maryland, College Park, and her M.B.A. from San DiegoState University.

Michael A. Newman has served as our Vice President &General Counsel since September 2002. From April 1999 to September 2002,he served in various capacities in the legal department of Gateway, Inc.,a publicly traded PC manufacturer, most recently as Senior Staff Counsel,Securities, Finance and Corporate Development. From February 1996 to April 1999,he practiced as an attorney in 

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the San Diego office ofCooley Godward, LLP, a law firm specializing in the representation ofhigh-growth information technology and life sciences companies. Mr. Newmanreceived his B.S. in Business Administration from Georgetown University, and aJ.D. from Harvard Law School.

Kian Saneii has served as our Vice President ofBusiness Development since August 2001 and also as our Vice President ofMarketing from August 2003 to May 2004. From August 1999 to February 2001,he was Senior Vice President of Worldwide Marketing and Business Development atIPNet Solutions, Inc., a provider of business-to-business integration andsupply-chain collaboration solutions. From July 1997 to July 1999, heserved as Senior Vice President of Worldwide Marketing for IMA Corporation, asupplier of customer relationship management solutions. Mr. Saneiireceived his B.S. in Computer Science from New York University, and an M.S. inComputer Science from Rutgers University.

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**Item 1A. Risk Factors**

You should carefully consider the followinginformation in addition to other information in this report before you decideto purchase our common stock. The risks and uncertainties described below arethose that we currently deem to be material and that we believe are specific toour company and our industry. In addition to these risks, our business may besubject to risks currently unknown to us. If any of these or other risksactually occur, our business may be adversely affected, the trading price ofour common stock could decline, and you may lose all or part of your investmentin Websense.

*Our future success depends on our ability to sellnew, renewal and upgraded subscriptions to Websense Enterprise and the relatedadd-on products.*

All of our revenue comes from new and renewalsubscriptions to Websense Enterprise and its related add-on products, and weexpect this trend to continue for the foreseeable future. If WebsenseEnterprise or the add-on products**fail to meetthe needs of our existing and target customers, or if they do not compare favorablyin price and performance to competing products, our operating results and ourbusiness will be significantly impaired. If we cannot sufficiently increase ourcustomer base with the addition of new customers, we will not be able to growour business to meet expectations.

Subscriptions for Websense Enterprise typically havedurations of 12, 24 or 36 months. Our customers have no obligation to renewtheir subscriptions upon expiration. In order to maintain our revenue we mustbe successful in selling renewal subscriptions and in selling furthersubscriptions to existing customers in order to add additional seats or productofferings within their respective organizations. This may require increasinglycostly sales efforts targeting senior management and other management personnelassociated with our customers’ internet and security infrastructure. We may notbe able to maintain or continue to generate increasing revenue from existingcustomers.

*Failure of our add-on products, particularly oursecurity products, to achieve more widespread market acceptance will seriouslyharm our business.*

Our future financial performance depends on ourability to diversify our offerings by successfully developing, introducing andgaining customer acceptance of our new products and services, particularly oursecurity offerings. We currently have two platforms for our core software,Websense Enterprise and Websense Enterprise—Corporate Edition. We also sell anumber of add-on products such as our three Premium Groups (Security,Productivity and Bandwidth), Remote Filtering, Client Policy Manager, Real-TimeSecurity Updates, Bandwidth Optimizer and Instant Messaging Attachment Manager.In addition, we have developed security services that we include within ourWebsense Web Security Suites, such as ThreatWatcher, BrandWatcher andSiteWatcher. We may not be successful in achieving market acceptance of theseor any new products that we develop or of enhanced versions of WebsenseEnterprise. Moreover, our recent increased emphasis on the development,marketing and sale of our security offerings could distract us from sales ofour core Websense Enterprise offering, negatively impacting our overall sales. Anyfailure or delay in diversifying our existing offerings, or diversification atthe detriment to our core Websense Enterprise offering, could harm ourbusiness, results of operations and financial condition.

*We face increasing competition, which placespressure on our pricing and which could prevent us from increasing revenue ormaintaining profitability. In addition, as we increase our emphasis on oursecurity-oriented products, we face competition from better-establishedsecurity companies that have significantly greater resources.*

The market for ourproducts is intensely competitive and is likely to become even more so in thefuture, within both the employee internet management, or EIM, market as well asthe web security market. Our current principal EIM competitors frequently offertheir products at a significantly lower price than our products, which hasresulted in pricing pressures on sales of our product and potentially couldresult in the commoditization of EIM products. We also face current andpotential competition from vendors of 

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internetservers, operating systems and networking hardware, many of which now, or mayin the future, develop and/or bundle EIM or other competitive products withtheir products. If we are unable to maintain the current pricing on sales ofour products or increase our pricing in the future, our profitability could benegatively impacted. Even if our products provide greater functionality and aremore effective than certain other competitive products, potential customersmight accept this limited functionality in lieu of purchasing our products. Inaddition, our own indirect sales channels may decide to develop or sellcompeting products instead of our products. Pricing pressures and increasedcompetition generally could result in reduced sales, reduced margins or thefailure of our products to achieve or maintain more widespread marketacceptance, any of which could have a material adverse effect on our business,results of operations and financial condition. Our current principalcompetitors include:

·       companiesoffering web filtering products, such as SurfControl, Secure Computing,Computer Associates, Microsoft, St. Bernard Software and Trend Micro;

·       companiesintegrating web filtering into specialized security appliances, such as 8e6Technologies, Blue Coat Systems, Cisco Systems, McAfee and SonicWALL;

·       companiesoffering web security solutions, such as McAfee, Microsoft, Symantec and TrendMicro; and

·       companiesoffering desktop security solutions such as Check Point Software, Cisco Systems,McAfee, Microsoft and Symantec.

As we develop and market our products with anincreasing security-oriented emphasis, we also face increasing competition fromsecurity solutions providers. Many of our competitors within the web securitymarket, such as Symantec Corporation, McAfee, Inc., Trend Micro, CiscoSystems and Microsoft Corporation enjoy substantial competitive advantages,including:

·       greatername recognition and larger marketing budgets and resources;

·       establishedmarketing relationships and access to larger customer bases; and

·       substantiallygreater financial, technical and other resources.

As a result, we may be unable to gain sufficienttraction as a provider of web security solutions, and our competitors may beable to respond more quickly and effectively than we can to new or changingopportunities, technologies, standards or customer requirements. In addition,current and potential competitors have established or may establish cooperativerelationships among themselves or with third parties to increase thefunctionality of their products to address customer needs. Accordingly, newcompetitors or alliances among competitors may emerge and rapidly acquiresignificant market share. For all of the foregoing reasons, we may not be ableto compete successfully against our current and future competitors.

*The market for our products continues to emerge,and if we are not successful in promoting awareness of the need for ourproducts and of our Websense brand, our growth may be limited.*

Based on our experience with potential customers, webelieve that many corporations do not recognize or acknowledge the existence orscope of problems caused by misuse or abuse of the internet or of networkcomputers. In addition, there may be a time-limited opportunity to achieve andmaintain a significant share of the market for web security solutions due inpart to the emerging nature of these markets and the substantial resourcesavailable to our existing and potential competitors. If employers do notrecognize or acknowledge the problems associated with unrestricted employeeaccess to the Internet, the gaps in their traditional security infrastructuresand the ability of Websense security products to provide an additional layer ofprotection, then the market for our products may develop more slowly than weexpect, which could adversely affect our operating results. Developing andmaintaining awareness of 

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our Websense brand iscritical to achieving widespread acceptance of our existing and futureproducts. Furthermore, we believe that the importance of brand recognition willincrease as competition in our market develops. Successful promotion of ourWebsense brand will depend largely on the effectiveness of our marketingefforts and on our ability to develop reliable and useful products atcompetitive prices. If we fail to successfully promote our Websense brand, orif our expenses to promote and maintain our Websense brand are greater thananticipated, our results of operations and financial condition could suffer.

*Because we recognize revenue from subscriptions forour products ratably over the term of the subscription, downturns in sales maynot be immediately reflected in our revenue.*

We expect that nearly all of our revenue for theforeseeable future will come from subscriptions to Websense Enterprise and ouradd-on products. Upon execution of a subscription agreement, we invoice ourcustomers for the full term of the subscription agreement. We then recognizerevenue from customers monthly over the terms of their subscription agreements,which typically have durations of 12, 24 or 36 months. As a result, a majorityof the revenue we report in each quarter is deferred revenue from subscriptionagreements entered into and paid for during previous quarters. Because of thisfinancial model, the revenue we report in any quarter or series of quarters maymask significant downturns in sales and the market acceptance of our products.

*Sales to customers outside the United States haveaccounted for a significant portion of our revenue, and we expect this trend tocontinue, which exposes us to risks inherent in international sales.*

We market and sellour products outside the United States through value-added resellers,distributors and other resellers. International sales represented approximately33% of our total revenue in 2005 and approximately 32% in 2004, andinternational sales increased 37% in absolute dollars in 2005 compared with2004. As a key component of our business strategy, we intend to expand ourinternational sales, but success cannot be assured. In addition to the risksassociated with our domestic sales, our international sales are subject to thefollowing risks:

·       dependenceon foreign distributors and their sales channels;

·       localizationof our products and our ability to properly categorize and filter websitescontaining foreign languages;

·       lawsand business practices favoring local competitors;

·       compliancewith multiple, conflicting and changing governmental laws and regulations,  including tax laws and regulations;

·       foreigncurrency fluctuations;

·       longeraccounts receivable payment cycles and other collection difficulties; and

·       regionaleconomic and political conditions.

Such factors could have a material adverse effect onour future international sales. Any reduction in international sales, or ourfailure to further develop our international distribution channels, could havea material adverse effect on our business, results of operations and financial condition.

Our international revenue is currently primarilydenominated in U.S. dollars. As a result, fluctuations in the value of the U.S.dollar and foreign currencies may make our products more expensive forinternational customers, which could harm our business. In 2005, we beganbilling certain international customers in Euros. In 2006, we anticipatebilling certain international customers in other foreign currencies. This mayincrease our risks associated with fluctuations in foreign currency exchangerates since we cannot be assured of receiving the same U.S. dollar equivalentas when we bill exclusively in 

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U.S. dollars. Weengage in currency hedging activities with the intent of limiting the risk ofexchange rate fluctuation. Our hedging activities also involve inherent risksthat could result in an unforeseen loss. If we fail to properly forecast ratefluctuations these activities could have a negative impact.

*We may not be able to develop acceptable newproducts or enhancements to our existing products at a rate required by ourrapidly changing market.*

Our future success depends on our ability to developnew products or enhancements to our existing products that keep pace with rapidtechnological developments and that address the changing needs of ourcustomers. Although our products are designed to operate with a variety ofnetwork hardware and software platforms, we will need to continuously modifyand enhance our products to keep pace with changes in internet-relatedhardware, software, communication, browser and database technologies. We maynot be successful in either developing such products or introducing them to themarket in a timely fashion. In addition, uncertainties about the timing andnature of new network platforms or technologies, or modifications to existingplatforms or technology could increase our research and development expenses.The failure of our products to operate effectively with the existing and futurenetwork platforms and technologies will limit or reduce the market for ourproducts, result in customer dissatisfaction and seriously harm our business,results of operations and financial condition.

*If we acquire any companies or technologies in thefuture, they could prove difficult to integrate, disrupt our business, dilutestockholder value and adversely affect our operating results.*

We may acquire or make investments in complementarycompanies, services and technologies in the future. We have not made anyacquisitions or investments to date, and therefore our ability as anorganization to make acquisitions or investments is unproven. Although wereview the records of companies or businesses we are interested in acquiring,even an in-depth review may not reveal existing or potential problems or permitus to become familiar enough with a business to assess fully its capabilitiesand deficiencies.

Acquisitions andinvestments involve numerous risks, including:

·       difficultiesin integrating operations, technologies, services and personnel;

·       diversionof financial and management resources from existing operations;

·       riskof entering new markets;

·       potentialloss of key employees;

·       assumptionof liabilities of the acquired company, including debt and litigation; and

·       inabilityto generate sufficient revenue to offset acquisition or investment costs.

In addition, if we finance acquisitions by issuingconvertible debt or equity securities, our existing stockholders may be dilutedwhich could affect the market price of our stock. As a result, if we fail toproperly evaluate and execute acquisitions or investments, our business andprospects may be seriously harmed.

*Our quarterly operating results may fluctuatesignificantly, and these fluctuations may cause our stock price to fall.*

Our quarterly operating results have variedsignificantly in the past, and will likely vary in the future primarily as theresult of fluctuations in our billings, revenues, operating expenses and taxprovisions. Although a significant portion of our revenue in any quarter comesfrom previously deferred revenue, a meaningful portion of our revenue in anyquarter depends on subscriptions to our products that are sold in that quarter.The risk of quarterly fluctuations is increased by the fact that a significantportion of our quarterly sales have historically been generated during the lastmonth of each fiscal quarter, with many of 

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the largest enterprisecustomers purchasing subscriptions to our products nearer to the end of thelast month of each quarter. Due to the unpredictability of these end-of-periodbuying patterns, forecasts may not be achieved.

We expect that ouroperating expenses will increase substantially in the future as we expand ourselling and marketing activities, increase our research and development effortsand hire additional personnel. In addition, our operating expenses historicallyhave fluctuated, and may continue to fluctuate in the future, as the result ofthe factors described below and elsewhere in this quarterly report:

**·****     **timingof marketing expenses for activities such as trade shows and advertising campaigns;

·       quarterlyvariations in general and administrative expenses, such as recruiting expensesand professional services fees;

·       increasedresearch and development costs prior to new or enhanced product launches; and

·       timingof expenses associated with commissions paid on sales of subscriptions to ourproducts.

Consequently, our results of operations may not meetthe expectations of current or potential investors. If this occurs, the priceof our common stock may decline.

*The market price of our common stock is likely tobe highly volatile and subject to wide fluctuations.*

The market price ofour common stock has been and likely will continue to be highly volatile andcould be subject to wide fluctuations in response to a number of factors thatare beyond our control, including:

·       announcementsof technological innovations or new products or services by our competitors;

·       demandfor our products, including fluctuations in subscription renewals;

·       changesin the pricing policies of our competitors; and

·       changesin government regulations.

In addition, themarket price of our common stock could be subject to wide fluctuations inresponse to:

·       announcementsof technological innovations or new products or services by us;

·       changesin our pricing policies; and

·       quarterlyvariations in our revenues and operating expenses.

Further, the stock market has experienced significantprice and volume fluctuations that have particularly affected the market priceof the stock of many internet-related companies, and that often have beenunrelated or disproportionate to the operating performance of these companies.A number of publicly traded internet-related companies have current marketprices below their initial public offering prices. Market fluctuations such asthese may seriously harm the market price of our common stock. In the past,securities class action suits have been filed following periods of marketvolatility in the price of a company’s securities. If such an action wereinstituted, we would incur substantial costs and a diversion of managementattention and resources, which would seriously harm our business, results ofoperations and financial condition.

*We must develop and expand our indirect saleschannels to increase revenue and improve our operating results.*

We depend on our indirect sales channels, includingvalue-added resellers, distributors, and providers of managed internetservices, to offer our products to a larger customer base than can be reachedthrough a direct sales effort. We need to expand our existing indirect saleschannel relationships and enter into new 

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indirect sales channelrelationships to increase our current and future market share and revenue. Wemay be unable to maintain and expand our existing relationships or enter intonew relationships on commercially reasonable terms or at all. If we are unableto maintain and expand our existing relationships or enter into newrelationships, we would lose customer introductions and co-marketing benefitsand our operating results could suffer. Our ability to meaningfully increasethe amount of our products sold through our sales channels also depends on ourability to adequately and efficiently support these channel partners with,among other things, appropriate financial incentives to encourage pre-salesinvestment and sales tools, such as sales training, technical training andproduct collateral needed to support their customers and prospects. Any failureto properly and efficiently support our sales channels will result in lostsales opportunities.

*Our reliance on indirect sales channels couldresult in reduced revenue growth because we have little control over ourvalue-added resellers, distributors and original equipment manufacturers.*

We anticipate that sales from our various indirectsales channels, including value-added resellers, distributors, providers ofmanaged internet services and others, will continue to account for asignificant majority of our total revenue in future periods. None of theseparties is obligated to continue selling our products or to make any purchasesfrom us. Our ability to generate increased revenue depends upon the ability andwillingness of our indirect sales channels to market and sell our products. Ifthey are unsuccessful in their efforts or are unwilling or unable to market andsell our new product offerings such as our security-oriented offerings, ouroperating results will suffer. We cannot control the level of effort theseparties expend or the extent to which any of them will be successful inmarketing and selling our products. Some of our indirect sales channels alsomarket and sell products that compete with our products or may decide to do soin the future. We may not be able to prevent these parties from devotinggreater resources to support our competitors’ products and/or eliminating theirefforts to sell our products.

*Any failure to protect our proprietary technologyor establish our Websense brand would negatively impact our business.*

Intellectual property is critical to our success, andwe rely upon trademark, copyright and trade secret laws in the United Statesand other jurisdictions as well as confidentiality procedures and contractualprovisions to protect our proprietary technology and our Websense brand. Werely on trade secrets to protect technology where we believe patent protectionis not appropriate or obtainable. However, trade secrets are difficult toprotect. While we require employees, collaborators and consultants to enterinto confidentiality agreements, we cannot assure that these agreements willnot be breached or that we will have adequate remedies for any breach. We maynot be able to adequately protect our trade secrets or other proprietaryinformation in the event of any unauthorized use or disclosure or the lawfuldevelopment by others of such information.

We have registered our Websense and WebsenseEnterprise trademarks in several countries and have registrations for theWebsense trademark pending in several other countries. Effective trademarkprotection may not be available in every country where our products areavailable. Furthermore, any of our trademarks may be challenged by others orinvalidated through administrative process or litigation.

We currently haveonly three issued patents in the United States and one corresponding issuedpatent internationally, and we may be unable to obtain further patentprotection in the future. We have several pending patent applications in theUnited States and in other countries. We cannot ensure that:

·       wewere the first to make the inventions covered by each of our pending patentapplications;

·       wewere the first to file patent applications for these inventions;

·       otherswill not independently develop similar or alternative technologies or duplicateany of our technologies;

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·       anyof our pending patent applications will result in issued patents;

·       anypatents issued to us will provide us with any competitive advantages or willnot be challenged by third parties;

·       wewill develop additional proprietary technologies that are patentable; or

·       thepatents of others will not have a negative effect on our ability to dobusiness.

Furthermore, legal standards relating to the validity,enforceability and scope of protection of intellectual property rights areuncertain. Effective patent, trademark, copyright and trade secret protectionmay not be available to us in every country in which our products areavailable. The laws of some foreign countries may not be as protective ofintellectual property rights as United States laws, and mechanisms for enforcementof intellectual property rights may be inadequate. As a result our means ofprotecting our proprietary technology and brands may not be adequate.Furthermore, despite our efforts, we may be unable to prevent third partiesfrom infringing upon or misappropriating our intellectual property, includingthe misappropriation or misuse of the content of our proprietary databases ofuniversal resource locators (URLs) and software applications. Any suchinfringement or misappropriation could have a material adverse effect on ourbusiness, results of operations and financial condition.

*We may be sued by third parties for allegedinfringement of their proprietary rights.*

The software and internet industries are characterizedby the existence of a large number of patents, trademarks and copyrights and byfrequent litigation based on allegations of patent infringement or otherviolations of intellectual property rights. As we expand our product offeringsin the security area where larger companies with large patent portfolioscompete, the possibility of an intellectual property claim against us grows. Wemay also incur more expense in our product development efforts if we need tolicense patents or design around patents to avoid infringement claims. Ourtechnologies and products may not be able to withstand any third-party claimsor rights against their use. Any intellectual property claims, with or withoutmerit, could be time-consuming and expensive to litigate or settle, and coulddivert management attention from executing our business plan.

