** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-K**

 

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

 

**For the fiscal year ended December 31, 2003**

**OR**

 

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

 

**For the Transition Period from                  to                **

** **

**Commission File Number 000-30093**

 

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**Websense, Inc.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                   |   | **51-0380839**                         |
|----------------------------------------------------------------|--------|----------------------------------------|
| (State or other jurisdiction of incorporation or organization) |   | (I.R.S.Employer Identification Number) |

 

**10240 Sorrento Valley Road**

**San Diego, California 92121**

**858-320-8000**

(Address of principal executive offices, zip code and telephone number)

 

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Securities registered pursuant to Section 12(b) of the Act:  **None**

 

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

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days. (1)Yes ý  No o  (2) Yes ý  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 to this Form 10-K. ý

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Exchange Act Rule12(b)-2): Yes ý  No o

 

The aggregate market value ofthe voting stock held by non-affiliates of the registrant, as of June 30, 2003was approximately $303 million (based on the closing price for shares of theregistrant’s Common Stock as reported by the Nasdaq National Market for thatdate). Shares of Common Stock held by each officer, director and holder of 10%or more of the outstanding Common Stock have been excluded in that such personsmay be deemed affiliates. Exclusion of shares held by any person should not beconstrued to indicate that such person possesses the power, direct or indirect,to direct or cause the direction of management or policies of the registrant,or that such person is controlled by or under common control with theregistrant.

 

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of February 29, 2004 was 22,841,938.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of the definitiveProxy Statement to be delivered to stockholders in connection with the AnnualMeeting of Stockholders to be held June 2, 2004 are incorporated by referenceinto Part III.

 

Certain exhibits filed with the registrant’s prior registration statements and forms 10-K are incorporated herein by reference into Part IV of this Report.

 

 

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**Websense, Inc.**

**Form 10-K**

**For the FiscalYear Ended December 31, 2003**

 

**TABLE OFCONTENTS**

 
| Part I    |                                                                                                                                                                     |   |
|-----------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item  1.  | Business................................................................................................................................................................ | 1      |
| Item 2.   | Properties.............................................................................................................................................................. | 17     |
| Item 3.   | Legal Proceedings................................................................................................................................................        | 17     |
| Item 4.   | Submission of Matters to  a Vote of Security Holders.........................................................................................                            | 17     |
|      |                                                                                                                                                                     |   |
| Part II   |                                                                                                                                                                     |   |
| Item  5.  | Market for the Registrant’s Common  Equity and Related Stockholder Matters..................................................                                        | 18     |
| Item  6.  | Selected Financial Data........................................................................................................................................          | 19     |
| Item  7.  | Management’s Discussion and  Analysis of Financial Condition and Results of Operations..............................                                                | 20     |
| Item  7A. | Quantitative and Qualitative  Disclosures About Market Risk.............................................................................                                 | 38     |
| Item  8.  | Financial Statements and Supplementary  Data....................................................................................................                         | 39     |
| Item  9.  | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure.............................                                                    | 60     |
| Item 9A.  | Controls and Procedures.......................................................................................................................................           | 60     |
|      |                                                                                                                                                                     |   |
| Part III  |                                                                                                                                                                     |   |
| Item  10. | Directors  and Executive Officers of the Registrant..............................................................................................                        | 60     |
| Item  11. | Executive Compensation......................................................................................................................................             | 61     |
| Item 12.  | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters............                                                              | 61     |
| Item  13. | Certain  Relationships and Related Transactions..................................................................................................                        | 62     |
| Item 14.  | Principal  Accountant Fees and Services...............................................................................................................                   | 62     |
|      |                                                                                                                                                                     |   |
| Part IV   |                                                                                                                                                                     |   |
| Item 15.  | Exhibits,  Financial Statement Schedules, and Reports on Form 8-K...................................................................                                     | 63     |
|      | Signatures.............................................................................................................................................................  | 65     |

 

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**PART I**

 

#### **Forward Looking Statements**

 

**Thisreport on Form 10-K may contain “forward-looking statements” within the meaningof the federal securities laws made pursuant to the safe harbor provisions ofthe Private Securities Litigation Reform Act of 1995. These statements, whichrepresent our expectations or beliefs concerning various future events, may containwords such as “may,” “will,” “expects,” “anticipates,” “intends,” “plans,”“believes,” “estimates,” or other words indicating future results. Suchstatements may include but are not limited to statements concerning thefollowing:**

 

•                  anticipatedtrends in revenue;

•                  growth opportunities in domestic andinternational markets;

•                  customer acceptance and satisfaction with ourproducts;

•                  expected trendsin operating and other expenses;

•                  anticipated cashand intentions regarding usage of cash;

•                  changes ineffective tax rates; and

•                  anticipatedproduct enhancements or releases.

 

**These forward-looking statementsare subject to risks and uncertainties that could cause actual results todiffer materially from those anticipated as of the date of this report. Weassume no obligation to update any forward-looking statements to reflect eventsor circumstances arising after the date of this report.**

 

You should carefully review and consider the variousdisclosures in this report regarding factors that could cause actual results todiffer materially from anticipated results, including those factors under thecaption “Risks and Uncertainties” under Item 7 below, and elsewhere in thisreport.

 

**Item 1. Business**

 

**Overview**

 

We provide employee Internetmanagement (EIM) products that enable organizations to analyze, report andmanage how their employees use computing resources, including Internet access,instant messaging (IM), peer-to-peer file sharing, network bandwidth anddesktop applications.  Our primaryproduct offering is the Websense Enterprise® software application, our centralpolicy engine and management console. Websense Enterprise gives businesses the ability to improve employeeproductivity, conserve network bandwidth, mitigate potential legal liability,and enhance network security by identifying potential risks and rapidlyconfiguring and implementing policies to manage their employees’ Internetaccess and use of software applications. Websense Enterprise also serves as aplatform for related Websense add-on modules, such as Client ApplicationManagerTM, Bandwidth OptimizerTM, Instant Messaging (IM) Attachment ManagerTM, andClient Policy ManagerTM, and supports a variety of reporting options that alloworganizations to document patterns of employees’ use of computing resources.

 

Our flexible softwareapplications operate in conjunction with our proprietary databases to manageemployee access to websites, employee use of network bandwidth, and employeesoftware application use at the desktop. They operate at three primary pointsof policy enforcement:  the Internetgateway, the network and the employee desktop. Our databases, including website URLs, commonly used network andInternet protocols, software applications, and other executable files, areavailable for daily differential downloads. The Websense URL database isorganized into more than 90 categories and encompasses more than 5.5 millionwebsites as of December 31, 2003, representing more than one billion

 

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webpages. The software application database has classified over 250,000software executable files in more than 50 categories. Our databases are updatedeach business day using a proprietary process of automated content assessmentand classification, with manual verification.

 

Websense Enterprise and theadd-on modules are easy to deploy and use. Our products are integrated with awide range of network access platforms, including market-leading firewalls,caching appliances, proxy-servers, switches, routers and other network appliances,and can scale with our customers’ needs to serve an unlimited number of usersacross multiple locations.

 

We currently operatein one industry segment, as defined by generally accepted accountingprinciples.

 

Our businesswas incorporated in 1994 as NetPartners Internet Solutions, as a reseller ofcomputer network security products. In 1996, we released Websense InternetScreening System, our first product as a software developer. In 1999, wereleased Websense Enterprise Version 4, a redesigned version of our software,and changed our name to Websense, Inc. to reflect the shift in our businessfocus from a value-added reseller of network security products to a developerof EIM software solutions. The newest generation of our EIM software, WebsenseEnterprise Version 5, was released in March 2003. Our principal offices arelocated at 10240 Sorrento Valley Road, San Diego, CA  92121.

 

**Industry Background**

 

As a highly flexible networkcapable of carrying almost any type of digital traffic, the Internet continuesto evolve as a critical business tool and an important communications andcommerce platform for enterprises worldwide. As part of their overall businessstrategies, many organizations are using the Internet to enable businessapplications that are accessed over their corporate networks. Companies utilizethe Internet to optimize their extended supply chains, automate their salesforces, track shipments and communicate with employees, customers, partners andsuppliers. Due to the efficiencies, cost-savings and competitive advantagesthat can be gained by leveraging the Internet, many businesses are continuingto build out their computer networks and information technology infrastructure.In order to accommodate a significant number of simultaneous users and theincreasing volume of data transfer associated with enterprise Internet use,many organizations continue to make substantial investments in wide-bandwidthconnections such as dedicated T-1 lines, enabling high-speed Internet access.

 

The Internet has also becomea highly popular consumer medium for communication, entertainment, informationand commerce. Market research firm International Data Corp. (IDC) has projectedthat the number of corporate Internet users worldwide will grow from anestimated 250 million in 2002 to more than 449 million in 2006. This rapidadoption of the Internet has been accompanied by remarkable growth in thenumber of consumer-oriented content and commerce websites and by an expandingassortment of Web-based consumer services and applications. Internet userstoday have the ability to communicate through e-mail and instant messaging,retrieve news and information from numerous Internet sources, download music,movies and other high-bandwidth content, share files over peer-to-peernetworks, make online purchases of goods and services ranging from books toairline tickets, and generally access a broad range of non-business content andcommerce websites. As the rapid evolution of Internet technology and Webcontent continues, the amount and types of data, as well as the way peopleaccess it, has increased, creating growing challenges for employers.

 

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Internet access in theworkplace is fast, convenient and essentially free to employees. According torecent data from Internet research firm ComScore Networks, only approximately28 percent of people accessing the Internet from home use a high-speedconnection, compared to 87 percent at work. Therefore, in general, employees enjoy quicker and relativelyunrestricted Internet access from their work desktop computers. As a result,many employees use their employers’ computing resources for recreational “websurfing,” peer-to-peer file sharing, downloading of high-bandwidth content,instant messaging and other personal matters during business hours. However,this unmanaged non-business use of company computing and network resources,including Internet access, can result in increased risk and cost to theemployer, including lost employee productivity, increased network bandwidthconsumption, increased network security risks, and potential legal liability.Additionally, an employee’s use of websites that offer free software downloads,pirated software and peer-to-peer applications may introduce spyware and othermalicious code to the employee’s desktop and to the corporate network, placingvaluable corporate data at risk.  Inrecent years, the rapid rise in the use of instant messaging and peer-to-peerfile sharing in the workplace has created new conduits for viruses andmalicious code that bypass traditional network security measures.  All of these factors can contribute tohigher costs for companies that make computing and network resources availableto their employees.

 

Businesses are increasinglyrecognizing the multiple risks and hidden costs associated with personalInternet and computer use in the workplace. For example, recent studiesindicate that as many as nine out of 10 desktop computers are infected withspyware. Additionally, 45 percent of businesses in a 2003 FBI survey detectedunauthorized access to corporate data by inside employees. According to a studywe commissioned with Harris Interactive, more than 75 percent of mid- tolarge-sized companies surveyed had reprimanded or disciplined employees forInternet misuse while at work with nearly half of those companies having alsoterminated employees for inappropriate Internet activity.

 

Traditionally, employershave attempted to mitigate the legal liability, productivity and bandwidthwaste risks through written policies governing acceptable employee use ofcomputing resources, and they have sought to protect against security riskswith a combination of external firewalls and anti-virus software.  With the growth in multi-media content, theproliferation of blended viruses and the rapid increase in employee use ofinstant messaging and peer-to-peer file sharing, employers are finding thatthese measures are increasingly inadequate. Written Internet access andsoftware application use policies are easily ignored, difficult to enforce andoften require manual review of log files, which is both cumbersome andtime-consuming. Because this method of enforcement does not proactively curtailundesirable Internet and software application usage, employers are forced totake potentially costly disciplinary actions after the fact. Firewalls canprovide protection against external threats such as hacking, but do little toprevent employees from accessing unauthorized data from within an organization.Anti-virus software provides protection from e-mail borne viruses, but does notprevent the possible theft or corruption of corporate data by spyware andoffers only limited protection against viruses that proliferate viapeer-to-peer networks and instant messaging.

 

To address these problems,businesses are recognizing the need for a proactive approach to managingemployee use of the Internet and computing resources, as well as the need tolayer security and policy enforcement measures across multiple network accesspoints, including the Internet gateway, the internal network infrastructure,and employees’ desktops.  In the past,many businesses have sought products that enable them to proactively managetheir employees’ Internet access through filtering of URLs. Early Internetfiltering software for the enterprise was largely derived from products thatwere originally

 

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developed to help parentsprevent their children from accessing adult content at home or in schools, andused keyword matching and dynamic page review to block content. These products,and other more recent products, are limited to filtering of website URLs and donot address the evolving nature of Internet use with the accompanying rise inthe use of instant messaging and peer-to-peer file sharing. Additionally, theytypically lack the ability to meet the needs of growing organizations, cannotoperate on multiple network platforms, do not provide the flexibility requiredby management and can be labor-intensive to deploy, consuming valuableinformation technology resources. Moreover, these applications generally do notoperate in conjunction with a comprehensive database that is consistentlyrefreshed and as effective.

 

Workplace management ofnon-business-related use of computing resources and Internet access is anincreasingly important priority because of its impact on employee productivity,network bandwidth consumption, network and data security and potential legalliability. Given the necessity of corporate Internet access and consumers’continuing adoption of the Web as a mass communication, entertainment,information and commerce medium, we believe there is a significant opportunityfor an employee Internet management solution that effectively addresses theneeds of businesses to manage employee usage of the computing environment,including Internet access and desktop application use. Additionally, althoughthe Web and e-mail are the primary drivers of Internet traffic today, the rapidemergence of Internet-enabled applications creates the need for software thatapplies management policies to file types, applications, and protocols, as wellas Web pages, at multiple points on the network. Software tools are needed toimplement policy-based bandwidth management and regulation of applications suchas instant messaging, peer-to-peer file exchange tools, interactive games anddesktop software applications.  Thesesolutions must also be adaptable enough to manage new applications and technologiesas they are developed.

 

**Our Employee Internet Management Solutions**

 

We provide EIM products thatenable businesses to analyze, report, and manage how their employees use theInternet, the network and their desktop computers. Our primary product is WebsenseEnterprise, a software application and database package that gives businessmanagers the ability to implement customized Internet access and use policiesfor different users and groups within the business, and supports anorganization’s efforts to improve employee productivity, conserve networkbandwidth, enhance network security, and mitigate potential legalliability.  Websense Enterprise alsoserves as a policy platform and management console for related add-onmodules.   Websense Enterprise and theadd-on modules are sold on a subscription basis.

 

The application component ofWebsense Enterprise allows managers patented flexibility to select the types ofInternet content and applications they wish to allow, block or continue accessto based on the database categories we have defined. Our software enforcesthese managerial selections at the Internet gateway, on the network, and at thedesktop by comparing website and application launch requests withmanagement-defined policies and the URLs, applications and protocols we havecategorized in our databases.

 

The add-on modules extendand enhance the policy enforcement capabilities of Websense Enterprise to thenetwork and to the employee’s desktop computer.  Client Application Manager installs an agent on the employee’sdesktop that allows managers to apply block, continue, and allow policies tothe launch of more than 50 categories of software applications and executables,including business productivity, instant messaging, peer-to-peer file sharing,games and hacking applications. Client Application Manager compliments existingnetwork and desktop security measures by blocking the launch of maliciousapplications at the desktop, such as hacking tools, keystroke loggers, spywareand worms. The functionality of Client Application Manager will be enhancedthrough the planned release of Client Policy Manager in May 2004.  Bandwidth Optimizer utilizes a network agentto monitor and manage network traffic, allowing managers to create Internet usepolicies that disable non-business related traffic when available networkbandwidth drops

 

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below pre-determinedthresholds. IM Attachment Manager enhances the built-in instant messagingmanagement capabilities of Websense Enterprise by allowing managers to controlthe sending and receiving of file attachments. All of these add-on modules are enabled and managed from the centralmanagement console of Websense Enterprise.

 

The principal benefits of our products include:

 

*Enhanced Network and Data Security.*Websense Enterprise adds an additional layerof protection to an organization’s network and data security by blockingemployee access to security-risk sites such as those containingmalicious mobile code or spyware.  Thisallows an organization to proactively reduce the risk of malicious mobile codeattacks - such as Web-based worms, viruses, Visual Basic scripts and more – andprevent back-channel communication of important corporate or personal data byspyware programs.  Additionally, ClientApplication 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 laptop computer,including when disconnected from the network, preventing the spread of virusesthroughout the network and reducing the risk of unauthorized data access byemployees.

 

*Increased Employee Productivity.* Our software gives businesses the ability tomore effectively manage employees’ use of corporate computing resources,including Internet access, application use at the desktop and networkbandwidth, 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 non-business related contentand applications such as instant messaging and peer-to-peer file sharing. Inaddition, our software allows managers to permit or deny Internet access basedon the employee, type of user, time of day, amount of personal surfing time,and type of content being accessed. Websense Enterprise may also be configuredto set time-based quotas for each employee, allowing for limited personalsurfing during the workday, limiting workplace distractions but allowingappropriate use of the organization’s high-speed Internet connection.  Our Client Application Manager add-on moduleallows managers to apply similar policies to employees’ use of non-business relatedapplications on their desktop computers, such as games and hacking tools.

 

*Conservation of IT Resources.* We believe Websense Enterprise allowsorganizations to reduce bandwidth consumption by managing personal Internet useand access to websites, in particular those which may containbandwidth-intensive content, such as streaming audio and video, MP3 musicfiles, multi-player games and other new media. The Bandwidth Optimizer add-onmodule, used in conjunction with Websense Enterprise, further enhancesbandwidth management capabilities by monitoring network usage in real-time andby allowing employee access management based on bandwidth thresholds. Forexample, Bandwidth Optimizer can temporarily disable non-business networktraffic when available bandwidth drops below pre-determined thresholds.Reducing the bandwidth consumed by non-business-related Internet traffic allowsan organization to use its network more efficiently and effectively, and helpsensure that bandwidth is available for mission-critical business applicationssuch as voice-over-IP. In addition, by limiting access to bandwidth-intensivecontent, organizations are able to save valuable network storage from beingcluttered with MP3s, images and other files. This avoids costs arising from theneed to buy additional networking equipment or storage servers.

 

*Reduced Exposure to Potential Legal Liabilities.* Websense Enterprise supports organizations’efforts to reduce exposure to legal liability resulting from the improper useof the Internet in the workplace. By implementing our products in conjunctionwith an overall corporate Internet usage policy, organizations can proactivelycurtail access to objectionable Internet content such as adult entertainment,illegal activities, hate and racism. Websense Enterprise can also manage the use of peer-to-peer filesharing, reducing the risk that unauthorized copyrighted material is beingdownloaded and stored on company servers.

 

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In addition to the benefits above, our products provide these keyfeatures:

 

*Access to Comprehensive Databases of URLs, SoftwareApplications and Network Protocols.* We provide access to proprietary databases that categorize websiteURLs, software applications and executables and commonly used network andInternet protocols. We have categorized more than 5.5 million websites in ourURL database, and more than 1.5 million dead links that have been purged fromthe database.  These website URLs havebeen classified into more than 90 different categories to enable organizationsto determine the types of Internet content that are appropriate for theirworkplace culture. We add approximately 5,000 newly categorized websites eachbusiness day to our URL databases and make these updates available to ourcustomers for daily differential downloads. This daily two-way communication with our customers allows us to refreshthe databases to remove inactive links and irrelevant content and identify changingcontent and newly emerging sites.  Inthe software application database, we have categorized over 250,000 softwareexecutable files in more than 50 categories, such as instant messaging,spyware, hacking and games.

 

*Ability to Configure and Manage Employee Internet andApplication Usage Policies from a Single Management Console.* Websense Enterprise allows organizations toconfigure specific Internet and application usage policies for various groups,user types or individuals from a single management console. Through oureasy-to-use interface, we allow managers to implement Internet and applicationuse policies with limited investment of information technology resources andpersonnel.  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 the use of applications atthe desktop, specifying permissions based on application category, user group,workstation, or IP address.

 

*Multiple Options for Identifying, Analyzing and Reporting onEmployee Internet and Application Use.*Websense Enterprise includes several analysisand reporting modules to provide managers and IT administrators with multipleoptions for identifying, analyzing and reporting on Internet and desktopapplication activity and the risks associated with employee computing. Theseoptions include a full-featured reporting engine with pre-defined andcustomizable report templates, a real-time analyzer that provides a currentview of network activity and browser-based reporting tools that allownon-technical managers to view Internet and application use data.

 

*Ability to Adapt to our Customers’ Employee ComputingPatterns.* We utilizeour relationship with our customers to help our software adapt to evolvingemployee computing and Internet access patterns. We accomplish this withWebCatcherTM, a patent-pendingfeature by which customers anonymously send uncategorized websites visited bytheir employees to us for review and categorization into the Websense URLdatabase. AppCatcher,TM another patent-pending feature, creates the samefeedback mechanism for software applications and network protocols.  As new websites, protocols and applicationsare categorized, the updated databases are available for daily download by theentire customer base.

