**UNITED STATESSECURITIES 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, 2004**                                                                                                          |
|                                                                                                                                                          |
| **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 RoadSan Diego, California 92121858-320-8000**   |
| (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 whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. (1) Yes ý  No o  (2) Yes ý  No o

 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12(b)-2): Yes ý  No o

 

The aggregate market value of the voting stock held by non-affiliates of the registrant, as of June 30, 2004 was approximately $793 million (based on the closing price for shares of the registrant’s Common Stock as reported by the Nasdaq National Market for that date). 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 persons may be deemed affiliates. Exclusion of shares held by any person should not be construed 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 the registrant.

 

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of February 28, 2005 was 23,745,455.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of the definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held June 7, 2005 are incorporated by reference into Part III.

 

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

 

 

 

**Websense,Inc.****Form 10-KFor the Fiscal Year Ended December 31, 2004**

 

**TABLE OF CONTENTS**

 
|      |                                                                                                                    | **Page**   |
|-----------|-------------------------------------------------------------------------------------------------------------------------|------------|
| Part I    |                                                                                                                    | ** ** |
| Item 1.   | Business                                                                                                                | 1          |
| Item  2.  | Properties                                                                                                              | 15         |
| Item 3.   | Legal Proceedings                                                                                                       | 15         |
| Item  4.  | Submission  of Matters to a Vote of Security Holders                                                                    | 15         |
|      |                                                                                                                    |       |
| Part II   |                                                                                                                    |       |
| Item  5.  | Market  for the Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities | 16         |
| Item 6.   | Selected Financial Data                                                                                                 | 18         |
| Item  7.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                             | 19         |
| Item  7A. | Quantitative  and Qualitative Disclosures About Market Risk                                                             | 37         |
| Item  8.  | Financial  Statements and Supplementary Data                                                                            | 39         |
| Item  9.  | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                                   | 59         |
| Item 9A.  | Controls and  Procedures                                                                                                | 59         |
|      |                                                                                                                    |       |
| Part III  |                                                                                                                    |       |
| Item  10. | Directors  and Executive Officers of the Registrant                                                                     | 61         |
| 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 and Financial Statement Schedules                                                                              | 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, maycontain words 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;

•                  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.**

** **

You shouldcarefully review and consider the various disclosures in this report regardingfactors that could cause actual results to differ materially from anticipatedresults, including those factors under the caption “Risks and Uncertainties”under Item 7 below, and elsewhere in this report.

 

**Item 1. Business**

 

**Overview**

 

We provide employee internetmanagement (EIM) software products that enable organizations to analyze, reportand manage how their employees use computing resources, including internetaccess, instant messaging (IM), peer-to-peer file sharing, network bandwidthand desktop applications, and to enhance security.  Our primary product offering is the WebsenseEnterprise® software application, our central policy engine and managementconsole.  Websense Enterprise givesorganizations the ability to enhance security, improve employee productivity,conserve network bandwidth and mitigate potential legal liability byidentifying potential risks and rapidly configuring and implementing policiesto manage their employees’ internet access and use of software applications.Websense Enterprise also serves as a platform for related Websense add-onmodules, such as the Premium Groupsä, Real Time Security UpdatesTM, BandwidthOptimizerTM, Instant Messaging (IM) Attachment ManagerTM, and Client PolicyManagerTM. We have also created suites of some of our products to addressspecific customer needs, such as the Websense Security SuiteTM. The WebsenseSecurity Suite includes Websense Enterprise, the Security Premium Group,Instant Message Attachment Manager, and Real Time Security Updates in a singlesolution to allow organizations to block access to sites associated withspyware, phishing, hacking tools and other malware, and to block maliciousattachments delivered through instant messages. Websense Enterprise alsosupports a variety of reporting options that allow organizations to documentand analyze patterns of employees’ use of computing resources and assess therisks associated with these patterns.

 

Our flexible softwareapplications operate in conjunction with our proprietary databases of websiteuniversal resource locators (URLs), including sites containing spyware, virusesand other malware; commonly used network and internet protocols, such as http,instant messaging protocols and peer-to-peer protocols; and softwareapplications and executable files, including commonly used productivityapplications, games, hacking tools, viruses and other malware.  They operate at three primary points of

 

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policy enforcement: the internet gateway, the network and the employee desktop.  All of the databases are available for dailydifferential downloads, with real time updates available for security riskcategories in the URL and application databases.