*Our database categories and our process forclassifying URLs and software applications within those categories aresubjective, and we may not be able to categorize URLs and software applicationsin accordance with our customers’ expectations.*

We may not succeed in accurately categorizing internetand application content to meet our customers’ expectations. We rely upon acombination of automated filtering technology and human review to categorizeURLs and software applications in our proprietary databases. Our customers maynot agree with our determinations that particular URLs and softwareapplications should be included or not included in specific categories of ourdatabases. In addition, it is possible that our filtering processes may placeobjectionable or security risk material in categories that are generallyunrestricted by our users’ internet and computer access policies, which couldresult in such material not being blocked from the network. Anymiscategorization could result in customer dissatisfaction and harm ourreputation. Any failure to effectively categorize and filter URLs and softwareapplications according to our customers’ expectations will impair the growth ofour business and our efforts to increase brand acceptance.

*Our databases may fail to keep pace with the rapidgrowth and technological change of the Internet.*

The success of our products depend on the breadth andaccuracy of our databases. Although our databases currently catalog more than15 million URLs and over 1.4 million software applications and executablefiles, they contain only a portion of such material that exists. In addition,the total number of URLs and software applications is growing rapidly, and weexpect this rapid growth rate to continue in the future. In particular, URLsand software applications that pose security risks tend to develop and evolveat a much faster rate than other content that we identify and categorize. Accordingly,we must identify and 

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categorize content for oursecurity risk categories at an extremely rapid rate with our Real Time SecurityUpdates. Our databases and database technologies may not be able to keep pacewith the growth in the number of URLs and software applications, especially thegrowing amount of content utilizing foreign languages and the increasingsophistication of malicious code and the delivery mechanisms associated withspyware, phishing and other hazards associated with the Internet. Further, theongoing evolution of the Internet and computing environments will require us tocontinually improve the functionality, features and reliability of ourdatabases. Because our products primarily manage access to URLs and softwareapplications included in our databases, if our databases do not contain ameaningful portion of relevant content, the effectiveness of WebsenseEnterprise will be significantly diminished. Any failure of our databases tokeep pace with the rapid growth and technological change of the Internet willimpair the market acceptance of our products, which in turn will harm ourbusiness, results of operations and financial condition.

*Failure of our products to work properly or misuseof our products could impact sales, increase costs, and create risks ofpotential negative publicity and legal liability.*

Our products are complex and are deployed in a widevariety of complex network environments. Our products may have errors ordefects that users identify after deployment, which could harm our reputationand our business. In addition, products as complex as ours frequently containundetected errors when first introduced or when new versions or enhancementsare released. We have from time to time found errors in versions of ourproducts, and we may find such errors in the future. Because customers rely onour products to manage employee behavior and to protect against security risks,any significant defects or errors in our products may result in negativepublicity or legal claims. For example, an actual or perceived breach ofnetwork or computer security at one of our customers, regardless of whether thebreach is attributable to our products, could adversely affect the market’sperception of our security products. Moreover, parties whose websites orsoftware applications are placed in security-risk categories or othercategories with negative connotations may seek redress against us for falselylabeling them or for interfering with their business. The occurrence of errorscould adversely affect sales of our products, divert the attention ofengineering personnel from our product development efforts and causesignificant customer relations or legal problems.

Our products may also be misused or abused bycustomers or non-customer third parties who obtain access and use of ourproducts. These situations may arise where an organization uses our products ina manner that impacts their end users’ or employees’ privacy or where ourproducts are misappropriated to censor private access to the internet. Any ofthese situations could result in negative press coverage and negatively affectour reputation.

*Our worldwide income tax provisions and other taxaccruals may be insufficient if any taxing authorities assume taxing positionsthat are contrary to our positions.*

Significant judgment is required in determining ourworldwide provision for income taxes and for our accruals for other state,federal and international taxes such as sales and VAT taxes. In the ordinarycourse of a global business, there are many transactions for which the ultimatetax outcome is uncertain. Some of these uncertainties arise as a consequence ofintercompany arrangements to share revenue and costs. In such arrangementsthere are uncertainties about the amount and manner of such sharing, whichcould ultimately result in changes once the arrangements are reviewed by taxingauthorities. Although we believe that our approach to determining the amount ofsuch arrangements is reasonable, no assurance can be given that the final taxauthority review of these matters will not be materially different than thatwhich is reflected in our historical income tax provisions and other taxaccruals. Such differences could have a material effect on our income taxprovisions or benefits, or other tax accruals, in the period in which suchdetermination is made, and consequently, on our net income for such period.

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From time to time, we are also audited by variousstate, federal and international authorities relating to tax matters. We fullycooperate with all audits. Our audits are in various stages of completion;however, no outcome for a particular audit can be determined with certaintyprior to the conclusion of the audit and appeals process. As each audit isconcluded, adjustments, if any, are appropriately recorded in our financialstatements in the period determined. To provide for potential tax exposures, wemaintain allowances for tax contingencies based on reasonable estimates of ourpotential exposure with respect to the tax liabilities that may result fromsuch audits. However, if the reserves are insufficient upon completion of any audits,there could be an adverse impact on our financial position and results ofoperations.

*We are subject to changes in financial accountingstandards, which may adversely affect our reported financial results or the waywe conduct business.*

Accounting policies affecting software revenuerecognition have been the subject of frequent interpretations, significantlyaffecting the way we sell our products. Future changes in financial accountingstandards, including pronouncements relating to revenue recognition, may have asignificant effect on our reported results, including reporting of transactionscompleted before the effective date of the changes.

In December 2004, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards (SFAS) No. 123(revised 2004), Share-Based Payment (SFAS No. 123R), which will beeffective in our first quarter of fiscal 2006.  As permitted by SFAS No. 123, Accountingfor Stock-Based Compensation (SFAS No. 123), we currently account forshare-based payments to employees using the intrinsic value method inaccordance with Accounting Principles Board (APB) No. 25, Accounting forStock Issued to Employees (APB No. 25), and, as such, generally recognize nocompensation cost for employee stock option grants or the discounts that weprovide under our employee stock purchase plans. Under the new rules,commencing with our first quarter of fiscal 2006, we are required to adopt afair value-based method for measuring the compensation expense related toemployee stock awards; we anticipate that this will lead to an additionalcompensation expense of approximately $5.0 million in the first quarter of2006, thereby reducing net income and earnings per share. Note 1 to ourConsolidated Financial Statements in this report provides our pro forma netincome and earnings per share as if we had used a fair value-based methodsimilar to the methods required under SFAS 123R to measure thecompensation expense for employee stock awards during fiscal 2005, 2004 and 2003.In addition, the adoption of this standard could limit our ability to continueto use stock options as an incentive and retention tool, which could, in turn,hurt our ability to recruit employees and retain existing employees. However,overall, our cash flows will be unaffected.

*We are dependent on our management team, and theloss of any key member of this team may prevent us from implementing ourbusiness plan in a timely manner.*

Our success depends largely upon the continuedservices of our executive officers and other key management personnel. We arealso substantially dependent on the continued service of our existingengineering personnel because of the complexity of our products andtechnologies. We do not have employment agreements with a majority of ourexecutive officers, key management or development personnel and, therefore,they could terminate their employment with us at any time without penalty. Wedo not maintain key person life insurance policies on any of our employees. Theloss of one or more of our key employees could seriously harm our business,results of operations and financial condition. In such an event we may beunable to recruit personnel to replace these individuals in a timely manner, orat all, on acceptable terms. In January 2006, we hired a new CEO, GeneHodges, to succeed John Carrington who had served as our CEO since 1999. Wecannot provide any assurance that our new CEO will lead the company’s strategicdirection or anticipate market changes and requirements in the same manner orwith the same results as our former CEO.

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*Ourgrowth could strain our personnel and infrastructure resources, and if we areunable to implement appropriate controls and procedures to manage our growth,we may not be able to successfully implement our business plan.*

We continue to experience rapid growth in ouroperations, which has placed, and will continue to place, a significant strainon our management, administrative, operational and financial infrastructure.Our future success will depend in part upon the ability of our seniormanagement to manage growth effectively. This will require us to hire and trainadditional personnel to manage our expanding operations. In addition, we willbe required to continue to improve our operational, financial and managementcontrols and our reporting systems and procedures. If we fail to successfullymanage our growth, we will be unable to execute our business plan.

*Because competition for our target employees isintense, we may not be able to attract and retain the highly skilled employeeswe need to support our planned growth.*

To execute our growth plan, we must attract and retainhighly qualified personnel. We need to hire additional personnel in virtuallyall operational areas, including selling and marketing, research anddevelopment, operations and technical support, customer service andadministration. Competition for these personnel is intense, especially forengineers with high levels of experience in designing and developing softwareand internet-related products. We may not be successful in attracting andretaining qualified personnel. We have from time to time in the pastexperienced, and we expect to continue to experience in the future, difficultyin hiring and retaining highly skilled employees with appropriatequalifications. Many of the companies with which we compete for experiencedpersonnel have greater resources than we have. If we fail to attract newpersonnel or retain and motivate our current personnel, our business and futuregrowth prospects could be severely harmed.

*Our systems may be vulnerable to security risks orservice disruptions that could harm our business.*

Although we have taken measures to secure our systemsagainst security risks and other causes of disruption of electronic services,our servers are vulnerable to physical or electronic break-ins and servicedisruptions, which could lead to interruptions, delays, loss of data or theinability to process customer requests. Such events could be very expensive toremedy, could damage our reputation and could discourage existing and potentialcustomers from using our products.

*Evolving regulation of the internet may affect usadversely.*

As internet commerce continues to evolve, increasingregulation by federal, state or foreign agencies becomes more likely. Suchregulation is likely in the areas of user privacy, pricing, content and qualityof products and services. Taxation of internet use or other charges imposed bygovernment agencies or by private organizations for accessing the internet mayalso be imposed. Laws and regulations applying to the solicitation, collectionor processing of personal or consumer information could affect our activities.Furthermore, any regulation imposing fees for internet use could result in adecline in the use of the internet and the viability of internet commerce,which could have a material adverse effect on our business, results ofoperations and financial condition.

*It may be difficult for a third party to acquireus, even if doing so would be beneficial to our stockholders.*

Some provisions of our certificate of incorporationand bylaws, as well as some provisions of Delaware law, may discourage, delayor prevent third parties from acquiring us, even if doing so would bebeneficial to our stockholders. For example, our certificate of incorporationprovides for a classified board, with each board member serving a staggeredthree-year term. It also provides that stockholders may not fill boardvacancies, call stockholder meetings or act by written consent. Our bylawsfurther provide that advance written notice is required prior to stockholderproposals. Each of these provisions makes it more difficult for stockholders toobtain control of our board or initiate actions that are opposed by the then current

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board. Additionally, wehave authorized preferred stock that is undesignated, making it possible forthe board to issue up to 5,000,000 shares of preferred stock with voting orother rights and preferences that could impede the success of any attemptedchange of control. Delaware law also could make it more difficult for a thirdparty to acquire us. Section 203 of the Delaware General Corporation Lawmay have an anti-takeover effect with respect to transactions not approved inadvance by our board, including discouraging attempts that might result in apremium over the market price of the shares of common stock held by our stockholders.

*We do not intend to pay dividends.*

We have not declared orpaid any cash dividends on our common stock since we have been a publiclytraded company. We currently intend to retain any future cash flows fromoperations to fund growth and, do not expect to pay any dividends in theforeseeable future.

**Item 1B. Unresolved Staff Comments**

None.

**Item 2. Properties**

Our corporate headquartersand principal offices are located in San Diego, California, where we leasedapproximately 105,000 square feet as of December 31, 2005. This leaseexpires in December 2008, with an option to extend the lease for anadditional five years and an option to terminate the lease early as of December 31,2007. We believe that our current space is adequate for our current needs andsufficient space is available to meet our identified future needs. We leaseoffice space in Brazil, France, Germany, Ireland, Italy, Japan and the UK inexecutive suite arrangements on monthly, annual or two-year arrangements,depending on the local market.

**Item 3. Legal Proceedings**

We are not a party to anymaterial legal proceedings.

**Item 4. Submission of Matters to a Vote of SecurityHolders**

There were no matters submitted to a vote of thesecurity holders during the fourth quarter of the fiscal year-ended December 31,2005.

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**Part II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities

Ourcommon stock is traded on the Nasdaq National Market (Nasdaq) under the symbol “WBSN.”The following table sets forth the range of high and low closing prices onNasdaq of our common stock for the periods indicated, as reported by Nasdaq.Such quotations represent inter-dealer prices without retail markup, markdownor commission and may not necessarily represent actual transactions.

| **Year Ended December 31, 2005** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------------------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter                                        |       | $          | 61.52      |     | $          | 45.00   |       |
| Second Quarter                                       |       | 56.37      |       | 45.82    |       |
| Third Quarter                                        |       | 54.22      |       | 46.21    |       |
| Fourth Quarter                                       |       | 67.95      |       | 51.08    |       |
|                                                      |            |            |            |          |            |         |            |  |  |

 

| **Year Ended December 31, 2004** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------------------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter                                        |       | $          | 32.90      |     | $          | 26.18   |       |
| Second Quarter                                       |       | 37.48      |       | 28.57    |       |
| Third Quarter                                        |       | 43.65      |       | 30.01    |       |
| Fourth Quarter                                       |       | 52.66      |       | 38.96    |       |
|                                                      |            |            |            |          |            |         |            |  |  |

 

To date, we have neither declared nor paid any cashdividends on our common stock. We currently intend to retain all futureearnings, if any, for use in the operation and development of our business andfor stock repurchases and, therefore, do not expect to declare or pay any cashdividends on our common stock in the foreseeable future. As of February 15,2006, there were approximately 7,100 holders of record of our common stock. SeeItem 12—“Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters” for information regarding our equity compensationplans.

On January 31, 2006, we announced that our Board ofDirectors authorized a two-for-one stock split of our common stock, to beeffected in the form of a special dividend of one share of our common stock foreach share outstanding. The additional shares issued as a result of the stocksplit will be distributed on or about March 17, 2006 to stockholders ofrecord at the close of business on February 13, 2006. The shares and pershare data presented above and in the accompanying consolidated financialstatements and notes thereto have not been restated to give effect to thispending stock split.

**Use of Proceeds**

On March 28, 2000, wecompleted our initial public offering for the sale of 4,000,000 shares ofcommon stock at a price to the public of $18 per share, which resulted in netproceeds of $65.7 million after payment of the underwriters’ commissions anddeductions of offering expenses. The registration statement (No. 333-95619)relating to our initial public offering was declared effective on March 28,2000. Subsequent to our initial public offering, a portion of the offeringproceeds were used to repay the $1.5 million balance of our fixed termloan agreements with financial institutions. The remaining proceeds haveconformed with our intended use outlined in the prospectus related to suchoffering. We currently have approximately $64.2 million remaining from our IPOproceeds.

**IssuerPurchases of Equity Securities**

On April 3,2003, we announced that our Board of Directors authorized a stock repurchaseprogram of up to 2 million shares of our common stock. On August 15, 2005,we announced that our Board of Directors increased the size of the stockrepurchase program by an additional 2 million shares of our 

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common stock, for a total program size of up to 4million shares of our common stock. The following table provides informationregarding our stock repurchases in the quarter ended December 31, 2005:

| **Month**                                        | ** ** | ** ** | ** ** | **Number of shares  purchased during month(1)** | ** ** | **Average price  paid per share** | ** ** | **Cumulative number  of shares purchased  as part of publicly  announced plan** | ** ** | **Maximum number of  shares that may yet be  purchased under the plan** | ** ** |
|--------------------------------------------------|------------|------------|------------|---------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|
| October 1st through 31st of 2005  |       |       | —     |                                                                |       |                                             | —     |                                                                                                               |       |                                                                                                                 | 1,835,030  |   |   |   | 2,164,970 |   |   |
| November 1st through 30th of 2005 |       |       | 27,500     |                                                                |       |                                             | $          | 63.62                                                                                                              |       |                                                                                                                 |       | 1,862,530 |   |   |   | 2,137,470 |   |   |
| December 1st through 31st of 2005 |       |       | 72,500     |                                                                |       |                                             | $          | 65.32                                                                                                              |       |                                                                                                                 |       | 1,935,030 |   |   |   | 2,064,970 |   |   |
| Total                                            |       |       | 100,000    |                                                                |       |                                             | $          | 64.86                                                                                                              |       |                                                                                                                 |       | 1,935,030 |   |   |   | 2,064,970 |   |   |

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(1)          Thepurchases were made in open-market transactions.

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**Item 6.**                        SelectedFinancial Data

Youshould read the following selected financial data in conjunction with ourfinancial statements and related notes and “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” appearing elsewherein this annual report. We derived the income statement data for the years endedDecember 31, 2005, 2004 and 2003 and the balance sheet data as of December 31,2005 and 2004 from our financial statements audited by Ernst & YoungLLP, which appear elsewhere in this report. We derived the income statementdata for the years ended December 31, 2002 and 2001 and the balance sheetdata as of December 31, 2003, 2002 and 2001 from our financial statementsaudited by Ernst & Young LLP, which are not included in this annualreport. Our historical results are not necessarily indicative of operatingresults to be expected in the future.

| ** **                                | ** ** | **Years Ended December 31,**                                 | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **2005**                                                                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                | ** ** | **(In thousands, except for per share data)** | ** ** |
| **Income Statement Data:**                |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Revenues                                  |       | $                                                                           | 148,636    |   | $ | 111,859 |   | $ | 81,734 |   | $ | 60,965 |   | $ | 35,893 |   |
| Cost of revenues                          |       | 10,642                                                                      |       | 7,769 |   | 5,523 |   | 4,170 |   | 3,602 |   |
| Gross margin                              |       | 137,994                                                                     |       | 104,090 |   | 76,211 |   | 56,795 |   | 32,291 |   |
| Operating expenses:                       |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Selling and marketing                     |       | 55,288                                                                      |       | 42,625 |   | 31,845 |   | 26,201 |   | 19,707 |   |
| Research and development                  |       | 16,277                                                                      |       | 14,509 |   | 12,843 |   | 10,957 |   | 7,642 |   |
| General and administrative                |       | 11,729                                                                      |       | 8,200 |   | 6,649 |   | 5,960 |   | 5,358 |   |
| Amortization of stock-based  compensation |       | —                                                                      |       | — |   | 83 |   | 448 |   | 860 |   |
| Total operating expenses                  |       | 83,294                                                                      |       | 65,334 |   | 51,420 |   | 43,566 |   | 33,567 |   |
| Income (loss)  from operations            |       | 54,700                                                                      |       | 38,756 |   | 24,791 |   | 13,229 |   | (1,276 | ) |
| Other income, net                         |       | 5,411                                                                       |       | 2,226 |   | 2,292 |   | 2,711 |   | 4,500 |   |
| Income before  income taxes               |       | 60,111                                                                      |       | 40,982 |   | 27,083 |   | 15,940 |   | 3,224 |   |
| Provision  (benefit) for income taxes     |       | 21,343                                                                      |       | 14,806 |   | 10,395 |   | (797 | ) | 108 |   |
| Net income                                |       | $                                                                           | 38,768     |   | $ | 26,176 |   | $ | 16,688 |   | $ | 16,737 |   | $ | 3,116 |   |
| Net income per share:                     |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Basic                                     |       | $                                                                           | 1.63       |   | $ | 1.13 |   | $ | 0.76 |   | $ | 0.79 |   | $ | 0.16 |   |
| Diluted                                   |       | $                                                                           | 1.58       |   | $ | 1.09 |   | $ | 0.73 |   | $ | 0.72 |   | $ | 0.14 |   |
| Weighted average  shares—basic       |       | 23,746                                                                      |       | 23,080 |   | 22,038 |   | 21,211 |   | 20,082 |   |
| Weighted average  shares—diluted     |       | 24,598                                                                      |       | 24,114 |   | 22,976 |   | 23,338 |   | 22,780 |   |

 

| ** **                                           | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                           | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                           | ** ** | **(In thousands)**               | ** ** |
| **Balance Sheet Data:**                              |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents and marketable securities |       | $                                     | 320,389    |   | $ | 243,788 |   | $ | 182,859 |   | $ | 140,466 |   | $ | 103,108 |   |
| Working capital                                      |       | 255,103                               |       | 195,635 |   | 145,322 |   | 114,459 |   | 79,846 |   |
| Total assets                                         |       | 403,675                               |       | 315,293 |   | 233,613 |   | 180,188 |   | 119,812 |   |
| Deferred revenue                                     |       | 179,925                               |       | 132,317 |   | 93,960 |   | 64,679 |   | 43,478 |   |
| Total stockholders’  equity                     |       | 205,811                               |       | 167,944 |   | 128,929 |   | 106,711 |   | 70,680 |   |
|                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

The following discussionand analysis should be read in conjunction with the financial statements andrelated notes contained elsewhere in this report. See “Risk Factors” under Item1A above regarding certain factors known to us that could cause reportedfinancial information not to be necessarily indicative of future results.