 

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*Premium Group Database Categories for Emerging Web Content.* Websense has developed Premium Group (PG)categories for our database of URLs that encompass emerging Web content.Websense Productivity PGTM focuses on productivity management by allowingadministrators to manage message boards and clubs, advertisements, freeware/shareware,instant messaging, online brokerage and trading, and pay-to-surf sites.Websense Bandwidth PGTM focuses on bandwidth management and features sitesrelating to Internet radio and TV, peer-to-peer file sharing, personal networkstorage/backup, Internet telephony and streaming media.  Websense Security PGTM focuses on networksecurity by categorizing websites containing malicious mobile code and spyware.

 

*Ability to Scale and Operate on a Variety of NetworkPlatforms.* 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, Cisco,Microsoft, Netscreen, Network Appliance, and Nokia.

 

**Products and Services**

 

*Websense Enterprise*. Websense Enterprise is the foundation ofour software offerings and includes our proprietary central policy engine,central management console and multiple reporting options. Websense Enterpriseallows organizations to manage employees’ use of corporate computing resourcesby filtering access to websites, applications, protocols and bandwidth based onmanagement-defined policies.  We sellsubscriptions to the Websense Enterprise platform and databases based on thenumber of users to be managed. Additional application modules and enhancedtechnical support are priced separately. Revenues from sales of subscriptionsto Websense Enterprise accounted for 100% of total revenues in 2003 and 2002,and 99% of total revenues in 2001.

 

Websense Enterprise integrates with an organization’s network server,proxy server, switch, router or firewall and is designed to work in networks ofvirtually any size and configuration. We currently offer three deploymentoptions:

 

•                  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.

 

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The table below describes many of the platforms with which WebsenseEnterprise can be integrated:

 
| Firewall Solutions:                                                  | Cache/Proxy Solutions:                                                      |
|----------------------------------------------------------------------|-----------------------------------------------------------------------------|
| •     Check  Point                          | •     Cisco  Content Engine                        |
| •     Cisco  PIX                            | •     Dell  PowerApp Cache                         |
| •     CyberGuard                            | •     HP  ProLiant                                 |
| •     Lightspeed                            | •     HP Web  Cache                                |
| •     Netscreen                             | •     IMimic  DataReactor                          |
| •      ServGate                        | •     InfoLibria  DynaCache                        |
| •     SLMsoft                               | •     Inktomi  Traffic Server                      |
| •      SonicWall                       | •     Microsoft  ISA Server                        |
|                                                                 | •     Microsoft  Proxy Server                      |
| Switch/Router Solutions:                                             | •     Network  Appliance NetCache                  |
| •     Cisco  Catalyst 6500                  | •     Novell  Volera Excelerator                   |
| •     Cisco  Router Series 800 through 7400 | •     ServGate                                     |
|                                                                 | •     Squid                                        |
| Appliance Solutions:                                                 | •     Stratacache  StrataCORE                      |
| •     Blue  Coat Systems                    | •     Sun ONE  Web Proxy Server (formerly iPlanet) |
| •     Crossbeam  X40S Blade Server          | •     3Com  Webcache                               |
| •     Immunex                               |                                                                        |
| •     Nokia                                 |                                                                        |

 

*Web Filtering.* Websense Enterprise enables employers toproactively analyze, report and manage employee access to websites based on thecontent of the requested website. Our software application gives managerspatented ability to customize, implement and modify Internet access policiesfor various groups, user types and individuals by filtering access to websites.A graphical interface enables business managers to define the categories ofwebsites to which access will be managed. The filtering software examines eachInternet access request, determines the category of the requested website andapplies the policies that have been defined by the company. Some examples ofmanagement options include:

 

•                  Allow. The requestis allowed to proceed, because the organization has chosen not to restrictaccess to the category applicable to the website.

 

•                  Block. The requestedwebsite is in a category that is not allowed to be accessed according to thepolicy in effect.

 

•                  Time-basedQuotas. Users are allowed a specified amount of personal surfing timewithin categories that are determined by the administrator. Once the userreaches his or her quota time, he or she is no longer able to access sites inthose categories.

 

•                  Continue with Exception Report. The user is reminded about the organization’s Internet usage policy,but can choose to access the requested website.

 

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•                  Time of Day.  Filtering options can be managed by time ofday.  For example, access to shoppingsites could be blocked during business hours and permitted at all other times.

 

*The Websense URL Database*. We offer extensive and regularly updateddatabases of websites. Our URL database currently catalogs more than 5.5million websites, representing approximately one billion webpages in more than50 languages, cataloged into more than 90 categories. Through proprietarytechniques that create unique digital fingerprints of individual webpages, aswell as customer features such as WebCatcher, we add approximately 5,000 newlycategorized websites per business day to our database and make these updatesavailable for daily differential downloads. In addition, our database isrefreshed daily to remove dead links and irrelevant content and to identifychanging content and newly emerging sites.

 

Thebreadth and specificity of website categories we have defined provideflexibility in selecting which types of material should be allowed, blocked orreported. We identify the types of content that we believe employers would deemto be unacceptable, inappropriate or undesirable in a work environment based oninput we receive from our customers, and define the categories accordingly.Categories in our databases include the following:

 
| •     Abortion               | •     Image  Servers                                    |
|-------------------------------------------------------|---------------------------------------------------------------------------------------|
| •  Pro-Choice                               | •     Image (Media)                                          |
| •   Pro-Life                           | •     Network Error                                          |
| •     Adult Material         | •     Private IP Address                                     |
| •  Adult Content                            | •     Uncategorized                                          |
| •  Lingerie & Swimsuit                  | •     News & Media                                       |
| •  Nudity                                   | •  Alternative Journals                                                     |
| •  Sex                                      | •     Productivity PG                                        |
| •  Sex Education                            | •     Advertisements                                         |
| •     Advocacy Groups        | •     Freeware & Software Download                       |
| •     Business & Economy | •     Instant Messaging                                      |
| •  Financial Data & Services            | •     Message Boards & Clubs                             |
| •     Drugs                  | •     Online Brokerage & Trading                         |
| •  Abused Drugs                             | •     Pay-to-Surf                                            |
| •  Marijuana                                | •     Bandwidth PG                                           |
| •  Prescribed Medications                   | •     Internet Radio & TV                                |
| •  Supplements & Unregulated Compounds  | •     Internet Telephony                                     |
| •     Education              | •     Peer-to-Peer File Sharing                              |
| •  Cultural Institutions                    | •     Personal Network Storage and Backup                    |
| •  Educational Institutions                 | •     Streaming Media                                        |
| •  Educational Materials                    | •     Security PG                                            |
| •  Reference Materials                      | •     Malicious Web Sites                                    |
| •     Entertainment          | •     Spyware                                                |
| •  MP3                                      | •     Racism & Hate                                      |
| •     Gambling               | •     Religion                                               |
| •     Games                  | •     Non-Traditional Religions & Occult  & Folklore |
| •     Government             | •     Traditional Religions                                  |
| •  Military                                 | •     Shopping                                               |
| •  Political Organizations                  | •     Internet Auctions                                      |
|                                                  | •     Real Estate                                            |

 

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| •     Health                    | •     Social Organizations                     |
|----------------------------------------------------------|-------------------------------------------------------------------------|
| •     Illegal or Questionable   | •     Professional  and Worker Organizations   |
| •     Information Technology    | •     Service and Philanthropic  Organizations |
| •  Computer Security                           | •     Social and Affiliation  Organizations    |
| •  Hacking                                     | •     Society & Lifestyles                 |
| •  Proxy Avoidance                             | •     Alcohol & Tobacco                    |
| •  Search Engines & Portals                | •     Gay  or Lesbian  or Bisexual Issues |
| •  URL Translation Sites                       | •     Hobbies                                  |
| •  Web Hosting                                 | •     Personal Web Sites                       |
| •     Internet Communication    | •     Personals Dating                         |
| •  Web Chat                                    | •     Restaurants & Dining                 |
| •  Web-based Email                             | •     Special Events                           |
| •     Job Search                | •     Sports                                   |
| •     Militancy & Extremist | •     Sport Hunting & Gun Clubs            |
| •     Miscellaneous             | •     Tasteless                                |
| •  Content Delivery Networks                   | •     Travel                                   |
| •  Dynamic Content                             | •     User-Defined                             |
| •  File Download Servers                       | •     Vehicles                                 |
|                                                     | •     Violence                                 |
|                                                     | •     Weapons                                  |

 

*Reporting and Analysis.*Websense Enterprise includes several reporting modules**tomeet the 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 to identify potential risks and bandwidthbottlenecks associated with different types 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-OnApplication Modules.*InMarch 2003, we introduced Websense Enterprise v5, which extended the reach ofour policy enforcement capabilities beyond the Internet gateway to include theemployee desktop computer and the network. We also introduced two new modulesthat provide enterprises with additional flexibility in managing employee useof corporate computing resources: Client Application Manager (manages softwareapplications at the desktop and employees' laptop computers) and BandwidthOptimizer (manages bandwidth consumption on the network). In February 2004, weintroduced the IM Attachment Manager (manages the sending and receiving ofattachments with instant messages). These new modules rely on the applicationframework of the Websense Enterprise platform and our proprietary databases ofsoftware applications and protocols. We plan to continue to develop and marketnew products and services based on our Websense Enterprise platform and ourproprietary search and categorization technologies, including Client PolicyManager, which was announced in February 2004 for launch in May 2004.

 

•                  *Client Application Manager/Client Policy Manager*.  TheClient Application Manager (CAM) module allows our customers to implementmanagement policies, such as block, allow or continue, for usage of softwareapplications and other executables on desktop computers, by application type,by user type, or

 

10

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by individualuser. CAM can be used to inventory desktop software, provide a categorized viewof applications in the desktop environment and identify potential securitythreats from hacking and spyware applications. It can also be used to createlists of allowable applications and block the launch of others, enhancingnetwork security by preventing the launch of viruses or other maliciousexecutables.  The functionality of CAMwill be enhanced through the planned release of the Client Policy Manager (CPM)module in May 2004.

 

CAM utilizes the applicationframework of Websense Enterprise and references our Client Application Managerdatabase of over 250,000 software executable files. We are expanding thisdatabase as well as adapting the database to actual employee computing patternsthrough the use of AppCatcherTM, a patent-pending feature by which customersanonymously send uncategorized applications and other executables launched bytheir employees to us for review and categorization into our Client ApplicationManager database.  CAM includes tworeporting modules, CAM Reporter, which provides Web-based reports based onhistorical application usage, and Explorer for CAM, a click-throughbrowser-based interface that provides immediate access to application usageinformation by user, group, category, machine or risk class.

 

•                  *Bandwidth Optimizer.* The Bandwidth Optimizer module allowscustomers to dynamically manage network traffic by prioritizing business andnon-business related traffic flows.  Ourcustomers can apply management policies based on content category, protocols,user, group or network segment. Bandwidth Optimizer relies on the central policy engine in the WebsenseEnterprise platform, a network agent that monitors network traffic anddatabases of protocols, file types and content categories to automaticallymonitor network bandwidth levels and dynamically allow or deny networkapplication requests.

 

•                  *Instant Messaging (IM) Attachment Manager. *The IM Attachment Manager module allows organizations to control theability to transmit and receive files via instant messaging clients.  Used in conjunction with the IM managementcapabilities in Websense Enterprise, 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 withBandwidth Optimizer, the IM Attachment Manager can manage the transmission ofattachments by bandwidth availability.

 

**Customers**

 

Our more than 20,000 customers range from companies with as few as 100employees to members of the Global 1000 to government agencies and educational institutions.  In total, these customers have subscribed toapproximately 16.4 million seats as of December 31, 2003. No customer accountedfor more than 10% of our total revenues in 2003, 2002 or 2001.

 

**Sales, Marketing and Distribution**

 

*Sales*. We sell our products and services through both indirect and directchannels. For 2003, indirect channel sales comprised more than 80% of totalrevenues.  In the United States, we sellour products through a network of more than 950 value added resellers.  Internationally, we sell our productsthrough a multi-tiered distribution network of more than 150 distributors andresellers in over 80 countries.

 

Our channel sales efforts are coordinated worldwide through a salesteam of approximately 115 individuals. Customers that buy direct from us aretypically large organizations that prefer a direct relationship with us.

 

11

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In 2003, we generated 31% of our total revenue from customers outsideof the United States. Revenue generated in the United Kingdom represented 9% ofour total revenues.  Our currentinternational efforts are focused on expanding our indirect sales channels inAsia/Pacific, Europe, Latin America and Australia. Our continuing reliance onsales in international markets exposes us to risks attendant to foreign sales.See “Item 7. Risks and Uncertainties – 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*. Our marketing strategy is to raise awareness of the potential risksassociated with unmanaged employee use of corporate computing resources,generate qualified sales leads for our channel partners and increaserecognition of Websense as a provider of employee Internet managementsolutions.

 

Our marketing efforts are targeted toward business executives,including information technology professionals, chief executives, upper levelmanagement and human resource personnel. We actively manage our publicrelations programs, communicating directly with technology professionals andthe media, in an effort to promote greater awareness of the growing problemscaused by employee misuse of the Internet and other computing resources atwork. We also provide potential customers and channel partners with free trialsof Websense Enterprise and the add-on modules, typically for 30-day periods. Our additional marketing initiativesinclude:

 

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

 

•                  participationin and sponsorship of trade shows and industry events;

 

•                  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 

 

•      providingand distributing soft- and hard-copy collateral on our company, products,solutions, technologies, partnerships and benefits.

 

**Customer Service, Training and Support**

 

We believe that superior customer support is critical to retaining andexpanding our customer base. Our technical support group provides dependableand timely resolution of customer technical inquiries and is available tocustomers by telephone, e-mail and over the Web. Our training services groupdelivers education, training and pre-sales support to our customers. We alsooffer online training to our customers and resellers to provide them with theknowledge and skills to successfully deploy, use and maintain our products. Ourcustomer service team is responsible for handling general customer inquiries,answering questions about the ordering process, updating and maintainingcustomer account information, investigating the status of orders and payments,as well as processing customer orders. In addition, our customer service teamproactively updates customers on a variety of topics, including release datesof new products and updates to existing products.

 

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**Research and Development**

 

We have invested significant time and resourcesin creating a structured process for undertaking product and databasedevelopment projects. Our research and development department is divided intoseveral groups, which include database production, software development,validation and testing, documentation and research. Individuals are groupedalong product lines and work as part of cross-disciplined teams designed toprovide a framework for defining and addressing the activities required tobring product concepts and development projects to market successfully.Research and development expenses totaled $12.8 million in 2003, $11.0 millionin 2002 and $7.6 million in 2001. Research and development expenses as a percentage of revenue were 16% in2003, 18% in 2002 and 21% in 2001.

 

#### **Technology**

 

*Software Architecture*. Websense Enterprise is a server-basedsystem 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 up to 50,000 users on a single server and networks ofvirtually any size using multiple servers. Websense Enterprise integrates withmajor firewalls, proxy servers, caching engines, network switches and routers.We have designed our products to run on multiple network platforms and inmultiple locations. With the introduction of Websense Enterprise Version 5 inMarch 2003, the server-based platform has been augmented with agents at thedesktop and on the network that now allow customers to manage applications,protocols, and network bandwidth, as well as website access.

 

*Database Content Analysis and Updating*. We use a process of automated contentassessment and classification with manual verification to gather and classifynew 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 optional WebCatcher and AppCatcher features ofWebsense Enterprise collect unrecognized sites, software applications andprotocols from customers and return them to us for review and categorization.

 

**Competition**

 

The market for our products is fragmented, highly and increasinglycompetitive, quickly evolving and subject to rapid technological change.Increased competition may result in reduced market acceptance of our products,pricing pressure and reduced gross margins, any of which could seriously harmour business. Competitors vary in size and in the scope and breadth of theproducts and services they offer. Our current principal competitors include:

 

•                  companiesoffering network filtering products, such as SurfControl, Secure Computing,Symantec, 8e6 Technologies, Webwasher, Elron and Cerberian;

 

•                  companiesoffering network reporting products, such as NetIQ and Wavecrest Computing; and

 

•                  companiesintegrating URL filtering into specialized security appliances, such asSonicWALL and Internet Security Systems.

 

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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 employee Internetmanagement or other competitive products with their offerings. We competeagainst and expect increased competition from anti-virus software developers,traditional network management software developers and Web management serviceproviders. We may face new competition from companies offering quality ofservice solutions, such as Packeteer, companies with a direct presence oncomputer desktops, such as Microsoft, and companies offering desktop managementsolutions, such as Altiris.  Many of ourcurrent and potential competitors have longer operating histories and significantlygreater financial, technical, marketing or other resources than we do. They mayhave significantly greater name recognition, established marketingrelationships and access to a larger installed base of customers. In addition,current and potential competitors have established or may establish cooperativerelationships among themselves or with third parties to increasethe functionality of their products toaddress customer needs. Accordingly, new competitors or alliances amongcompetitors may emerge and rapidly acquire significant market share.

 

We believe that the principal competitive factors inthe 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 database;

 

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

 

•                  depthof monitoring, reporting and analysis capabilities;

 

•                  capacityto integrate with key network providers;

 

•                  qualityof customer support; and

 

•                  price.

 

 

**IntellectualProperty Rights**

 

Our intellectual property rights areimportant to our business. We rely on a combination of trademark, copyright,patent and trade secret laws in the United States and other jurisdictions aswell as confidentiality procedures and contractual provisions to protect ourproprietary technology and Websense brand. We have registered our Websensetrademark in the United States, Japan, the European Union, Canada, Australia,China, Switzerland, Norway, Mexico, Colombia, Argentina, India, Singapore,Taiwan and Turkey. We have also registered the Websense Enterprise trademark inthe United States, Japan, Canada, Australia and China.  In addition, we have registrations for theWebsense trademark pending in several other countries. Effective trademarkprotection may not be available in every country where our products areavailable.

 

We currently have two patents issued in theUnited States, three patent applications pending in the United States andthirteen pending international patent applications that seek to protect ourproprietary

 

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database and filteringtechnologies, including issued and pending patents relating to our flexiblefiltering management options, and pending patents relating to our WebCatcherand AppCatcher product features. No assurance can be given that our pendingpatent applications will result in issued patents.

 

Our policy is to enter into confidentialityand invention assignment agreements with all employees and consultants, andnondisclosure agreements with all other parties to whom we discloseconfidential information. These protections, however, may not be adequate toprotect our intellectual property rights.

 

**Employees**

 

As of February 29, 2004, we had 400 employees. None of our employees isrepresented by a labor union, and we have never experienced a work stoppage. Webelieve that our relations with our employees are good.

 

#### **Website Access to SEC Filings**

 

#### **We maintain an Internet website at *www.websense.com*.  We make available free of charge through ourInternet website our annual report on Form 10-K, quarterly reports on Form10-Q, current reports on Form 8-K, and amendments to those reports filed orfurnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon asreasonably practicable after we electronically file such material with, orfurnish it to, the SEC.**

 

#### **Executive Officers**

 

Our executive officers and their ages as of February 29, 2004 are asfollows:

 
| **Name**           |   | **Age** |   | **Position(s)**                                       |   |
|--------------------|--------|---------|--------|-------------------------------------------------------|--------|
|               |   |    |   |                                                  |   |
| John B. Carrington |   | 59      |   | Chairman  of the Board and Chief Executive Officer    |   |
| Curtis H. Staker   |   | 44      |   | President                                             |   |
| Douglas C. Wride   |   | 50      |   | Chief  Financial Officer                              |   |
| Harold M. Kester   |   | 57      |   | Chief  Technology Officer                             |   |
| Karen V. Goodrum   |   | 46      |   | Vice  President of Finance & Accounting           |   |
| Michael A. Newman  |   | 34      |   | Vice President & General Counsel                  |   |
| Kian Saneii        |   | 39      |   | Vice  President of Marketing and Business Development |   |

 

John B. Carrington has served as our Chief Executive Officer since May1999 and has served as a Director and our Chairman since June 1999. Mr.Carrington also served as our President from May 1999 to January 2003. Prior tojoining Websense, Mr. Carrington was Chairman, President and Chief ExecutiveOfficer of Artios, Inc., a provider of hardware and software design solutionsto companies in the packaging industry, from August 1996 until it was acquiredby BARCO n.a. in December 1998. He received his B.S. in Business Administrationfrom the University of Texas.

 

Curtis H. Staker has served as our Presidentsince January 2003. Prior to that, he had served as our Executive VicePresident of Worldwide Sales since February 2001. Prior to joining us, Mr.Staker was with Structural Dynamics Research Corporation (SDRC) from July 1989to February 2001 serving in a variety of management positions, including VicePresident and General Manager of Americas Operations (North and South Americaregions) and Vice President and General Manager of Asia-Pacific Operations.SDRC, a provider of e-business collaboration solutions, is now owned byElectronic Data Systems (EDS). Mr. Staker began his career as an engineer forCaterpillar Tractor Co. after receiving his B.S. in Mechanical Engineering fromBradley University.