 

The Websense URL database isorganized into more than 90 categories and encompasses more than 8 millionwebsites as of December 31, 2004. The software application database hasclassified over 650,000 software applications and executable files in more than50 categories. Our databases are updated each business day using a proprietaryprocess of automated content assessment and classification, with manual verification.  Subscribers to the Real Time Security Updatesproduct receive updates of the security risk categories of the URL andapplication databases in real time as new URLs and executable files areidentified and categorized.

 

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 networkappliances, and can scale with our customers’ needs to serve an unlimitednumber of users across multiple locations.

 

We currently operate in oneindustry segment, as defined by generally accepted accounting principles.

 

Our business wasincorporated in 1994 as NetPartners Internet Solutions, as a reseller ofcomputer security products. In 1996, we released Websense Internet ScreeningSystem, our first product as a software developer. In 1999, we changed our nameto Websense, Inc. to reflect the shift in our business focus from a value-addedreseller of security products to a developer of employee internet managementsoftware solutions. Our principal offices are located at 10240 Sorrento ValleyRoad, San Diego, CA 92121.

 

**Industry Background**

 

As part of their overallbusiness strategies, many organizations use the internet to enable criticalbusiness applications that are accessed over their corporate networks. Manyemployees also use their organization’s computing resources for recreational “websurfing,” peer-to-peer file sharing, downloading of high-bandwidth content,instant messaging and other personal matters. However, unmanaged use oforganizational computing and network resources, including internet access, canresult in increased risk and cost to the organization, including increasedsecurity risks, lost employee productivity, increased network bandwidthconsumption, and potential legal liability.

 

Traditionally, organizationshave 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 external securityrisks with a combination of firewalls, intrusion detection/prevention softwareand anti-virus software. With the growth in spyware, key logging applications,and phishing sites, combined with the rapid increase in employee use of instantmessaging and peer-to-peer file sharing and the proliferation of blendedattacks on computing networks, organizations are finding that existing securitymeasures leave significant time and technology gaps in their protection.Written internet access and software application use policies are easilyignored, difficult to enforce and do not proactively curtail undesirableinternet and software application usage. Firewalls can provide protection against external threats such ashacking, but do little to prevent employees from accessing unauthorized datafrom within an organization. Anti-virus software provides protection frome-mail borne viruses, but does not prevent the possible theft or corruption ofcorporate data by spyware and offers only limited protection against virusesthat proliferate via peer-to-peer networks and instant

 

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messaging. Existing anti-virus and anti-spyware software also requires time toidentify and reverse engineer the virus or spyware application before it can beremediated and removed from infected systems.

 

Given the necessity ofcorporate internet access and the continuing adoption of the web as a masscommunication, entertainment, information and commerce medium, we believe thereis a significant opportunity for an employee internet management solution thateffectively addresses the needs of organizations to manage employee usage ofthe computing environment, including internet access and desktop applicationuse. Additionally, although the web and e-mail are the primary drivers ofinternet traffic today, the rapid emergence of internet-enabled applicationscreates the need for software that applies management policies to file types,applications, and protocols, as well as web pages, at multiple points on theinformation technology infrastructure. Software tools are needed to implementpolicy-based bandwidth management and regulation of applications such asinstant 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 ManagementSolutions**

 

We provide employee internetmanagement products that enable businesses to analyze, report, and manage howtheir employees use the internet, the network and their desktop or laptopcomputers. Our primary product is Websense Enterprise, a software applicationand database package that gives business managers the ability to implementcustomized internet access and use policies for different users and groupswithin the business, and supports an organization’s efforts to improve employeeproductivity, conserve network bandwidth, enhance security, and mitigatepotential legal liability.  WebsenseEnterprise also serves as a policy platform and management console for relatedadd-on products.  Websense Enterprise and the add-on productsare sold on a subscription basis.