**Forward Looking Statements**

This report on Form 10-Kmay contain “forward-looking statements” within the meaning of the federalsecurities laws made pursuant to the safe harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. These statements, which represent ourexpectations or beliefs concerning various future events, may contain wordssuch as “may,” “will,” “expects,” “anticipates,” “intends,” “plans,” “believes,”“estimates,” or other words indicating future results. Such statements mayinclude but are not limited to statements concerning the following:

·       anticipatedtrends in revenue;

·       growthopportunities in domestic and international markets;

·       customeracceptance and satisfaction with our products;

·       expectedtrends in operating and other expenses;

·       anticipatedcash and intentions regarding usage of cash;

·       changesin effective tax rates; and

·       anticipatedproduct enhancements or releases.

These forward-lookingstatements are subject to risks and uncertainties that could cause actualresults to differ materially from those anticipated as of the date of thisreport. We assume no obligation to update any forward-looking statements toreflect events or circumstances arising after the date of this report.

**Overview**

We provide employee internet management (EIM) and websecurity software products that enable organizations to reduce the risksassociated with web-based malicious attacks, spyware, and phishing, as well asanalyze, report and manage how their employees use computing resources. At thefoundation of our product offering is the Websense Enterprise® softwareapplication, which serves as a central policy engine and management andreporting console and enables the extended functionality of our add-on products.Websense Enterprise gives organizations the ability to enhance networksecurity, improve employee productivity, mitigate potential legal liability andconserve network bandwidth by allowing organizations to identify potential riskareas and implement web access and application usage policies that reduce theserisks.

In 1996, we released our first software product, WebsenseInternet Screening System. Since that time, we have focused our business ondeveloping and selling EIM and web security solutions. Websense Enterprise andWebsense Enterprise—Corporate EditionTM are our core web filtering solutions andprovide fully featured web filtering and serve as management platforms forrelated Websense add-on modules, such as our Premium GroupsTM, Real TimeSecurity UpdatesTM, Bandwidth OptimizerTM, Instant Messaging (IM) AttachmentManagerTM, Client Policy ManagerTM and Remote Filtering. We have also createdsuites of some of our products to address specific customer needs, such as theWebsense Web Security SuiteTM and Websense Web Security Suite—Lockdown EditionTM.We currently derive all of our revenue from subscriptions to the WebsenseEnterprise-based solutions and expect this trend to continue in the future asmore offerings are added to the Websense Enterprise platforms. In October 2005,we 

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announced an agreementwith Nortel Networks to develop a web content filtering solution to protectGSM/UMTS mobile handsets from receiving and accessing unwanted content. Weexpect the product to be generally available from Nortel Networks in mid-2006.

During 2005, we derived 33% of revenue frominternational sales, compared with 32% for 2004, with the United Kingdomcomprising approximately 10% of our total revenue in both years. We believeinternational markets continue to represent a significant growth opportunityand we are continuing to expand our international operations, particularly in selectedcountries in the European, Asia/Pacific and Latin American markets.

We sell Websense Enterprise through both indirect anddirect channels. Sales through indirect channels currently account for morethan 80% of our revenue, and our strategy is to continue to rely on indirectsales channels for a significant majority of our sales.

As described elsewhere inthis report, we recognize revenue from subscriptions to Websense Enterprise,including add-on modules, on a monthly straight-line basis over the term of thesubscription. We recognize the operating expenses related to these sales asthey are incurred. These operating expenses include sales commissions, whichare based on the total amount of the subscription contract and are fullyexpensed in the period the product is delivered. Operating expenses havecontinued to increase as compared with prior periods due to expanded sellingand marketing efforts, continued product research and development andinvestments in administrative infrastructure to support subscription sales thatwe will recognize as revenue in subsequent periods.

**Critical Accounting Policies**

We believe the following critical accounting policiesaffect our more significant judgments and estimates used in the preparation ofour consolidated financial statements.

*RevenueRecognition.**  *Whena purchase decision is made for Websense Enterprise, customers enter into asubscription agreement, which is generally 12, 24 or 36 months in duration andfor a fixed number of users. Other services such as upgrades/enhancements andstandard post-contract technical support services are sold together withWebsense Enterprise and provided throughout the subscription term. We recognizerevenue on a monthly straight-line basis, commencing with the month the subscriptionbegins, over the term of the subscription agreement provided collectability isreasonably assured. Upon entering into a subscription arrangement for a fixedor determinable fee, we electronically deliver access codes to users and thenpromptly invoice customers for the full amount of their subscriptions. Paymentis due for the full term of the subscription, generally within 30 to 60 days ofthe invoice. We record amounts billed to customers in excess of recognizablerevenue as deferred revenue on our balance sheet. Upon expiration of thesubscription, customers who wish to re-subscribe typically must do so at thencurrent rates to continue using Websense Enterprise. Our revenue issignificantly influenced by new and renewal subscriptions, and a decrease insubscription amounts could negatively impact our future revenue.

*Accountingfor Share-Based Compensation.**  *Through December 31, 2005, weaccounted for our share-based employee compensation plans under the measurementand recognition provisions of APB Opinion No. 25,  and related Interpretations, as permitted byFinancial Accounting Standards Board (FASB) SFAS No. 123. Inconjunction with our initial public offering, we reviewed our exercise pricesand arrived at the deemed fair value for each option grant during 1999. Withrespect to the 3,220,500 options granted during 1999 and through March 27,2000, we recorded deferred compensation of $5.4 million for the differencebetween the exercise price per share and the deemed fair value per share at thegrant date. The approximate weighted-average exercise price per share and theapproximate weighted-average deemed fair value per share for the options was$1.64 and $3.31, respectively. Deferred stock compensation was recognized andamortized on an accelerated basis in accordance with Financial AccountingStandards Board Interpretation (FIN) No. 28, Accounting for StockAppreciation Rights and 

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Other Variable Stock OptionAward Programs (FIN No. 28), over the vesting period of the relatedoptions, generally four years. Deferred stock compensation was fully amortizedas of December 31, 2003. Beyond the $5.4 million of deferred compensationrelated to our IPO, we recorded no other share-based employee compensationexpense for options granted under our Amended and Restated 2000 Stock IncentivePlan (2000 Plan), its predecessor plans (or options granted as non-planinducement options) as all other options granted had exercise prices equal tothe fair market value of our common stock on the date of grant. We alsorecorded no compensation expense in connection with our Employee Stock PurchasePlan as the purchase price of the stock was not less than 85% of the lower ofthe fair market value of our common stock at the beginning of each offeringperiod or at the end of each purchase period. In accordance with SFAS No. 123and SFAS No. 148, Accounting for Stock-Based Compensation—Transitionand Disclosure (SFAS No. 148), we disclosed our net income or lossand net income or loss per share as if we had applied the fair value-basedmethod in measuring compensation expense for our share-based incentiveprograms.

Effective January 1, 2006, we will adopt the fairvalue recognition provisions of SFAS No. 123(R), using the modifiedprospective transition method. Under that transition method, compensationexpense that we recognize beginning on that date will include: (a) compensationexpense for all share-based payments granted prior to, but not yet vested asof, January 1, 2006, based on the grant date fair value estimated inaccordance with the original provisions of SFAS No. 123, and (b) compensationexpense for all share-based payments granted on or after January 1, 2006,based on the grant date fair value estimated in accordance with the provisionsof SFAS No. 123(R). Results for prior periods will not be restated. At December 31,2005, there was $32.5 million of total unrecognized compensation costrelated to non-vested share-based compensation arrangements granted under allequity compensation plans. We expect to recognize that cost over a weightedaverage period of 2.0 years.

We estimate the fair value of options granted usingthe Black-Scholes option valuation model and the assumptions shown in Note 1 tothe financial statements. We estimate the expected term of options grantedbased on the history of grants and exercises in our option database. Weestimate the volatility of our common stock at the date of grant based on boththe historical volatility as well as the implied volatility of publicly tradedoptions on our common stock, consistent with SFAS No. 123(R) andSecurities and Exchange Commission Staff Accounting Bulletin No. 107. Webase the risk-free interest rate that we use in the Black-Scholes optionvaluation model on the implied yield in effect at the time of option grant onU.S. Treasury zero-coupon issues with equivalent remaining terms. We have neverpaid any cash dividends on our common stock and we do not anticipate paying anycash dividends in the foreseeable future. Consequently, we use an expecteddividend yield of zero in the Black-Scholes option valuation model. We amortizethe fair value ratably over the vesting period of the awards, which istypically four years. We may elect to use different assumptions under theBlack-Scholes option valuation model in the future or select a different optionvaluation model altogether, which could materially affect our net income orloss and net income or loss per share in the future.

*Allowancefor Doubtful Accounts.*   We maintain an allowancefor doubtful accounts for estimated losses resulting from the inability orunwillingness of our customers to pay their invoice(s). If the financialcondition of our customers were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances may be required.

*DeferredTax Assets.*   As required by SFAS No. 109, Accountingfor Income Taxes (SFAS No. 109), we recognize tax assets on thebalance sheet if it is “more likely than not” that they will be realized onfuture tax returns. At December 31, 2005, we had deferred tax assets of$21.8 million. We believe that it is more likely than not that our deferred taxassets will be realized. Factors considered by us included: our earningshistory, projected earnings based on current operations, and projected futuretaxable income in excess of stock option deductions. However, should wedetermine that we would not be able to realize all or part of our deferred taxassets in the future, an adjustment to the deferred tax assets would be charged

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against income oradditional paid-in capital in the period such determination was made. See Note8 of Notes to the Consolidated Financial Statements for further explanation ofour deferred tax assets.

*Income Tax Provision andTax Contingency Reserve.**  *Significantjudgment is required in determining our consolidated income tax provision andevaluating our U.S. and foreign tax positions. It is our policy to maintain taxcontingency reserves for tax audit issues that are likely to occur and canreasonably be estimated. We review the reserves as circumstances warrant andadjust the reserves as events occur that affect our potential liability foradditional taxes, such as lapsing of applicable statutes of limitations,conclusion of tax audits, additional exposure based on current calculations,identification of new issues or rendering of court decisions affecting aparticular tax issue. Tax reserve contingencies and changes to the reserves areevaluated and recorded in our tax provision in the period in which the abovenoted events occur.

**Results ofOperations**

Thefollowing table summarizes our operating results as a percentage of totalrevenues for each of the periods shown.

| ** **                  | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues                    |       |                                        | 100        | % |   |   | 100 | % |   |   | 100 | % |   |
| Cost of revenues            |       |                                        | 7          |   |   |   | 7 |   |   |   | 7 |   |   |
| Gross margin                |       |                                        | 93         |   |   |   | 93 |   |   |   | 93 |   |   |
| Operating  expenses:        |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Selling and marketing       |       |                                        | 37         |   |   |   | 38 |   |   |   | 39 |   |   |
| Research and development    |       |                                        | 11         |   |   |   | 13 |   |   |   | 16 |   |   |
| General and administrative  |       |                                        | 8          |   |   |   | 7 |   |   |   | 8 |   |   |
| Total operating expenses    |       |                                        | 56         |   |   |   | 58 |   |   |   | 63 |   |   |
| Income from  operations     |       |                                        | 37         |   |   |   | 35 |   |   |   | 30 |   |   |
| Other income, net           |       |                                        | 3          |   |   |   | 2 |   |   |   | 3 |   |   |
| Income before  income taxes |       |                                        | 40         |   |   |   | 37 |   |   |   | 33 |   |   |
| Provision for  income taxes |       |                                        | 14         |   |   |   | 14 |   |   |   | 13 |   |   |
| Net income                  |       |                                        | 26         | % |   |   | 23 | % |   |   | 20 | % |   |

 

**Years ended December 31, 2005 and 2004**

**Revenue**

**Revenueincreased to $148.6 million in 2005 from $111.9 million in 2004. The increasewas primarily a result of the addition of new, renewed and upgradedsubscriptions from our customers. Approximately 65% of subscription revenuerecognized in 2005 was derived from renewal business. We expect total revenuegrowth amounts in 2006 to exceed total revenue growth in 2005, although thepercentage revenue growth rate may be lower in 2006 than in 2005 as a result ofthe increasing overall revenue base.**

**Cost of Revenue**

**Cost ofrevenue consists of the costs of content review, technical support andinfrastructure costs associated with maintaining our databases. Cost of revenueincreased to $10.6 million in 2005 from $7.8 million in 2004. The increasewas primarily due to the costs associated with additional personnel in ourtechnical support and database groups, as well as allocated costs. We allocatethe total costs for human resources, employee benefits, payroll taxes,information technology, facilities, fixed asset depreciation and legal costs toeach of our functional areas based on salaries and headcount data. We expectcost of revenue to increase in the future due to stock-based compensationexpense and to support the growth and**

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**maintenanceof our databases as well as the technical support needs of our customers. As apercentage of revenue, cost of revenue remained unchanged at 7% during theyears-ended 2005 and 2004. We expect that cost of revenue, as a percentage ofrevenue, will remain below 10% of revenue for the foreseeable future.**

**Gross Margin**

**Grossmargin increased to $138.0 million in 2005 from $104.1 million in 2004. Theincrease was due to increased revenue. As a percentage of revenue, gross marginremained unchanged at 93% for the years-ended 2005 and 2004. We expect thatgross margin, as a percentage of revenue, will remain in excess of 90% ofrevenue for the foreseeable future.**

**Operating Expenses**

***Selling and marketing.  ******Selling and marketing expensesconsist primarily of salaries, commissions and benefits related to personnelengaged in selling, marketing and customer support functions, along with costsrelated to public relations, advertising, promotions and travel as well asallocated costs. Selling and marketing expenses increased to $55.3 million in2005 from $42.6 million in 2004. The increase in selling and marketing expensesof $12.7 million was primarily due to increased personnel costs and relatedtravel and allocated costs as well as higher commission related to higher saleslevels. We expect selling and marketing expenses to increase significantly inabsolute dollars in the future driven primarily by stock-based compensationexpense, and also as more personnel are added to support our expanding sellingand marketing efforts worldwide and as increased sales result in higher overallsales commission expenses.***

***Research and development.  ******Research and development expensesconsist primarily of salaries and benefits for software developers, contractprogrammers and allocated costs. Research and development expenses increased to$16.3 million in 2005 from $14.5 million in 2004. The increase of $1.8 millionin research and development expenses was primarily a result of increasedpersonnel needed to support our expanding list of technology partners, theenhancements of Websense Enterprise and additional products as well asincreased allocated costs. We expect research and development expenses toincrease significantly in absolute dollars in future periods driven primarilyby stock-based compensation expense, and also as a result of our continuedenhancements of our products.***

*General and administrative.*   Generaland administrative expenses consist primarily of salaries, benefits and relatedexpenses for our executive, finance, human resources and administrativepersonnel, third party professional service fees and allocated costs. Generaland administrative expenses increased to $11.7 million in 2005 from $8.2million in 2004. The $3.5 million increase in general and administrativeexpenses was primarily a result of additional personnel needed to support ourgrowing operations, increased allocated costs and an increase in professionalaccounting fees driven by compliance with the Sarbanes-Oxley Act of 2002. Weexpect general and administrative expenses to increase significantly inabsolute dollars in future periods driven primarily by stock-based compensationexpense, including stock-based compensation expense associated with the hiringof our new CEO, and also reflecting growth in operations, increasing expensesassociated with being a public company and expansion of our internationaloperations.

**Other Income, Net**

**Netother income increased to $5.4 million in 2005 from $2.2 million in 2004. Theincrease was due primarily to higher interest rates realized on our increasedbalances of cash, cash equivalents and marketable securities as of December 31,2005 compared with December 31, 2004. The majority of our investments ofcash and cash equivalents and marketable securities are tax-exempt. We expectthat the**

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**majorityof our cash and cash equivalents and marketable securities will continue to beheld in tax-exempt investments during the foreseeable future.**

**Provision for Income Taxes**

In 2005, United States and foreign income tax expensewas $21.3 million as compared to $14.8 million for 2004. The annual effectiveincome tax rate for 2005 was 35.5% compared to 36.1% for 2004. The annualeffective tax rate for 2005 was lower than the 2004 effective tax rateprimarily due to an increase in foreign earnings taxed at less than the UnitedStates federal income tax rate, an increase in tax-exempt interest income andan increase in federal and state research and development tax credits.

In 2006 and thereafter, weanticipate that our effective tax rate may continue to decrease due to benefitsderived from lower tax rates associated with foreign income.

**Years ended December 31, 2004 and 2003**

**Revenue**

Revenue increased to$111.9 million in 2004 from $81.7 million in 2003. The increase was primarily aresult of the addition of new, renewed and upgraded subscriptions from ourcustomers. Approximately 65% of subscription revenue recognized in 2004 wasderived from renewal business.

**Cost of Revenue**

**Cost ofrevenue increased to $7.8 million in 2004 from $5.5 million in 2003. Theincrease was primarily due to the costs associated with additional personnel inour technical support and database groups, as well as allocated costs. As apercentage of revenue, cost of revenue remained unchanged at 7% during theyears-ended 2004 and 2003.**

**Gross Margin**

**Gross margin increased to $104.1million in 2004 from $76.2 million in 2003. The increase was due to increasedrevenue. As a percentage of revenue, gross margin remained unchanged at 93% forthe years-ended 2004 and 2003.**

**Operating Expenses**

*Sellingand marketing.*   Selling and marketing expensesincreased to $42.6 million in 2004 from $31.8 million in 2003. Theincrease in selling and marketing expenses of $10.8 million was primarily dueto increased headcount costs and related travel and allocated costs as well ashigher commission and co-op marketing expenses related to higher sales levels.

*Researchand development.*   Research and development expensesincreased to $14.5 million in 2004 from $12.8 million in 2003. The increase of$1.7 million in research and development expenses was primarily a result ofincreased compensation costs and allocated costs to support our expanding listof technology partners and enhancements of our products.

*General and administrative*.   Generaland administrative expenses increased to $8.2 million in 2004 from $6.6 millionin 2003. The $1.6 million increase in general and administrative expenses wasprimarily a result of an increase in professional accounting fees drivenprimarily by compliance with the Sarbanes-Oxley Act of 2002, and allocatedcosts and additional personnel needed to support our growing operations.

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**Other Income, Net**

Net other income decreased to $2.2 million in 2004from $2.3 million in 2003. The decrease was due primarily to lower interestrates realized on our cash, cash equivalents and marketable securities despiteincreased balances as of December 31, 2004 as compared withDecember 31, 2003. The lower interest rates were substantially the resultof our strategy beginning in the second quarter of 2003 to purchase lowerinterest tax-exempt investments in order to maximize the after-tax return onour investments. Also contributing to the decrease were realized losses fromsettled foreign currency forward contracts. As of December 31, 2004, themajority of our total cash and cash equivalents and marketable securities weretax-exempt.