 

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Douglas C. Wride has served as our ChiefFinancial Officer since June 1999. From March 1997 to December 1998, Mr. Wrideserved as Chief Financial Officer of Artios, Inc. Mr. Wride also served asChief Operating Officer of Artios from July 1997 to December 1998. From April1996 to March 1997, Mr. Wride served as Chief Operating Officer and ChiefFinancial Officer of NetCount, LLC, a provider of Internet measurement andresearch services. Mr. Wride is a C.P.A. and received his B.S. inBusiness/Accounting from the University of Southern California.

 

Harold M. Kester has served as our ChiefTechnology Officer since June 1999. Prior to joining us, from August 1993 toJune 1999, Mr. Kester served as Vice President of Encyclopedia Britannica, aprovider of general reference materials on a multitude of subjects, and GeneralManager and Chief Scientist of its La Jolla Research Laboratory. Mr. Kesterreceived his B.A. in Mathematics from California State University, Long Beach.

 

Karen V. Goodrum has served as our Vice President of Finance &Accounting since October 2003, and prior to that, as Vice President of Finance& Administration from August 2000. From January 1997 to February 2000, Ms.Goodrum served as Chief Financial Officer for COMPS.Com, Inc., a provider ofcommercial real estate information services. Ms. Goodrum received her B.A. in Education from the University ofMaryland, College Park, and her M.B.A. from San Diego State University.

 

Michael A. Newman has served as our VicePresident & General Counsel since September 2002.  From April 1999 to September 2002, he served in variouscapacities in the legal department of Gateway, Inc., a publicly traded PCmanufacturer, most recently as Senior Staff Counsel, Securities, Finance andCorporate Development.  From February1996 to April 1999, he practiced as an attorney in the San Diego office ofCooley Godward, LLP, a law firm specializing in the representation ofhigh-growth information technology and life sciences companies.  Mr. Newman received his B.S. in BusinessAdministration from Georgetown University, and a J.D. from Harvard Law School.

 

Kian Saneii has served as our Vice Presidentof Business Development since August 2001 and as our Vice President ofMarketing since August 2003. From August 1999 to February 2001, he was SeniorVice President of Worldwide Marketing and Business Development at IPNetSolutions, Inc., a provider of business-to-business integration andsupply-chain collaboration solutions. From July 1997 to July 1999, he served asSenior Vice President of Worldwide Marketing for IMA Corporation, a supplier ofcustomer relationship management solutions. Mr. Saneii received his B.S. inComputer Science from New York University, and an M.S. in Computer Science fromRutgers University.

 

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**Item 2. Properties**

 

Our corporate headquarters and principal offices are located in SanDiego, California, where we leased approximately 75,000 square feet as ofDecember 31, 2003. This lease expires in December 2007, with an option toextend the lease for an additional five years. We believe that our currentspace is adequate for our current needs and sufficient space is available tomeet our identified future needs. We lease office space in the UK, Ireland,Japan and France in executive suite arrangements on an annual basis.

 

**Item 3. LegalProceedings**

 

We are not a party to any material legal proceedings.

 

**Item 4. Submissionof Matters to a Vote of Security Holders**

 

There were no matters submitted to a vote of the security holdersduring the fourth quarter of the fiscal year-ended December 31, 2003.

 

17

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##### **Part II**

 

**Item 5****. Market for Registrant’sCommon Equity and Related Stockholder Matters**

 

Our common stock is traded on the NasdaqNational Market under the symbol “WBSN.” The following table sets forth therange of high and low closing prices on the Nasdaq National Market of ourcommon stock for the periods indicated, as reported by Nasdaq. Such quotationsrepresent inter-dealer prices without retail markup, markdown or commission andmay not necessarily represent actual transactions.

 

| **Year Ended  December 31, 2003** |   | **High** |   | **Low** |   |
|-----------------------------------|--------|----------|--------|---------|--------|
| First Quarter                     |   | $        | 24.55  |    | $      | 13.48 |   |
| Second Quarter                    |   | 18.31    |   | 11.79   |   |
| Third Quarter                     |   | 25.07    |   | 14.81   |   |
| Fourth Quarter                    |   | 29.27    |   | 20.69   |   |
|                                   |        |          |        |         |        |  |  |

 

| **Year Ended  December 31, 2002** |   | **High** |   | **Low** |   |
|-----------------------------------|--------|----------|--------|---------|--------|
| First Quarter                     |   | $        | 34.03  |    | $      | 22.41 |   |
| Second Quarter                    |   | 30.09    |   | 21.51   |   |
| Third Quarter                     |   | 25.37    |   | 11.19   |   |
| Fourth Quarter                    |   | 27.41    |   | 10.84   |   |
|                                   |        |          |        |         |        |  |  |

 

To date, we have neither declared nor paid any dividends on the commonstock. We currently intend to retain all future earnings, if any, for use inthe operation and development of our business and, therefore, do not expect todeclare or pay any cash dividends on the common stock in the foreseeablefuture. As of February 29, 2004, there were approximately 5,500 holders ofrecord of the common stock.

 

**Use of Proceeds**

 

**On March28, 2000, we completed our initial public offering for the sale of 4,000,000shares of common stock at a price to the public of $18 per share, whichresulted in net proceeds of $65.7 million after payment of the underwriters’commissions and deductions of offering expenses.  The registration statement (No. 333-95619) relating to ourinitial public offering was declared effective on March 28, 2000.  Subsequent to our initial public offering, aportion of the offering proceeds were used to repay the $1.5 million balance ofour fixed term loan agreements with financial institutions.  The remaining proceeds have conformed withour intended use outlined in the prospectus related to such offering.  We currently have approximately $64.2million remaining from our IPO proceeds.**

 

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**Item 6**. Selected Financial Data

 

You should read the following selected financial data in conjunctionwith our financial 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, 2003, 2002 and 2001 and the balance sheet data as of December 31,2003 and 2002 from our financial statements audited by Ernst & Young LLP,which appear elsewhere in this report. We derived the income statement data forthe years ended December 31, 2000 and 1999 and the balance sheet data as ofDecember 31, 2001, 2000 and 1999 from our financial statements audited by Ernst& Young LLP, which are not included in this annual report. Our historicalresults are not necessarily indicative of operating results to be expected inthe future.

 
|                                     |   | **Years Ended December 31,**                   |   |
|------------------------------------------|--------|------------------------------------------------|--------|
| **Income Statement Data:**               |   | **2003**                                       |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                     |   | **(In thousands, except for  per share data)** |   |
|                                     |   |                                           |   |   |   |   |   |   |   |   |   |
| Revenues                                 |   | $                                              | 81,734 |   | $ | 60,965 |   | $ | 35,893 |   | $ | 17,441 |   | $ | 8,647 |   |
|                                     |   |                                           |   |   |   |   |   |   |   |   |   |
| Cost of revenues                         |   | 5,523                                          |   | 4,170 |   | 3,602 |   | 2,707 |   | 2,275 |   |
|                                     |   |                                           |   |   |   |   |   |   |   |   |   |
| Gross margin                             |   | 76,211                                         |   | 56,795 |   | 32,291 |   | 14,734 |   | 6,372 |   |
| Operating expenses:                      |   |                                           |   |   |   |   |   |   |   |   |   |
| Selling and marketing                    |   | 31,845                                         |   | 26,201 |   | 19,707 |   | 12,726 |   | 6,311 |   |
| Research and development                 |   | 12,843                                         |   | 10,957 |   | 7,642 |   | 6,287 |   | 3,913 |   |
| General and administrative               |   | 6,649                                          |   | 5,960 |   | 5,358 |   | 3,491 |   | 3,805 |   |
| Amortization of stock-based compensation |   | 83                                             |   | 448 |   | 860 |   | 1,938 |   | 1,822 |   |
| Total operating expenses                 |   | 51,420                                         |   | 43,566 |   | 33,567 |   | 24,442 |   | 15,851 |   |
| Income (loss) from operations            |   | 24,791                                         |   | 13,229 |   | (1,276 | ) | (9,708 | ) | (9,479 | ) |
| Other income, net                        |   | 2,292                                          |   | 2,711 |   | 4,500 |   | 3,761 |   | 225 |   |
| Income (loss) before income taxes        |   | 27,083                                         |   | 15,940 |   | 3,224 |   | (5,947 | ) | (9,254 | ) |
| Provision (benefit) for income taxes     |   | 10,395                                         |   | (797 | ) | 108 |   | — |   | — |   |
| Net income (loss)                        |   | $                                              | 16,688 |   | $ | 16,737 |   | $ | 3,116 |   | $ | (5,947 | ) | $ | (9,254 | ) |
|                                     |   |                                           |   |   |   |   |   |   |   |   |   |
| Net income (loss) per share:             |   |                                           |   |   |   |   |   |   |   |   |   |
| Basic                                    |   | $                                              | 0.76   |   | $ | 0.79 |   | $ | 0.16 |   | $ | (0.35 | ) | $ | (1.25 | ) |
| Diluted                                  |   | $                                              | 0.73   |   | $ | 0.72 |   | $ | 0.14 |   | $ | (0.35 | ) | $ | (1.25 | ) |
| Weighted average shares - basic          |   | 22,038                                         |   | 21,211 |   | 20,082 |   | 16,882 |   | 7,403 |   |
| Weighted average shares - diluted        |   | 22,976                                         |   | 23,338 |   | 22,780 |   | 16,882 |   | 7,403 |   |

 
|                                                |   | **As of December 31,** |       |
|-----------------------------------------------------|--------|------------------------|------------|
| **Balance Sheet Data:**                             |   | **2003**               |       | **2002** |   | **2001** |   | **2000** |   | **1999** | ** ** |
|                                                |   | **(In thousands )**    | ** ** |
|                                                |   |                   |       |
| Cash and cash equivalents and marketable securities |   | $                      | 182,859    |   | $ | 140,466 |   | $ | 103,108 |   | $ | 81,259 |   | $ | 10,735 |   |
| Working capital                                     |   | 145,322                |       | 114,459 |   | 79,846 |   | 69,019 |   | 5,222 |   |
| Total assets                                        |   | 232,949                |       | 180,188 |   | 119,812 |   | 92,454 |   | 16,756 |   |
| Deferred revenue                                    |   | 93,960                 |       | 64,679 |   | 43,478 |   | 24,487 |   | 11,593 |   |
| Debt                                                |   | —                 |       | — |   | — |   | — |   | 1,497 |   |
| Total stockholders’ equity                     |   | 128,929                |       | 106,711 |   | 70,680 |   | 64,064 |   | 1,642 |   |
|                                                     |        |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

The following discussion and analysis should be read in conjunctionwith the financial statements and related notes contained elsewhere in thisreport. See “Risks and Uncertainties” regarding certain factors known to usthat could cause reported financial information not to be necessarilyindicative of future results.

** **

**Forward Looking Statements**

** **

This report on Form 10-K may contain“forward-looking statements” within the meaning of the federal securities lawsmade pursuant to the safe harbor provisions of the Private SecuritiesLitigation 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. Suchstatements may include but are not limited to statements concerning thefollowing:

 

•                  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-looking statementsare subject to risks and uncertainties that could cause actual results todiffer materially from those anticipated as of the date of this report. Weassume no obligation to update any forward-looking statements to reflect eventsor circumstances arising after the date of this report.**

 

# **Overview**

 

We provideEmployee Internet Management, or EIM, solutions that enable organizations toanalyze, report and manage how their employees use computing resources at work,including Internet access, instant messaging, peer-to-peer file sharing,network bandwidth and desktop applications. Our primary product, WebsenseEnterprise®, gives organizations the ability to rapidly implement and configureInternet access policies in support of their efforts to improve employeeproductivity, conserve network bandwidth, mitigate potential legal liabilityand enhance network security. In 1996, we released our first software product,Websense Internet Screening System, and since that time, we have focused ourbusiness on developing and selling EIM solutions. In December 1999, we releasedWebsense Enterprise Version 4, which was sold through March 2003. We launchedthe next generation of Websense software - Websense Enterprise Version 5 - inMarch 2003, including enhanced EIM capabilities.  We have also introduced add-on application modules featuring newnetwork and application management technology such as Client ApplicationManagerTM, Bandwidth OptimizerTM, Instant Messaging Attachment ManagerTM, andClient Policy ManagerTM. We currently derive nearly all of ourrevenue from subscriptions to the Websense Enterprise solution and expect thistrend to continue in the future as more offerings are added to the WebsenseEnterprise platform.

 

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**During2003, we derived 31% of revenue from international sales compared with 32% for2002.  As a percentage of total revenue,international sales increased 30% in 2003, with the United Kingdom comprisingapproximately 9% of our total revenue. We believe international markets represent a significant growthopportunity and are continuing to expand our international operations,particularly in selected countries in the European and Asia/Pacific markets.**

 

**We sellWebsense Enterprise through both indirect and direct channels. Sales throughindirect and direct channels, Sales through indirect channels currently accountfor more than 80% of our revenue, and our strategy is to continue to rely onindirect sales channels for a significant majority of our sales.**

 

**Asdescribed below, we recognize revenue from subscriptions to Websense Enterpriseon a monthly straight-line basis over the term of the subscription. Werecognize the operating expenses related to these sales as they are incurred.These operating expenses include sales commissions, which are based on thetotal amount of the subscription contract and are fully expensed in the periodthe product is delivered. Operating expenses have continued to increase ascompared with prior periods due to expanded selling and marketing efforts,continued product research and development and investments in administrativeinfrastructure to support subscription sales that we will recognize as revenuein subsequent periods.**

 

**Critical Accounting Policies**

 

**Webelieve the following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our consolidated financialstatements.**

 

***Revenue Recognition.***When apurchase decision is made, customers enter into a subscription agreement, whichis generally 12, 24 or 36 months in duration and for a fixed number of users.We recognize revenue on a monthly straight-line basis over the term of thesubscription agreement. We promptly invoice customers for the full amount oftheir subscriptions at the time a subscription is activated. Payment is due forthe full term of the subscription, generally within 30 days of the invoice. Werecord amounts billed to customers in excess of recognizable revenue asdeferred revenue on our balance sheet. Upon expiration of the subscription,customers who wish to re-subscribe typically must do so at then current ratesto continue using Websense Enterprise. Our revenue is significantly influencedby subscription renewals, and a decrease in subscription renewals amounts couldnegatively impact our future revenue.

 

***Allowance for Doubtful Accounts.***We maintain an allowance for doubtful accounts for estimated lossesresulting from the inability or unwillingness of our customers to make requiredpayments to pay their invoice(s). If the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to makepayments, additional allowances may be required.

 

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*Deferred Tax Assets.* As required by Statement of Financial Accounting StandardsNo. 109 (“FAS 109”), we recognize tax assets on the balance sheet if it is“more likely than not” that they will be realized on future tax returns.  At December 31, 2002, we had deferred taxassets of $15.4 million. During 2002, we reassessed the valuation allowancepreviously established against U.S. deferred tax assets. Factors considered byus included: our earnings history, projected earnings based on currentoperations, and projected future taxable income in excess of stock optiondeductions. Based on this evidence, we concluded that it was more likely thannot that the U.S. deferred tax assets would be realized. Accordingly, wereleased the full valuation allowance of $14.3 million, which resulted in anincome tax benefit of approximately $9.3 million. The remaining $5.0 millionwas credited to additional paid-in capital as it related to the tax benefit ofstock option deductions. However, should we determine that we would not be ableto realize all or part of our deferred tax assets in thefuture, anadjustment to the deferred tax assets would be charged against income in theperiod such determination was made. As of December 31, 2003, we had $17.4million in deferred tax assets. See Note 8 of Notes to the ConsolidatedFinancial Statements for further explanation of our deferred tax assets.

 

**Results of Operations**

 

The followingtable summarizes our operating results as a percentage of total revenues foreach of the periods shown.

 
|                                     |   | **Years ended December 31,** |   |
|------------------------------------------|--------|------------------------------|--------|
|                                     |   | **2003**                     |   | **2002** |   | **2001** |   |
|                                     |   |                         |   |   |   |   |   |
| Revenues                                 |   | 100                          | %      | 100 | % | 100 | % |
|                                     |   |                         |   |   |   |   |   |
| Cost of revenues                         |   | 7                            |   | 7 |   | 10 |   |
|                                     |   |                         |   |   |   |   |   |
| Gross margin                             |   | 93                           |   | 93 |   | 90 |   |
|                                     |   |                         |   |   |   |   |   |
| Operating expenses:                      |   |                         |   |   |   |   |   |
| Selling and marketing                    |   | 39                           |   | 43 |   | 55 |   |
| Research and development                 |   | 16                           |   | 18 |   | 21 |   |
| General and administrative               |   | 8                            |   | 9 |   | 15 |   |
| Amortization of stock-based compensation |   | 0                            |   | 1 |   | 2 |   |
| Total operating expenses                 |   | 63                           |   | 71 |   | 93 |   |
|                                     |   |                         |   |   |   |   |   |
| Income (loss) from operations            |   | 30                           |   | 22 |   | (3 | ) |
|                                     |   |                         |   |   |   |   |   |
| Other income, net                        |   | 3                            |   | 4 |   | 12 |   |
|                                     |   |                         |   |   |   |   |   |
| Income before income taxes               |   | 33                           |   | 26 |   | 9 |   |
|                                     |   |                         |   |   |   |   |   |
| Provision (benefit) for income taxes     |   | 13                           |   | (1 | ) | — |   |
|                                     |   |                         |   |   |   |   |   |
| Net income                               |   | 20                           | %      | 27 | % | 9 | % |

 

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# **Years ended December 31,2003 and 2002**

 

# **Revenue**

 

# **Revenue increased to $81.7 million in2003 from $61.0 million in 2002. This increase was primarily a result of theaddition of new customers and increased sales to existing customers.Approximately 40% of subscription revenue recognized in 2003 was derived fromsales to first-time customers, who initially purchased one-, two-, orthree-year subscriptions to Websense Enterprise in 2003 or prior years. Theremaining 60% of subscription revenue was generated from renewal and expandedbusiness levels with existing customers. We expect revenue to grow at a slowerrate in 2004 than we did in 2003, principally as a result of the larger revenuebase at year-end 2003 compared with year-end 2002.**

 

# **Cost of Revenue**

 

# **Cost of revenue consists of the costsof content review, technical support and infrastructure costs associated withmaintaining our databases. Cost of revenue increased to $5.5 million in 2003from $4.2 million in 2002. The increase was primarily due to the costsassociated with additional personnel in our technical support and databasegroups. We expect cost of revenue to increase in the future as we support thegrowth and maintenance of our databases as well as the technical support needsof our customers. As a percentage of revenue, cost of revenue remainedunchanged at 7% during the years-ended 2003 and 2002. We expect that cost ofrevenue, as a percentage of revenue, will remain below 10% of revenue for theforeseeable future.**

 

# **Gross Margin**

 

# **Gross margin increased to $76.2million in 2003 from $56.8 million in 2002. The increase was primarily due toincreased revenue. As a percentage of revenue, gross margin remained unchangedat 93% during the years-ended 2003 and 2002.**Weexpect that gross margin, as a percentage of revenue, will remain in excess of90% of revenue for the foreseeable future.

 

# **Operating Expenses**

 

# ***Selling andmarketing***. 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, investor relations, advertising, promotions andtravel as well as allocated facilities costs and depreciation expenses. Sellingand marketing expenses increased to $31.8 million in 2003 from $26.2 million in2002. The increase in selling and marketing expenses of $5.6 million wasprimarily due to increased headcount costs as well as increased commission expensesrelated to higher sales levels. We expect selling and marketing expenses toincrease in the future as more personnel are added to support our expandingselling and marketing efforts worldwide and as increased sales result in higheroverall sales commission expenses.

 

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*Research and development*.Research and development expenses consist primarily of salaries and benefitsfor software developers, contract programmers, allocated facilities costs andequipment depreciation. Research and development expenses increased to $12.8million in 2003 from $11.0 million in 2002. The increase of $1.8 million inresearch and development expenses was primarily a result of personnel addedduring 2003 to support our expanded list of technology partners, theenhancements of Websense Enterprise, including the development and launch ofWebsense Enterprise Version v5.0, and additional products. We expect researchand development expenses to increase in the future, as more personnel are addedto support additional technology partners, product enhancements and expansionof our product offerings.

 

*General and administrative*.General and administrative expenses consist primarily of salaries, benefits andrelated expenses for our executive, finance, human resources and administrativepersonnel, third party professional service fees and allocated facilities anddepreciation expenses. General and administrative expenses increased to $6.6million in 2003 from $6.0 million in 2002. The $0.6 million increase in generaland administrative expenses in 2003 was primarily due to the addition ofpersonnel to support our growing operations, both domestically andinternationally. We expect general and administrative expenses to increase infuture periods, reflecting growth in operations, increasing expenses associatedwith being a public company and expansion of our international operations.

 

# ***Amortization ofstock-based compensation***.Amortization of stock-based compensation was not significant in 2003 and was$0.4 million in 2002. The decrease in the amortization expense was primarilydue to the accelerated method of amortization that we have applied since ourinitial public offering. Deferred stock-based compensation was fully amortizedas of December 31, 2003.