 

The application component ofWebsense Enterprise enables managers to select the types of internet content,protocols and software applications they wish to allow, and to block or deferaccess with our patented flexible filtering technology based on the databasecategories we have defined. Our software enforces these managerial selectionsat the internet gateway, on the network, and at the desktop (or disconnectedlaptop) 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 at allthree points of policy enforcement. The three Premium Groups augment thedatabase categories included with Websense Enterprise and provide additionalpolicy enforcement options at the internet gateway. Security Premium GroupTMallows management of access to sites associated with spyware, phishing, andmalicious mobile code. Bandwidth Premium GroupTM allows management of access tobandwidth intensive sites, including streaming media, internet radio andtelevision, personal network storage/backup, internet telephony, andpeer-to-peer file sharing. Productivity Premium GroupTM allows management ofaccess to advertisements, message boards, freeware/software downloads, onlinebrokerage & trading, instant messaging, and pay-to-surf sites.

 

Client Policy Managerenables managers to apply block, continue, and allow policies to the launch ofmore than 50 categories of software applications and executable files at theemployee’s desktop or disconnected laptop, including business productivity,instant messaging, peer-to-peer file sharing, games and hacking applications.Bandwidth Optimizer utilizes a network agent to monitor and manage networktraffic, allowing managers to create internet use policies that disablenon-business related traffic when available network bandwidth drops belowpre-determined thresholds. Instant Messaging Attachment Manager enhances thebuilt-in instant messaging management capabilities of Websense Enterprise by

 

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allowing managers to control the sending andreceiving of file attachments from within the popular instant messagingapplications.  The Real Time SecurityUpdates module allows subscribers to receive updates to the security-riskcategories of the Security Premium Group and Client Policy Manager databases inreal time as they are categorized. All of these add-on products are enabled andmanaged from the central management console of Websense Enterprise.

 

The principal benefits of our products include:

 

*EnhancedNetwork and Data Security.*Websense Enterprise adds an additional layer of protection to anorganization’s network and data security by blocking employee access to sitesposing security-risks such as those containing malicious code, spyware or “backchannel” servers collecting data from spyware applications.  This allows an organization to proactivelyreduce the risk of malicious code attacks — such as Web-based worms, viruses,Visual Basic scripts and more — and prevent back-channel communication ofimportant corporate or personal data by spyware and key logging programs.  Additionally, Client Policy Manager can beused to prevent the launch of viruses, hacking tools, peer-to-peer file sharingprograms and other malicious executable files or otherwise unauthorizedapplications at the employee’s desktop or laptop computer, including whendisconnected from the network.  Thishelps prevent the spread of viruses throughout the network and reduces the riskof unauthorized data access by employees. To further enhance security and reduce the window of exposure to virusesand other malware, Real Time Security Updates can be downloaded in real time asnew threats are identified and categorized. Instant Messaging Attachment Manager also increases the built-in instantmessaging management capabilities of Websense Enterprise by allowing managersto control the sending and receiving of file attachments.

 

*IncreasedEmployee Productivity.*Our software gives businesses the ability to more effectively manage employees’use of corporate computing resources, including internet access, applicationuse at the desktop and network bandwidth, thereby reducing non-productive useof these assets by employees. Websense Enterprise enables organizations toidentify the pattern and scope of employees’ internet use, and to manage accessto potentially non-business related content and applications such as instantmessaging and peer-to-peer file sharing. In addition, our software allowsmanagers to permit or deny internet access based on the employee, type of user,time of day, amount of personal surfing time, and type of content beingaccessed. Websense Enterprise may also be configured to set time-based quotasfor each employee, allowing for limited personal surfing during the workday,limiting workplace distractions but allowing appropriate use of the organization’shigh-speed internet connection.  OurClient Policy Manager add-on module allows managers to apply similar policiesto employees’ use of non-business related applications on their desktopcomputers, such as games and hacking tools.

 

*Conservationof Information Technology Resources.* We believe Websense Enterprise allows organizations to reducebandwidth consumption by managing personal internet use and access to websites,in particular those which may contain bandwidth-intensive content, such as streamingaudio and video, MP3 music files, multi-player games and other new media. TheBandwidth Optimizer add-on module, used in conjunction with WebsenseEnterprise, further enhances bandwidth management capabilities by monitoringnetwork usage in real-time and by allowing employee access management based onavailable 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 or other non-business files.

 

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*ReducedExposure 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 or otherinappropriate content is being downloaded and stored on company servers.