**Provision for Income Taxes**

In 2004, United States andforeign income tax expense was $14.8 million as compared to $10.4 million for2003. The annual effective income tax rate for 2004 was 36.1% compared to 38.4%for 2003. The annual effective tax rate for 2004 was lower than the 2003effective tax rate primarily due to an increase in foreign earnings taxed atless than the United States federal income tax rate, an increase in tax-exemptinterest income and an increase in federal and state research and developmenttax credits.

**Liquidity and Capital Resources**

As of December 31, 2005, we had cash and cashequivalents of $61.6 million, investments in marketable securities of $258.8million, and retained earnings of $56.4 million. As of December 31, 2004,we had cash and cash equivalents of $38.9 million, investments in marketablesecurities of $204.9 million and retained earnings of $17.7 million.

Net cash provided by operating activities was $100.7million in 2005 compared with net cash provided by operating activities of$65.2 million in 2004. The $35.5 million increase in cash provided by operatingactivities in 2005 was primarily due to an increase in our net income, anincrease in tax benefit from exercise of stock options and an increase indeferred revenue (subscription amounts in excess of recognizable revenue arerecorded as deferred revenue). Our operating cash flow is significantlyinfluenced by subscription renewals and accounts receivable collections, and adecrease in subscription renewals or accounts receivable collections would negativelyimpact our operating cash flow.

Net cash used in investing activities was $57.6million in 2005 compared with net cash used in investing activities of $61.1million in 2004. The $3.5 million decrease in net cash used by investing activitiesin 2005 was primarily due to fewer purchases of marketable securities to offsetmaturities and sales of marketable securities.

Net cash used by financing activities was $20.4million in 2005 compared with net cash used by financing activities of $0.6million in 2004. The $19.8 million increase in net cash used by financingactivities in 2005 was primarily due to the use of $48.3 million forrepurchases of 929,030 shares of our common stock in 2005, compared with theuse of $23.0 million for repurchases of 610,000 shares of our common stock in2004.

We have operating lease and software licensecommitments of approximately $2.2 million in 2006, $2.0 million in 2007, and$0.3 million in 2008. A significant majority of our operating lease commitmentsare related to our corporate headquarters lease, which extends through 2008.Our corporate headquarters lease includes escalating rent payments from 2004 to2008. The rent expense related to our corporate headquarters lease is recordedmonthly on a straight-line basis in accordance with generally acceptedaccounting principles.

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Future minimumannual payments under non-cancelable operating leases and software licenses at December 31,2005 are as follows (in thousands):

| ** ** | ** ** | **Operating  Leases** | ** ** | **Software  Licenses** | ** ** | **Total** | ** ** |
|------------|------------|-----------------------|------------|------------------------|------------|-----------|------------|
| 2006       |       |                  | $          | 1,889                  |       |      |       | $ | 314 |   |   | $ | 2,203 |   |
| 2007       |       |                  | 1,937      |                   |       |      | 79         |   |   | 2,016 |   |
| 2008       |       |                  | 325        |                   |       |      | —     |   |   | 325 |   |
|       |       |                  | $          | 4,151                  |       |      |       | $ | 393 |   |   | $ | 4,544 |   |

 

As of December 31, 2005 and 2004, we did not haveany relationships with unconsolidated entities or financial partners, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. As such,we are not materially exposed to any financing, liquidity, market or creditrisk that could arise if we had engaged in such relationships.

On April 3, 2003, we announced that our Board ofDirectors authorized a stock repurchase program of up to 2 million shares of ourcommon stock. On August 15, 2005, we announced that our Board of Directorsincreased the size of the stock repurchase program by an additional 2 millionshares, for a total program size of up to 4 million shares. The repurchaseswill be made from time to time on the open market at prevailing market pricesor in privately negotiated transactions. Depending on market conditions andother factors, purchases under this program may be commenced or suspended atany time, or from time to time, without prior notice. As of December 31,2005, we had repurchased 1,935,030 shares of our common stock under thisprogram, for an aggregate of $79.0 million at an average price of $40.83 pershare.

As of December 31, 2004, we had retired all1,006,000 shares of our common stock that had been repurchased prior to thatdate. In accordance with APB Opinion No. 6, Status of Accounting ResearchBulletins, the treasury stock retirement was effected by reducing the followingon our Consolidated Balance Sheets: treasury stock by $30.7 million, common stock by $0.1 million,additional paid-in capital by $6.4 million and retained earnings by $24.2million. There was no effect to our overall equity position as a result of theretirement. We do not expect to retire shares of our common stock that werepurchased during 2005, or shares that we may repurchase during 2006, in theforeseeable future.

On January 31,2006, we announced that our Board of Directors authorized a two-for-one stocksplit of our common stock, to be effected in the form of a special dividend ofone share of our common stock for each share outstanding. The additional sharesissued as a result of the stock split will be distributed on or about March 17,2006 to stockholders of record at the close of business on February 13,2006. The shares and per share data presented in the accompanying consolidatedfinancial statements and notes thereto have not been restated to give effect tothis pending stock split.

We believe that our cashand cash equivalents balances and investments in marketable securities will besufficient to satisfy our cash requirements for the foreseeable future. Weintend to continue to invest our cash in excess of current operatingrequirements and stock repurchases in interest-bearing, investment-gradesecurities.

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**SummarizedQuarterly Data (Unaudited)**

Thefollowing tables present unaudited quarterly financial information for theeight quarters ended December 31, 2005. We believe this informationreflects all adjustments (consisting only of normal recurring adjustments) thatwe consider necessary for a fair presentation of such information in accordancewith generally accepted accounting principles. The results for any quarter arenot necessarily indicative of results for any future period.

| ** **                   | ** ** | **1st Quarter**                                               | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|------------------------------|------------|--------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| ** **                   | ** ** | **(In thousands, except per share data)** | ** ** |
| **2005**                     |       |                                                               |       |                 |       |                 |       |                 |       |   |   |   |   |   |   |   |   |
| Revenue                      |       |                                                               | $          | 34,182               |       |                 |       | $                    | 36,026     |   |   |   | $ | 38,300 |   |   |   | $ | 40,128 |   |   |
| Gross margin                 |       |                                                               | 31,682     |                 |       |                 | 33,525     |                 |       |   | 35,471 |   |   |   | 37,316 |   |   |
| Income from  operations      |       |                                                               | 12,459     |                 |       |                 | 12,708     |                 |       |   | 14,465 |   |   |   | 15,068 |   |   |
| Income before  income taxes  |       |                                                               | 13,413     |                 |       |                 | 13,909     |                 |       |   | 16,000 |   |   |   | 16,789 |   |   |
| Net income                   |       |                                                               | 8,612      |                 |       |                 | 8,934      |                 |       |   | 10,111 |   |   |   | 11,111 |   |   |
| Basic income per  share(1)   |       |                                                               | $          | 0.36                 |       |                 |       | $                    | 0.37       |   |   |   | $ | 0.43 |   |   |   | $ | 0.47 |   |   |
| Diluted income  per share(1) |       |                                                               | $          | 0.35                 |       |                 |       | $                    | 0.36       |   |   |   | $ | 0.41 |   |   |   | $ | 0.45 |   |   |
| **2004**                     | ** ** |                                                               |       |                 |       |                 |       |                 |       |   |   |   |   |   |   |   |   |
| Revenue                      |       |                                                               | $          | 24,611               |       |                 |       | $                    | 26,643     |   |   |   | $ | 28,917 |   |   |   | $ | 31,688 |   |   |
| Gross margin                 |       |                                                               | 22,920     |                 |       |                 | 24,869     |                 |       |   | 26,914 |   |   |   | 29,387 |   |   |
| Income from  operations      |       |                                                               | 7,718      |                 |       |                 | 8,753      |                 |       |   | 10,678 |   |   |   | 11,607 |   |   |
| Income before income  taxes  |       |                                                               | 8,131      |                 |       |                 | 9,209      |                 |       |   | 11,276 |   |   |   | 12,366 |   |   |
| Net income                   |       |                                                               | 5,127      |                 |       |                 | 5,807      |                 |       |   | 7,106 |   |   |   | 8,136 |   |   |
| Basic income per  share(1)   |       |                                                               | $          | 0.23                 |       |                 |       | $                    | 0.25       |   |   |   | $ | 0.31 |   |   |   | $ | 0.35 |   |   |
| Diluted income per share(1)  |       |                                                               | $          | 0.22                 |       |                 |       | $                    | 0.24       |   |   |   | $ | 0.29 |   |   |   | $ | 0.33 |   |   |

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(1)          Basicand diluted net income per share computations for each quarter are independentand may not add up to the net income per share computation for the respectiveyear. See Note 1 of Notes to the Consolidated Financial Statements for anexplanation of the determination of basic and diluted net income per share.

**Item 7A.**                Quantitative andQualitative Disclosures About Market Risk

Our market risk exposures are related to our cash,cash equivalents and investments. We primarily invest our excess cash in highlyliquid short-term investments, municipal securities, commercial paper andcorporate bonds. These investments are not held for trading or otherspeculative purposes. Changes in interest rates affect the investment income weearn on our investments and therefore impact our cash flows and results ofoperations.

We are exposed to changes in interest rates primarilyfrom our short-term available-for-sale investments. Under our current policies,we do not use interest rate derivative instruments to manage exposure to interestrate changes. A hypothetical 100 basis point adverse move in interest ratesalong the entire interest rate yield curve would not materially affect the fairvalue of our interest sensitive financial instruments at December 31,2005. Changes in interest rates over time will, however, affect our interestincome.

We utilize foreign currency forward contracts andzero-cost collar contracts to hedge foreign currency market exposures ofunderlying assets and liabilities. In April 2005, we began billing customersin Euro-denominated countries in the Euro. In addition, working fundsnecessary to facilitate the short-term operations of our subsidiaries are keptin the local currencies in which they do business. Our objective is to 

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reduce the risk toearnings and cash flows associated with changes in foreign currency exchangerates. We do not use foreign currency contracts for speculative or tradingpurposes.

As of December 31, 2005 and 2004 we had committedto foreign currency forward contracts in the Euro with a notional amount of$4.0 and $0.4 million, respectively. Our Euro commitment at December 31,2005 and 2004, represents 3.4 and 0.3 million Euros at a weighted averageforward rate of 1.184 and 1.329, respectively. The fair value of these forwardcontracts was $4.0 and $0.4 million at December 31, 2005 and 2004. All ofthe foreign currency forward contracts will be settled before March 31,2006. The $3.6 million increase in our Euro hedged position is primarily due toour billing customers in Euro-denominated countries in the Euro, starting in April 2005.For the year-ended December 31, 2005, less than 10% of our total billingswere denominated in the Euro. In 2006, we will continue billing certaininternational customers in Euros, and we expect to continue to hedge thecorresponding exposure consistent with 2005. We do not expect foreign currencybillings to represent more than 15% of our total billings during 2006.

As of December 31, 2005, we had committed tozero-cost collar contracts in the British Pound, with a notional amount of $4.3million. As of December 31, 2004 we had committed to foreign currencyforward contracts in the British Pound, with a notional amount of $0.6 million.As of December 31, 2005, our British Pound commitment represents 2.4 millionBritish Pounds at a weighted average ceiling and floor of 1.8025 and 1.7460,respectively. As of December 31, 2004, our British Pound commitmentrepresented 300,000 British Pounds at a weighted average forward rate of 1.912.The fair value of these zero-cost collar and foreign currency forward contractswas $4.2 and $0.6 million at December 31, 2005 and 2004, respectively. Allof the zero-cost collar contracts will be settled before June 30, 2006. The$3.7 million increase in our British Pound hedged position is primarily due toour decision to lengthen the period hedged as well as increase the percentageof working funds hedged. In 2006, we expect an increase in British Poundexpenditures and our corresponding hedged commitments to be consistent with ourincrease in overall operating expenditures.

Given our foreignexchange position, a 10% change in foreign exchange rates upon which theseforeign exchange contracts are based would result in exchange gains and losses.In all material aspects, these exchange gains and losses would be fully offsetby exchange gains and losses on the underlying net monetary exposures for whichthe contracts are designated as hedges. We do not expect material exchange rategains and losses from unhedged foreign currency exposures.

41

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**Item 8.**                        FinancialStatements and Supplementary Data

**Reportof Independent Registered Public Accounting Firm**

The Board of Directors and StockholdersWebsense, Inc.

We have audited the accompanying consolidated balancesheets of Websense, Inc. as of December 31, 2005 and 2004, and therelated consolidated statements of income, stockholders’ equity, and cash flowsfor each of the three years in the period ended December 31, 2005. Ouraudits also included the financial statement schedule listed in the Index atItem 15(a). These financial statements and schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, 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 consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Websense, Inc. at December 31, 2005 and 2004, and theresults of its operations and its cash flows for each of the three years in theperiod ended December 31, 2005, in conformity with U.S. generally acceptedaccounting principles. Also, in our opinion, the related financial statementschedule, when considered in relation to the basic financial statements takenas a whole, presents fairly in all material respects the information set forththerein.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Websense Inc.’s internal control overfinancial reporting as of December 31, 2005, based on criteria establishedin Internal Control-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated February 22,2006 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

San Diego, CaliforniaFebruary 22, 2006

42

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**Websense, Inc.Consolidated Balance Sheets(In thousands, except per share amounts)**

| ** **                                                                                                                                             | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                             | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Assets**                                                                                                                                             |       |                  |       |   |   |   |   |
| Current assets:                                                                                                                                        |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                              |       |                  | $          | 61,629 |   |   | $ | 38,878 |   |
| Marketable securities                                                                                                                                  |       |                  | 258,760    |   |   | 204,910 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $1,460 and  $1,140 at December 31, 2005 and 2004                             |       |                  | 50,570     |   |   | 44,309 |   |
| Prepaid income taxes                                                                                                                                   |       |                  | 1,962      |   |   | 3,201 |   |
| Current portion of deferred income taxes                                                                                                               |       |                  | 15,772     |   |   | 8,530 |   |
| Other current assets                                                                                                                                   |       |                  | 3,467      |   |   | 1,525 |   |
| Total current assets                                                                                                                                   |       |                  | 392,160    |   |   | 301,353 |   |
| Property and equipment, net                                                                                                                            |       |                  | 4,923      |   |   | 3,955 |   |
| Deferred income  taxes, less current portion                                                                                                           |       |                  | 6,043      |   |   | 9,523 |   |
| Deposits and  other assets                                                                                                                             |       |                  | 549        |   |   | 462 |   |
| Total assets                                                                                                                                           |       |                  | $          | 403,675 |   |   | $ | 315,293 |   |
| **Liabilities  and stockholders’ equity**                                                                                                         |       |                  |       |   |   |   |   |
| Current liabilities:                                                                                                                                   |       |                  |       |   |   |   |   |
| Accounts payable                                                                                                                                       |       |                  | $          | 2,073 |   |   | $ | 1,100 |   |
| Accrued payroll and related benefits                                                                                                                   |       |                  | 8,476      |   |   | 7,163 |   |
| Other accrued expenses                                                                                                                                 |       |                  | 5,085      |   |   | 5,011 |   |
| Income taxes payable                                                                                                                                   |       |                  | 2,305      |   |   | 1,758 |   |
| Current portion of deferred revenue                                                                                                                    |       |                  | 119,118    |   |   | 90,686 |   |
| Total current liabilities                                                                                                                              |       |                  | 137,057    |   |   | 105,718 |   |
| Deferred revenue, less current portion                                                                                                                 |       |                  | 60,807     |   |   | 41,631 |   |
| Stockholders’  equity:                                                                                                                            |       |                  |       |   |   |   |   |
| Common stock—$0.01 par value; 100,000 shares authorized; 23,971  and 23,526 shares issued and outstanding at December 31, 2005 and 2004 |       |                  | 249        |   |   | 235 |   |
| Additional paid-in capital                                                                                                                             |       |                  | 198,077    |   |   | 150,447 |   |
| Treasury stock                                                                                                                                         |       |                  | (48,340    | ) |   | — |   |
| Retained earnings                                                                                                                                      |       |                  | 56,449     |   |   | 17,681 |   |
| Accumulated other comprehensive loss                                                                                                                   |       |                  | (624       | ) |   | (419 | ) |
| Total stockholders’ equity                                                                                                                        |       |                  | 205,811    |   |   | 167,944 |   |
| Total liabilities and stockholders’ equity                                                                                                        |       |                  | $          | 403,675 |   |   | $ | 315,293 |   |

 

See accompanying notes.

43

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**Websense, Inc.Consolidated Income Statements(In thousands, except per share amounts)**

| ** **                                                                                                                                                                                     | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues                                                                                                                                                                                       |       | $                                           | 148,636    |   | $ | 111,859 |   | $ | 81,734 |   |
| Cost of revenues                                                                                                                                                                               |       | 10,642                                      |       | 7,769 |   | 5,523 |   |
| Gross margin                                                                                                                                                                                   |       | 137,994                                     |       | 104,090 |   | 76,211 |   |
| Operating  expenses:                                                                                                                                                                           |       |                                        |       |   |   |   |   |
| Selling and marketing (exclusive of $0, $0 and $32  for the years ended December 31, 2005, 2004 and 2003, respectively, reported  below as amortization of stock-based compensation)      |       | 55,288                                      |       | 42,625 |   | 31,845 |   |
| Research and development (exclusive of $0, $0 and  $17 for the years ended December 31, 2005, 2004 and 2003, respectively, reported  below as amortization of stock-based compensation)   |       | 16,277                                      |       | 14,509 |   | 12,843 |   |
| General and administrative (exclusive of $0, $0 and  $34 for the years ended December 31, 2005, 2004 and 2003, respectively, reported  below as amortization of stock-based compensation) |       | 11,729                                      |       | 8,200 |   | 6,649 |   |
| Amortization of stock-based compensation                                                                                                                                                       |       | —                                      |       | — |   | 83 |   |
| Total operating expenses                                                                                                                                                                       |       | 83,294                                      |       | 65,334 |   | 51,420 |   |
| Income from operations                                                                                                                                                                         |       | 54,700                                      |       | 38,756 |   | 24,791 |   |
| Other income, net                                                                                                                                                                              |       | 5,411                                       |       | 2,226 |   | 2,292 |   |
| Income before income taxes                                                                                                                                                                     |       | 60,111                                      |       | 40,982 |   | 27,083 |   |
| Provision for income taxes                                                                                                                                                                     |       | 21,343                                      |       | 14,806 |   | 10,395 |   |
| Net income                                                                                                                                                                                     |       | $                                           | 38,768     |   | $ | 26,176 |   | $ | 16,688 |   |
| Net income per  share:                                                                                                                                                                         |       |                                        |       |   |   |   |   |
| Basic net income per share                                                                                                                                                                     |       | $                                           | 1.63       |   | $ | 1.13 |   | $ | 0.76 |   |
| Diluted net income per share                                                                                                                                                                   |       | $                                           | 1.58       |   | $ | 1.09 |   | $ | 0.73 |   |
| Weighted average shares—basic                                                                                                                                                             |       | 23,746                                      |       | 23,080 |   | 22,038 |   |
| Weighted average shares—diluted                                                                                                                                                           |       | 24,598                                      |       | 24,114 |   | 22,976 |   |

 

 

See accompanying notes.