 

# **Other Income, Net**

 

# **Net other income decreased to $2.3million in 2003 from $2.7 million in 2002. The decrease is due primarily tolower interest rates generated by our cash and cash equivalents and marketablesecurities despite increased balances as of December 31, 2003 as comparedwith December 31, 2002. The lower interest rates are substantially theresult of the lower interest rate environment combined with our strategy tomaximize the after-tax return on our investments by purchasing lower interesttax-exempt investments beginning in the second quarter of 2003. As ofDecember 31, 2003, the majority of our total cash and cash equivalents andmarketable securities were tax-exempt, compared to no such investments atDecember 31, 2002. We expect the majority of our cash and cash equivalentsand marketable securities will continue to be held in tax-exempt investmentsduring 2004.**

 

# **Provision for Income Taxes**

# ** **

# **In 2002, we recorded an income taxbenefit of $0.8 million, primarily attributable to the release of the valuationallowance against our deferred tax assets. Our 2002 provision for income taxesincluded income taxes related to our wholly owned subsidiaries in the UnitedKingdom, Japan and Australia as well as several domestic state income taxes.The release of our valuation allowance offset these taxes as well as theprovision for federal and California income taxes, which resulted in aneffective net benefit rate of 5% for 2002. During 2003, we recorded a provision for income taxes of $10.4 million,for an effective tax rate of 38.4%.  The2003 provision for income taxes relates to our wholly owned subsidiaries in theUnited Kingdom, Japan, Australia, France and Germany as well as U.S. federaland state income taxes.**

 

# **In 2004 and thereafter, we anticipatethat our effective tax rate may decrease due to benefits derived from lower taxrates associated with foreign income.**

 

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# **Years ended December 31,2002 and 2001**

 

# **Revenue**

 

# **Revenue increased to $61.0 million in2002 from $35.9 million in 2001. This increase was primarily a result of theaddition of new customers. Approximately 53% of subscription revenue recognizedin 2002 was derived from sales to first-time customers, who initially purchasedone-, two-, or three-year subscriptions to Websense Enterprise in 2002 or prioryears. The remaining 47% of subscription revenue was generated from renewal andexpanded business levels with existing customers.**

 

# **Cost of Revenue**

 

# **Cost of revenue increased to $4.2million in 2002 from $3.6 million in 2001. The increase was primarily due tothe costs associated with additional personnel in our technical support group.As a percentage of revenue, cost of revenue decreased to 7% in 2002 from 10% in2001. This decrease was primarily due to benefits derived from the automationof database search and support processes as well as the leveraging of databaseand technical support costs over a larger revenue base.**

 

# **Gross Margin**

 

# **Gross margin increased to $56.8million in 2002 from $32.3 million in 2001. The increase was primarily due toincreased revenue. As a percentage of revenue, gross margin increased to 93% in2002 from 90% in 2001. This increase was primarily due to increased revenue andto benefits derived from the automation of database search and supportprocesses, as well as the leveraging of database and technical support costsover a larger revenue base**.

 

# **Operating Expenses**

 

# ***Selling andmarketing***. Selling and marketing expensesincreased to $26.2 million in 2002 from $19.7 million in 2001. The increase inselling and marketing expenses of $6.5 million was primarily due to increasedheadcount costs and increased advertising and promotional activities in NorthAmerica, Europe and Asia.

 

# ***Research anddevelopment***. Research and development expensesincreased to $11.0 million in 2002 from $7.6 million in 2001. The increase of$3.4 million in research and development expenses was primarily a result ofpersonnel and consultants added since 2001 to support our expanded list oftechnology partners, enhancements of Websense Enterprise, including thedevelopment of Websense Enterprise Version 5, and additional products.

 

*General and administrative*.General and administrative expenses increased to $6.0 million in 2002 from $5.4million in 2001. The $0.6 million increase in general and administrativeexpenses in 2002 was primarily due to the addition of personnel to support ourgrowing operations, both domestically and internationally, higher state salestax expenses, higher foreign income tax consulting expenses, as well as higherinfrastructure costs in Europe.

 

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# ***Amortization ofstock-based compensation***.Amortization of stock-based compensation decreased to $0.4 million in 2002 from$0.9 million in 2001. The decrease in the amortization expense in 2002 wasprimarily due to the accelerated method of amortization used that resulted inhigher expense in 2001 as compared with 2002.

 

# **Other Income, Net**

 

# **Net other income decreased to $2.7million in 2002 from $4.5 million in 2001. The decrease is due primarily tolower interest income due to lower interest rates earned by our cash, cashequivalents and marketable securities despite increased balances as of December31, 2002 as compared with December 31, 2001.**

 

# **Provision for Income Taxes**

# ** **

# **In 2001, our provision for incometaxes of $0.1 million related to our wholly owned subsidiary in the UnitedKingdom. During 2002, we recorded an income tax benefit of $0.8 million,primarily attributable to the release of the valuation allowance against ourdeferred tax assets. Our 2002 provision for income taxes included income taxesrelated to our wholly owned subsidiaries in the United Kingdom, Japan andAustralia as well as several domestic state income taxes. The release of ourvaluation allowance offset these taxes as well as the provision for federal andCalifornia income taxes. The result was a net benefit of $0.8 million and aneffective benefit rate of 5% for 2002.**

 

**Liquidity and Capital Resources**

 

As of December 31, 2003, we had cash and cash equivalents of $35.3million and investments in marketable securities of $147.5 million andaccumulated earnings of $15.7 million.

 

**Net cash provided by operating activities was $46.0 millionin 2003 compared with $33.6 million in 2002 and $20.8 million in 2001. In 2003,the increase in cash provided by operating activities was primarily due to anincrease in our deferred revenue (our subscriptions are initially recorded asdeferred revenue). In 2002, the increase in cash provided by operatingactivities was primarily due to an increase in our net income. Our operatingcash flow and revenue are significantly influenced by subscription renewals,and a decrease in subscription renewals would negatively impact our operatingcash flow and revenue.**

 

Netcash used in investing activities was $38.8 million in 2003 compared with $22.4million in 2002 and $24.0 million in 2001. The increase in cash used ininvesting activities in 2003 is primarily due to increased purchases ofmarketable securities exceeding both maturities and sales of marketablesecurities. Cash used in investing activities in 2002 is consistent with cashused in investing activities in 2001.

 

Net cash used in financing activities was $1.1 million in 2003 comparedwith net cash provided of $5.5 million in 2002 and $2.6 million in 2001. Thedecrease in cash from financing activities in 2003 is primarily due to the useof $7.7 million for the repurchase of 396,000 shares of our common stock.The increase in cash provided by financing activities in 2002 was primarily dueto proceeds received from the exercise of stock options as well as the issuanceof common stock pursuant to our employee stock purchase plan.

 

Wehave operating lease commitments of $1.2 million in 2004, $1.2 million in 2005,$1.2 million in 2006 and $1.3 million in 2007. A significant majority of ouroperating lease commitments are related to our corporate headquarters lease,which was renewed in April 2002. The lease renewal incentives resulted in norent payments in the third and fourth quarters of 2002 and escalating rentpayments from 2004 to

 

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2007. The rent expense relatedto our corporate headquarters lease renewal will be recorded monthly on astraight-line basis in accordance with generally accepted accountingprinciples.

 

Futureminimum annual lease payments under non-cancelable operating leases at December31, 2003 are as follows (in thousands):

 

| 2004   |   | $     | 1,158  |   |
|--------|--------|-------|--------|--------|
| 2005   |   | 1,193 |   |
| 2006   |   | 1,228 |   |
| 2007   |   | 1,253 |   |
|   |   | $     | 4,832  |   |

 

As of December 31, 2003 and 2002,we did not have any other relationships with unconsolidated entities orfinancial partners, such as entities often referred to as structured finance orspecial purpose entities, which would have been established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. As such, we are not materially exposed to any financing,liquidity, market or credit risk that could arise if we had engaged in suchrelationships.

 

OnApril 3, 2003, we announced that our Board of Directors authorized a stockrepurchase program of up to 2 million shares of our common stock. Therepurchases will be made from time to time on the open market at prevailingmarket prices or in privately negotiated transactions. Depending on marketconditions and other factors, purchases under this program may be commenced orsuspended at any time, or from time to time, without prior notice. As ofDecember 31, 2003, we had repurchased 396,000 shares of our common stock underthis program, for an aggregate of $7.7 million at an average price of $19.40per share.

 

We believe that our cash and cashequivalents balances and investments in marketable securities will be sufficientto satisfy our cash requirements for the foreseeable future. We intend tocontinue to invest our cash in excess of current operating requirements ininterest bearing, investment-grade securities. If existing cash is insufficientto satisfy our liquidity requirements, we may seek to sell additional equity ordebt securities. We have not made arrangements to obtain additional financingand there is no assurance that financing, if required, will be available inamounts or on terms acceptable to us, if at all.

 

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**Summarized Quarterly Data (Unaudited)**

 

The following tables presentunaudited quarterly financial information for the eight quarters ended December31, 2003. We believe this information reflects all adjustments (consisting onlyof normal recurring adjustments) that we consider necessary for a fairpresentation of such information in accordance with generally acceptedaccounting principles. The results for any quarter are not necessarilyindicative of results for any future period.

 
|                         |   | **1st Quarter**                           |       | **2nd Quarter** |       | **3rd Quarter** |       | **4th Quarter** |       |
|------------------------------|--------|-------------------------------------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|
|                         |   | **(In thousands, except per share data)** |       |
| **2003**                     |   |                                      |       |            |       |            |       |            |       |
| Revenue                      |   | $                                         | 18,504     |            | $          | 19,524          |       | $               | 21,006     |   | $ | 22,700 |   |
| Gross margin                 |   | 17,199                                    |       | 18,234          |       | 19,594          |       | 21,184          |       |
| Income from operations       |   | 5,759                                     |       | 5,888           |       | 6,353           |       | 6,791           |       |
| Income before income taxes   |   | 6,434                                     |       | 6,668           |       | 6,771           |       | 7,210           |       |
| Net income                   |   | 3,860                                     |       | 4,088           |       | 4,232           |       | 4,508           |       |
| Basic income per share (1)   |   | $                                         | 0.18       |            | $          | 0.19            |       | $               | 0.19       |   | $ | 0.20 |   |
| Diluted income per share (1) |   | $                                         | 0.17       |            | $          | 0.18            |       | $               | 0.18       |   | $ | 0.19 |   |
|                         |   |                                      |       |            |       |            |       |            |       |
| **2002**                     |   |                                      | ** ** |            | ** ** |            | ** ** |            | ** ** |
| Revenue                      |   | $                                         | 13,035     |            | $          | 14,550          |       | $               | 16,005     |   | $ | 17,375 |   |
| Gross margin                 |   | 12,102                                    |       | 13,489          |       | 14,924          |       | 16,280          |       |
| Income from operations       |   | 2,029                                     |       | 3,119           |       | 3,653           |       | 4,428           |       |
| Income before income taxes   |   | 2,742                                     |       | 3,807           |       | 4,318           |       | 5,073           |       |
| Net income                   |   | 2,656                                     |       | 3,546           |       | 4,038           |       | 6,497           |       |
| Basic income per share (1)   |   | $                                         | 0.13       |            | $          | 0.17            |       | $               | 0.19       |   | $ | 0.30 |   |
| Diluted income per share (1) |   | $                                         | 0.11       |            | $          | 0.15            |       | $               | 0.18       |   | $ | 0.28 |   |

 

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**(1) Basic and diluted net income per share computationsfor each quarter are independent and may not add up to the net income per sharecomputation for the respective year. See Note 1 of Notes to the ConsolidatedFinancial Statements for an explanation of the determination of basic anddiluted net income per share.**

 

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**Risks and Uncertainties**

 

Youshould carefully consider the following information in addition to otherinformation in this report before you decide to purchase our common stock. Therisks and uncertainties described below are those that we currently deem to bematerial and that we believe are specific to our company and our industry. Inaddition to these risks, our business may be subject to risks currently unknownto us. If any of these or other risks actually occurs, our business may beadversely affected, the trading price of our common stock could decline, andyou may lose all or part of your investment.

 

*Because we expect toderive a substantial portion of our future revenue from subscription fees forWebsense Enterprise, any failure of this product to satisfy customer demands orto achieve more widespread market acceptance will seriously harm our business.*

 

A substantial portion of our revenue comes from subscriptions toWebsense Enterprise and we expect this trend will continue for the foreseeablefuture. As a result, if for any reason revenue from Websense Enterprisedeclines or does not grow as rapidly as we anticipate, our operating resultsand our business will be significantly impaired. If Websense Enterprise failsto meet the needs of our existing and target customers, or if it does notcompare favorably in price and performance to competing products, our growthwill be limited. Our future financial performance also will depend, in part, onour ability to diversify our offerings by successfully developing, introducingand gaining customer acceptance of new products and enhanced versions ofWebsense Enterprise, including add-on application modules such as ClientApplication Manager, Bandwidth Optimizer, Instant Messaging Attachment Manager,and Client Policy Manager. We may not be successful in achieving marketacceptance of any new products that we develop or of enhanced versions ofWebsense Enterprise. Any failure or delay in diversifying our existingofferings could harm our business, results of operations and financialcondition.

 

*Our future successdepends on our existing customers renewing and purchasing additionalsubscriptions to Websense Enterprise.*

 

Our future success depends on achieving substantial revenue fromcustomer renewals for subscriptions to Websense Enterprise. Subscriptions forWebsense Enterprise typically have durations of 12, 24 or 36 months. Ourcustomers have no obligation to renew their subscriptions upon expiration. Wemay be unable to generate significant revenue from renewals. In order tomaintain our revenue we must be successful in selling renewal subscriptions.

 

Our future success also depends on our ability to sell furthersubscriptions to existing customers in order to add additional seats or productofferings within their respective organizations. As a result, to increase ourrevenue we must sell our existing customers additional subscriptions forWebsense Enterprise to get greater coverage of their workforces. This mayrequire increasingly costly sales efforts targeting senior management and othermanagement personnel associated with our customers’ Internet infrastructure.

 

*We face increasingcompetition, which places pressure on our pricing and which could prevent usfrom increasing revenue or maintaining profitability. In addition, we may facecompetition from better-established companies that have significantly greaterresources.*

 

The market for our products is intensely competitive and is likely to becomeeven more so in the future. Our current principal competitors frequently offertheir products at a significantly lower price than Websense Enterprise, whichhas resulted in pricing pressures on sales of our product and potentially couldresult in the commoditization of employee Internet management, or EIM,products. If we are unable to maintain the current pricing on sales of WebsenseEnterprise or increase our pricing in the future, our profitability could benegatively impacted. In addition, pricing pressures and increased competitiongenerally could result in reduced sales, reduced margins or the failure ofWebsense Enterprise to achieve

 

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or maintain more widespreadmarket acceptance, any of which could have a material adverse effect on ourbusiness, results of operations and financial condition. Our current principalcompetitors include:

 

•                  companiesoffering network filtering products, such as SurfControl plc, Secure Computing,Symantec Corporation, 8e6 Technologies, Webwasher, Elron Software, Inc., andCerberian;

•                  companiesoffering network reporting products, such as NetIQ and Wavecrest Computing; and

•                  companiesintegrating URL filtering into specialized security appliances, such asSonicWALL and Internet Security Systems.

 

We also face current and potential competition from vendors of 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. We compete against, and expect increased competition from,anti-virus software developers, traditional network management softwaredevelopers and Web management service providers. We may face new competitionfrom companies offering quality of service solutions, such as Packeteer,companies with a direct presence on computer desktops, such as Microsoft, andcompanies offering desktop management solutions, such as Altiris. If EIMfunctions become standard features of Internet-related hardware or software,the demand for Websense Enterprise will decrease. Furthermore, even if WebsenseEnterprise provides greater functionality and is more effective than certainother competitive products, potential customers might accept this limitedfunctionality in lieu of purchasing Websense Enterprise. In addition, our ownindirect sales channels may decide to develop or sell competing productsinstead of Websense Enterprise. Many of our potential competitors enjoysubstantial competitive advantages, such as:

 

•                  greater namerecognition and larger marketing budgets and resources;

•                  establishedmarketing relationships and access to larger customer bases; and

•                  substantiallygreater financial, technical and other resources.

 

As a result, they may be able to respond more quickly and effectivelythan we can to new or changing opportunities, technologies, standards orcustomer requirements. For all of the foregoing reasons, we may not be able tocompete successfully against our current and future competitors.

 

*Sales to customers outside the United Stateshave accounted for a significant portion of our revenue, and we expect thistrend to continue, which exposes us to risks inherent in international sales.*

 

We market and sell our products outside the United States throughvalue-added resellers, distributors and other resellers. International salesrepresented approximately 31% of our total revenue in 2003 and approximately32% in 2002, and international sales increased 30% in absolute dollars in 2003compared with 2002. As a key component of our business strategy, we intend toexpand our international sales but, as evidenced by the recent trend of ourinternational sales as a percentage of our total sales mix, success cannot beassured. In addition to the risks associated with our domestic sales, ourinternational sales are subject to the following risks:

 

•                  dependence onforeign distributors and their sales channels;

•                  localization ofour Websense Enterprise products and our products’ ability to properlycategorize and filter websites containing foreign languages;

•                  laws andbusiness practices favoring local competitors;

•                  compliance withmultiple, conflicting and changing governmental laws and regulations, includingtax laws and regulations;

•                  foreign currencyfluctuations;

•                  longer accountsreceivable payment cycles and other collection difficulties; and

•                  regionaleconomic and political conditions.

 

Such factors could have a material adverse effect on our futureinternational sales. Any further reduction in international sales, or ourfailure to further develop our international distribution channels,

 

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could have a material adverseeffect on our business, results of operations and financial condition. Ourinternational revenue is currently denominated in U.S. dollars. As a result,fluctuations in the value of the U.S. dollar and foreign currencies may makeWebsense Enterprise more expensive for international customers, which couldharm our business. We engage in currency hedging activities with the intent oflimiting the risk of exchange rate fluctuation.

 

*The market for ourproducts continues to emerge, and if we are not successful in promotingawareness of the need for Websense Enterprise and of our Websense brand, ourgrowth may be limited.*

 

Based on our experience with potential customers, we believe that manycorporations do not recognize or acknowledge the existence or scope of problemscaused by employee misuse of the Internet or of their computers. In addition, theremay be a time-limited opportunity to achieve and maintain a significant shareof the market for EIM and our other products due in part to the emerging natureof these markets and the substantial resources available to our existing andpotential competitors. If employers do not recognize or acknowledge theseproblems, then the market for Websense Enterprise may develop more slowly thanwe expect, which could adversely affect our operating results. Developing andmaintaining awareness of our Websense brand is critical to achieving widespreadacceptance of our existing and future products. Furthermore, we believe thatthe importance of brand recognition will increase as competition in our marketdevelops. Successful promotion of our Websense brand will depend largely on theeffectiveness of our marketing efforts and on our ability to develop reliableand useful products at competitive prices. If we fail to successfully promoteour Websense brand, or if our expenses to promote and maintain our Websensebrand are greater than anticipated, our results of operations and financialcondition could suffer.

 

*Because we recognizerevenue from subscriptions for Websense Enterprise ratably over the term of thesubscription, downturns in sales may not be immediately reflected in ourrevenue.*

 

We expect that nearly all of our revenue for the foreseeable futurewill come from subscriptions to Websense Enterprise. Upon execution of asubscription agreement, we invoice our customers for the full term of thesubscription agreement. We then recognize revenue from customers monthly overthe terms of their subscription agreements, which typically have durations of12, 24 or 36 months. As a result, a majority of the revenue we report in eachquarter is deferred revenue from subscription agreements entered into and paidfor during previous quarters. Because of this financial model, the revenue wereport in any quarter or series of quarters may mask significant downturns insales and the market acceptance of Websense Enterprise.

 

*We may not be ableto develop acceptable new products or enhancements to our existing products ata rate required by our rapidly changing market.*

 

Our future success depends on our ability to develop new products orenhancements to our existing products that keep pace with rapid technologicaldevelopments and that address the changing needs of our customers. AlthoughWebsense Enterprise is designed to operate with a variety of network hardwareand software platforms, we will need to continuously modify and enhanceWebsense Enterprise to keep pace with changes in Internet-related hardware,software, communication, browser and database technologies. We may not besuccessful in either developing such products or timely introducing them to themarket. In addition, uncertainties about the timing and nature of new networkplatforms or technologies, or modifications to existing platforms or technologycould increase our research and development expenses. The failure of ourproducts to operate effectively with the existing and future network platformsand technologies will limit or reduce the market for our products, result incustomer dissatisfaction and seriously harm our business, results of operationsand financial condition.

 

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* *

*Our quarterlyoperating results may fluctuate significantly, and these fluctuations may causeour stock price to fall.*

 

Our quarterly operating results have varied significantly in the past,and will likely vary in the future primarily as the result of fluctuations inour billings, revenues and operating expenses. We expect that our operatingexpenses will increase substantially in the future as we expand our selling andmarketing activities, increase our research and development efforts and hireadditional personnel. In addition, our operating expenses historically havefluctuated, and may continue to fluctuate in the future, as the result of thefactors described below and elsewhere in this quarterly report:

 

•                  concentration ofmarketing expenses for activities such as trade shows and advertisingcampaigns;

•                  concentration ofgeneral and administrative expenses, such as recruiting expenses andprofessional services fees;

•                  concentration ofresearch and development costs; and

•                  concentration ofexpenses associated with commissions paid on sales of subscriptions to WebsenseEnterprise.