 

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

 

*Access toComprehensive Databases of URLs, Software Applications and Network Protocols.* We provide access to proprietary databasesthat categorize website URLs, software applications and executables andcommonly used network and internet protocols. We have categorized more than 8million websites in our URL database, and more than two million dead links havebeen purged from the database.  Thesewebsite URLs have been classified into more than 90 different categories toenable organizations flexibility in determining the types of internet contentthat are appropriate for their workplace culture. In the software applicationdatabase, we have categorized over 650,000 software applications and executablefiles in more than 50 categories, such as instant messaging, spyware, hackingand games.      We add newly categorized websites andapplications each business day to our databases and make these updatesavailable to our customers for daily differential downloads. Subscribers toReal Time Security Updates are able to update the security categories of thedatabases in real time as new threats are identified and categorized.

 

*Ability toConfigure and Manage Employee Internet and Application Usage Policies from aSingle Management Console.* Websense Enterprise allows organizations to configure specificinternet and application usage policies for various groups, user types orindividuals from a single management console. Through our easy-to-useinterface, we allow managers to implement internet and application use policieswith limited investment of information technology resources and personnel.  Organizations may choose internet use optionswhich include blocking websites, setting time periods for access, allowingaccess but generating an exception report, allowing users a specified amount ofpersonal surfing or deferring access until additional network bandwidth isavailable. Organizations can apply similar policies to the use of applicationsat the desktop, specifying permissions based on application category, usergroup, workstation, or IP address.

 

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

 

*Ability toAdapt to our Customers’ Employee Computing Patterns.* We utilize our relationship with ourcustomers to help our software adapt to evolving employee computing andinternet access patterns. We accomplish this with WebCatcherTM, a patent-pendingfeature by which customers anonymously send uncategorized websites visited bytheir employees to us for review and categorization into the Websense URLdatabase. AppCatcherTM, another patent-pending feature, creates the samefeedback mechanism for software applications and network protocols.  As new websites, protocols and applications arecategorized, the updated databases are available for daily download by theentire customer base.  Updates to thesecurity categories are available in real time to subscribing customers.

 

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*Ability toScale and Operate on a Variety of Network Platforms.* Our software is designed to have minimalimpact on network performance. Websense Enterprise is available on a broadrange of network platforms, and can support up to 50,000 users on a singleserver. Our software works with popular proxy servers, firewalls, cacheengines, switches and routers offered by internet infrastructure providers suchas Blue Coat Systems, Check Point Software, Cisco Systems, JuniperNetworks/NetScreen, Microsoft, Network Appliance, and Nokia.

 

**Products and Services**

 

*WebsenseEnterprise*. WebsenseEnterprise is the foundation of our software offerings and includes ourproprietary central policy engine, central management console and multiplereporting options. Websense Enterprise and its available add-on modules alloworganizations to manage employees’ use of corporate computing resources byfiltering access to websites, applications, protocols and bandwidth based onmanagement-defined policies.

 

We sell subscriptions to theWebsense Enterprise platform and databases based on the number of users to bemanaged. Additional premium database categories, application modules andenhanced technical support are priced separately. We recently introduced suitesthat include Websense Enterprise and a select group of products and services fora single price to address identified customer needs, such as the need forenhanced network security. Revenues from sales of subscriptions to WebsenseEnterprise and related add-on products accounted for 100% of total revenues in2004, 2003 and 2002.

 

Websense Enterpriseintegrates with an organization’s network server, proxy server, switch, routeror firewall and is designed to work in networks of virtually any size andconfiguration. We currently offer three deployment options:

 

•                  Integrated deployment on a separate serverthat is tightly integrated with the network gateway platform to offerpass-through filtering that maximizes stability, scalability and performance.

 

•                  Embedded deployment on an appliance orgateway product to reduce hardware expense and enhance ease-of-use,particularly in remote locations.

 

•                  Stand-alone deployment utilizing a networkagent to deliver pass-by filtering capabilities in any network environment.