44

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**Websense, Inc.Consolidated Statements of Stockholders’ Equity(In thousands)**

| ** **                                                                                 | ** ** | **Common stock** | ** ** | **Additional  paid-in** | ** ** | **Treasury** | ** ** | **Deferred** | ** ** | **Retained  earnings** | ** ** | **Accumulated other  comprehensive** | ** ** | **Total   stockholders’** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------|------------|--------------|------------|------------------------|------------|-------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                 | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **capital**  | ** ** | **stock**    | ** ** | **compensation**       | ** ** | **(deficit)**                             | ** ** | **income (loss)**              | ** ** | **equity** | ** ** |
| Balance at December 31, 2002                                           |       |                  | 21,734     |                    |       |         | $          | 217          |       |                   |       | $                                         | 107,058    |                                |       |   | $ | — |   |   |   | $ | (83 | ) |   |   | $ | (957 | ) |   |   | $ | 476 |   |   |   | $ | 106,711 |   |   |
| Issuance of common  stock upon exercise of options                                         |       |                  | 953        |                    |       |         | 10         |         |       |                   | 4,723      |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 4,733 |   |   |
| Issuance of common  stock for stock purchase plan                                          |       |                  | 151        |                    |       |         | 1          |         |       |                   | 1,831      |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,832 |   |   |
| Issuance of common  stock upon exercise of warrant                                         |       |                  | 3          |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Amortization of  deferred compensation                                                     |       |                  | —     |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | 83 |   |   |   | — |   |   |   | — |   |   |   | 83 |   |   |
| Purchase of  treasury stock                                                                |       |                  | (396       | )                       |       |         | —     |         |       |                   | —     |                                      |       |                                | (7,684     | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (7,684 | ) |   |
| Tax benefit of  stock options                                                              |       |                  | —     |                    |       |         | —     |         |       |                   | 7,027      |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 7,027 |   |   |
| Comprehensive income:                                                                      |       |                  |       |                    |       |         |       |         |       |                   |       |                                      |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                 |       |                  | —     |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | — |   |   |   | 16,688 |   |   |   | — |   |   |   | 16,688 |   |   |
| Net change in  unrealized loss on marketable securities                                    |       |                  | —     |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | (461 | ) |   |   | (461 | ) |   |
| Comprehensive  income                                                                      |       |                  |       |                    |       |         |       |         |       |                   |       |                                      |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 16,227 |   |   |
| Balance at  December 31, 2003                                                         |       |                  | 22,445     |                    |       |         | 228        |         |       |                   | 120,639    |                                      |       |                                | (7,684     | ) |   |   | — |   |   |   | 15,731 |   |   |   | 15 |   |   |   | 128,929 |   |   |
| Issuance of common  stock upon exercise of options                                         |       |                  | 1,473      |                    |       |         | 15         |         |       |                   | 19,811     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 19,826 |   |   |
| Issuance of common  stock for stock purchase plan                                          |       |                  | 190        |                    |       |         | 2          |         |       |                   | 2,531      |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 2,533 |   |   |
| Issuance of common  stock upon exercise of warrant                                         |       |                  | 28         |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase of  treasury stock                                                                |       |                  | (610       | )                       |       |         | —     |         |       |                   | —     |                                      |       |                                | (22,980    | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (22,980 | ) |   |
| Retirement of  treasury stock                                                              |       |                  |       |                    |       |         | (10        | )            |       |                   | (6,428     | )                                         |       |                                | 30,664     |   |   |   |   |   |   |   | (24,226 | ) |   |   |   |   |   |   | — |   |   |
| Tax benefit of  stock options                                                              |       |                  | —     |                    |       |         | —     |         |       |                   | 13,894     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 13,894 |   |   |
| Comprehensive income:                                                                      |       |                  |       |                    |       |         |       |         |       |                   |       |                                      |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                 |       |                  | —     |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | — |   |   |   | 26,176 |   |   |   | — |   |   |   | 26,176 |   |   |
| Net change in unrealized  loss on marketable securities                                    |       |                  | —     |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | (442 | ) |   |   | (442 | ) |   |
| Net change in  unrealized gain on fair market valuation of foreign currency contracts |       |                  | —     |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | 8 |   |   |   | 8 |   |   |
| Comprehensive  income                                                                      |       |                  |       |                    |       |         |       |         |       |                   |       |                                      |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 25,742 |   |   |
| Balance at  December 31, 2004                                                         |       |                  | 23,526     |                    |       |         | 235        |         |       |                   | 150,447    |                                      |       |                                | —     |   |   |   | — |   |   |   | 17,681 |   |   |   | (419 | ) |   |   | 167,944 |   |   |
| Issuance of common  stock upon exercise of options                                         |       |                  | 1,217      |                    |       |         | 12         |         |       |                   | 24,594     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 24,606 |   |   |
| Issuance of common  stock for stock purchase plan                                          |       |                  | 157        |                    |       |         | 2          |         |       |                   | 3,356      |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 3,358 |   |   |
| Purchase of  treasury stock                                                                |       |                  | (929       | )                       |       |         | —     |         |       |                   | —     |                                      |       |                                | (48,340    | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (48,340 | ) |   |
| Tax benefit of  stock options                                                              |       |                  | —     |                    |       |         | —     |         |       |                   | 19,680     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 19,680 |   |   |
| Comprehensive income:                                                                      |       |                  |       |                    |       |         |       |         |       |                   |       |                                      |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                 |       |                  | —     |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | — |   |   |   | 38,768 |   |   |   | — |   |   |   | 38,768 |   |   |
| Net change in  unrealized loss on marketable securities                                    |       |                  | —     |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | (112 | ) |   |   | (112 | ) |   |
| Net change in  unrealized loss on fair market valuation of foreign currency contracts |       |                  | —     |                    |       |         | —     |         |       |                   | —     |                                      |       |                                | —     |   |   |   | — |   |   |   | — |   |   |   | (93 | ) |   |   | (93 | ) |   |
| Comprehensive  income                                                                      |       |                  |       |                    |       |         |       |         |       |                   |       |                                      |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 38,563 |   |   |
| Balance at  December 31, 2005                                                         |       |                  | 23,971     |                    |       |         | $          | 249          |       |                   |       | $                                         | 198,077    |                                |       |   | $ | (48,340 | ) |   |   | $ | — |   |   |   | $ | 56,449 |   |   |   | $ | (624 | ) |   |   | $ | 205,811 |   |   |

 

See accompanying notes.

45

 

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**Websense, Inc.Consolidated Statements of Cash Flows(In thousands)**

| ** **                                                                              | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Operating activities:**                                                               | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                              |       | $                                           | 38,768     |   | $ | 26,176 |   | $ | 16,688 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation                                                                            |       | 2,631                                       |       | 2,277 |   | 2,016 |   |
| Amortization of deferred compensation                                                   |       | —                                      |       | — |   | 83 |   |
| Deferred revenue                                                                        |       | 47,608                                      |       | 38,357 |   | 29,281 |   |
| Unrealized gain (loss) on hedging contracts                                             |       | (93                                         | )          | 8 |   | — |   |
| Tax benefit from exercise of stock options                                              |       | 19,680                                      |       | 13,894 |   | 7,027 |   |
| Changes in  operating assets and liabilities:                                           |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                     |       | (6,261                                      | )          | (16,310 | ) | (8,159 | ) |
| Prepaid income taxes                                                                    |       | 1,239                                       |       | (2,537 | ) | (664 | ) |
| Other current assets                                                                    |       | (1,942                                      | )          | (254 | ) | (87 | ) |
| Deposits and other assets                                                               |       | (87                                         | )          | (44 | ) | (119 | ) |
| Deferred income taxes                                                                   |       | (3,762                                      | )          | (648 | ) | (1,973 | ) |
| Accounts payable                                                                        |       | 973                                         |       | 357 |   | (18 | ) |
| Accrued payroll and related benefits                                                    |       | 1,313                                       |       | 1,922 |   | 1,614 |   |
| Other accrued expenses                                                                  |       | 74                                          |       | 1,176 |   | 395 |   |
| Income taxes payable                                                                    |       | 547                                         |       | 853 |   | (65 | ) |
| Net cash provided  by operating activities                                              |       | 100,688                                     |       | 65,227 |   | 46,019 |   |
| **Investing  activities:**                                                              | ** ** | ** **                                  |       |   |   |   |   |
| Purchase of  property and equipment                                                     |       | (3,599                                      | )          | (3,235 | ) | (2,046 | ) |
| Purchases of  marketable securities                                                     |       | (477,282                                    | )          | (270,130 | ) | (197,880 | ) |
| Maturities of  marketable securities                                                    |       | 422,278                                     |       | 211,120 |   | 83,233 |   |
| Sales of  marketable securities                                                         |       | 1,042                                       |       | 1,193 |   | 77,854 |   |
| Net cash used in  investing activities                                                  |       | (57,561                                     | )          | (61,052 | ) | (38,839 | ) |
| **Financing  activities:**                                                              | ** ** | ** **                                  |       |   |   |   |   |
| Proceeds from  exercise of stock options and warrants                                   |       | 24,606                                      |       | 19,826 |   | 4,733 |   |
| Proceeds from  issuance of common stock for stock purchase plan                         |       | 3,358                                       |       | 2,533 |   | 1,832 |   |
| Purchase of  treasury stock                                                             |       | (48,340                                     | )          | (22,980 | ) | (7,684 | ) |
| Net cash used in financing  activities                                                  |       | (20,376                                     | )          | (621 | ) | (1,119 | ) |
| Increase in cash and cash equivalents                                                   |       | 22,751                                      |       | 3,554 |   | 6,061 |   |
| Cash and cash equivalents at beginning of year                                          |       | 38,878                                      |       | 35,324 |   | 29,263 |   |
| Cash and cash equivalents at end of year                                                |       | $                                           | 61,629     |   | $ | 38,878 |   | $ | 35,324 |   |
| **Supplemental  disclosures of cash flow information:**                                 | ** ** | ** **                                  |       |   |   |   |   |
| Income taxes paid                                                                       |       | $                                           | 3,656      |   | $ | 3,447 |   | $ | 6,211 |   |
| Unrealized loss  on marketable securities                                               |       | $                                           | (112       | ) | $ | (442 | ) | $ | (461 | ) |

 

See accompanying notes.

46

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**Websense, Inc. Notes to Consolidated Financial Statements December 31, 2005**

**1.**   Summary ofSignificant Accounting Policies

**Description of Business**

Websense, Inc. (“Websense”or the “Company”) commenced operations in 1994. The Company provides employeeinternet management (EIM) and web security software products that enableorganizations to reduce the risks associated with web-based malicious attacks,spyware and phishing, as well as to analyze, report and manage how theiremployees use computing resources, including internet access, instant messaging(IM), peer-to-peer file sharing, network bandwidth and software applications.The Company’s Websense Enterprise solution supports an organization’s effortsto enhance security, improve employee productivity, mitigate potential legalliability and conserve network bandwidth.

**Use of Estimates**

The preparation of theconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the amounts reported in the financial statementsand accompanying notes. Actual results could differ from those estimates.

**Reclassifications**

Certain prior year reclassificationshave been made for consistent presentation.

**Principles of Consolidation**

The consolidated financial statements include theaccounts of the Company and its wholly owned subsidiaries in the UnitedKingdom, Japan, Ireland, Australia, France, Germany, Brazil and Italy.Significant intercompany accounts and transactions have been eliminated inconsolidation. Activities performed by the subsidiaries are a direct andintegral extension of the Company’s primary business.

For the years ended December 31,2005, 2004 and 2003, the Company’s billings were primarily denominated in itsfunctional currency, which is the U.S. dollar. As such, the Company has notrecorded foreign currency translation gains or losses. However, the Companyincurred foreign currency transaction losses of $32,000, $76,000 and $57,000for the years ended December 31, 2005, 2004 and 2003, respectively.

**Revenue Recognition**

The Company has adopted American Institute ofCertified Public Accountants Statement of Position No. 97-2,Software Revenue Recognition (SOP No. 97-2) as amended by SOP No. 98-9,as well as Staff Accounting Bulletin No. 104, Revenue Recognition, asissued by the Securities and Exchange Commission. These statements and bulletinprovide guidance for recognizing revenue related to sales by software vendors.

The Company sells Websense Enterprise on asubscription basis. A subscription is generally 12, 24 or 36 months in durationand for a fixed number of users. Other services such as upgrades/enhancementsand standard post-contract technical support services are sold together withWebsense Enterprise and provided throughout the subscription term. The Companyrecognizes revenue on a monthly straight-line basis, commencing with the monththe subscription begins, over the term of the subscription agreement

47

----

**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**1.**   Summary of Significant Accounting Policies (Continued)

provided collectability is reasonably assured. Uponentering into a subscription arrangement for a fixed or determinable fee, theCompany electronically delivers access codes to users and then promptlyinvoices customers for the full amount of their subscriptions. Payment is duefor the full term of the subscription, generally within 30-60 days ofinvoicing.

The Company recordsamounts billed to customers in excess of recognizable revenue as deferredrevenue in the accompanying balance sheets.

**Cash and Cash Equivalents**

The Company considers allhighly liquid investments with a maturity of ninety days or less when purchasedto be cash equivalents. The Company generally invests its excess cash in fixedincome obligations with strong credit ratings. Such investments are made inaccordance with the Company’s investment policy, which establishes guidelinesrelative to diversification and maturities designed to maintain safety andliquidity. These guidelines are periodically reviewed and modified if necessaryto take advantage of trends in yields and interest rates. The Company has notexperienced any losses on its cash and cash equivalents.

**Marketable Securities**

Marketable securities at December 31, 2005consist of tax-exempt auction rate notes and municipal bonds. The Companycurrently classifies all investment securities as available for sale.Securities classified as available for sale are reported at fair value,adjusted for other than temporary declines in value. The Company records otherthan temporary declines in value to earnings as realized losses. Unrealizedholding gains and losses on securities available for sale are reported as a netamount in a separate component of stockholders’ equity until realized. Realizedgains and losses are recorded based on the specific identification method.

Historically, the fairvalues of the Company’s tax-exempt auction rate notes have not changed due tothe high credit quality and short-term nature of these securities. However, ifthe fair value of its tax-exempt auction notes did change when interest ratesand/or dividends reset at auction, the Company would recognize unrealizedholding gains and/or losses on these investments as a net amount in a separatecomponent of stockholders’ equity until realized. The Company would thenrecognize realized gains and/or losses based on the specific identificationmethod.

**Intereston Cash and Marketable Securities**

The Company’s interest on cash and marketable securities,included as a component of other income, net, is $6.1 million, $2.5 million and$2.2 million for the years ended December 31, 2005, 2004 and 2003,respectively.

**DisclosuresAbout Fair Value of Financial Instruments**

The fair values ofinvestment securities have been determined using values supplied by an independentpricing service and are disclosed together with carrying amounts in Note 2. Thecarrying value 

48

----

**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**1.**   Summary of Significant Accounting Policies (Continued)

of cashand cash equivalents, accounts receivable, accounts payable and accruedliabilities approximate their fair values.

**Foreign CurrencyHedges**

Statement of FinancialAccounting Standards (SFAS) No. 133, Accounting for Derivative Instrumentsand Hedging Activities, as amended, established accounting and reportingstandards requiring recognition of all derivatives as assets or liabilities inthe consolidated balance sheets and measurement of those instruments at fairvalue. Gains and losses resulting from changes in the fair values of thosederivative instruments will be recorded to earnings or other comprehensiveincome depending on the use of the derivative instrument and whether itqualifies for hedge accounting. The Company uses derivatives to manage foreigncurrency risk and not for speculative or trading purposes. The Company’sobjective is to reduce the risk to earnings and cash flows associated withchanges in foreign currency exchange rates.

Beginning in 2004, the Company has utilized foreigncurrency forward contracts. Beginning in 2005, the Company also started to utilizezero-cost collar contracts to hedge anticipated British Pound expenses. Allsuch contracts entered into were designated as either fair value hedges or cashflow hedges and were considered effective, where desired, as defined by SFAS No.133, as amended. None of the contracts were terminated prior to settlement. Netrealized losses related to these contracts settled during the year are includedin other income, net in the accompanying consolidated income statements andamounted to $195,000 and $186,000 in 2005 and 2004, respectively.

As of December 31, 2005 and 2004, the Company hadcommitted to foreign currency forward contracts in the Euro, with a notionalamount of $4.0 and $0.4 million, respectively. The Company’s Euro commitmentrepresents 3.4 and 0.3 million Euros at a weighted average forward rate of 1.184and 1.329, respectively. Euro commitments at December 31, 2005 weredesignated as fair value hedges and were not required to be tested foreffectiveness as hedge accounting was not desired. Euro commitments at December 31,2004 were designated as cash flow hedges and determined effective. The fairvalue of these forward contracts was $4.0 and $0.4 million at December 31,2005 and 2004. All of the foreign currency forward contracts will be settledbefore March 31, 2006. Realized gains or losses related to thesettlements, if any, will be recorded in other income, net at the time ofsettlement.

As of December 31,2005, the Company had committed to zero-cost collar contracts in the BritishPound, with a notional amount of $4.3 million. As of December 31, 2004,the Company had committed to foreign currency forward contracts in the BritishPound, with a notional amount of $0.6 million. All of these contracts weredesignated as cash flow hedges and were determined effective as of December 31,2005 and 2004. The fair value of these zero-cost collar and foreign currencyforward contracts was $4.2 and $0.6 million at December 31, 2005 and 2004,respectively. All of the zero-cost collar contracts will be settled before June 30,2006. Realized gains and losses related to the settlements, if any, will berecorded in all operating categories the Company hedges its British Poundexpenditures against.

49

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**1.**   Summary of Significant Accounting Policies (Continued)

**Concentration ofCredit Risk**

The Company sells itsproducts to customers primarily in the United States, Canada, Europe, Asia,Australia, and Latin America. The Company maintains a reserve for potentialcredit losses and historically such losses have been within management’sestimates.

**Property andEquipment**

Property and equipment arestated at cost and are depreciated using the straight-line method over theirestimated useful lives of three to seven years.

**Computer Software Costs**

In accordance with SFAS No. 86, Accounting forthe Costs of Computer Software to be Sold, Leased, or Otherwise Marketed, costsare capitalized, when significant, in the development of specific computersoftware products after establishment of technological feasibility andmarketability. There have been no such costs capitalized to date as the costsincurred during the period between technological feasibility to general releasehave not been significant.

The Company accounts forinternally developed computer software costs, incurred in the applicationstage, in accordance with SOP No. 98-1, Accounting for Costs of ComputerSoftware Developed or Obtained for Internal Use. There have been no such costscapitalized to date as the costs incurred for internally developed computersoftware have not been significant.

**Advertising Expenses**

Advertising costs areexpensed as incurred. Total advertising costs for the years ended December 31,2005, 2004 and 2003 were $4.8 million, $4.1 million and $3.4 million,respectively.

**Stock-Based Compensation**

The Company has elected to follow AccountingPrinciples Board (APB) No. 25, Accounting for Stock Issued to Employees,and related interpretations in accounting for its employee stock optionsbecause the alternative fair value accounting provided for under SFAS No. 123,Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transitionand Disclosure, issued in December 2002, requires the use of optionvaluation models for traded options that were not developed for use in valuingemployee stock options which have vesting restrictions and are not traded.Under APB No. 25, when the exercise price of the Company’s employee stockoptions is not less than the fair value for the underlying stock on the date ofgrant, no compensation expense is recognized. At the time stock options weregranted, the Company believed that the exercise price was at a price not lessthan the fair value of the underlying common stock. In conjunction with theCompany’s initial public offering, the Company reviewed its exercise prices andarrived at the deemed fair value for each option grant during 1999. Withrespect to the 3,220,500 options granted during 1999 and through March 27,2000, the Company recorded deferred compensation of $5.4 million for thedifference between the exercise price per share and the deemed fair value pershare at the grant date. The approximate weighted-average exercise price pershare and the approximate weighted-average deemed fair value per share for theoptions 

50

----

**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**1.**   Summary of Significant Accounting Policies (Continued)

was $1.64 and $3.31,respectively. Deferred stock compensation was recognized and amortized on anaccelerated basis in accordance with Financial Accounting Standards BoardInterpretation FIN No. 28 over the vesting period of the related options,generally four years. Deferred stock compensation was fully amortized as of December 31,2003.

Pro forma information regarding net income is requiredby SFAS No. 123, as amended by SFAS No. 148, and has been determinedas if the Company has accounted for its employee stock options and employeestock purchase plan under the fair value method of SFAS No. 123, as amended bySFAS No. 148.