 

As a result, our results of operations may not meet the expectations ofcurrent or potential investors. If this occurs, the price of our common stockmay decline.

 

*The market price ofour common stock is likely to be highly volatile and subject to widefluctuations.*

 

The market price of our common stock has been and likely will continueto be highly volatile and could be subject to wide fluctuations in response to anumber of factors that are beyond our control, including:

 

•                  announcements oftechnological innovations or new products or services by our competitors;

•                  demand forWebsense Enterprise, including fluctuations in subscription renewals;

•                  fluctuations inrevenue from our indirect sales channels;

•                  changes in thepricing policies of our competitors; and

•                  changes ingovernment regulations.

 

In addition, the market price of our common stock could be subject towide fluctuations in response to:

 

•                  announcements oftechnological innovations or new products or services by us;

•                  changes in ourpricing policies;

•                  quarterlyvariations in our revenues and operating expenses; and

•                  ourtechnological capabilities to accommodate the future growth in our operationsor our customers.

 

Further, the stock market has experienced significant price and volumefluctuations that have particularly affected the market price of the stock ofmany Internet-related companies, and that often have been unrelated or disproportionateto the operating performance of these companies. A number of publicly tradedInternet-related companies have current market prices below their initialpublic offering prices. Market fluctuations such as these may seriously harmthe market price of our common stock. In the past, securities class actionsuits have been filed following periods of market volatility in the price of acompany’s securities. If such an action were instituted, we would incursubstantial costs and a diversion of management attention and resources, whichwould seriously harm our business, results of operations and financialcondition.

 

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* *

*If we acquire anycompanies or technologies in the future, they could prove difficult tointegrate, disrupt our business, dilute stockholder value and adversely affectour operating results.*

 

We may acquire or make investments in complementary companies, servicesand technologies in the future. We have not made any acquisitions orinvestments to date, and therefore our ability as an organization to make acquisitionsor investments is unproven.

 

Acquisitions and investments involve numerous risks, including:

 

•                  difficulties inintegrating operations, technologies, services and personnel;

•                  diversion offinancial and management resources from existing operations;

•                  risk of enteringnew markets;

•                  potential lossof key employees; and

•                  inability togenerate sufficient revenue to offset acquisition or investment costs.

 

In addition, if we finance acquisitions by issuing convertible debt orequity securities, our existing stockholders may be diluted which could affectthe market price of our stock. As a result, if we fail to properly evaluate andexecute acquisitions or investments, our business and prospects may beseriously harmed.

 

*We must develop andexpand our indirect sales channels to increase revenue and improve ouroperating results.*

 

We currently sell a significant majority of our products indirectly. Weintend to continue to rely on our indirect sales channels for a significantmajority of revenue. We depend on our indirect sales channels, includingvalue-added resellers, distributors, and providers of managed Internetservices, to offer Websense Enterprise to a larger customer base than can bereached through a direct sales effort. We will need to expand our existingrelationships and enter into new relationships to increase our current andfuture market share and revenue. We may be unable to maintain and expand ourexisting relationships or enter into new relationships on commerciallyreasonable terms or at all. If we are unable to maintain and expand ourexisting relationships or enter into new relationships, we would lose customerintroductions and co-marketing benefits and our operating results could suffer.

 

*Our reliance onindirect sales channels could result in reduced revenue growth because we havelittle control over our value-added resellers, distributors and originalequipment manufacturers.*

 

Our indirect sales channels accounted for more than 80% of our revenuein 2003 and for more than 75% of our revenue in 2002. We anticipate that salesfrom our various indirect sales channels, including value-added resellers,distributors, providers of managed Internet services and others, will continueto account for a significant majority of our total revenue in future periods.None of these parties is obligated to continue selling our products or to makeany purchases from us. Our ability to generate increased revenue dependssignificantly upon the ability and willingness of our indirect sales channelsto market and sell our products to organizations worldwide. If they areunsuccessful in their efforts or are unwilling or unable to market and sell ournew product offerings such as Client Application Manager, Bandwidth Optimizer,IM Attachment Manager, and Client Policy Manager, our operating results willsuffer. We cannot control the level of effort these parties expend or theextent to which any of them will be successful in marketing and selling our products.A number of our value-added resellers and distributors have been adverselyaffected by the recent global economic downturn and we believe that theirfinancial difficulties may negatively impact their ability to sell and marketWebsense Enterprise. Some of our indirect sales channels also market and sellproducts that compete with Websense Enterprise or may decide to do so in thefuture. We may not be able to prevent these parties from devoting greaterresources to support our competitors’ products and/or eliminating their effortsto sell Websense Enterprise.

 

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*Negative economic conditions in the United States and in the othercountries and geographic areas in which we offer our products may negativelyimpact our ability to maintain profitability.*

 

Since 2001, the United States and other international markets in whichwe offer our products have experienced a significant economic downturn. Inaddition, the United States and other countries suffered significant acts ofhostility and terror, and are now facing the threat of future acts ofhostility. These or similar acts in the future, as well as fears relating tothe mere possibility of future acts of hostility, may increase or prolong thenegative economic conditions. The economic downturn may impact our ability tosustain profitability by:

 

•                  negativelyaffecting demand for our products and services;

•                  decreasing therenewal rate of subscriptions by our existing customers; and

•                  decreasing thestrength of our indirect sales channels.

 

In addition, the economic downturn may force companies to prioritizeexpenditures, and these companies may decide not to purchase our product in aslowing economy. There can be no certainty as to the degree or severity of theduration of this downturn. We also cannot predict the extent and timing of theimpact of the economic downturn in the United States and in other countries andgeographic regions in which we conduct our business.

 

*Any failure toprotect our intellectual property rights could impair our ability to protectour proprietary technology and establish our Websense brand.*

 

Intellectual property is critical to our success, and we rely upontrademark, copyright and trade secret laws in the United States and otherjurisdictions as well as confidentiality procedures and contractual provisionsto protect our proprietary technology and our Websense brand. Any of ourtrademarks may be challenged by others or invalidated through administrativeprocess or litigation. We currently have only two issued patents and may beunable to obtain further patent protection in the future. In addition, anyissued patents may not provide us with any competitive advantages, or may bechallenged by third parties. Furthermore, legal standards relating to thevalidity, enforceability and scope of protection of intellectual propertyrights are uncertain. Effective patent, trademark, copyright and trade secretprotection may not be available to us in every country in which our productsare available. 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 database ofwebsites. Any such infringement or misappropriation could have a materialadverse effect on our business, results of operations and financial condition.

 

*We may be sued bythird parties for alleged infringement of their proprietary rights.*

 

The software and Internet industries are characterized by the existenceof a large number of patents, trademarks and copyrights and by frequentlitigation based on allegations of patent infringement or other violations ofintellectual property rights. As the number of entrants into our marketincreases, the possibility of an intellectual property claim against us grows.Our technologies and products may not be able to withstand any third-partyclaims or rights against their use. Any intellectual property claims, with orwithout merit, could be time-consuming and expensive to litigate or settle, andcould divert management attention from executing our business plan.

 

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* *

*Our databasecategories and our process for classifying websites and software applicationswithin those categories are subjective, and we may not be able to categorizewebsites and software applications in accordance with our customers’expectations.*

 

We may not succeed in accurately categorizing Internet and applicationcontent to meet our customers’ expectations. We rely upon a combination ofautomated filtering technology and human review to categorize websites andsoftware applications in our proprietary databases. Our customers may not agreewith our determinations that particular websites and software applicationsshould be included or not included in specific categories of our databases. Inaddition, it is possible that our filtering processes may place objectionablematerial in categories that are generally unrestricted by our users’ Internetand computer access policies, which could result in employees having access tosuch material in the workplace. Any miscategorization could result in customerdissatisfaction and harm our reputation. Furthermore, we select our categoriesbased on content we believe employers want to manage. We may not now, or in thefuture, succeed in properly identifying the categories of content thatemployers want to manage. Any failure to effectively categorize and filterwebsites and software applications according to our customers’ expectationswill impair the growth of our business and our efforts to increase brandacceptance.

 

*Failure of ourproducts to work properly could impact sales, increase costs, and create risksof potential negative publicity and legal liability.*

 

Because our products are complex and are deployed in a wide variety ofcomplex network environments, they may have errors or defects that usersidentify after deployment, which could harm our reputation and our business. Inaddition, products as complex as ours frequently contain undetected errors whenfirst introduced or when new versions or enhancements are released. We havefrom time to time found errors in versions of Websense Enterprise and our add-onapplication modules, and we may find such errors in the future. The occurrenceof errors could adversely affect sales of our products, divert the attention ofengineering personnel from our product development efforts and causesignificant customer relations problems.

 

In addition, because customers rely on Websense Enterprise to manageemployee behavior, any significant defects or errors in our products may resultin negative publicity or legal claims. Negative publicity or legal claims couldseriously harm our business, results of operations and financial condition. Inaddition, Websense Enterprise’s capability to report Internet data retrievalrequests and software application execution requests along with theworkstations from which they originated may result in negative publicity orlegal claims based on potential privacy violations.

 

*Our databases mayfail to keep pace with the rapid growth and technological change of theInternet.*

 

The success of Websense Enterprise depends on the breadth and accuracyof our databases. Although our databases currently catalog more than 5.5million websites and over 250,000 software executable files, they contain onlya portion of such material that exists. In addition, the total number ofwebsites and software applications is growing rapidly, and we expect this rapidgrowth rate to continue in the future. Our databases and database technologiesmay not be able to keep pace with the growth in the number of websites andsoftware applications, especially the growing amount of content utilizingforeign languages. Further, the ongoing evolution of the Internet and computingenvironments will require us to continually improve the functionality, featuresand reliability of our databases. Because Websense Enterprise can only manageaccess to websites and software applications included in our databases, if ourdatabases do not contain a meaningful portion of relevant content, theeffectiveness of Websense Enterprise will be significantly diminished. Anyfailure of our databases to keep pace with the rapid growth and technologicalchange of the Internet will impair the market acceptance of WebsenseEnterprise, which in turn will harm our business, results of operations andfinancial condition.

 

35

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*Our worldwide incometax provisions and accruals may be insufficient if any taxing authoritiesassume taxing positions that are contrary to the company’s positions.*

 

**Significantjudgment is required in determining our worldwide provision for income taxes.In the ordinary course of a global business, there are many transactions forwhich the ultimate tax outcome is uncertain. Some of these uncertainties ariseas a consequence of intercompany arrangements to share revenue and costs. Insuch arrangements there are uncertainties about the amount and manner of suchsharing, which could ultimately result in changes once the arrangements arereviewed by taxing authorities. Although we believe that our approach todetermining the amount of such arrangements is reasonable, no assurance can begiven that the final exposure of these matters will not be materially differentthan that which is reflected in our historical income tax provisions andaccruals. Such differences could have a material effect on our income taxprovisions or benefits in the period in which such determination is made, andconsequently, on our net income for such period.**

 

*Our systems may bevulnerable to security risks or service disruptions that could harm ourbusiness.*

 

Although we have taken measures to secure our systems against securityrisks and other causes of disruption of electronic services, our servers arevulnerable to physical or electronic break-ins and service disruptions, whichcould lead to interruptions, delays, loss of data or the inability to processcustomer requests. Such events could be very expensive to remedy, could damageour reputation and could discourage existing and potential customers from usingour products.

* *

*Evolving regulationof the Internet may affect us adversely.*

 

As Internet commerce continues to evolve, increasing regulation byfederal, state or foreign agencies becomes more likely. Such regulation islikely in the areas of user privacy, pricing, content and quality of productsand services. Taxation of Internet use or other charges imposed by governmentagencies or by private organizations for accessing the Internet may also beimposed. Laws and regulations applying to the solicitation, collection or processingof personal or consumer information could affect our activities. Furthermore,any regulation imposing fees for Internet use could result in a decline in theuse of the Internet and the viability of Internet commerce, which could have amaterial adverse effect on our business, results of operations and financialcondition.

 

*We are dependent onour management team, and the loss of any key member of this team may prevent usfrom implementing our business plan in a timely manner.*

 

Our success depends largely upon the continued services of our executiveofficers and other key management and development personnel. We are alsosubstantially dependent on the continued service of our existing engineeringpersonnel because of the complexity of our products and technologies. We do nothave employment agreements with a majority of our executive officers, keymanagement or development personnel and, therefore, they could terminate theiremployment with us at any time without penalty. We do not maintain key personlife insurance policies on any of our employees. The loss of one or more of ourkey employees could seriously harm our business, results of operations andfinancial condition. In such an event we may be unable to recruit personnel toreplace these individuals in a timely manner, or at all, on acceptable terms.

 

36

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* *

*Our growth couldstrain our personnel and infrastructure resources, and if we are unable to implementappropriate controls and procedures to manage our growth, we may not be able tosuccessfully implement our business plan.*

 

We continue to experience rapid growth in our operations, which hasplaced, and will continue to place, a significant strain on our management,administrative, operational and financial infrastructure. Our future successwill depend in part upon the ability of our senior management to manage growtheffectively. This will require us to hire and train additional personnel tomanage our expanding operations. In addition, we will be required to continueto improve our operational, financial and management controls and our reportingsystems and procedures. If we fail to successfully manage our growth, we willbe unable to execute our business plan.

 

*Because competitionfor our target employees is intense, we may not be able to attract and retainthe highly skilled employees we need to support our planned growth.*

 

To execute our growth plan, we must attract and retain highly qualifiedpersonnel. We need to hire additional personnel in virtually all operationalareas, including selling and marketing, research and development, operationsand technical support, customer service and administration. Competition forthese personnel is intense, especially for engineers with high levels ofexperience in designing and developing software and Internet-related products.We may not be successful in attracting and retaining qualified personnel. Wehave from time to time in the past experienced, and we expect to continue toexperience in the future, difficulty in hiring and retaining highly skilledemployees with appropriate qualifications. Many of the companies with which wecompete for experienced personnel have greater resources than we have. If wefail to attract new personnel or retain and motivate our current personnel, ourbusiness and future growth prospects could be severely harmed.

 

*It may be difficultfor a third party to acquire us, even if doing so would be beneficial to ourstockholders.*

 

Some provisions of our certificate of incorporation and bylaws, as wellas some provisions of Delaware law, may discourage, delay or prevent thirdparties from acquiring us, even if doing so would be beneficial to our stockholders.For example, our certificate of incorporation provides for a classified board,with each board member serving a staggered three-year term. It also providesthat stockholders may not fill board vacancies, call stockholder meetings oract by written consent. Our bylaws further provide that advance written noticeis required prior to stockholder proposals. Each of these provisions makes itmore difficult for stockholders to obtain control of our board or initiateactions that are opposed by the then current board. Additionally, we haveauthorized preferred stock that is undesignated, making it possible for theboard to issue preferred stock with voting or other rights and preferences thatcould impede the success of any attempted change of control. Delaware law alsocould make it more difficult for a third party to acquire us. Section 203 ofthe Delaware General Corporation Law may have an anti-takeover effect withrespect to transactions not approved in advance by our board, includingdiscouraging attempts that might result in a premium over the market price ofthe shares of common stock held by our stockholders.

 

*We do not intend topay dividends.*

 

We have not declared or paid any cash dividends on our common stocksince we have been a publicly traded company. We currently intend to retain anyfuture cash flows from operations to fund growth and do not expect to pay anydividends in the foreseeable future.

 

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

 

**Ourmarket risk exposures are related to our cash, cash equivalents andinvestments. We invest our excess cash in highly liquid short-term investments,commercial paper, corporate bonds, mortgage-backed securities and municipalsecurities. These investments are not held for trading or other speculativepurposes. Changes in interest rates affect the investment income we earn on ourinvestments and therefore impact our cash flows and results of operations.**

 

We are exposed to changes in interest ratesprimarily from our short-term available-for-sale investments. Under our currentpolicies, we do not use interest rate derivative instruments to manage exposureto interest rate changes. A hypothetical 100 basis point adverse move ininterest rates along the entire interest rate yield curve would not materiallyaffect the fair value of our interest sensitive financial instruments atDecember 31, 2003. Declines in interest rates over time will, however, reduceour interest income.

 

For the year ended December 31, 2003, all ofour billings, including those billed by our operations in Ireland, weredenominated in our functional currency, which is the U.S. dollar.  Working funds necessary to facilitate theshort-term operations of our subsidiaries are kept in the local currencies inwhich they do business.

 

We expect to begin hedging certain foreigncurrency transactions, primarily related to transactions denominated in theEuro and British Pound, in 2004. Management’s objective is to reduce the risk to earnings and cash flowsassociated with changes in foreign currency exchange rates.  We will utilize foreign exchange forwardcontracts to offset the fluctuations on specific foreign currency operatingexpenses.

 

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**Item 8**. Financial Statements andSupplementary Data

 

 

**REPORT OFERNST & YOUNG LLP, INDEPENDENT AUDITORS**

 

The Board of Directors and Stockholders

Websense, Inc.

 

We have audited the accompanying consolidatedbalance sheets of Websense, Inc. as of December 31, 2003 and 2002 and therelated consolidated statements of income, stockholders’ equity, and cash flowsfor each of the three years in the period ended December 31, 2003. Our auditsalso included the financial statement schedule listed in the Index at Item15(a)(1). These financial statements and schedule are the responsibility of theCompany’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 auditingstandards generally accepted in the United States. Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Websense, Inc. at December 31, 2003 and 2002, and the consolidatedresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2003, in conformity with accounting principlesgenerally accepted in the United States. Also, in our opinion, the relatedfinancial statement schedule, when considered in relation to the basicfinancial statements taken as a whole, presents fairly in all material respectsthe information set forth therein.

 
|                  | /s/ Ernst & Young LLP |   |
|-----------------------|---------------------------|--------|
|                  |                      |
|                  |                      |
| San Diego, California |                      |
| January 16, 2004      |                      |

 

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**Websense,Inc.**

**ConsolidatedBalance Sheets**

**(Inthousands, except per share amounts)**

 
|                                                                                                                                             |   | **December 31,** |    |
|--------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------|---------|
|                                                                                                                                             |   | **2003**         |    | **2002** |   |
| **Assets**                                                                                                                                       |   |             |    |   |   |
| Current assets:                                                                                                                                  |   |             |    |   |   |
| Cash and cash equivalents                                                                                                                        |   | $                | 35,324  |   | $ | 29,263 |   |
| Marketable securities                                                                                                                            |   | 147,535          |    | 111,203 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $525 and $180 at December 31, 2003 and 2002                                      |   | 27,999           |    | 19,840 |   |
| Deferred income taxes                                                                                                                            |   | 8,733            |    | 8,731 |   |
| Other current assets                                                                                                                             |   | 1,271            |    | 1,184 |   |
| Total current assets                                                                                                                             |   | 220,862          |    | 170,221 |   |
|                                                                                                                                             |   |             |    |   |   |
| Property and equipment, net                                                                                                                      |   | 2,997            |    | 2,967 |   |
| Deferred income taxes, less current portion                                                                                                      |   | 8,672            |    | 6,701 |   |
| Deposits and other assets                                                                                                                        |   | 418              |    | 299 |   |
| Total assets                                                                                                                                     |   | $                | 232,949 |   | $ | 180,188 |   |
|                                                                                                                                             |   |             |    |   |   |
| **Liabilities and stockholders’  equity**                                                                                                   |   |             |    |   |   |
| Current liabilities:                                                                                                                             |   |             |    |   |   |
| Accounts payable                                                                                                                                 |   | $                | 743     |   | $ | 761 |   |
| Accrued payroll and related benefits                                                                                                             |   | 5,241            |    | 3,627 |   |
| Other accrued expenses                                                                                                                           |   | 3,835            |    | 3,440 |   |
| Income taxes payable                                                                                                                             |   | 241              |    | 970 |   |
| Current portion of deferred revenue                                                                                                              |   | 65,480           |    | 46,964 |   |
| Total current liabilities                                                                                                                        |   | 75,540           |    | 55,762 |   |
|                                                                                                                                             |   |             |    |   |   |
| Deferred revenue, less current portion                                                                                                           |   | 28,480           |    | 17,715 |   |
|                                                                                                                                             |   |             |    |   |   |
| Stockholders’ equity:                                                                                                                       |   |             |    |   |   |
| Common stock - $0.01 par value; 100,000 shares  authorized;  22,445 and 21,734 shares  issued and outstanding at December 31, 2003 and 2002 |   | 228              |    | 217 |   |
| Additional paid-in capital                                                                                                                       |   | 120,639          |    | 107,058 |   |
| Treasury stock                                                                                                                                   |   | (7,684           | )       | — |   |
| Deferred compensation                                                                                                                            |   | —           |    | (83 | ) |
| Retained earnings (deficit)                                                                                                                      |   | 15,731           |    | (957 | ) |
| Accumulated other comprehensive income                                                                                                           |   | 15               |    | 476 |   |
| Total stockholders’ equity                                                                                                                  |   | 128,929          |    | 106,711 |   |
| Total liabilities and stockholders’ equity                                                                                                  |   | $                | 232,949 |   | $ | 180,188 |   |

 

See accompanying notes.