 

The table below lists manyof the platforms with which Websense Enterprise can be integrated:

 

| Firewall Solutions:      | Cache/Proxy Solutions |
|--------------------------|-----------------------|
| •                   |                  | Check Point Software | • | Blue Coat Systems |
| •                   |                  | Cisco PIX | • | Cisco Content Engine |
| •                   |                  | CyberGuard | • | Dell PowerApp Cache |
| •                   |                  | Lightspeed | • | HP ProLiant |
| •                   |                  | Juniper Networks/NetScreen | • | HP Web Cache |
| •                   |                  | Microsoft ISA Server | • | IMimic DataReactor |
| •                   |                  | ServGate | • | InfoLibria DynaCache |
| •                   |                  | SLMsoft | • | Inktomi Traffic Server |
| •                   |                  | SonicWall | • | Microsoft Proxy Server |
|                     | •                | Network Appliance NetCache |
| Switch/Router Solutions: | •                | Novell Volera Excelerator |
| •                   |                  | Cisco Catalyst 6500 | • | ServGate |
| •                   |                  | Cisco Router Series 800 through 7400 | • | Squid |
|                     |                  |   | • | Stratacache StrataCORE |

 

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Appliance Solutions:

•           Blue Coat Systems 

•           Cisco Content Engine

•           Crossbeam X40S Blade Server

•           Immunix

•           Network Appliance NetCache

•           Nokia

•           Sun ONE Web Proxy Server (formerly iPlanet)

•           3Com Webcache

 

*WebFiltering.* WebsenseEnterprise enables employers to proactively analyze, report and manage employeeaccess to websites based on the content of the requested website. Our softwareapplication provides patented flexibility for managers when customizing,implementing and modifying internet access policies for various groups, usertypes and individuals. A graphical interface enables business managers to definethe categories of websites to which access will be managed. The filteringsoftware examines each internet access request, determines the category of therequested website and applies the policies that have been defined by thecompany. Some examples of management options include:

 

•                  Allow. The request is allowed to proceed, because the organization haschosen not to restrict access to the category applicable to the website.

 

•                  Block. The requested website is in a category that is not allowed to beaccessed according to the policy in effect.

 

•                  Time-based Quotas. Users are allowed a specified amount ofpersonal surfing time within categories that are determined by theadministrator. Once the user reaches his or her quota time, he or she is nolonger able to access sites in those categories.

 

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

 

•                  Time of Day. Filtering options can be managed by time of day.  For example, access to shopping sites couldbe blocked during business hours and permitted at all other times.

 

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

 

*Reportingand Analysis.*WebsenseEnterprise includes several reporting modules**to meet the information needs of different management groups.

 

•                  Websense Reporter is a batch-based reportingapplication that can generate more than 80 tabular and graphical reports based onan organization’s historical internet use. It analyzes information frominternet monitoring logs and builds visual charts in a variety of pre-set orcustomizable formats for easy distribution to and interpretation by managers.

 

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•                  Websense Real-Time AnalyzerTM utilizes thenetwork agent in Websense Enterprise to monitor and analyze network trafficon-the-fly.  This allows IT managers toidentify potential risks and bandwidth bottlenecks associated with differenttypes of network traffic.

 

•                  Websense Explorer is a browser-basedforensics and analytics reporting tool for non-technical business managers thatenables them to drill down on internet use data by risk class, user group, orindividual.

 

*Add-On Modules.*We offer add-on modules that rely on theapplication framework of the Websense Enterprise platform and our proprietarydatabases of software applications and protocols. We plan to continue todevelop and market new products and services based on our Websense Enterpriseplatform and our proprietary search and categorization technologies.  For example, in February 2005, weintroduced the Websense Security SuiteTM and the Websense Security Suite —Lockdown EditionTM, each of which combines existing Websense products withadditional functionality.

 

•                  *Client Policy Manager*.  TheClient Policy Manager (CPM) module allows our customers to implement managementpolicies, such as block, allow or defer, for usage of software applications andother executables on desktop computers, by application type, by user type, orby individual user. CPM can be used to inventory desktop software, provide acategorized view of applications in the desktop environment, and identifypotential possible security threats from hacking and spyware applications. It canalso be used to create lists of allowable applications and block the launch ofothers, enhancing security by preventing the launch of certain categories ofexecutables such as hacking tools or spyware.