The pro forma effects ofstock-based compensation on net income and net income per share have beenestimated at the date of grant using the Black-Scholes option pricing modelbased on the following weighted average assumptions:

| ** **                          | ** ** | **Stock Options**                | ** ** | **Employee  Stock Purchase Plan** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                          | ** ** | **Year Ended December 31,** | ** ** | **Year Ended December 31,**       | ** ** |
| ** **                          | ** ** | **2005**                              | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Average expected  life (years)      |       | 4.88                                  |       | 5.00                                        |       | 5.00 |   | 1.25 |   | 1.25 |   | 1.25 |   |
| Average expected  volatility factor |       | 44.16                                 | %          | 52.06                                       | %          | 98.94 | % | 44.57 | % | 59.30 | % | 86.75 | % |
| Average risk-free  interest rate    |       | 3.99                                  | %          | 3.39                                        | %          | 2.53 | % | 3.63 | % | 2.15 | % | 1.36 | % |
| Average expected  dividend yield    |       | —                                |       | —                                      |       | — |   | — |   | — |   | — |   |

 

TheCompany’s adjusted pro forma information is as follows (in thousands, exceptper share amounts):

| ** **                                                                                                            | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income as  reported                                                                                               |       | $                                           | 38,768     |   | $ | 26,176 |   | $ | 16,688 |   |
| Add: Stock-based employee compensation cost included  in net income as reported, net of tax(1),(2)                    |       | —                                      |       | — |   | 51 |   |
| Deduct: Total stock-based compensation expense  determined under fair value method for all awards, net of tax(2) |       | (10,794                                     | )          | (9,700 | ) | (9,185 | ) |
| Pro forma net  income                                                                                                 |       | $                                           | 27,974     |   | $ | 16,476 |   | $ | 7,554 |   |
| Basic net income per share as reported                                                                                |       | $                                           | 1.63       |   | $ | 1.13 |   | $ | 0.76 |   |
| Pro forma basic net income per share                                                                                  |       | $                                           | 1.18       |   | $ | 0.71 |   | $ | 0.34 |   |
| Diluted net income per share as reported                                                                              |       | $                                           | 1.58       |   | $ | 1.09 |   | $ | 0.73 |   |
| Pro forma diluted  net income per share                                                                               |       | $                                           | 1.14       |   | $ | 0.68 |   | $ | 0.33 |   |

----

(1)          The Company wasrecognizing deferred stock-based compensation expense on the deemed fair valueof options granted prior to the initial public offering in March 2000. Thisexpense was amortized on an accelerated basis, in accordance with FIN No. 28,over approximately a four-year period, which began in March 2000 and endedin December 2003.

51

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**1.**   Summary of Significant Accounting Policies (Continued)

(2)          The Company had aneffective tax rate of approximately 36%, 36% and 38% in 2005, 2004 and 2003,respectively.

For purposes of pro forma disclosures, the estimatedfair value is amortized to expense ratably over the options vesting period. Theeffect of applying SFAS No. 123, as amended by SFAS No. 148, for purposes ofproviding pro forma disclosures may not be representative of the effects on theCompany’s operating results in future years.

The appropriate volatilityfactor for stock options and for the Employee Stock Purchase Plan is the estimatedfuture volatility of the Company’s stock over the expected life of the options.Prior to the fourth quarter of 2005, the Company estimated the volatilityfactors for stock options, and for the Employee Stock Purchase Plan using thehistorical volatility of the Company’s stock only. Beginning in the fourthquarter of 2005, the Company estimated the volatility factors for both theCompany’s stock options and for the Company’s Employee Stock Purchase Planusing a blended formula that considers both the historical volatility of theCompany’s stock as well as the implied volatility of the Company’s stock basedon publicly traded options, which the Company believes provides a more accurateestimate of expected volatility factors over the life of the options.

In December 2004, theFASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R),which will be effective in the Company’s first quarter of fiscal 2006. Aspermitted by SFAS No. 123, the Company currently accounts forshare-based payments to employees using the intrinsic value method inaccordance with APB No. 25 and, as such, generally recognizes nocompensation cost for employee stock option grants or the discounts the Companyprovides under its employee stock purchase plans. Under the new rules,commencing with the Company’s first quarter of fiscal 2006, the Company isrequired to adopt a fair value-based method for measuring the compensationexpense related to employee stock awards; this will lead to additionalcompensation expense of approximately $5.0 million, thereby reducing net incomeand earnings per share. Had the Company adopted SFAS No. 123R in priorperiods, the impact of that standard would have approximated the impact of SFASNo. 123 as described above, with additional compensation expense ofapproximately $16.7 million in 2005. The fourth quarter of 2005 alonerepresents approximately $4.4 million. SFAS No. 123R also requiresthe benefits of tax deductions in excess of recognized compensation cost to bereported as a financing cash flow, rather than as an operating cash flow asrequired under current guidance. This requirement will reduce the Company’s netoperating cash flows and increase net financing cash flows in periods afteradoption. The Company cannot estimate what those amounts will be in the future,however, the amount of operating cash flows recognized in 2005, 2004 and 2003for such tax deductions were $19.7 million, $13.9 million and $7.0 million, respectively.However, overall, the Company’s cash flows will be unaffected.

**Comprehensive Income**

The Company has adoptedSFAS No. 130, Reporting Comprehensive Income, which requires that allcomponents of comprehensive income, including net income, be reported in thefinancial statements in the period in which they are recognized. Comprehensiveincome is defined as the change in equity during a period from transactions andother events and circumstances from non-owner sources. Net income and othercomprehensive income, including foreign currency translation adjustments, andunrealized gains and 

52

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**1.**   Summary of Significant Accounting Policies (Continued)

losses on investments, shall be reported, net of theirrelated tax effect, to arrive at comprehensive income. Comprehensive income forthe years ended December 31, 2005, 2004 and 2003 was $38.6 million, $25.7 millionand $16.2 million, respectively. The difference from reported net income, inthe years ended December 31, 2005, 2004 and 2003 is due to the changes inunrealized loss on marketable securities of ($112,000), ($442,000) and($461,000), respectively, and to the changes in unrealized gain (loss) on thefair market valuation of foreign currency forward contracts of ($93,000),$8,000 and $0, respectively.

**AccumulatedOther Comprehensive Loss**

Accumulated othercomprehensive loss consists of the following (in thousands):

| ** **                                                              | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                              | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Unrealized loss  on marketable securities                               |       | $                     | 539        |   | $ | 427 |   |
| Unrealized loss  on fair market valuation of foreign currency contracts |       | 85                    |       | (8 | ) |
|                                                                    |       | $                     | 624        |   | $ | 419 |   |

 

**Net Income Per Share**

Websense computes net income per share in accordancewith SFAS No. 128, Earnings Per Share (EPS). Under the provisions of SFAS No. 128,basic net income per share is computed by dividing the net income for theperiod by the weighted average number of common shares outstanding during theperiod. Diluted net income per share is computed by dividing the net income forthe period by the weighted average number of common and common equivalentshares outstanding during the period. Common equivalent shares for all periodspresented consist of dilutive stock options.

Dilutive securities include options, warrants andpreferred stock as if converted and restricted stock subject to vesting. In2005, the difference between the weighted average shares used in determiningbasic EPS versus diluted EPS related to dilutive stock options totaled 852,000.Potentially dilutive securities totaling 106,000, 201,000 and 1,376,000 for theyears ended December 31, 2005, 2004 and 2003, respectively, were excludedfrom historical basic and diluted earnings per share because of theiranti-dilutive effect as a result of stock options which have exercise pricesgreater than the average market price of the common shares.

53

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**1.**   Summary of Significant Accounting Policies (Continued)

The following is areconciliation of numerator and denominator of Basic EPS to the numerator anddenominator of Diluted EPS for all periods presented.

| ** **                   | ** ** | **Net Income**                                                   | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                   | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)** | ** ** | **Amount**         | ** ** |
| ** **                   | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the Years Ended:**     | ** ** |                                                                  | ** ** | ** **        |       |               | ** ** | ** ** |   |   | ** ** | ** ** |   |
| **December 31, 2005:**  | ** ** |                                                                  | ** ** | ** **        |       |               | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Basic EPS                    |       |                                                                  | $          | 38,768            | ** ** |               |       | 23,746 | ** ** |   |   | $ | 1.63 |   |   |
| Effect of options            |       |                                                                  | —     | ** **        |       |               | 852        | ** ** |   |   | (0.05 | ) |   |
| Diluted EPS                  |       |                                                                  | $          | 38,768            | ** ** |               |       | 24,598 | ** ** |   |   | $ | 1.58 |   |   |
| **December 31,  2004:** | ** ** |                                                                  | ** ** | ** **        |       |               |       | ** ** |   |   | ** ** | ** ** |   |
| Basic EPS                    |       |                                                                  | $          | 26,176            | ** ** |               |       | 23,080 | ** ** |   |   | $ | 1.13 |   |   |
| Effect of options            |       |                                                                  | —     | ** **        |       |               | 1,034      | ** ** |   |   | (0.04 | ) |   |
| Diluted EPS                  |       |                                                                  | $          | 26,176            | ** ** |               |       | 24,114 | ** ** |   |   | $ | 1.09 |   |   |
| **December 31,  2003:** |       |                                                                  |       | ** **        |       |               |       | ** ** |   |   |   |   |   |
| Basic EPS                    |       |                                                                  | $          | 16,688            | ** ** |               |       | 22,038 | ** ** |   |   | $ | 0.76 |   |   |
| Effect of options            |       |                                                                  | —     | ** **        |       |               | 938        | ** ** |   |   | (0.03 | ) |   |
| Diluted EPS                  |       |                                                                  | $          | 16,688            | ** ** |               |       | 22,976 | ** ** |   |   | $ | 0.73 |   |   |

 

**Tax Matters**

Fromtime to time, the Company is audited by various state, federal andinternational authorities relating to tax matters. The Company fully cooperateswith all audits, but defends its positions vigorously. The Company’s audits arein various stages of completion; however, no outcome for a particular audit canbe determined with certainty prior to the conclusion of the audit and appealsprocess. As each audit is concluded, adjustments, if any, are appropriatelyrecorded in the Company’s financial statements in the period determined.

**RecentlyIssued Accounting Standards**

Beyond the adoption ofSFAS No. 123R in the Company’s first quarter of fiscal 2006, as describedabove under “Stock-Based Compensation”, the Company does not expect anyrecently issued accounting standards to have a material impact on the resultsof its operations in the foreseeable future.

**2.   MarketableSecurities**

Investmentsin marketable securities consisted of the following at December 31, 2005(in thousands):

| ** **          | ** ** | **Amortized  Cost** | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  (Losses)** | ** ** | **Estimated Fair  Value** | ** ** |
|---------------------|------------|---------------------|------------|-----------------------|------------|--------------------------|------------|--------------------------------|------------|
| Auction Rate  Notes |       | $                   | 66,469     |                  |       | $                        | —     |                           |       |   | $ | — |   |   |   | $ | 66,469 |   |   |
| Municipal Bonds     |       | 192,830             |       |                  | —     |                     |       |                           | (539       | ) |   |   | 192,291 |   |   |
|                |       | $                   | 259,299    |                  |       | $                        | —     |                           |       |   | $ | (539 | ) |   |   | $ | 258,760 |   |   |

 

54

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**2.**   Marketable Securities (Continued)

Investments in marketablesecurities consisted of the following at December 31, 2004 (in thousands):

| ** **          | ** ** | **Amortized  Cost** | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  (Losses)** | ** ** | **Estimated Fair  Value** | ** ** |
|---------------------|------------|---------------------|------------|-----------------------|------------|--------------------------|------------|--------------------------------|------------|
| Auction Rate  Notes |       | $                   | 68,101     |                  |       | $                        | —     |                           |       |   | $ | — |   |   |   | $ | 68,101 |   |   |
| Municipal Bonds     |       | 137,236             |       |                  | —     |                     |       |                           | (427       | ) |   |   | 136,809 |   |   |
|                |       | $                   | 205,337    |                  |       | $                        | —     |                           |       |   | $ | (427 | ) |   |   | $ | 204,910 |   |   |

 

Theamortized cost and estimated fair value of the securities at December 31,2005 and 2004, by contractual maturity, are shown below (in thousands).

| ** **                 | ** ** | **2005**            | ** ** | **2004**                       | ** ** |
|----------------------------|------------|---------------------|------------|--------------------------------|------------|
| ** **                 | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Due within 1 year          |       | $                   | 230,677    |                           | $          | 230,299 |   | $ | 155,537 |   | $ | 155,346 |   |
| Due between 1 and  3 years |       | 28,622              |       | 28,461                         |       | 49,800 |   | 49,564 |   |
|                       |       | $                   | 259,299    |                           | $          | 258,760 |   | $ | 205,337 |   | $ | 204,910 |   |

 

Realized gains (losses)from investments in marketable securities for the years ended 2005, 2004 and2003 were ($5,000), $4,000 and $194,000, respectively.

55

----

**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**3.   Property andEquipment**

Propertyand equipment consist of the following (in thousands):

| ** **                      | ** ** | **Estimated**         | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **Useful Lives** | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Computer hardware  and software |       |                  | 3  years   |                  |       | $ | 14,756 |   |   | $ | 11,563 |   |   |
| Office furniture  and equipment |       |                  | 3-7  years |                  |       | 2,452 |   |   | 2,097 |   |   |
| Other equipment                 |       |                  | 3  years   |                  |       | 590 |   |   | 539 |   |   |
|                            |       |                  |       |                  |       | 17,798 |   |   | 14,199 |   |   |
| Accumulated depreciation        |       |                  |       |                  |       | (12,875 | ) |   | (10,244 | ) |   |
|                            |       |                  |       |                  |       | $ | 4,923 |   |   | $ | 3,955 |   |   |

 

Depreciation expense for2005, 2004 and 2003 was $2.6 million, $2.3 million and $2.0 million,respectively.

**4.   GeographicInformation**

Thefollowing illustrates revenues attributed to customers located in the Company’scountry of domicile (the United States) and those attributed to foreigncustomers (in thousands):

| ** **                      | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States                   |       | $                                           | 99,589     |   | $ | 75,891 |   | $ | 56,006 |   |
| Europe, Middle  East and Africa |       | 33,429                                      |       | 23,831 |   | 16,932 |   |
| Asia/Pacific                    |       | 6,124                                       |       | 4,861 |   | 4,045 |   |
| Canada and Latin  America       |       | 9,494                                       |       | 7,276 |   | 4,751 |   |
|                            |       | $                                           | 148,636    |   | $ | 111,859 |   | $ | 81,734 |   |

 

The United Kingdomrepresented $14.2 million, $10.1 million and $7.4 million of total revenue forthe years ended 2005, 2004 and 2003, respectively. No other foreign countryrepresented more than 5% of total revenue.

**5.**   DeferredRevenue

TheCompany expects to recognize revenues related to subscriptions in existence asof December 31, 2005 as follows (in thousands):

| **Years Ending December 31:** |   |   |    |
|----------------------------------------------|--------|--------|---------|
| 2006                                         |   | $      | 119,118 |   |
| 2007                                         |   | 43,982 |    |
| 2008 and  thereafter                         |   | 16,825 |    |
|                                         |   | $      | 179,925 |   |

 

56

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**6.**   Commitmentsand Guarantees

The Company leases its facilities and certainequipment under non-cancelable operating leases, which expire at various datesthrough December 2008. The facilities leases contain renewal options andare subject to cost increases.

Futureminimum annual payments under non-cancelable operating leases and softwarelicenses at December 31, 2005 are as follows (in thousands):

| ** **                          | ** ** | **Operating  Leases** | ** ** | **Software  Licenses** | ** ** | **Total** | ** ** |
|-------------------------------------|------------|-----------------------|------------|------------------------|------------|-----------|------------|
| **Years  Ending December 31:** |       |                  |       |                   |       |      |       |   |   |   |   |
| 2006                                |       |                  | $          | 1,889                  |       |      |       | $ | 314 |   |   | $ | 2,203 |   |
| 2007                                |       |                  | 1,937      |                   |       |      | 79         |   |   | 2,016 |   |
| 2008                                |       |                  | 325        |                   |       |      | —     |   |   | 325 |   |
|                                |       |                  | $          | 4,151                  |       |      |       | $ | 393 |   |   | $ | 4,544 |   |

 

Rent expense totaled $3.9 million, $2.8 million and$2.3 million for the years ended December 31, 2005, 2004 and 2003,respectively.

FIN No. 45, Guarantees of Indebtedness of Others (FIN No.45), elaborates on previously existing disclosure requirements for mostguarantees, including loan guarantees such as standby letters of credit. Italso clarifies that at the time a company issues a guarantee, the company mustrecognize an initial liability for the fair value, or market value, of theobligations it assumes under the guarantee and must disclose that informationin its interim and annual financial statements. The provisions related torecognizing a liability at inception of the guarantee for the fair value of theguarantor’s obligations does not apply to product warranties, indemnificationsor to guarantees accounted for as derivatives.

The Company providesindemnifications of varying scope and size to certain customers against claimsof intellectual property infringement made by third parties arising from theuse of its products. The Company evaluates estimated losses for suchindemnifications under SFAS No. 5, Accounting for Contingencies, as interpretedby FIN No. 45. The Company considers such factors as the degree of probabilityof an unfavorable outcome and the ability to make a reasonable estimate of theamount of loss. To date, the Company has not encountered material costs as aresult of such obligations and has not accrued any liabilities related to suchindemnifications in its financial statements.

**7.**   Stockholders’Equity

**Warrants**

In connection with theCompany’s Series B convertible preferred stock offering between June andSeptember 1999, the Company issued warrants to purchase 62,500 shares ofcommon stock for $3.00 per share to financial consultants. The warrants wereexercisable in whole or in part at any time and from time to time until theirexpiration. In April 2000, warrants to purchase 4,688 shares of commonstock were exercised. In November 2001, warrants to purchase 23,437 sharesof common stock were exercised. In July 2003, April 2004 and July 2004,warrants to purchase 4,000, 9,375 and 21,000 shares of common stock 

57

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**7.**   Stockholders’ Equity (Continued)

wereexercised, which resulted in 3,406, 8,467 and 19,287 shares of common stockbeing issued, respectively, due to the cashless exercise of these warrants. Atthe end of 2004, all warrants had been exercised.

**Stock Option Plan**

In May 1998, the Company’s Board of Directorselected to replace the 1997 Stock Option/Stock Issuance Plan with the 1998Stock Option/Stock Issuance Plan (1998 Stock Plan) under which 4,600,000 sharesof the Company’s common stock were authorized for future issuance, and reservedfor purchase upon exercise of options granted. The 1998 Stock Plan provided forthe grant of incentive and non-statutory options and issuances of common stockto employees and directors.

The Board of Directors replaced the 1998 Stock Planwith the Amended and Restated 2000 Stock Incentive Plan (2000 Plan) under which4,500,000 shares of the Company’s common stock were initially authorized forfuture issuance, and reserved for purchase upon exercise of options granted. Inaddition, the 2000 Plan provides for automatic annual increases in the numberof shares authorized and reserved for issuance thereunder (beginning in 2001)equal to the lesser of (i) 4% of the Company’s outstanding shares on thelast business day in December of the calendar year immediately precedingor (ii) 1,500,000 shares. At December 31, 2005, a total of 8,820,233shares have been authorized and reserved for issuance under the 2000 Plan ofwhich 793,240 remain available for grant.

The 2000 Plan provides forthe grant of options to the Company’s directors, officers, employees andconsultants. The 2000 Plan provides for the grant of incentive andnon-statutory stock options and rights to purchase stock to employees,directors or consultants of the Company. The 2000 Plan provides that incentivestock options will be granted only to employees and are subject to certainlimitations as to fair value during a calendar year.

The exercise price ofincentive stock options must equal at least the fair value on the date of grantand the exercise price of non-statutory stock options and the issuance price ofcommon stock under the stock issuance program may be no less than 85% of thefair value on the date of grant or issuance. Through April 2005, theoption grants were generally exercisable for a period of ten years, andbeginning in May 2005, the option grants are generally exercisable for aperiod of seven years after the date of grant and generally vest 25% one yearfrom date of grant and ratably each month thereafter for a period of 36 months.Unvested common shares obtained through early exercise of options are subjectto repurchase by the Company at the original issue price. To date, onlynon-statutory options have been granted under the 2000 Plan.