 

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**Websense,Inc.**

**ConsolidatedIncome Statements**

**(Inthousands, except per share amounts)**

 
|                                                                                                                                                                                           |   | **Years ended December 31,** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                                                                                                                           |   | **2003**                     |   | **2002** |   | **2001** | ** ** |
|                                                                                                                                                                                           |   |                         |   |   |   |   |   |
| Revenues                                                                                                                                                                                       |   | $                            | 81,734 |   | $ | 60,965 |   | $ | 35,893 |   |
|                                                                                                                                                                                           |   |                         |   |   |   |   |   |
| Cost of revenues                                                                                                                                                                               |   | 5,523                        |   | 4,170 |   | 3,602 |   |
|                                                                                                                                                                                           |   |                         |   |   |   |   |   |
| Gross margin                                                                                                                                                                                   |   | 76,211                       |   | 56,795 |   | 32,291 |   |
|                                                                                                                                                                                           |   |                         |   |   |   |   |   |
| Operating expenses:                                                                                                                                                                            |   |                         |   |   |   |   |   |
| Selling and marketing (exclusive of $32,  $121 and $192 for the years ended December  31, 2003, 2002 and 2001, respectively, reported below as amortization of  stock-based compensation) |   | 31,845                       |   | 26,201 |   | 19,707 |   |
| Research and development (exclusive of $17, $73  and $139 for the years ended December 31, 2003, 2002 and 2001, respectively,  reported below as amortization of stock-based compensation)     |   | 12,843                       |   | 10,957 |   | 7,642 |   |
| General and administrative (exclusive of $34,  $254, $529 for the years ended December 31, 2003, 2002 and 2001, respectively,  reported below as amortization of stock-based compensation)     |   | 6,649                        |   | 5,960 |   | 5,358 |   |
| Amortization of stock-based compensation                                                                                                                                                       |   | 83                           |   | 448 |   | 860 |   |
| Total operating expenses                                                                                                                                                                       |   | 51,420                       |   | 43,566 |   | 33,567 |   |
|                                                                                                                                                                                           |   |                         |   |   |   |   |   |
| Income (loss) from operations                                                                                                                                                                  |   | 24,791                       |   | 13,229 |   | (1,276 | ) |
|                                                                                                                                                                                           |   |                         |   |   |   |   |   |
| Other income, net                                                                                                                                                                              |   | 2,292                        |   | 2,711 |   | 4,500 |   |
|                                                                                                                                                                                           |   |                         |   |   |   |   |   |
| Income before income taxes                                                                                                                                                                     |   | 27,083                       |   | 15,940 |   | 3,224 |   |
|                                                                                                                                                                                           |   |                         |   |   |   |   |   |
| Provision (benefit) for income taxes                                                                                                                                                           |   | 10,395                       |   | (797 | ) | 108 |   |
|                                                                                                                                                                                           |   |                         |   |   |   |   |   |
| Net income                                                                                                                                                                                     |   | $                            | 16,688 |   | $ | 16,737 |   | $ | 3,116 |   |
|                                                                                                                                                                                           |   |                         |   |   |   |   |   |
| Net income per share:                                                                                                                                                                          |   |                         |   |   |   |   |   |
| Basic net income per share                                                                                                                                                                     |   | $                            | 0.76   |   | $ | 0.79 |   | $ | 0.16 |   |
| Diluted net income per share                                                                                                                                                                   |   | $                            | 0.73   |   | $ | 0.72 |   | $ | 0.14 |   |
| Weighted average shares – basic                                                                                                                                                           |   | 22,038                       |   | 21,211 |   | 20,082 |   |
| Weighted average shares – diluted                                                                                                                                                         |   | 22,976                       |   | 23,338 |   | 22,780 |   |

 

See accompanying notes.

 

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**Websense, Inc.**

**Consolidated Statements of Stockholders’ Equity**

**(In thousands)**

 
|                                                    |   |              |   |           |   |                 |   |         |   | **Retained**     |   | **Accumulated  other** |   | **Total**              |   |
|---------------------------------------------------------|--------|-------------------|--------|----------------|--------|----------------------|--------|--------------|--------|------------------|--------|------------------------|--------|------------------------|--------|
|                                                    |   | **Common  stock** |   | **Additional** |   | **Treasury**         |   | **Deferred** |   | **earnings**     |   | **comprehensive**      |   | **stockholders’** |   |
|                                                    |   | **Shares**        |   | **Amount**     |   | **paid-in  capital** |   | **stock**    |   | **compensation** |   | **(deficit****)**      |   | **income**             |   | **equity** |   |
| Balance at December 31, 2000                            |   | 19,705            |   | $              | 197    |                 | $      | 86,111       |   | $                | — |                   | $      | (1,459                 | )      | $ | (20,810 | ) | $ | 25 |   | $ | 64,064 |   |
| Issuance of common stock upon exercise of options       |   | 782               |   | 8              |   | 1,553                |   | —       |   | —           |   | —                 |   | —                 |   | 1,561 |   |
| Issuance of common stock upon exercise of warrant       |   | 23                |   | —         |   | 70                   |   | —       |   | —           |   | —                 |   | —                 |   | 70 |   |
| Issuance of common stock for stock purchase plan        |   | 86                |   | 1              |   | 973                  |   | —       |   | —           |   | —                 |   | —                 |   | 974 |   |
| Deferred compensation (net of forfeitures)              |   | —            |   | —         |   | (68                  | )      | —       |   | 68               |   | —                 |   | —                 |   | — |   |
| Amortization of deferred compensation                   |   | —            |   | —         |   | —               |   | —       |   | 860              |   | —                 |   | —                 |   | 860 |   |
| Comprehensive income:                                   |   |              |   |           |   |                 |   |         |   |             |   |                   |   |                   |   |   |   |
| Net income                                              |   | —            |   | —         |   | —               |   | —       |   | —           |   | 3,116                  |   | —                 |   | 3,116 |   |
| Net change in unrealized gain on marketable  securities |   | —            |   | —         |   | —               |   | —       |   | —           |   | —                 |   | 35                     |   | 35 |   |
| Comprehensive income                                    |   |              |   |           |   |                 |   |         |   |             |   |                   |   |                   |   | 3,151 |   |
| Balance at December 31, 2001                            |   | 20,596            |   | 206            |   | 88,639               |   | —       |   | (531             | )      | (17,694                | )      | 60                     |   | 70,680 |   |
| Issuance of common stock upon exercise of options       |   | 1,029             |   | 10             |   | 4,013                |   | —       |   | —           |   | —                 |   | —                 |   | 4,023 |   |
| Issuance of common stock for stock purchase plan        |   | 109               |   | 1              |   | 1,469                |   | —       |   | —           |   | —                 |   | —                 |   | 1,470 |   |
| Amortization of deferred compensation                   |   | —            |   | —         |   | —               |   | —       |   | 448              |   | —                 |   | —                 |   | 448 |   |
| Tax benefit of stock options                            |   | —            |   | —         |   | 12,937               |   | —       |   | —           |   | —                 |   | —                 |   | 12,937 |   |
| Comprehensive income:                                   |   |              |   |           |   |                 |   |         |   |             |   |                   |   |                   |   |   |   |
| Net income                                              |   | —            |   | —         |   | —               |   | —       |   | —           |   | 16,737                 |   | —                 |   | 16,737 |   |
| Net change in unrealized gain on marketable  securities |   | —            |   | —         |   | —               |   | —       |   | —           |   | —                 |   | 416                    |   | 416 |   |
| Comprehensive income                                    |   |              |   |           |   |                 |   |         |   |             |   |                   |   |                   |   | 17,153 |   |
| 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 gain 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 |   |

 

See accompanying notes.

 

42

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**Websense, Inc.**

**Consolidated Statements of Cash Flows**

**(In thousands)**

 
|                                                                               |   | **Years ended December 31,** |       |
|------------------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                               |   | **2003**                     |       | **2002** |   | **2001** |   |
| **Operating activities:**                                                          |   |                         | ** ** |   | ** ** |   | ** ** |
| Net income                                                                         |   | $                            | 16,688     |   | $ | 16,737 |   | $ | 3,116 |   |
|                                                                               |   |                         |       |   |   |   |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |   |                         |       |   |   |   |   |
| Depreciation                                                                       |   | 2,016                        |       | 1,929 |   | 1,700 |   |
| Amortization of deferred compensation                                              |   | 83                           |       | 448 |   | 860 |   |
| Deferred revenue                                                                   |   | 29,281                       |       | 21,201 |   | 18,991 |   |
| Tax benefit from exercise of stock options                                         |   | 7,027                        |       | 12,937 |   | — |   |
| Changes in operating assets and liabilities:                                       |   |                         |       |   |   |   |   |
| Accounts receivable                                                                |   | (8,159                       | )          | (7,314 | ) | (4,928 | ) |
| Deposits and other assets                                                          |   | (206                         | )          | (15 | ) | (664 | ) |
| Deferred income taxes                                                              |   | (1,973                       | )          | (15,432 | ) | — |   |
| Accounts payable                                                                   |   | (18                          | )          | 121 |   | (175 | ) |
| Accrued payroll and related benefits                                               |   | 1,614                        |       | 877 |   | 986 |   |
| Other accrued expenses                                                             |   | 395                          |       | 1,176 |   | 940 |   |
| Income taxes payable                                                               |   | (729                         | )          | 970 |   | — |   |
| Net cash provided by operating activities                                          |   | 46,019                       |       | 33,635 |   | 20,826 |   |
|                                                                               |   |                         |       |   |   |   |   |
| **Investing activities:**                                                          |   |                         |       |   |   |   |   |
| Purchase of property and equipment                                                 |   | (2,046                       | )          | (2,186 | ) | (1,617 | ) |
| Purchases of marketable securities                                                 |   | (197,880                     | )          | (112,763 | ) | (79,142 | ) |
| Maturities of marketable securities                                                |   | 83,233                       |       | 92,569 |   | 56,737 |   |
| Sales of marketable securities                                                     |   | 77,854                       |       | — |   | — |   |
| Net cash used in investing activities                                              |   | (38,839                      | )          | (22,380 | ) | (24,022 | ) |
|                                                                               |   |                         |       |   |   |   |   |
| **Financing activities:**                                                          |   |                         |       |   |   |   |   |
| Proceeds from exercise of stock options                                            |   | 4,733                        |       | 4,023 |   | 1,631 |   |
| Proceeds from issuance of common stock for stock  purchase plan                    |   | 1,832                        |       | 1,470 |   | 974 |   |
| Treasury stock                                                                     |   | (7,684                       | )          | — |   | — |   |
| Net cash (used in) provided by financing  activities                               |   | (1,119                       | )          | 5,493 |   | 2,605 |   |
|                                                                               |   |                         |       |   |   |   |   |
| Increase (decrease) in cash and cash equivalents                                   |   | 6,061                        |       | 16,748 |   | (591 | ) |
|                                                                               |   |                         |       |   |   |   |   |
| Cash and cash equivalents at beginning of year                                     |   | 29,263                       |       | 12,515 |   | 13,106 |   |
|                                                                               |   |                         |       |   |   |   |   |
| Cash and cash equivalents at end of year                                           |   | $                            | 35,324     |   | $ | 29,263 |   | $ | 12,515 |   |
|                                                                               |   |                         |       |   |   |   |   |
| **Supplemental disclosures of cash  flow information:**                            |   |                         |       |   |   |   |   |
| Income taxes paid                                                                  |   | $                            | 6,211      |   | $ | 687 |   | $ | — |   |

 

See accompanying notes.

 

43

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**Websense, Inc.**

**Notes to Consolidated Financial Statements**

**December 31, 2003**

 

**1. Summary of Significant Accounting Policies**

 

**Description of Business**

 

Websense, Inc. (“Websense”or the “Company”) was founded in 1994. The Company provides employee Internetmanagement (EIM) products that enable businesses to analyze, report and managehow their employees use workplace computing resources, including Internetaccess, instant messaging, peer-to-peer file sharing, network bandwidth anddesktop applications. The Company’s Websense Enterprise solution supports anorganization’s efforts to improve employee productivity, conserve network bandwidth,mitigate potential legal liability, and enhance network security.

 

**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.

 

#### **Principles of Consolidation**

 

The consolidated financialstatements include the accounts of the Company and its wholly ownedsubsidiaries in the United Kingdom, Japan, Ireland, Australia, France andGermany. Significant intercompany accounts and transactions have beeneliminated in consolidation. Activities performed by the subsidiaries are adirect and integral extension of the Company’s primary business.

 

For the years ended December31, 2003, 2002 and 2001, all of our billings were denominated in our functionalcurrency, which is the U.S. dollar.  Assuch, the Company has not recorded foreign currency translation gains orlosses.  However, the Company incurredforeign currency transaction costs of $57,000, $106,000 and $138,000 for theyears ended December 31, 2003, 2002 and 2001, respectively.

 

**Reclassifications**

 

Certain reclassifications have been made for consistent presentation.

 

**Revenue Recognition**

 

The Company has adoptedAmerican Institute of Certified Public Accountants Statement of Position No.97-2, Software Revenue Recognition (SOP 97-2) as amended by SOP 98-9. Thesestatements provide guidance for recognizing revenue related to sales bysoftware vendors.

 

The Company sells WebsenseEnterprise on a subscription basis. A subscription is generally 12, 24 or 36months in duration and for a fixed number of users. Upon entering into asubscription arrangement, the Company invoices customers. Generally, payment isdue for the full term of the subscription within 30 days of invoicing. TheCompany recognizes revenue on a monthly straight-line basis over the term ofthe subscription agreement. The Company records amounts billed to customers inexcess of recognizable revenue as deferred revenue in the accompanying balancesheets.

 

44

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**Cash and Cash Equivalents**

 

The Company considers allhighly liquid investments with a maturity of three months or less whenpurchased to be cash equivalents. The Company generally invests its excess cashin certificates of deposit, municipalities and corporations with strong creditratings. Such investments are made in accordance with the Company’s investmentpolicy, which establishes guidelines relative to diversification and maturitiesdesigned to maintain safety and liquidity. These guidelines are periodicallyreviewed and modified if necessary to take advantage of trends in yields andinterest rates. The Company has not experienced any losses on its cash and cashequivalents.

 

**Marketable Securities**

 

Marketable securities atDecember 31, 2003 consist of tax-exempt auction rate notes and municipal bonds.The Company currently classifies all investment securities as available forsale. Securities available for sale are reported at fair value, adjusted forother than temporary declines in value. Unrealized holding gains and losses onsecurities available for sale are reported as a net amount in a separatecomponent of stockholders’ equity until realized. Realized gains and losses arerecorded based on the specific identification method.

 

#### **Disclosures About Fair Valueof Financial Instruments**

 

The fair values ofinvestment securities have been determined using values supplied by independentpricing services and are disclosed together with carrying amounts in Note 2.The carrying value of cash and cash equivalents, accounts receivable, accountspayable and accrued liabilities approximate their fair values.

 

**Concentration of Credit Risk**

 

The Company sells itsproducts to customers primarily in the United States, Canada, Europe, Asia, andLatin America. The Company maintains a reserve for potential credit losses andhistorically such losses have been within management’s estimates.

 

**Property and Equipment**

 

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

 

**Computer Software Costs**

 

In accordance with Statementof Financial Accounting Standards (SFAS) No. 86, Accounting for the Costs ofComputer Software to be Sold, Leased, or Otherwise Marketed, costs arecapitalized, when significant, in the development of specific computer softwareproducts after establishment of technological feasibility and marketability.There have been no such costs capitalized to date as the costs incurred duringthe period between technological feasibility to general release have not beensignificant.

 

45

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SOP 98-1, Accounting forCosts of Computer Software Developed or Obtained for Internal Use, requirescompanies to capitalize qualifying computer software costs, which are incurredduring the application development stage and amortize them over the software’sestimated useful life. The Company adopted SOP 98-1 effective January 1, 1999with no material effect on the financial statements.

 

**Advertising Expenses**

 

Advertising costs areexpensed as incurred. Total advertising costs for the years ended December 31,2003, 2002 and 2001 were $3.4 million, $3.5 million and $2.0 million,respectively.

 

**Stock–Based Compensation**

 

The Company has elected tofollow APB No. 25, Accounting for Stock Issued to Employees, and relatedinterpretations in accounting for its employee stock options because thealternative fair value accounting provided for under SFAS No. 123, Accountingfor Stock-Based Compensation, as amended by SFAS 148, Accounting for Stock-Based Compensation —Transition and Disclosure, issued in December 2002, requires the use of option valuation modelsfor traded options that were not developed for use in valuing employee stockoptions which have vesting restrictions and are not traded. Under APB 25, whenthe exercise price of the Company’s employee stock options is not less than thefair value for the underlying stock on the date of grant no compensationexpense is recognized. At the time stock options were granted, the Companybelieved that the exercise price was at a price not less than the fair value ofthe underlying common stock. In conjunction with the Company’s initial publicoffering, the Company reviewed its exercise prices and arrived at the deemedfair value for each option grant during 1999. With respect to the 3,220,500options granted during 1999 and through March 27, 2000, the Company recordeddeferred compensation of $5.4 million for the difference between the exerciseprice per share and the deemed fair value per share at the grant date. Theapproximate weighted-average exercise price per share and the approximateweighted-average deemed fair value per share for the options was $1.64 and$3.31, respectively. Deferred stock compensation was recognized and amortizedon an accelerated 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 ofDecember 31, 2003.

 

Deferred compensation foroptions and warrants granted to non-employees has been determined at the grantdate in accordance with SFAS No. 123, as amended by SFAS 148, and Emerging Issues Task Force (EITF) No.96-18, Accounting for Equity Instruments that are Issued to Other thanEmployees for Acquiring, or in Conjunction with Selling Goods or Services, andhas been recorded at the fair value of the consideration received or the fairvalue of the equity instruments issued, whichever is more reliably measured.Such deferred compensation is recognized over the period the related servicesare rendered.

 

46

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Pro forma informationregarding net income (loss) is required by SFAS 123, as amended by SFAS 148,and has been determined as if the Company has accounted for its employee stockoptions under the fair value method of SFAS 123, as amended by SFAS 148. Thepro forma effects of stock-based compensation on net income and net income pershare have been estimated at the date of grant using the Black-Scholes optionpricing model based on the following weighted average assumptions since theCompany’s initial public offering in March of 2000: risk free interest rates of2.36% to 6.0%, dividend yields of 0%, expected volatility of 95% to 132%, andlife of 5 years..

 

The Company’s adjusted proforma information is as follows (in thousands, except per share amounts):

 
|                                                                                                              |   | **Years  Ended December 31,** |   |
|-------------------------------------------------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                                                              |   | **2003**                      |   | **2002** |   | **2001** |   |
| Net income as reported                                                                                            |   | $                             | 16,688 |   | $ | 16,737 |   | $ | 3,116 |   |
|                                                                                                              |   |                          |   |   |   |   |   |
| Add: Stock-based employee compensation cost  included in net income as reported, net of tax (1), (2)              |   | 51                            |   | 448 |   | 831 |   |
|                                                                                                              |   |                          |   |   |   |   |   |
| Deduct: Total stock-based compensation expense  determinedunder fair  value method for all awards, net of tax (2) |   | (8,255                        | )      | (11,146 | ) | (6,142 | ) |
|                                                                                                              |   |                          |   |   |   |   |   |
| Pro forma net income (loss)                                                                                       |   | $                             | 8,484  |   | $ | 6,039 |   | $ | (2,195 | ) |
|                                                                                                              |   |                          |   |   |   |   |   |
| Basic net income per share as reported                                                                            |   | $                             | 0.76   |   | $ | 0.79 |   | $ | 0.16 |   |
|                                                                                                              |   |                          |   |   |   |   |   |
| Pro forma basic net income (loss) per share                                                                       |   | $                             | 0.38   |   | $ | 0.28 |   | $ | (0.11 | ) |
|                                                                                                              |   |                          |   |   |   |   |   |
| Diluted net income per share as reported                                                                          |   | $                             | 0.73   |   | $ | 0.72 |   | $ | 0.14 |   |
|                                                                                                              |   |                          |   |   |   |   |   |
| Pro forma diluted net income (loss) per share                                                                     |   | $                             | 0.37   |   | $ | 0.26 |   | $ | (0.10 | ) |

 

----

(1)          The Company was recognizing deferredstock-based compensation expense on the deemed fair value of options grantedprior to the initial public offering in March 2000.  This expense was amortized on an accelerated basis , inaccordance with FIN 28, over approximately a four-year period, which began inMarch 2000.

 

(2)          TheCompany had an effective tax rate of 38%, (5%), and 3% in 2003, 2002 and 2001,respectively.  Because of the taxbenefit of 5% in 2002, the additions and deductions were assumed to beunaffected.

 

For purposes of pro forma disclosures, the estimated fair value isamortized to expense over the options vesting period.  The effect of applying SFAS 123, as amended by SFAS 148, forpurposes of providing pro forma disclosures may not be representative of theeffects on our operating results in future years.