 

CPM utilizes the applicationframework of Websense Enterprise and references our Client Policy Managerdatabase of over 650,000 software applications and executable files. We areexpanding this database as well as adapting the database to actual employeecomputing patterns through the use of AppCatcher, a patent-pending feature bywhich customers anonymously send uncategorized applications and otherexecutables launched by their employees to us for review and categorizationinto our database.  CPM includes tworeporting modules, CPM Reporter, which provides Web-based reports based onhistorical application usage, and Explorer for CPM, 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 usage by prioritizing business andnon-business related traffic flows.  Ourcustomers can apply management policies based on content category, protocols,user group, individual or network segment. Bandwidth Optimizer relies on the central policy engine in the WebsenseEnterprise platform, a network agent that monitors network traffic and adatabase 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 allowsorganizations to control the ability to transmit and receive files via instantmessaging clients.  Used in conjunctionwith the IM management capabilities in Websense Enterprise, the IM AttachmentManager module allows customers to apply policies to file attachments over themost popular IM applications, define custom file attachment policies by user,by group, or by workstation, using popular management options such aswarn/continue screens, and provide real-time and historical views of employeeuse of IM file attachments.  Used inconjunction with Bandwidth Optimizer, the IM Attachment Manager can manage thetransmission of attachments by bandwidth availability.

 

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•                  *Real Time SecurityUpdates. *Real Time Security Updates allow subscribingorganizations to receive database updates for web-based and application-basedthreats in real time as they are identified and categorized by us.

 

•     *Sitewatcher*TM and *Brandwatcher*TM. The Sitewatcher and Brandwatcher servicesmonitor our customer's web sites and brands for malicious code or illegal usein a phishing attack and notify the customer if either occurs.

 

•     *Priority One 24x7 Support.  *Priority One support gives customers accessto a dedicated team of senior technical support specialists 24 hours a day viaa toll-free support hotline.

 

**Customers**

 

Our more than 24,000customers range from companies with as few as 50 employees to members of theGlobal 1000 to government agencies and educational institutions.  In total, these customers have subscribed toapproximately 19.8 million seats as of December 31, 2004. No customeraccounted for more than 10% of our total revenues in 2004, 2003 or 2002.

 

**Sales, Marketing and Distribution**

 

*Sales*. We sell our products and services throughboth indirect and direct channels. For 2004, indirect channel sales comprisedover 80% of total revenues. In the United States, we typically sell ourproducts through a network of approximately 1,000 value added resellers.  Internationally, we sell our products througha multi-tiered distribution network of more than 200 distributors and resellersin over 75 countries, who sell to customers located in over 125 countries.

 

Our channel sales effortsare coordinated worldwide through a sales team of approximately 140individuals. Customers that buy direct from us are typically largeorganizations that prefer a direct relationship.

 

In 2004, we generated 32% ofour total revenue from customers outside of the United States. Revenuegenerated in the United Kingdom represented 9% of our total revenues. See Note4 of Notes to the Consolidated Financial Statements for further explanation ofour revenue based on geography.  Ourcurrent international efforts are focused on expanding our indirect saleschannels in Europe, Latin America, Asia/Pacific, and Australia. Our continuingreliance on sales in international markets exposes us to risks attendant toforeign sales. See “Item 7. Risks and Uncertainties — Sales to customersoutside the United States have accounted for a significant portion of ourrevenue, and we expect this trend to continue, which exposes us to risksinherent in international sales.”

 

*Marketing*. Our marketing strategy is to raiseawareness of the potential risks associated with unmanaged employee use ofcorporate computing resources, generate qualified sales leads for our channelpartners, and increase recognition of Websense as a provider of employeeinternet management solutions.

 

Our marketing efforts aretargeted toward business executives, including information technologyprofessionals, chief executives, upper level management and human resourcepersonnel. We actively manage our public relations programs, communicatingdirectly with technology professionals and the media, in an effort to promotegreater awareness of the growing problems caused by viruses, spyware, phishingsites, and key logging, as well as employee misuse of the internet and othercomputing resources at work. We also provide potential customers and channelpartners with free trials of Websense Enterprise and the add-on modules,typically for 30-day periods. Our additional marketing initiatives include:

 

•                  advertising online and in high-technologytrade magazines, management journals and other business oriented periodicals;

 

•                  participation in and sponsorship of tradeshows and industry events;

 

9

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•                  hosting regional and international seminars,webinars, and training sessions for our sales organization and resellerpartners, as well as customers and prospects;

 

•                  cooperative marketing efforts with ourinternet infrastructure partners including Web link exchanges, joint pressannouncements, joint trade show activities, channel marketing campaigns, roadshows and seminars;

 

•                  conducting speaking engagements on topics ofinterest to our customers and prospects;

 

•                  use of our website to communicate with ourindirect sales channels, and provide product and company information tointerested parties; and

 

•                  providing and distributing soft and hard-copycollateral on our company, products, solutions, technologies, partnerships andbenefits.