In 2002, the Companyissued options as an incentive for certain persons to commence employment thatwere not covered under the 2000 Plan. In accordance with Section 4350(i) ofthe NASD Marketplace Rules for the Nasdaq Stock Market, in 2002 theCompany issued 177,000 such options, which have substantially the same terms asoptions issued under the 2000 Plan.

58

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**7.**   Stockholders’ Equity (Continued)

The following tablesummarizes stock option activity under the 1998 and 2000 Stock Plans andoptions issued in 2002 not covered under a formal plan and related information:

| ** **                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** **              |
|------------------------------------|------------|----------------------------|------------|----------------------------------------|-------------------------|
| Balance at  December 31, 2002 |       | 4,262,836                  |       |                                   | $                       | 14.39 |   |   |
| Granted                            |       | 971,750                    |       |                                   |   17.45            |   |   |
| Exercised                          |       | (952,391                   | )          |                                   |     4.97 |   |   |
| Cancelled                          |       | (347,119                   | )          |                                   |   21.82            |   |   |
| Balance at  December 31, 2003 |       | 3,935,076                  |       |                                   |   16.77            |   |   |
| Granted                            |       | 976,000                    |       |                                   |   37.26            |   |   |
| Exercised                          |       | (1,473,028                 | )          |                                   |   13.46            |   |   |
| Cancelled                          |       | (321,468                   | )          |                                   |   22.28            |   |   |
| Balance at  December 31, 2004 |       | 3,116,580                  |       |                                   |   24.18            |   |   |
| Granted                            |       | 1,019,500                  |       |                                   |   52.40            |   |   |
| Exercised                          |       | (1,217,756                 | )          |                                   |   20.21            |   |   |
| Cancelled                          |       | (310,976                   | )          |                                   |   35.53            |   |   |
| Balance at  December 31, 2005 |       | 2,607,348                  |       |                                   |   35.72            |   |   |

 

The following tablesummarizes all options outstanding and exercisable by price range as of December 31,2005:

| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Average**                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Remaining**                | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**        | ** ** | **Number of**           | ** ** | **Contractual Life**    | ** ** | **Average** | ** ** | **Number of** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | ** **                   | ** ** | **Shares**                   | ** ** | **In Years** | ** ** | **Exercise Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| $  0.20-$18.50 |       | 548,332                      |       |                         | 5.99       |   |   |   | $ | 13.17 |   |   |   | 386,988 |   |   |   | $ | 12.64 |   |   |
| $18.81-$32.23            |       | 536,010                      |       |                         | 6.88       |   |   |   |   26.29 |   |   |   | 342,475 |   |   |   |   26.95 |   |   |
| $32.27-$45.50            |       | 523,631                      |       |                         | 8.53       |   |   |   |   37.06 |   |   |   | 125,270 |   |   |   |   36.87 |   |   |
| $46.01-$51.25            |       | 629,925                      |       |                         | 7.04       |   |   |   |   50.12 |   |   |   | 4,538 |   |   |   |   50.15 |   |   |
| $51.37-$67.52            |       | 369,450                      |       |                         | 7.81       |   |   |   |   56.43 |   |   |   | 8,688 |   |   |   |   52.12 |   |   |
|                     |       | 2,607,348                    |       |                         | 7.19       |   |   |   | 35.72 |   |   |   | 867,959 |   |   |   |   22.38 |   |   |
|                          |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The weighted average fairvalue of options granted during 2005, 2004 and 2003 was $22.76, $17.98 and$13.03 per share, respectively.

59

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**7.**   Stockholders’ Equity (Continued)

The following table summarizes the shares reserved forfuture grants:

| Shares reserved for future grants at December 31,  2002                                              |   | 72,729     |   |
|------------------------------------------------------------------------------------------------------|--------|------------|--------|
| Shares reserved for future grants during 2003 based  on the automatic increase in shares authorized  |   | 869,375    |   |
| Shares granted during 2003                                                                           |   | (971,750   | )      |
| Shares cancelled during 2003                                                                         |   | 347,119    |   |
| Shares reserved for future grants at December 31,  2003                                              |   | 317,473    |   |
| Shares reserved  for future grants during 2004 based on the automatic increase in shares  authorized |   | 897,796    |   |
| Shares granted  during 2004                                                                          |   | (976,000   | )      |
| Shares cancelled  during 2004                                                                        |   | 321,468    |   |
| Shares reserved  for future grants at December 31, 2004                                              |   | 560,737    |   |
| Shares reserved  for future grants during 2005 based on the automatic increase in shares  authorized |   | 941,027    |   |
| Shares granted  during 2005                                                                          |   | (1,019,500 | )      |
| Shares cancelled  during 2004                                                                        |   | 310,976    |   |
| Shares reserved for  future grants at December 31, 2005                                              |   | 793,240    |   |

**Employee StockPurchase Plan**

In February 2000,the Company adopted the 2000 Employee Stock Purchase Plan. The purchase planprovides for automatic annual increases in the number of shares reserved forissuance thereunder (beginning in 2001) equal to the lesser of (i) 1% ofthe Company’s outstanding shares on the last business day in December ofthe calendar year immediately preceding or (ii) 375,000 shares. Thepurchase plan is intended to qualify as an employee stock purchase plan withinthe meaning of Section 423 of the Internal Revenue Code. Under thepurchase plan, the Board of Directors may authorize participation by eligibleemployees, including officers, in periodic offerings following commencement ofthe purchase plan. Shares issued and available for issuance are as follows:

| Shares reserved  for issuance at December 31, 2002                                        |   | 420,679  |   |
|------------------------------------------------------------------------------------------------|--------|----------|--------|
| Shares reserved  for issuance during 2003 based on the automatic increase in shares authorized |   | 217,344  |   |
| Shares issued  during 2003                                                                     |   | (150,739 | )      |
| Shares reserved  for issuance at December 31, 2003                                        |   | 487,284  |   |
| Shares reserved  for issuance during 2004 based on the automatic increase in shares authorized |   | 224,449  |   |
| Shares issued  during 2004                                                                     |   | (189,988 | )      |
| Shares reserved  for issuance at December 31, 2004                                        |   | 521,745  |   |
| Shares reserved  for issuance during 2005 based on the automatic increase in shares authorized |   | 235,257  |   |
| Shares issued  during 2005                                                                     |   | (156,799 | )      |
| Shares reserved for  issuance at December 31, 2005                                        |   | 600,203  |   |

 

60

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**7.**   Stockholders’ Equity (Continued)

Unlessotherwise determined by the Board or precluded by laws of foreign jurisdictions,employees are eligible to participate in the purchase plan provided they areemployed for at least 20 hours per week and are customarily employed for atleast five months per calendar year. Employees who participate in an offeringmay have up to 15% of their earnings withheld pursuant to the purchase plan.The amount withheld is then used to purchase shares of common stock on specifieddates. The price of common stock purchased pursuant to the plan will be equalto 85% of the lower of the fair market value of the common stock at thecommencement date of each offering period or the relevant purchase date.Employees may end their participation in the offering at any time during theoffering period, and participation ends automatically on termination ofemployment.

**Shares Reserved for Future Issuance**

Thefollowing shares of common stock are reserved for future issuance as of December 31,2005:

| Stock options:                |   |      |   |
|-------------------------------|--------|-----------|--------|
| Granted and outstanding.      |   | 2,607,348 |   |
| Reserved for future grants    |   | 793,240   |   |
| Employee Stock Purchase Plan: |   |      |   |
| Reserved  for future issuance |   | 600,203   |   |
| Total:                        |   | 4,000,791 |   |

 

**Treasury Stock**

On April 3, 2003, the Company announced that itsBoard authorized a stock repurchase program of up to 2 million shares of itscommon stock. On August 15, 2005, the Company announced that its Boardincreased the size of the stock repurchase program by an additional 2 millionshares, for a total program size of up to 4 million shares. The repurchaseswill be made from time to time on the open market at prevailing market pricesor in privately negotiated transactions. Depending on market conditions andother factors, purchases under this program may be commenced or suspended atany time, or from time to time, without prior notice. As of December 31,2005, the Company had repurchased 1,935,030 shares of its common stock underthis program, for an aggregate of $79.0 million at an average price of $40.83per share.

As of December 31,2004, the Company had retired all 1,006,000 shares of its common stock that hadbeen repurchased prior to that date. No shares of common stock that wererepurchased during 2005 were retired. In accordance with APB No. 6, Status ofAccounting Research Bulletins, the treasury stock retirement was effected byreducing the following on the Company’s Consolidated Balance Sheets: treasurystock by $30.7 million, common stock by $0.1 million, additional paid-incapital by $6.4 million and retained earnings by $24.2 million. There was noeffect to the Company’s overall equity position as a result of the retirement.

61

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**8.**   Income Taxes

Forfinancial reporting purposes, income before income taxes includes the followingcomponents:

| ** **                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                  | ** ** | **(In thousands)**                    | ** ** |
| Income before income  taxes |       |                                       |       |   |   |   |   |
| United States               |       | $                                          | 50,321     |   | $ | 36,712 |   | $ | 26,551 |   |
| Foreign                     |       | 9,790                                      |       | 4,270 |   | 532 |   |
| Total                       |       | $                                          | 60,111     |   | $ | 40,982 |   | $ | 27,083 |   |

 

Theprovision for income taxes is as follows:

| ** **          | ** ** | **Year Ended December 31,** | ** ** |
|---------------------|------------|--------------------------------------------|------------|
| ** **          | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **          | ** ** | **(In thousands)**                    | ** ** |
| Current             |       |                                       |       |   |   |   |   |
| Federal             |       | $                                          | 19,590     |   | $ | 12,535 |   | $ | 10,103 |   |
| Foreign             |       | 1,909                                      |       | 759 |   | 401 |   |
| State               |       | 2,945                                      |       | 2,160 |   | 1,864 |   |
|                |       | 24,444                                     |       | 15,454 |   | 12,368 |   |
| Deferred            |       |                                       |       |   |   |   |   |
| Federal             |       | (2,750                                     | )          | (367 | ) | (1,735 | ) |
| Foreign             |       | (232                                       | )          | — |   | — |   |
| State               |       | (119                                       | )          | (281 | ) | (238 | ) |
|                |       | (3,101                                     | )          | (648 | ) | (1,973 | ) |
| Income tax  expense |       | $                                          | 21,343     |   | $ | 14,806 |   | $ | 10,395 |   |

 

The reconciliation ofincome tax computed at the federal statutory rate to the provision for incometaxes is as follows:

| ** **           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------|------------|--------------------------------------------|------------|
| ** **           | ** ** | ** 2005 **                       | ** ** | ** 2004 ** | ** ** | ** 2003 ** | ** ** |
| Statutory Rate       |       |                                       | 35.0       | % |   |   | 35.0 | % |   |   | 35.0 | % |   |
| Foreign tax          |       |                                       | (2.3       | ) |   |   | (0.9 | ) |   |   | 0.1 |   |   |
| State tax            |       |                                       | 4.8        |   |   |   | 5.5 |   |   |   | 5.9 |   |   |
| Valuation  allowance |       |                                       | (0.4       | ) |   |   | (0.9 | ) |   |   | (0.1 | ) |   |
| Credits              |       |                                       | (0.4       | ) |   |   | (1.7 | ) |   |   | (1.2 | ) |   |
| Tax-exempt  interest |       |                                       | (2.9       | ) |   |   | (2.1 | ) |   |   | (0.8 | ) |   |
| Other                |       |                                       | 1.7        |   |   |   | 1.2 |   |   |   | (0.5 | ) |   |
|                 |       |                                       | 35.5       | % |   |   | 36.1 | % |   |   | 38.4 | % |   |

 

62

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**8.      IncomeTaxes (Continued)**

Significantcomponents of the Company’s deferred tax assets and liabilities as ofDecember 31, are as follows:

| ** **                                   | ** ** | **2005**                | ** ** | **2004** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                   | ** ** | **(In thousands)** | ** ** |
| Deferred tax assets                          |       |                    |       |     |       |
| Tax credit carryforwards                     |       | $                       | 2,516      |     | $          | 2,306 |   |
| Deferred revenue                             |       | 17,410                  |       | 14,415   |       |
| Foreign deferred taxes                       |       | 778                     |       | 103      |       |
| Other                                        |       | 1,658                   |       | 1,332    |       |
| Total deferred tax assets                    |       | 22,362                  |       | 18,156   |       |
| Valuation  allowance for deferred tax assets |       | (547                    | )          | (103     | )          |
| Net deferred taxes                           |       | $                       | 21,815     |     | $          | 18,053 |   |

 

A valuation allowance is required when it is morelikely than not that all or a portion of a deferred tax asset will not berealized. Periodically, management reassesses the need for a valuationallowance. At December 31, 2005, the valuation allowance related to netoperating losses generated in 2004 and 2005 by the Company’s wholly-ownedsubsidiary in the United Kingdom. These losses are the result of stock optiondeductions and therefore, when the losses are utilized in the future, the taxbenefit will be credited to paid in capital rather than the provision forincome taxes.

As of December 31, 2005, the Company has federaland California research and development tax credit carryforwards ofapproximately $1.7 million and $1.3 million, respectively. These credits willbegin to expire in 2023 unless previously utilized.

Pursuant to Internal Revenue Code (IRC) Sections 382and 383, use of the Company’s tax credit carryforwards may be limited if acumulative change in ownership of more than 50% occurs within a three yearperiod. Based on IRC Sections 382 and 383, management believes that a change inownership may have occurred. However, management does not believe that suchchange would have a significant impact on the Company’s ability to utilize itstax credit carryforwards.

As of December 31, 2005, the Company hadapproximately $7.6 million of undistributed earnings related to its foreignsubsidiaries. Management believes that these earnings will be indefinitelyreinvested in foreign jurisdictions; accordingly, the Company has not providedfor U.S. federal income taxes related to these earnings. However, upondistribution of these earnings in the form of dividends or otherwise, theCompany would be subject to both U.S. income taxes and withholding taxes payableto the various foreign countries. It is estimated that the total tax liability,reduced by anticipated foreign tax credits, upon such a distribution would beapproximately $1.6 million.

It is the Company’s policyto establish reserves for taxes that will probably become payable in futureyears as a result of an examination by tax authorities. The Company establishesthe reserves based on management’s assessment of exposure associated withpermanent tax differences, tax credits and interest expense applied totemporary differences. The tax reserves are analyzed regularly and adjustmentsare made as events occur to warrant adjustment to the reserves.

63

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2005**

**9.      EmployeeRetirement Plan**

Effective May 1,1997, the Company established a 401(k) defined contribution retirementplan (401(k) Plan) covering substantially all employees. The 401(k) Planprovides for voluntary employee contributions from 1% to 50% of annualcompensation, as defined, and did not provide for matching contributions fromthe Company as of December 31, 2003. In January 2004, the Company’sBoard of Directors approved a discretionary employer matching contribution of25% for each employee deferral contribution made during the plan year, up to 6%of the participant’s compensation. The amount of employer expenses includingthe employer match contributed to the 401(k) Plan during the years ended December 31,2005 and 2004 were $430,000 and $369,000, respectively.

**10.   SubsequentEvents**

On January 9, 2006, the Company entered into anemployment agreement with Gene Hodges (the “Agreement”). Pursuant to theAgreement, Mr. Hodges agreed to serve as President and Chief ExecutiveOfficer of the Company, reporting to its Board of Directors, with employmentcommencing on a full-time basis on January 9, 2006, and continuing at willuntil either party gives notice of termination. At the Company’s January 24,2006 Board of Directors meeting, the Board increased the number of authorizeddirectors to seven and appointed Mr. Hodges as a director on the Board tofill the vacancy created by the increase.

As an inducement for Mr. Hodges to join the Company,Mr. Hodges was granted non-qualified stock options to purchase600,000 shares of common stock outside the Company’s Amended and Restated2000 Stock Incentive Plan. The option exercise price is equal to the closingprice of the Company’s common stock on the first date of Mr. Hodges’ employment.The options will vest over four to seven year periods in accordance withpre-determined vesting schedules, provided Mr. Hodges remains employed bythe Company, and are subject to partial or full acceleration of vesting undercertain circumstances. Additionally, Mr. Hodges was awarded 48,000restricted stock units pursuant to the Company’s Amended and Restated 2000 StockIncentive Plan. The restricted stock units vest equally over four years,provided Mr. Hodges remains employed by the Company, and are subject to fullacceleration of vesting under certain circumstances.

On January 31,2006, the Company announced that the Board of Directors authorized atwo-for-one stock split of the Company’s common stock, to be effected in theform of a special dividend of one share of its common stock for each share ofits common stock outstanding. The additional shares issued as a result of thestock split will be distributed on or about March 17, 2006 to stockholdersof record at the close of business on February 13, 2006.

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**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure

None

**Item 9A.**                Controlsand Procedures

We maintain disclosure controls and procedures whichare designed to ensure that information required to be disclosed in the reportswe file or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms, and that such information is accumulated andcommunicated to our management, including our chief executive officer, or CEO,and chief financial officer, or CFO, as appropriate to allow timely decisionsregarding required disclosure.

Under the supervision and with the participation ofour management, including our CEO and CFO, an evaluation was performed on theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of the period covered by this annual report. Based onthat evaluation, our management, including the CEO and CFO, concluded that ourdisclosure controls and procedures were effective as of December 31, 2005.

An evaluation was alsoperformed under the supervision and with the participation of our management,including our CEO and CFO, of any change in our internal controls overfinancial reporting that occurred during our last fiscal quarter and that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrols over financial reporting. That evaluation did not identify any changein our internal controls over financial reporting that occurred during ourlatest fiscal quarter and that has materially affected, or is reasonably likelyto materially affect, our internal controls over financial reporting.

**Management’sReport on Internal Control Over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rules 13a-15(f) and 15d-15(f). All internalcontrol systems, no matter how well designed, have inherent limitations. Thereforeeven those systems determined to be effective can provide only reasonableassurance with respect to financial statement preparation and presentation.

Under the supervision and with the participation ofour management, including our CEO and CFO, we conducted an evaluation of theeffectiveness of our internal control over financial reporting based on theframework in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.Based on our evaluation under the framework in *InternalControl—Integrated Framework*, our management concluded that ourinternal control over financial reporting was effective as of December 31,2005.

Our management’s assessment of the effectiveness ofour internal control over financial reporting as of December 31, 2005 hasbeen audited by Ernst & Young LLP, an independent registered publicaccounting firm, as stated in their report which is included herein.

65

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**Reportof Independent Registered Public Accounting Firm on Internal Control overFinancial Reporting**

The Board of Directors and StockholdersWebsense, Inc.

We have audited management’s assessment, included inthe accompanying “Management’s Report on Internal Control Over FinancialReporting” that Websense, Inc. maintained effective internal control overfinancial reporting as of December 31, 2005, based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria). Websense’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management’s assessment and an opinion on the effectiveness of the company’sinternal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that Websense, Inc.maintained effective internal control over financial reporting as of December 31,2005, is fairly stated, in all material respects, based on the COSO criteria.Also, in our opinion, Websense, Inc. maintained, in all material respects,effective internal control over financial reporting as of December 31,2005, based on the COSO criteria.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets asof December 31, 2005 and 2004, and the related consolidated statements ofincome, stockholders’ equity and cash flows for each of the three years in theperiod ended December 31, 2005 of Websense, Inc. and our report datedFebruary 22, 2006 expressed an unqualified opinion thereon.
|                         | /s/ ERNST & YOUNG LLP |
|-------------------------|--------------------------------|
| San Diego,  California  |                           |
| February 22,  2006 |                           |

 

66

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**Item 9B.**               OtherInformation.

None

**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant

(a)  Directors.   Informationconcerning our directors is incorporated by reference from the sectioncaptioned *“Proposal 1: Election of Directors”*contained in our Proxy Statement related to the Annual Meeting of Stockholdersto be held on June 6, 2006.