 

47

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**Comprehensive Income**

 

TheCompany has adopted SFAS No. 130, Reporting Comprehensive Income, whichrequires that all components of comprehensive income, including net income, bereported in the financial statements in the period in which they arerecognized. Comprehensive income is defined as the change in equity during aperiod from transactions and other events and circumstances from non-ownersources. Net income and other comprehensive income, including foreign currencytranslation adjustments, and unrealized gains and losses on investments, shallbe reported, net of their related tax effect, to arrive at comprehensiveincome. Comprehensive income for the years ended December 31, 2003, 2002 and2001 was $16.2 million, $17.2 million and $3.2 million, respectively. Thedifference from reported net income is due to the changes in unrealized gain(loss) on marketable securities for the years ended December 31, 2003, 2002 and2001 of ($461,000), $416,000 and $35,000, respectively.

 

**Net Income Per Share**

 

Websensecomputes net income per share in accordance with SFAS No. 128, Earnings PerShare (“EPS”). Under the provisions of SFAS No. 128, basic net income per shareis computed by dividing the net income for the period by the weighted averagenumber of common shares outstanding during the period. Diluted net income pershare is computed by dividing the net income for the period by the weightedaverage number of common and common equivalent shares outstanding during theperiod. Common equivalent shares for all periods presented consist of dilutivestock options.

 

Dilutive securities includeoptions, warrants and preferred stock as if converted and restricted stocksubject to vesting. In 2003, the difference between the weighted average sharesused in determining basic EPS versus diluted EPS related to dilutive stockoptions and warrants totaled 938,000. Potentially dilutive securities totaling1,376,000, 1,413,000 and 335,000 for the years ended December 31, 2003, 2002and 2001, respectively, were excluded from historical basic and dilutedearnings per share because of their anti-dilutive effect.

 

48

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Thefollowing is a reconciliation of numerator and denominator of Basic EPS to thenumerator and denominator of Diluted EPS for all periods presented.

 
|                             |   | **Net Income(Numerator)**                     |       | **Shares(Denominator)** |       | **Per ShareAmount** |       |
|----------------------------------|--------|-----------------------------------------------|------------|-------------------------|------------|---------------------|------------|
|                             |   | **(In  thousands, except per share amounts)** | ** ** |
| **For the Twelve Months Ended:** |   |                                          | ** ** |                    | ** ** |                | ** ** |
| **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 |   |
|                             |   |                                          | ** ** |                    | ** ** |                | ** ** |
| **December 31, 2002:**           |   |                                          | ** ** |                    | ** ** |                | ** ** |
| Basic EPS                        |   | $                                             | 16,737     |                    | 21,211     |                | $          | 0.79 |   |
| Effect of options                |   | —                                        |       | 2,127                   |       | (0.07               | )          |
| Diluted EPS                      |   | $                                             | 16,737     |                    | 23,338     |                | $          | 0.72 |   |
|                             |   |                                          |       |                    |       |                |       |
| **December 31, 2001:**           |   |                                          |       |                    |       |                |       |
| Basic EPS                        |   | $                                             | 3,116      |                    | 20,082     |                | $          | 0.16 |   |
| Effect of options                |   | —                                        |       | 2,698                   |       | (0.02               | )          |
| Diluted EPS                      |   | $                                             | 3,116      |                    | 22,780     |                | $          | 0.14 |   |

 

**Recently Issued Accounting Standards**

 

In May 2003, the Financial Accounting Standards Board (FASB) issuedSFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity.”  This statement clarifiesthe definition of a liability, as currently defined under FASB ConceptsStatement No. 6 “Elements of Financial Statements”, as well as other items. The statement requires that financial instruments that embody anobligation of an issuer be classified as a liability.  Furthermore, thestandard provides guidance for the initial and subsequent measurement as wellas disclosure requirements of these financial instruments.  This statementis effective for financial instruments entered into after May 31, 2003. The adoption of this statement has not had a material impact on ourresults of operations or financial condition.

 

49

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In April 2003, the FASB issued SFAS No. 149,“Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This statement amends and clarifies the financial accounting andreporting requirements, as were originally established in FASB Statement No.133, for derivative instruments and hedging activities.  FASB StatementNo. 149 provides greater clarification of the characteristics of a derivativeinstrument so that contracts with similar characteristics will be accounted forconsistently.  This statement is effective for contracts entered into ormodified after June 30, 2003, as well as for hedging relationships designatedafter June 30, 2003, excluding certain implementation issues that have been effectiveprior to this date under FASB Statement No. 133.  The adoption of thisstatement has not had a material impact on our results of operations orfinancial condition.

 

**2. Marketable Securities**

 

Investmentsin marketable securities consisted of the following at December 31, 2003 (inthousands):

 
|               |   | **Amortized  Cost** |    | **Unrealized  Gains** |   | **Unrealized  (Losses)** |   | **Estimated  Fair  Value** |   |
|--------------------|--------|---------------------|---------|-----------------------|--------|--------------------------|--------|----------------------------|--------|
| Auction Rate Notes |   | $                   | 94,147  |                  | $      | 1                        |   | $                          | — |   | $ | 94,148 |   |
| Municipal Bonds    |   | 53,373              |    | 14                    |   | —                   |   | 53,387                     |   |
|               |   | $                   | 147,520 |                  | $      | 15                       |   | $                          | — |   | $ | 147,535 |   |

 

Investments in marketable securities consisted ofthe following at December 31, 2002 (in thousands):

 
|                  |   | **Amortized  Cost** |    | **Unrealized  Gains** |   | **Unrealized  (Losses)** |   | **Estimated Fair  Value** |   |
|-----------------------|--------|---------------------|---------|-----------------------|--------|--------------------------|--------|---------------------------|--------|
| Action Rate Notes     |   | $                   | 32,450  |                  | $      | —                   |   | $                         | — |   | $ | 32,450 |   |
| Commercial Paper      |   |                | 4,032   |                  |   | —                   |   |                      | — |   |   | 4,032 |   |
| Government Securities |   | 54,223              |    | 296                   |   | —                   |   | 54,519                    |   |
| Corporate Bonds       |   | 20,022              |    | 180                   |   | —                   |   | 20,202                    |   |
|                  |   | $                   | 110,727 |                  | $      | 476                      |   | $                         | — |   | $ | 111,203 |   |

 

50

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**The amortized cost and estimatedfair value of the securities at December 31, 2003 and 2002, by contractualmaturity, are shown below (in thousands).**

 
|                      |   | **2003**            |    | **2002**       |       |
|---------------------------|--------|---------------------|---------|----------------|------------|
|                      |   | **Amortized  Cost** |    | **Fair Value** | ** ** | **Amortized  Cost** | ** ** | **Fair Value** | ** ** |
| Due within 1 year         |   | $                   | 104,189 |           | $          | 104,194 |   | $ | 67,128 |   | $ | 67,333 |   |
|                      |   |                |    |           |       |   |   |   |   |
| Due between 1 and 3 years |   | 43,331              |    | 43,341         |       | 43,599 |   | 43,870 |   |
|                      |   | $                   | 147,520 |           | $          | 147,535 |   | $ | 110,727 |   | $ | 111,203 |   |

 

Realized gains from investments in marketable securities were $194,000 in 2003, $8,000 in 2002 and $53,000 in 2001.

 

**3. Property and Equipment**

 

Property and equipment consist of the following (in thousands):

 
|                           |   | **Estimated**    |   | **December 31,** |   |
|--------------------------------|--------|------------------|--------|------------------|--------|
|                           |   | **Useful Lives** |   | **2003**         |   | **2002** |   |
|                           |   |             |   |             |   |   |   |
| Computer hardware and software |   | 3 years          |   | $                | 8,804  |   | $ | 6,973 |   |
| Office furniture and equipment |   | 3 years          |   | 1,853            |   | 1,678 |   |
| Other equipment                |   | 3 years          |   | 307              |   | 267 |   |
|                           |   |             |   | 10,964           |   | 8,918 |   |
|                           |   |             |   |             |   |   |   |
| Accumulated depreciation       |   |             |   | (7,967           | )      | (5,951 | ) |
|                           |   |             |   |             |   |   |   |
|                           |   |             |   | $                | 2,997  |   | $ | 2,967 |   |

 

Depreciation expense for 2003, 2002 and 2001 was$2.0 million, $1.9 million and $1.7 million, respectively.

 

51

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**4. Geographic Information**

 

The following illustrates revenues attributed tocustomers located in the Company’s country of domicile (the United States) andthose attributed to foreign customers (in thousands):

 
|                           |   | **Years Ended December 31,** |   |
|--------------------------------|--------|------------------------------|--------|
|                           |   | **2003**                     |   | **2002** |   | **2001** |   |
| United States                  |   | $                            | 56,006 |   | $ | 41,456 |   | $ | 23,377 |   |
| Europe, Middle East and Africa |   | 16,932                       |   | 11,888 |   | 7,242 |   |
| Asia\Pacific                   |   | 4,045                        |   | 4,085 |   | 3,273 |   |
| Canada and Latin America       |   | 4,751                        |   | 3,536 |   | 2,001 |   |
|                           |   | $                            | 81,734 |   | $ | 60,965 |   | $ | 35,893 |   |

 

TheUnited Kingdom represented $7.4 million, $4.9 million and $3.6 million of totalrevenue for the years ended 2003, 2002 and 2001, respectively. No other foreigncountry represented more than 5% of total revenue.

 

**5. Deferred Revenue**

 

The Company expects to recognize revenues related tosubscriptions in existence as of December 31, 2003 as follows (in thousands):

 
| 2004   |   | $      | 65,480 |   |
|--------|--------|--------|--------|--------|
| 2005   |   | 20,600 |   |
| 2006   |   | 7,595  |   |
| 2007   |   | 247    |   |
| 2008   |   | 38     |   |
|   |   | $      | 93,960 |   |

 

**6. Commitments and Guarantees**

 

The Company leases its facilities and certainequipment under non-cancelable operating leases, which expire at various datesthrough December 2007. The facilities leases contain renewal options and aresubject to cost increases.

 

Future minimum annual lease payments undernon-cancelable operating leases at December 31, 2003 are as follows (inthousands):

 
| 2004   |   | $     | 1,158  |   |
|--------|--------|-------|--------|--------|
| 2005   |   | 1,193 |   |
| 2006   |   | 1,228 |   |
| 2007   |   | 1,253 |   |
|   |   | $     | 4,832  |   |

 

Rent expense totaled $2.3 million, $2.0 million and$1.6 million for the years ended December 31, 2003, 2002 and 2001,respectively.

 

52

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*Guaranteesof Indebtedness of Others (FIN 45)*  FIN 45 elaborates onpreviously existing disclosure requirements for most guarantees, including loanguarantees such as standby letters of credit. It also clarifies that at thetime a company issues a guarantee, the company must recognize an initialliability for the fair value, or market value, of the obligations it assumesunder the guarantee and must disclose that information in its interim andannual financial statements. The provisions related to recognizing a liabilityat inception of the guarantee for the fair value of the guarantor’s obligationsdoes not apply to product warranties, indemnifications or to guaranteesaccounted for as derivatives. The initial recognition and initial measurementprovisions apply on a prospective basis to guarantees issued or modified afterDecember 31, 2002.

 

We provide indemnifications of varying scope andsize to certain customers against claims of intellectual property infringementmade by third parties arising from the use of our products. We evaluateestimated losses for such indemnifications under SFAS 5, Accounting forContingencies, as interpreted by FIN 45. We consider such factors as the degreeof probability of an unfavorable outcome and the ability to make a reasonableestimate of the amount of loss. To date, we have not encountered material costsas a result of such obligations and have not accrued any liabilities related tosuch indemnifications in our financial statements.

 

**7. Stockholders’ Equity**

 

**Convertible Preferred Stock**

 

All previously issued preferred stock automaticallyconverted into common stock concurrent with the closing of the Company’sinitial public offering of common stock on March 28, 2000. The Company issued7,037,036 shares of common stock upon conversion of Series A and Series Bconvertible preferred stock.

 

**Warrants**

 

In connection with the Company’s Series Bconvertible preferred stock offering between June and September 1999, theCompany issued warrants to purchase 62,500 shares of common stock for $3.00 pershare to financial consultants. The warrants are exercisable in whole or inpart at any time and from time to time until their expiration in June 2004. InApril 2000, warrants to purchase 4,688 shares of common stock were exercised.In November 2001, warrants to purchase 23,437 shares of common stock wereexercised. In July 2003, warrants to purchase 4,000 shares of common stock wereexercised, which resulted in 3,406 shares of common stock being issued due tothe cashless exercise of these warrants. The Company has reserved 30,375 sharesof common stock for issuance upon exercise of the remaining warrants.

 

53

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**Stock Option Plan**

 

In May 1998, the Board of Directors elected toreplace the 1997 Stock Option/Stock Issuance Plan with the 1998 StockOption/Stock Issuance Plan (the “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 provides forthe grant of incentive and non-statutory options and issuances of common stockto employees, directors and consultants.

 

In February 2000, the Board of Directors replacedthe 1998 Stock Plan with the 2000 Stock Incentive Plan (the “2000 Plan”) underwhich 4,500,000 shares of the Company’s common stock were initially authorizedfor future issuance, and reserved for purchase upon exercise of optionsgranted. In addition, the 2000 Plan provides for automatic annual increases inthe number of shares authorized and reserved for issuance thereunder (beginningin 2001) equal to the lesser of (i) 4% of the Company’s outstanding shares onthe last business day in December of the calendar year immediately preceding or(ii) 1,500,000 shares. At December 31, 2003, 6,981,410 shares were authorizedand reserved for issuance under the 2000 Plan.

 

The 2000 Plan provides for the grant of options tothe Company’s directors, officers, employees and consultants. The 2000 Planprovides for the grant of incentive and non-statutory stock options and rightsto purchase stock to employees, directors or consultants of the Company. The2000 Plan provides that incentive stock options will be granted only toemployees and are subject to certain limitations as to fair value during acalendar year.

 

The exercise price of incentive stock options mustequal at least the fair value on the date of grant and the exercise price ofnon-statutory stock options and the issuance price of common stock under thestock issuance program may be no less than 85% of the fair value on the date ofgrant or issuance. The options are exercisable for a period of up to ten yearsafter the date of grant and generally vest 25% one year from date of grant andratably each month thereafter for a period of 36 months. Unvested common sharesobtained through early exercise of options are subject to repurchase by theCompany at the original issue price. To date only non-statutory options havebeen granted under the 2000 Plan.

 

In 2002, the Company issued options as an incentivefor certain persons to commence employment that were not covered under the 2000Plan.  In accordance with Section4350(i) of the NASD Marketplace Rules for the Nasdaq Stock Market, the Companyissued 177,000 such options, which have substantially the same terms as optionsissued under the 2000 Plan.

 

54

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The following table summarizes stock option activityunder the 1998 and 2000 Stock Plans and options issued in 2002 not coveredunder a formal plan and related information through December 31, 2003:

 
|                         |   | **Number of  Shares** |   | **Weighted  Average  Exercise  Price** |   |
|------------------------------|--------|-----------------------|--------|----------------------------------------|--------|
| Balance at December 31, 2000 |   | 3,408,685             |   | $                                      | 3.38   |   |
| Granted                      |   | 1,567,600             |   | $                                      | 14.85  |   |
| Exercised                    |   | (781,876              | )      | $                                      | 1.99   |   |
| Cancelled                    |   | (252,641              | )      | $                                      | 8.02   |   |
| Balance at December 31, 2001 |   | 3,941,768             |   | $                                      | 7.92   |   |
| Granted                      |   | 1,592,050             |   | $                                      | 24.28  |   |
| Exercised                    |   | (1,028,554            | )      | $                                      | 3.91   |   |
| Cancelled                    |   | (242,428              | )      | $                                      | 18.59  |   |
| Balance at December 31, 2002 |   | 4,262,836             |   | $                                      | 14.39  |   |
| Granted                      |   | 971,750               |   | $                                      | 17.45  |   |
| Exercised                    |   | (952,391              | )      | $                                      | 20.94  |   |
| Cancelled                    |   | (347,119              | )      | $                                      | 21.82  |   |
| Balance at December 31, 2003 |   | 3,935,076             |   | $                                      | 16.77  |   |

 

The following table summarizes all optionsoutstanding and exercisable by price range as of December 31, 2003:

 
|                          |   | **Options  Outstanding** |       | **Options  Exercisable**                                     |       |
|-------------------------------|--------|--------------------------|------------|--------------------------------------------------------------|------------|
| **Range of  Exercise Prices** |   | **Number of  Shares**    | ** ** | **Weighted  Average  Remaining  Contractual Life  In Years** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number of****Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.20-$11.25                  |   | 971,691                  |       | 5.99                                                         |       | $ | 4.85 |   | 845,089 |   | $ | 3.97 |   |
| $11.61-$14.98                 |   | 947,272                  |       | 8.55                                                         |       | $ | 14.08 |   | 165,284 |   | $ | 13.50 |   |
| $15.00-$22.83                 |   | 790,548                  |       | 8.38                                                         |       | $ | 18.26 |   | 230,055 |   | $ | 17.61 |   |
| $22.88-$27.86                 |   | 1,019,690                |       | 8.22                                                         |       | $ | 26.84 |   | 438,668 |   | $ | 27.16 |   |
| $27.90-$34.25                 |   | 205,875                  |       | 7.93                                                         |       | $ | 29.83 |   | 105,074 |   | $ | 29.79 |   |
|                          |   |                     |       |                                                         |       |   |   |   |   |   |   |
|                          |   | 3,935,076                |       | 7.77                                                         |       | $ | 16.77 |   | 1,784,170 |   | $ | 13.83 |   |

 

The weighted average fair value of options grantedduring 2003, 2002 and 2001 was $17.45, $18.67 and $7.54 per share,respectively.

 

55

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**Employee Stock Purchase Plan**

 

In February 2000, the Company adopted the 2000Employee Stock Purchase Plan. The purchase plan provides for automatic annualincreases in the number of shares reserved for issuance thereunder (beginningin 2001) equal to the lesser of (i) 1% of the Company’s outstanding shares onthe last business day in December of the calendar year immediately preceding or(ii) 375,000 shares. The purchase plan is intended to qualify as an employeestock purchase plan within the meaning of Section 423 of the Internal RevenueCode. Under the purchase plan, the Board of Directors may authorizeparticipation by eligible employees, including officers, in periodic offeringsfollowing commencement of the purchase plan. Shares issued and available forissuance as of December 31, 2003 are as follows:

 
| Shares reserved for issuance at December 31, 2000                                              |   | 212,910  |   |
|------------------------------------------------------------------------------------------------|--------|----------|--------|
| Shares reserved for issuance during 2001 based on  the automatic increase in shares authorized |   | 197,049  |   |
| Shares issued during 2001                                                                      |   | (85,459  | )      |
| Shares reserved for issuance at December 31, 2001                                              |   | 324,500  |   |
| Shares reserved for issuance during 2002 based on  the automatic increase in shares authorized |   | 205,960  |   |
| Shares issued during 2002                                                                      |   | (109,781 | )      |
| 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  |   |

 

Unless otherwise determined by the Board, employeesare eligible to participate in the purchase plan provided they are employed forat least 20 hours per week and are customarily employed for at least fivemonths per calendar year. Employees who participate in an offering may have upto 15% of their earnings withheld pursuant to the purchase plan. The amountwithheld is then used to purchase shares of common stock on specified dates.The price of common stock purchased pursuant to the plan will be equal to 85%of the lower of the fair market value of the common stock at the commencementdate of each offering period or the relevant purchase date. Employees may endtheir participation in the offering at any time during the offering period, andparticipation ends automatically on termination of employment.

 

**Shares Reserved for Future Issuance**

 

The following shares of common stock are reservedfor future issuance as of December 31, 2003:

 
| Stock options:             |   |      |   |
|----------------------------|--------|-----------|--------|
| Granted and outstanding    |   | 3,935,076 |   |
| Reserved for future grants |   | 317,473   |   |
|                       |   | 4,252,549 |   |
| Warrants                   |   | 30,375    |   |
| Total:                     |   | 4,282,924 |   |

 

56

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**TreasuryStock**

 

OnApril 3, 2003, the Company announced that its Board of Directors authorized astock repurchase program of up to 2 million shares of our common stock. Therepurchases will be made from time to time on the open market at prevailing marketprices or in privately negotiated transactions. Depending on market conditionsand other factors, purchases under this program may be commenced or suspendedat any time, or from time to time, without prior notice. As of December 31,2003, 396,000 shares of common stock had been repurchased under this program,for an aggregate of  $7.7 million at anaverage price of $19.40 per share.