 

**Customer Service, Training andSupport**

 

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

 

**Research and Development**

 

We have investedsignificant time and resources in creating a structured process for undertakingproduct and database development projects. Our research and developmentdepartment is divided into several groups, which include database production,software development, quality and assurance, documentation and research.Individuals are grouped along product lines and work as part ofcross-disciplined teams designed to provide a framework for defining andaddressing the activities required to bring product concepts and developmentprojects to market successfully. Research and development expenses totaled$14.5 million in 2004, $12.8 million in 2003 and $11.0 million in 2002.  Research and development expenses as apercentage of revenue were 13% in 2004, 16% in 2003, and 18% in 2002.

 

10

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#### **Technology**

#### ** **

*SoftwareArchitecture*.Websense Enterprise is a server-based system designed to function in networksof virtually any size and configuration. Websense Enterprise is composed of asystem of analyzing, reporting and management applications integrated in aproprietary central policy engine. It is designed to accommodate network growthwithout impairing performance or requiring major infrastructure modificationsand can scale to support networks of nearly any size. Websense Enterpriseintegrates with major firewalls, proxy servers, caching engines, networkswitches and routers. We have designed our products to run on multiple networkplatforms and in multiple locations. Websense Enterprise can also includeagents at the desktop and on the network that allow customers to manageapplications, protocols, and network bandwidth through its Client PolicyManager product as well as other add-on application modules.

 

*DatabaseContent Analysis and Updating*. We use a process of automated content assessment and classificationwith manual verification to gather and classify new websites and applicationsfor our databases. Our automated search technology uses Java-based tools andproprietary algorithmic classification systems to automatically search theinternet to identify and catalog websites into one of our more than 90 databasecategories.  Additionally, the optionalWebCatcher and AppCatcher features of Websense Enterprise collect unrecognizedsites, software applications and protocols from customers and return them to usfor review and categorization.

 

**Competition**

 

The market for our productsis fragmented, highly and increasingly competitive, quickly evolving and subjectto rapid technological change. Increased competition may result in reducedmarket acceptance of our products, pricing pressure and reduced gross margins,any of which could seriously harm our business. Competitors vary in size and inthe scope and breadth of the products and services they offer. Our currentprincipal competitors include:

 

•                  companies offering web filtering products,such as SurfControl plc, Secure Computing, Symantec Corporation, CyberGuardCorporation, Computer Associates and Trend Micro;

 

•                  companiesintegrating web filtering into specialized security appliances, such asSonicWALL, 8e6 Technologies, Blue Coat Systems and Internet Security Systems;

 

•                  companiesoffering web security solutions, such as Symantec Corporation; and

 

•                  companiesoffering desktop security solutions such as Microsoft Corporation, CiscoSystems, Internet Security Systems, and Check Point Software.

 

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Wealso face current and potential competition from vendors of internet servers,operating systems and networking hardware, many of which now, or may in thefuture, develop and/or bundle employee internet management or other competitiveproducts with their offerings. We compete against and expect increased competitionfrom 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.  Many of our current and potential competitorshave longer operating histories and significantly greater financial, technical,marketing or other resources than we do. They may have significantly greatername recognition, established marketing relationships and access to a largerinstalled base of customers. In addition, current and potential competitorshave established or may establish cooperative relationships among themselves orwith third parties to increase the functionality of their products to addresscustomer needs. Accordingly, new competitors or alliances among competitors mayemerge and rapidly acquire significant market share.

 

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

 

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

 

•                  therobustness of the solution, allowing management of emerging software and internetapplications, protocols and URLs;

 

•                  qualityof a large and professionally maintained category database;

 

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

 

•                  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.

 

**Intellectual Property Rights**

 

Our intellectual propertyrights are important to our business. We rely on a combination of trademark,copyright, patent and trade secret laws in the United States and otherjurisdictions as well as confidentiality procedures and contractual provisionsto protect our proprietary technology and Websense brand. We have registeredour Websense trademark in the United States, Japan, the European Union, Canada,Australia, China, Switzerland, Norway, Mexico, Colombia, Argentina, 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.