(b) ExecutiveOfficers.   Information concerning our executive officers is set forthunder the section captioned *“ExecutiveOfficers”* in Part I of this report.

(c)  Compliancewith Section 16(a) of the Exchange Act.   Information concerningcompliance with Section 16(a) of the Exchange Act is incorporated byreference from the section captioned *“Section 16(a) BeneficialOwnership Reporting Compliance”* contained in our Proxy Statementrelated to the Annual Meeting of Stockholders to be held on June 6, 2006.

(d) The company has adopted a *Code ofBusiness Conduct* which, together with the policies referred totherein, is applicable to all directors, officers and employees of the company.In addition, the company has adopted a *Codeof Ethics for the Chief Executive Officer, Senior Financial Officers and AllFinance and Accounting Department Personnel* (“*Code of Ethics*”). The *Code of Business Conduct* and the *Code of Ethics* cover all areas ofprofessional conduct, including conflicts of interest, disclosure obligations,insider trading and confidential information, as well as compliance with alllaws, rules and regulations applicable to our business. The companyencourages all employees, officers and directors to promptly report anyviolations of any of the company’s policies. In the event that an amendment to,or a waiver from, a provision of the *Code ofBusiness Conduct* or *Code ofEthics* that applies to any of our directors or executive officers isnecessary, the company intends to post such information on its website. A copyof our *Code of Business Conduct*and our *Code of Ethics* can beobtained from our website at *www.websense.com*.

**Item 11.**                 ExecutiveCompensation

The information requiredby Item 11 of Form 10-K is incorporated by reference from theinformation contained in the section captioned *“ExecutiveCompensation and Other Information”* in our Proxy Statement relatedto the Annual Meeting of Stockholders to be held on June 6, 2006.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

The information required by Item 12 of Form 10-Kconcerning security ownership of certain beneficial owners and management isincorporated by reference from the information contained in the sectioncaptioned *“Ownership of Securities”*in our Proxy Statement related to the Annual Meeting of Stockholders to be heldon June 6, 2006.

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Thefollowing table provides information as of December 31, 2005 with respectto the shares of the Company’s common stock that may be issued under theCompany’s existing equity compensation plans:

| **Plan Category**                                         | ** ** | ** ** | ** ** | **Number of securities  to be issued upon  exercise of outstanding  options, warrants and  rights** | ** ** | **Weighted-  average  exercise price  of outstanding  options,  warrants and  rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities subject to  outstanding options,  warrants and rights)** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders(1)     |       |       | 2,542,303  |                                                                                                                                             |       |                                                                                                  | $          | 36.28                                                                                                                                                                                                                                               |       |   |   | 1,393,443 | (3) |   |
| Equity compensation plans not approved by security  holders(2) |       |       | 65,045     |                                                                                                                                             |       |                                                                                                  | $          | 13.84                                                                                                                                                                                                                                               |       |   |   | — |   |   |
| Total                                                          |       |       | 2,607,348  |                                                                                                                                             |       |                                                                                                  | $          | 35.72                                                                                                                                                                                                                                               |       |   |   | 1,393,443 |   |   |

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(1)          Consists solely of theAmended and Restated 2000 Stock Incentive Plan and the Employee Stock PurchasePlan.

(2)          Consists of 177,000stock option grants made to certain new employees in 2002 in order to inducethem to commence employment with the company, of which 65,045 are outstanding. Theoutstanding stock options have substantially the same terms as stock optionsissued under the Amended and Restated 2000 Stock Incentive Plan and have aweighted average exercise price of $13.84 per share.

(3)          Consistsof shares available for future issuance under the Employee Stock Purchase Planand the Amended and Restated 2000 Stock Incentive Plan. As of December 31,2005, an aggregate of 600,203 shares of Common Stock were available forissuance under the Employee Stock Purchase Plan and 793,240 shares of CommonStock were available for issuance under the Amended and Restated 2000 StockIncentive Plan. The number of shares of Common Stock available for issuanceunder the Employee Stock Purchase Plan and the Amended and Restated 2000 StockIncentive Plan automatically increases on the first trading day of January eachcalendar year by an amount equal to 1% and 4%, respectively, of the totalnumber of shares of Common Stock outstanding on the last trading day of December inthe immediately preceding calendar year but in no event will any such increaseexceed 375,000 shares and 1,500,000 shares, respectively, of Common Stock.

**Item 13.**                 CertainRelationships and Related Transactions

The information requiredby Item 13 of Form 10-K is incorporated by reference from theinformation contained in the section captioned *“CertainRelationships and Related Transactions”* in our Proxy Statement related to the Annual Meeting of Stockholdersto be held on June 6, 2006.

**Item 14.**                 PrincipalAccounting Fees and Services

The information required by Item 14 of Form 10-Kis incorporated by reference from the information contained in the sectioncaptioned *“Proposal 2: Ratification ofSelection of Independent Auditors”* in our Proxy Statement related tothe Annual Meeting of Stockholders to be held on June 6, 2006.

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**PART IV**

**Item 15.      Exhibitsand Financial Statement Schedules**

(a)    Thefollowing documents are filed as part of this report:

1.                FinancialStatement Schedules.

Schedule II Valuation and Qualifying Accounts

Schedules not listed above have been omitted because theyare not applicable, not required, or the information required to be set forththerein is included in the consolidated financial statements or notes thereto.

2.                Exhibits

| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                         | ** ** | **Description of Document** |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|
| 3.1(1)           |       | Amended and Restated Certificate of Incorporation                                                                                                                                                                                                                                                                                                  |
| 3.2(1)           |       | Restated Bylaws                                                                                                                                                                                                                                                                                                                                    |
| 4.1(1)           |       | Specimen Stock Certificate of Websense, Inc.                                                                                                                                                                                                                                                                                                  |
| 10.1(1)          |       | Amended and Restated Registration Rights Agreement  dated June 9, 1999                                                                                                                                                                                                                                                                        |
| 10.2(1)          |       | Form of Subscription Agreement regarding Series B  Preferred Stock                                                                                                                                                                                                                                                                       |
| 10.3(1)*         |       | Employment Agreement by and between  Websense, Inc. and John B. Carrington, dated May 10, 1999                                                                                                                                                                                                                                           |
| 10.4*            |       | Amendment to Employment Agreement by and between  Websense, Inc. and John B. Carrington, dated January 24, 2006                                                                                                                                                                                                                          |
| 10.5(1)*         |       | Employment Agreement by and between  Websense, Inc. and Douglas C. Wride, dated June 11, 1999                                                                                                                                                                                                                                            |
| 10.6*            |       | Amendment to Employment Agreement by and between  Websense, Inc. and Douglas C. Wride, dated January 24, 2006                                                                                                                                                                                                                            |
| 10.7(2)*         |       | Employment Agreement by and between  Websense, Inc. and Gene Hodges, dated January 9, 2006                                                                                                                                                                                                                                          |
| 10.8(1)*         |       | 1998 Equity Incentive Plan                                                                                                                                                                                                                                                                                                                         |
| 10.9(1)*         |       | Standard Terms and Conditions Relating to Incentive  Stock Option Under the 1998 Equity Incentive Plan                                                                                                                                                                                                                                             |
| 10.10*           |       | Amended and Restated 2000 Stock Incentive Plan                                                                                                                                                                                                                                                                                                     |
| 10.11(1)*        |       | 2000 Stock Incentive Plan, Notice of Grant of Stock  Option                                                                                                                                                                                                                                                                                        |
| 10.12(1)*        |       | 2000 Stock Incentive Plan, Form of Incentive  Stock Option Agreement                                                                                                                                                                                                                                                                          |
| 10.13*           |       | 2000 Stock Incentive Plan, Form of Deferred  Issuance Stock Issuance Agreement                                                                                                                                                                                                                                                                |
| 10.14(1)*        |       | 2000 Employee Stock Purchase Plan                                                                                                                                                                                                                                                                                                                  |
| 10.15*           |       | Form of Non-Plan Inducement Stock Option  Agreement for Gene Hodges dated January 9, 2006                                                                                                                                                                                                                                           |
| 10.16(1)         |       | Form of Indemnification Agreement between  Websense, Inc. and its directors                                                                                                                                                                                                                                                              |
| 10.17(1)         |       | Form of Indemnification Agreement between  Websense, Inc. and its officers                                                                                                                                                                                                                                                               |
| 10.18(3)*        |       | Officers’ Bonus Term Sheet                                                                                                                                                                                                                                                                                                                    |
| 10.19(3)*        |       | Non-Employee Directors Compensation Term Sheet                                                                                                                                                                                                                                                                                                     |
| 10.20(4)         |       | Lease Agreement between Websense, Inc. and  Legacy-RECP Sorrento OPCO, LLC, dated April 19, 2002; First Amendment to  Lease between Websense, Inc. and Legacy-RECP Sorrento OPCO, LLC, dated  October 1, 2002; Second Amendment to Lease between Websense, Inc.  and Sorrento Valley Road LLC, dated April 30, 2003. |
| 10.21(5)         |       | Third Amendment to Lease between Websense, Inc.  and Sorrento Valley Road LLC, dated July 30, 2004.                                                                                                                                                                                                                                      |

69

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| 10.22 |   | Fourth Amendment to Lease between  Websense, Inc. and Sorrento Valley Road LLC, dated March 24, 2005                                                                                 |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 21.1  |   | Subsidiaries of the Registrant                                                                                                                                                                 |
| 23.1  |   | Consent of Independent Registered Public Accounting  Firm                                                                                                                                      |
| 31.1  |   | Certification of Principal Executive Officer  pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a)                                                                                 |
| 31.2  |   | Certification of Principal Financial Officer  pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a)                                                                                 |
| 32.1  |   | Certification of Principal Executive Officer  pursuant to Exchange Act Rules 13a-14(b) and 15d-14(b) and  Section 1350 of Chapter 63 of Title 18 of the United States Code |
| 32.2  |   | Certification of Principal Financial Officer  pursuant to Exchange Act Rules 13a-14(b) and 15d-14(b) and  Section 1350 of Chapter 63 of Title 18 of the united States Code |

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*                    Indicatesmanagement contract or compensatory plan or arrangement.

(1)          Previously filed as anexhibit to our Registration Statement on Form S-1 (Registration No. 333-95619)and incorporated herein by reference.

(2)          Previously filed as anexhibit to our Form 8-K filed on January 11, 2006 andincorporated herein by reference.

(3)          Previously filed as anexhibit to our Form 10-K for the period ended December 31, 2004and incorporated herein by reference.

(4)          Previously filed as anexhibit to our Form 10-Q for the period ended June 30, 2003 andincorporated herein by reference.

(5)          Previously filed as anexhibit to our Form 10-Q for the period ended September 30,2004 and incorporated herein by reference.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|          | WEBSENSE,  INC. |
|----------|-----------------|
|     | By:             | /s/ DOUGLAS C. WRIDE |
|     |            | Douglas C. Wride |
| * * | * *        | *Chief Financial Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.
|                        | **Signature** | ** **                                       | ** ** | ** **         | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|------------------------|---------------|--------------------------------------------------|------------|--------------------|-----------|------------|------------|------------|----------|------------|
| /s/ GENE HODGES        |          | Director,  President and Chief Executive Officer |       | March 1, 2006 |
| Gene Hodges            |          | (principal executive  officer)                   |       |               |
| /s/ DOUGLAS C. WRIDE   |          | Chief Financial  Officer (principal financial    |       | March 1, 2006 |
| Douglas C. Wride       |          | and accounting officer)                          |       |               |
| /s/ JOHN B. CARRINGTON |          |                                             |       | March 1, 2006 |
| John B. Carrington     |          | Chairman of the Board                            |       |               |
| /s/ MARK ST.CLARE      |          |                                             |       | March 1, 2006 |
| Mark St.Clare          |          | Director                                         |       |               |
| /s/ BRUCE T. COLEMAN   |          |                                             |       | March 1, 2006 |
| Bruce T. Coleman       |          | Director                                         |       |               |
| /s/ JOHN SCHAEFER      |          |                                             |       | March 1, 2006 |
| John Schaefer          |          | Director                                         |       |               |
| /s/ GARY E. SUTTON     |          |                                             |       | March 1, 2006 |
| Gary E. Sutton         |          | Director                                         |       |               |
| /s/ PETER WALLER       |          |                                             |       | March 1, 2006 |
| Peter Waller           |          | Director                                         |       |               |

 

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**ScheduleII—VALUATION AND QUALIFYING ACCOUNTSWEBSENSE, INC.(In thousands)**

| A                                                      | ** ** | **B**      | ** ** | **C**                                          | ** ** | **D**                                         | ** ** | **E**                                               | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                             | ** ** | ** ** | ** ** | **Additions**                                  | ** ** | ** **                                    | ** ** | ** **                                          | ** ** |
| **Description**                                        | ** ** | ** ** | ** ** | **Balance at  beginning  of period** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Charged to  Other Accounts-  Describe** | ** ** | **Deductions-  Describe** | ** ** | **Balance at  End of  Period** | ** ** |
| YEAR ENDED DECEMBER 31, 2003                           |       |       |       |                                           |       |                                          |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Reserves and allowances deducted  from asset accounts: |       |       |       |                                           |       |                                          |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful  accounts                       |       |       | $          | 180                                            |       |                                          |       | —                                              |       |   |   | $ | 700 | (2) |   |   | $ | 355 | (1) |   |   | $ | 525 |   |   |
| YEAR ENDED DECEMBER 31,  2004                          |       |       |       |                                           |       |                                          |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Reserves and allowances deducted  from asset accounts: |       |       |       |                                           |       |                                          |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts                        |       |       | $          | 525                                            |       |                                          |       | —                                              |       |   |   | $ | 975 | (2) |   |   | $ | 360 | (1) |   |   | $ | 1,140 |   |   |
| YEAR ENDED DECEMBER 31, 2005                           |       |       |       |                                           |       |                                          |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Reserves and allowances deducted  from asset accounts: |       |       |       |                                           |       |                                          |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful  accounts                       |       |       | $          | 1,140                                          |       |                                          |       | —                                              |       |   |   | $ | 825 | (2) |   |   | $ | 505 | (1) |   |   | $ | 1,460 |   |   |
|                                                        |            |            |            |                                                |            |                                               |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Uncollectible accountswritten off, net of recoveries.

(2)          Amount representsreserve recorded as a reduction of deferred revenue and represents customerbalances deemed uncollectible. The reserve is amortized as a reduction ofrevenue over the average life of all subscriptions.

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** EXHIBIT INDEX**
| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                          | ** ** | **Description   of Document** |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|
| 3.1(1)           |       | Amended and Restated  Certificate of Incorporation                                                                                                                                                                                                                                                                                                  |
| 3.2(1)           |       | Restated Bylaws                                                                                                                                                                                                                                                                                                                                     |
| 4.1(1)           |       | Specimen Stock  Certificate of Websense, Inc.                                                                                                                                                                                                                                                                                                  |
| 10.1(1)          |       | Amended and  Restated Registration Rights Agreement dated June 9, 1999                                                                                                                                                                                                                                                                         |
| 10.2(1)          |       | Form of  Subscription Agreement regarding Series B Preferred Stock                                                                                                                                                                                                                                                                        |
| 10.3(1)*         |       | Employment  Agreement by and between Websense, Inc. and John B. Carrington, dated  May 10, 1999                                                                                                                                                                                                                                           |
| 10.4*            |       | Amendment to  Employment Agreement by and between Websense, Inc. and John B.  Carrington, dated January 24, 2006                                                                                                                                                                                                                          |
| 10.5(1)*         |       | Employment  Agreement by and between Websense, Inc. and Douglas C. Wride, dated  June 11, 1999                                                                                                                                                                                                                                            |
| 10.6*            |       | Amendment to  Employment Agreement by and between Websense, Inc. and Douglas C. Wride,  dated January 24, 2006                                                                                                                                                                                                                            |
| 10.7(2)*         |       | Employment  Agreement by and between Websense, Inc. and Gene Hodges, dated  January 9, 2006                                                                                                                                                                                                                                               |
| 10.8(1)*         |       | 1998 Equity  Incentive Plan                                                                                                                                                                                                                                                                                                                         |
| 10.9(1)*         |       | Standard Terms  and Conditions Relating to Incentive Stock Option Under the 1998 Equity  Incentive Plan                                                                                                                                                                                                                                             |
| 10.10*           |       | Amended and  Restated 2000 Stock Incentive Plan                                                                                                                                                                                                                                                                                                     |
| 10.11(1)*        |       | 2000 Stock  Incentive Plan, Notice of Grant of Stock Option                                                                                                                                                                                                                                                                                         |
| 10.12(1)*        |       | 2000 Stock  Incentive Plan, Form of Incentive Stock Option Agreement                                                                                                                                                                                                                                                                           |
| 10.13*           |       | 2000 Stock  Incentive Plan, Form of Deferred Issuance Stock Issuance Agreement                                                                                                                                                                                                                                                                 |
| 10.14(1)*        |       | 2000 Employee  Stock Purchase Plan                                                                                                                                                                                                                                                                                                                  |
| 10.15*           |       | Form of  Non-Plan Inducement Stock Option Agreement for Gene Hodges dated  January 9, 2006                                                                                                                                                                                                                                                |
| 10.16(1)         |       | Form of  Indemnification Agreement between Websense, Inc. and its directors                                                                                                                                                                                                                                                               |
| 10.17(1)         |       | Form of  Indemnification Agreement between Websense, Inc. and its officers                                                                                                                                                                                                                                                                |
| 10.18(3)*        |       | Officers’ Bonus  Term Sheet                                                                                                                                                                                                                                                                                                                    |
| 10.19(3)*        |       | Non-Employee  Directors Compensation Term Sheet                                                                                                                                                                                                                                                                                                     |
| 10.20(4)         |       | Lease Agreement  between Websense, Inc. and Legacy-RECP Sorrento OPCO, LLC, dated  April 19, 2002; First Amendment to Lease between Websense, Inc. and  Legacy-RECP Sorrento OPCO, LLC, dated October 1, 2002; Second Amendment  to Lease between Websense, Inc. and Sorrento Valley Road LLC, dated  April 30, 2003. |
| 10.21(5)         |       | Third Amendment  to Lease between Websense, Inc. and Sorrento Valley Road LLC, dated  July 30, 2004.                                                                                                                                                                                                                                      |
| 10.22            |       | Fourth Amendment  to Lease between Websense, Inc. and Sorrento Valley Road LLC, dated  March 24, 2005                                                                                                                                                                                                                                     |
| 21.1             |       | Subsidiaries of  the Registrant                                                                                                                                                                                                                                                                                                                     |
| 23.1             |       | Consent of Independent  Registered Public Accounting Firm                                                                                                                                                                                                                                                                                           |

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| 31.1 |   | Certification of Principal Executive Officer  pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a)                                                                                  |
|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of  Principal Financial Officer pursuant to Exchange Act Rules 13a-14(a) and  15d-14(a)                                                                                 |
| 32.1 |   | Certification of  Principal Executive Officer pursuant to Exchange Act Rules 13a-14(b) and  15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the  United States Code |
| 32.2 |   | Certification of  Principal Financial Officer pursuant to Exchange Act Rules 13a-14(b) and  15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the  united States Code |

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*                    Indicatesmanagement contract or compensatory plan or arrangement.

(1)          Previously filed as anexhibit to our Registration Statement on Form S-1 (Registration No. 333-95619)and incorporated herein by reference.

(2)          Previously filed as anexhibit to our Form 8-K filed on January 11, 2006 andincorporated herein by reference.

(3)          Previously filed as anexhibit to our Form 10-K for the period ended December 31, 2004and incorporated herein by reference.

(4)          Previously filed as anexhibit to our Form 10-Q for the period ended June 30, 2003 andincorporated herein by reference.

(5)          Previously filed as anexhibit to our Form 10-Q for the period ended September 30,2004 and incorporated herein by reference.

 

                

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