 

**8. Income Taxes**

 

The provision (benefit) for income taxes is as follows:

 
|                         |   | **December  31,**  | ** ** |
|------------------------------|--------|--------------------|------------|
|                         |   | **2003**           |       | **2002** | ** ** | **2001** | ** ** |
|                         |   | **(In thousands)** | ** ** |
| Current                      |   |               |       |   |   |   |   |
| Federal                      |   | $                  | 10,103     |   | $ | 7,255 |   | $ | — |   |
| Foreign                      |   | 401                |       | 557 |   | 108 |   |
| State                        |   | 1,864              |       | 1,792 |   | — |   |
|                         |   | 12,368             |       | 9,604 |   | 108 |   |
| Deferred                     |   |               |       |   |   |   |   |
| Federal                      |   | (1,735             | )          | (7,685 | ) | — |   |
| Foreign                      |   |               |       |   |   | — |   |
| State                        |   | (238               | )          | (2,716 | ) | — |   |
|                         |   | (1,973             | )          | (10,401 | ) | — |   |
|                         |   |               |       |   |   |   |   |
| Income Tax Expense (Benefit) |   | $                  | 10,395     |   | $ | (797 | ) | $ | 108 |   |

 

The reconciliation of incometax computed at the federal statutory rate to the provision (benefit) forincome taxes is as follows:

 
|                |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------|--------|----------|--------|----------|--------|----------|--------|
|                |   |     |   |     |   |     |   |
| Statutory Rate      |   | 35.0     | %      | 35.0     | %      | 35.0     | %      |
| Foreign tax         |   | 0.1      |   | 7.3      |   | 3.3      |   |
| State tax           |   | 5.9      |   | 8.1      |   | 5.1      |   |
| Valuation allowance |   | (0.1     | )      | (54.6    | )      | (20.0    | )      |
| Credits             |   | (1.2     | )      | (0.8     | )      | (16.4    | )      |
| Tax-exempt interest |   | (0.8     | )      | —   |   | —   |   |
| Other               |   | (0.5     | )      | —   |   | (3.8     | )      |
|                |   | 38.4     | %      | (5.0     | )%     | 3.2      | %      |

 

57

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Significant components of the Company’s deferred tax assets andliabilities as of December 31, 2003 and 2002 are as follows:

 
|                                        |   | **2003**           |       | **2002** |   |
|---------------------------------------------|--------|--------------------|------------|----------|--------|
|                                        |   | **(In thousands)** | ** ** |
| Deferred tax assets                         |   |               |       |     |   |
| Net operating loss carryforwards            |   | $                  | 184        |     | $      | 410 |   |
| Tax credit carryforwards                    |   | 0                  |       | 2,571    |   |
| Deferred revenue                            |   | 16,395             |       | 11,359   |   |
| Foreign deferred taxes                      |   | 464                |       | 490      |   |
| Other                                       |   | 826                |       | 1,092    |   |
| Total deferred tax assets                   |   | 17,869             |       | 15,922   |   |
|                                        |   |               |       |     |   |
| Valuation allowance for deferred tax assets |   | (464               | )          | (490     | )      |
| Net deferred taxes                          |   | $                  | 17,405     |     | $      | 15,432 |   |

 

A valuationallowance is required when it is more likely than not that all or a portion ofa deferred tax asset will not be realized. Periodically, management reassesses the need for a valuationallowance.  At December 31, 2003, thevaluation allowance related to net operating losses generated in 2002 by theCompany’s wholly-owned subsidiary in Ireland. During 2002, the Company released the valuation allowance against itsU.S. deferred tax assets.

 

At December31, 2003, the Company has California tax net operating loss carryforwards ofapproximately $3.2 million, which will begin to expire in 2005 unlesspreviously utilized.  Californialegislation suspended the utilization of California net operating losscarryforwards during 2002 and 2003.

 

Pursuant toInternal Revenue Code (IRC) Sections 382 and 383, use of the Company’s tax lossand credit carryforwards may be limited if a cumulative change in ownership ofmore than 50% occurs within a three year period. Based on IRC Sections 382 and383, management believes that a change in ownership may have occurred. However,management does not believe that such change would have a significant impact onthe Company’s ability to utilize its tax loss and credit carryforwards.

 

As ofDecember 31, 2003, the Company had approximately $2.2 million of undistributedearnings related to its foreign subsidiaries. Management believes that theseearnings will be indefinitely reinvested; accordingly, the Company has notprovided for 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 liabilityupon such a distribution would be approximately $0.1 million.

 

It is theCompany’s policy to establish reserves for taxes that may become payable infuture years as a result of an examination by tax authorities. The Companyestablishes the reserves based upon management’s assessment of exposureassociated with permanent tax differences, tax credits and interest expenseapplied to temporary difference adjustments. The tax reserves are analyzedperiodically and adjustments are made as events occur to warrant adjustment tothe reserve.

 

58

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**9. Employee Retirement Plan**

 

Effective May 1, 1997, the Company established a 401(k) definedcontribution retirement plan (401(k) Plan) covering substantially allemployees. The 401(k) Plan provides for voluntary employee contributions from1% to 50% of annual compensation, as defined, and did not provide for matchingcontributions from the Company as of December 31, 2003.  In January 2004, the Company’s Board ofDirectors approved a discretionary employer matching contribution of 25% foreach employee deferral contribution made during the plan year, up to 6% of theparticipant’s compensation. 

 

59

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**Item 9.Changes in and Disagreements with Accountants on Accounting and FinancialDisclosure**

 

None

 

**Item 9A. Controls and Procedures**

 

**Disclosure Controls and Procedures**

** **

**We maintain disclosure controlsand procedures, (as defined in Rules 13a – 15(e) and 15d – 15(e) of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)), designed toensure that we are able to collect the information we are required to disclosein the reports we file under the Exchange Act, and to record, process,summarize and report this information within the time periods specified in therules of the Securities and Exchange Commission.**Our Chief Executive and Chief Financial Officers evaluated ourdisclosure controls and procedures as of the end of the period covered by thisreport. Based on their evaluation, our Chief Executive and Chief FinancialOfficers have concluded that these controls and procedures are effective.

** **

**We also maintain a system ofinternal control over financial reporting (as defined in Rules 13a – 15(f) and15d – 15(f) of the Exchange Act) designed to provide reasonable assurance thattransactions are executed in accordance with management’s general or specificauthorization and that transactions are recorded as necessary (1) to permitpreparation of financial statements in conformity with generally acceptedaccounting principles, and (2) to maintain accountability for assets. Access toassets is permitted only in accordance with management’s general or specificauthorization, and the recorded accountability for assets is compared with theexisting assets at reasonable intervals and appropriate action is taken withrespect to any differences.**

 

Since thedate of the most recent evaluation of our internal control over financialreporting by our Chief Executive and Chief Financial Officers, there have beenno significant changes in our internal control over financial reporting or inother factors that could significantly affect our internal control over financialreporting, including any corrective actions with regard to significantdeficiencies and material weaknesses.

** **

**PART III**

 

**Item 10. Directors and Executive Officers of the Registrant**

 

(a) Directors. Information concerning our directorsis incorporated by reference from the section captioned *“Proposal 1: Election of Directors”*contained in our Proxy Statement related to the Annual Meeting of Stockholdersto be held on June 2, 2004.

 

(b) Executive Officers. Information concerning ourexecutive officers is set forth under the section captioned *“Executive Officers”* in Part I of thisreport.

 

(c) Compliance with Section 16(a) of the ExchangeAct. Information concerning compliance with Section 16(a) of the Exchange Actis incorporated by reference from the section captioned *“Section 16(a) Beneficial Ownership ReportingCompliance”* contained in our Proxy Statement related to the AnnualMeeting of Stockholders to be held on June 2, 2004.

 

(d) The company has adopted a *Code of Business Conduct* which, togetherwith the policies referred to therein, is applicable to all directors, officersand employees of the company.  Inaddition, the company has adopted a *Code ofEthics for the Chief Executive Officer, Senior Financial Officers and AllFinance*

 

60

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*and Accounting Department Personnel* (“*Code ofEthics*”).  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 company encourages all employee,officers and directors to promptly report any violations of any of thecompany’s policies.  In the event thatan amendment to, or a waiver from, a provision of the *Code of Business Conduct* or *Code of Ethics* that applies to any of ourdirectors or executive officers is necessary, the company intends to post suchinformation on its website. A copy of our *Codeof Business Conduct* and our *Codeof Ethics* can be obtained from our website at *www.websense.com/investors/governance/*.

 

**Item 11****. Executive Compensation**

 

The information required by item 11 of Form 10-K isincorporated by reference from the information contained in the sectioncaptioned *“Executive Compensation and OtherInformation”* in our Proxy Statement related to the Annual Meeting ofStockholders to be held on June 2, 2004.

 

**Item12. Security Ownership of**Certain Beneficial Ownersand Management and Related Stockholder Matters

** **

**The information required by item 12 concerning securityownership of certain beneficial owners and management is incorporated byreference from the information contained in the section captioned *“Ownership of Securities”* in our ProxyStatement related to the Annual Meeting of Stockholders to be held on June 2,2004.**

** **

**The following table provides information as of December 31,2003 with respect to the shares of the Company’s common stock that may beissued under the Company’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 reflected in  column (a))** |        |
|---------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|-----------|-------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|
| **Equity  compensation plans approved by security holders (1)**     |   | **3,771,742**                                                                                       | ** ** | **$**                                                                                  | **16.87** | ** **                                                                                                                                            | **804,757** | **(3)** |
|                                                                |   |                                                                                                |       |                                                                                   |      |                                                                                                                                                  |        |
| **Equity  compensation plans not approved by security holders (2)** |   | **193,709**                                                                                         | ** ** | **$**                                                                                  | **12.63** | ** **                                                                                                                                            | **—**  | ** ** |
|                                                                |   |                                                                                                |       |                                                                                   |      |                                                                                                                                                  |        |   |
| **Total**                                                           |   | **3,965,451**                                                                                       | ** ** | **$**                                                                                  | **16.66** | ** **                                                                                                                                            | **804,757** | ** ** |

 

----

**(1)**          Consistssolely of the 2000 Stock Incentive Plan and the Employee Stock Purchase Plan.

**(2)**          Consistsof 177,000 stock option grants made to certain new employees in 2002 in orderto induce them to commence employment with the company, of which 163,334 areoutstanding, and 30,375 warrants to purchase common stock issued to financialconsultants in connection with the Company’s Series B preferred stock offering in1999.  The stock options havesubstantially the same terms as stock options issued under the 2000 StockIncentive Plan and have a weighted

 

61

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**average exercise price of $14.42per share. The warrants are exercisable at any time prior to their expirationin June 2004 at an average exercise price of $3.00 per share.**

** **

**(3)**          Consistsof shares available for future issuance under the Employee Stock Purchase Planand the 2000 Stock Incentive Plan.  Asof December 31, 2003, an aggregate of 487,284 shares of Common Stock wereavailable for issuance under the Employee Stock Purchase Plan and 804,757shares of Common Stock were available for issuance under the Employee StockPurchase Plan and the 2000 Stock Incentive Plan.  The number of shares of Common Stock available for issuance underthe Employee Stock Purchase Plan and the 2000 Stock Incentive Planautomatically increases on the first trading day of January each calendar yearby an amount equal to 1% and 4%, respectively, of the total number of shares ofCommon Stock outstanding on the last trading day of December in the immediatelypreceding calendar year but in no event will any such increase exceed 375,000shares and 1,500,000 shares, respectively, of Common Stock.

** **

**Item 13. Certain Relationships and Related Transactions**

** **

The information required by item 13 isincorporated by reference from the information contained in the sectioncaptioned *“Certain Relationships andRelated Transactions”* in our Proxy Statement related to the Annual Meeting of Stockholdersto be held on June 2, 2004.

** **

**Item 14. Principal Accountant Fees and Services**

 

Theinformation required by item 14 is incorporated by reference from theinformation contained in the section captioned *“Proposal2: Ratification of Selection of Independent Auditors”* in our ProxyStatement related to the Annual Meeting of Stockholders to be held on June 2,2004.

 

62

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**PART IV**

 

**Item 15. Exh****ibits, Financial Statement Schedules and Reports on Form 8-K        **

 
| (a) The following documents are filed as part of this report: |                                                                             |
|---------------------------------------------------------------|----------------------------------------------------------------------------------|
|                                                          | 1. Financial Statement Schedules.  Schedule II Valuation and Qualifying Accounts |   |
|                                                               |                                                                                  |  |

 

Schedulesnot listed above have been omitted because they are not applicable, notrequired, or the information required to be set forth therein is included inthe 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)           |   | Warrant to Purchase Common Stock between Websense, Inc. and Alps  System Integration Co., Ltd., dated April 15, 1999                                                                                                                                                                                                                 |
| 10.4 (1)           |   | Form of Warrant to Purchase Common Stock between Websense, Inc. and  entities listed on Schedule A attached thereto, dated July 30, 1999                                                                                                                                                                                             |
| 10.5 (1)*          |   | Employment Agreement by and between Websense, Inc. and John B.  Carrington, dated May 10, 1999                                                                                                                                                                                                                                       |
| 10.6 (1)*          |   | Employment Agreement by and between Websense, Inc. and Douglas C.  Wride, dated June 11, 1999                                                                                                                                                                                                                                        |
| 10.7 (1)           |   | Lease Agreement between Websense, Inc. and Legacy-RECP Sorrento OPCO,  LLC, dated June 21, 1999, as amended                                                                                                                                                                                                                          |
| 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 (1)*         |   | 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 (1)*         |   | 2000 Employee Stock Purchase Plan                                                                                                                                                                                                                                                                                                    |
| 10.14 (1)          |   | Form of Indemnification Agreement between Websense, Inc. and its  directors                                                                                                                                                                                                                                                          |
| 10.15 (1)          |   | Form of Indemnification Agreement between Websense, Inc. and its  officers                                                                                                                                                                                                                                                           |
| 10.16 (2)          |   | Lease  Agreement between Websense, Inc. and Legacy-RECP Sorrento OPCO, LLC, dated  February 12, 2000                                                                                                                                                                                                                            |
| 10.17 (2)          |   | First Amendment to Lease Agreement between Websense, Inc. and Legacy-RECP Sorrento OPCO, LLC, dated June 2, 2000                                                                                                                                                                                                                |
| 10.18 (3)          |   | 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. |
| 21.1               |   | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                                       |
| 23.1               |   | Consent of Ernst & Young LLP, Independent Auditors                                                                                                                                                                                                                                                                               |
| 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).                                                                                                                                                                                                                          |

 

63

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| 32.2 |   | Certification  of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(b)  and 15d-14(b). |
|------|--------|-------------------------------------------------------------------------------------------------------------|

 

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*    Indicatesmanagement contract or compensatory plan or arrangement.

(1)          Previously filed as an exhibit to ourRegistration Statement on Form S-1 (Registration No. 333-95619) andincorporated herein by reference.

(2) Previously filed as an exhibit to our Form 10-K for the period endedDecember 31, 2000 and incorporated herein by reference.

(3)          Previously filed as an exhibit to our Form10-Q for the period ended June 30, 2003 and incorporated herein by reference.

 

(b) Reports on Form 8-K.

** **

**On October 21, 2003, the Companyfiled a Current Report on Form 8-K reporting that financial results for itsthird quarter ended September 30, 2003 were available in a press release datedOctober 21, 2003.**

 

SUPPLEMENTALINFORMATION

 

No Annual Report tostockholders or proxy materials has been sent to stockholders as of the date ofthis report. The Annual Report to stockholders and proxy material will befurnished to our stockholders subsequent to the filing of this report and wewill furnish such material to the SEC at that time.

 

64

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**SIGNATURES**

 

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

 

 
|   | WEBSENSE, INC. |                    |
|--------|----------------|-------------------------|
|   |           |
|   | By:            | /s/ Douglas C. Wride    |   |
|   |           | Douglas C. Wride        |
|   |           | Chief Financial Officer |
|        |                |                         |  |  |

 

Pursuant to the requirements of the Securities Exchange Actof 1934, this report has been signed below by the following persons on behalfof the registrant and in the capacities and on the dates indicated.

 
| **Signature**                |   | **Title**                                                             | **Date**       |
|------------------------------|--------|-----------------------------------------------------------------------|----------------|
|  /s/ John B. Carrington |   | Chairman of the Board and  Chief Executive Officer                    | March 12, 2004 |
|  John B. Carrington     |   |                                                                  |           |
|                         |   |                                                                  |           |
|  /s/ Douglas C. Wride   |   | Chief Financial Officer  (principal financial and accounting officer) | March 12, 2004 |
|  Douglas C. Wride       |   |                                                                  |           |
|                         |   |                                                                  |           |
|  /s/ Mark St.Clare      |   |                                                                  | March 12, 2004 |
|  Mark St.Clare          |   | Director                                                              |           |
|                         |   |                                                                  |           |
|  /s/ Bruce T. Coleman   |   |                                                                  | March 12, 2004 |
|  Bruce T. Coleman       |   | Director                                                              |           |
|                         |   |                                                                  |           |
|  /s/ John Schaefer      |   |                                                                  | March 12, 2004 |
|  John Schaefer          |   | Director                                                              |           |
|                         |   |                                                                  |           |
|  /s/ Gary E. Sutton     |   |                                                                  | March 12, 2004 |
|  Gary E. Sutton         |   | Director                                                              |           |
|                         |   |                                                                  |           |
|  /s/ Peter Waller       |   |                                                                  | March 12, 2004 |
|  Peter Waller           |   | Director                                                              |           |

 

65

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##### **ScheduleII — VALUATION AND QUALIFYING ACCOUNTS**

 

**WEBSENSE,INC.**

**(inthousands)**

 

 
| **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, 2001                           |   |                                 |       |                                |       |                                      |       |                      |       |   |   |
| Reserves and allowances deducted from asset  accounts: |   |                                 |       |                                |       |                                      |       |                      |       |   |   |
| Allowance for doubtful accounts                        |   | $125                                 |       | $226                                |       | $155                                      | (2)        | $172                      | (1)        | $334 |   |
| YEAR ENDED DECEMBER 31, 2002                           |   |                                 |       |                                |       |                                      |       |                      |       |   |   |
| Reserves and allowances deducted from asset  accounts: |   |                                 |       |                                |       |                                      |       |                      |       |   |   |
| Allowance for doubtful accounts                        |   | $334                                 |       | —                              |       | $250                                      | (2)        | $404                      | (1)        | $180 |   |
| YEAR ENDED DECEMBER 31, 2003                           |   |                                 |       |                                |       |                                      |       |                      |       |   |   |
| Reserves and allowances deducted from asset  accounts: |   |                                 |       |                                |       |                                      |       |                      |       |   |   |
| Allowance for doubtful accounts                        |   | $180                                 |       | —                              |       | $700                                      | (2)        | $355                      | (1)        | $525 |   |

 

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(1) Uncollectible accountswritten off, net of recoveries.

(2)Amount represents reserve recorded as a reduction of deferred revenue andrepresents customer balances deemed uncollectible. The reserve is amortized asa reduction of revenue over the average life of all subscriptions.

 

66

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**EXHIBIT INDEX**

 
| **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)   |   | Warrant to Purchase Common Stock between Websense, Inc. and Alps  System Integration Co., Ltd., dated April 15, 1999                                                                                                                                                                                                                 |
| 10.4 (1)   |   | Form of Warrant to Purchase Common Stock between Websense, Inc. and  entities listed on Schedule A attached thereto, dated July 30, 1999                                                                                                                                                                                             |
| 10.5 (1)*  |   | Employment Agreement by and between Websense, Inc. and John B.  Carrington, dated May 10, 1999                                                                                                                                                                                                                                       |
| 10.6 (1)*  |   | Employment Agreement by and between Websense, Inc. and Douglas C.  Wride, dated June 11, 1999                                                                                                                                                                                                                                        |
| 10.7 (1)   |   | Lease Agreement between Websense, Inc. and Legacy-RECP Sorrento OPCO,  LLC, dated June 21, 1999, as amended                                                                                                                                                                                                                          |
| 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 (1)* |   | 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 (1)* |   | 2000 Employee Stock Purchase Plan                                                                                                                                                                                                                                                                                                    |
| 10.14 (1)  |   | Form of Indemnification Agreement between Websense, Inc. and its  directors                                                                                                                                                                                                                                                          |
| 10.15 (1)  |   | Form of Indemnification Agreement between Websense, Inc. and its  officers                                                                                                                                                                                                                                                           |
| 10.16 (2)  |   | Lease  Agreement between Websense, Inc. and Legacy-RECP Sorrento OPCO, LLC, dated  February 12, 2000                                                                                                                                                                                                                            |
| 10.17 (2)  |   | First Amendment to Lease Agreement between Websense, Inc. and Legacy-RECP Sorrento OPCO, LLC, dated June 2, 2000                                                                                                                                                                                                                |
| 10.18 (3)  |   | 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. |
| 21.1       |   | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                                       |
| 23.1       |   | Consent of Ernst & Young LLP, Independent Auditors                                                                                                                                                                                                                                                                               |
| 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).                                                                                                                                                                                                                          |
| 32.2       |   | Certification  of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(b)  and 15d-14(b).                                                                                                                                                                                                                          |

 

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*    Indicatesmanagement contract or compensatory plan or arrangement.

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

#### **(2)**          Previouslyfiled as an exhibit to our Form 10-K for the period ended December 31, 2000 andincorporated herein by reference.

(3)          Previously filed as anexhibit to our Form 10-Q for the period ended June 30, 2003 and incorporatedherein by reference.

 

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