 

12

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We currently have twopatents issued in the United States, one patent issued in an internationalmarket, four patent applications pending in the United States and sixteenpending international patent applications that seek to protect our proprietarydatabase and filtering technologies, including issued and pending patentsrelating to our flexible filtering management options, and pending patentsrelating to our WebCatcher and AppCatcher product features. No assurance can begiven that our pending patent applications will result in issued patents.

 

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

 

**Employees**

 

As of February 28,2005, we had 500 employees.  None of ouremployees is represented by a labor union, and we have never experienced a workstoppage. We believe that our relations with our employees are good.

 

#### **Website Access toSEC Filings**

#### ** **

#### **We maintain an internet website at *www.websense.com*.  The content of our website is not part ofthis report.  We make available free ofcharge through our internet website our annual report on Form 10-K, quarterlyreports on Form 10-Q, current reports on Form 8-K, and amendments to thosereports filed or furnished pursuant to Section 13(a) or 15(d) of theSecurities Exchange Act of 1934, as amended, or the Exchange Act,  as soon as reasonably practicable after weelectronically file such material with, or furnish it to, the SEC.**

#### ** **

#### **Executive Officers**

#### ** **

Our executive officers andtheir ages as of February 28, 2005 are as follows:

 
| **Name**            | ** ** | **Age** | ** ** | **Position(s)**                                    | ** ** |
|---------------------|------------|---------|------------|----------------------------------------------------|------------|
|                |       |    |       |                                               |       |
| John B.  Carrington |       | 60      |       | Chairman of the Board and Chief Executive  Officer |       |
| Curtis H.  Staker   |       | 45      |       | President                                          |       |
| Douglas C.  Wride   |       | 51      |       | Chief Financial Officer                            |       |
| Leo Cole            |       | 47      |       | Vice President of Marketing                        |       |
| Karen V.  Goodrum   |       | 47      |       | Vice President of Finance & Accounting         |       |
| Michael A.  Newman  |       | 35      |       | Vice President & General Counsel               |       |
| Kian Saneii         |       | 40      |       | Vice President of Business Development             |       |

 

John B. Carrington has servedas our Chief Executive Officer since May 1999 and has served as a Director andour Chairman since June 1999. Mr. Carrington also served as our Presidentfrom May 1999 to January 2003. Prior to joining Websense, Mr. Carringtonwas Chairman, President and Chief Executive Officer of Artios, Inc., a providerof hardware and software design solutions to companies in the packagingindustry, from August 1996 until it was acquired by BARCO n.a. in December 1998.He

 

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received his B.S. in Business Administration fromthe University of Texas. In January 2005, Mr. Carrington and our Board ofDirectors initiated a succession process to identify a new chief executiveofficer for Websense before January 2006. There is no deadline for this process and our intention is for Mr.Carrington to retain his current role as chief executive officer until asuccessor is identified, and to retain his role as Chairman of the Boardfollowing the transition.

 

Curtis H. Staker has servedas our President since January 2003. Prior to that, he had served as ourExecutive Vice President of Worldwide Sales since February 2001. Prior tojoining us, Mr. Staker was with Structural Dynamics Research Corporation (SDRC)from July 1989 to February 2001 serving in a variety of managementpositions, including Vice President and General Manager of Americas Operations(North and South America regions) and Vice President and General Manager ofAsia-Pacific Operations. SDRC, a provider of e-business collaborationsolutions, is now owned by Electronic Data Systems (EDS). Mr. Staker began hiscareer as an engineer for Caterpillar Tractor Co. after receiving his B.S. inMechanical Engineering from Bradley University.

 

Douglas C. Wride has served as our Chief FinancialOfficer since June 1999. From March 1997 to December 1998, Mr.Wride served as Chief Financial Officer of Artios, Inc. Mr. Wride also servedas Chief Operating Officer of Artios from July 1997 to December 1998.From April 1996 to March 1997, Mr. Wride served as Chief OperatingOfficer and Chief Financial Officer of NetCount, LLC, a provider of internetmeasurement and research services. Mr. Wride is a C.P.A. and received his B.S.in Business/Accounting from the University of Southern California.

 

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

 

Karen V. Goodrum has servedas our Vice President of Finance & Accounting since October 2003, andprior to that, as Vice President of Finance & Administration from August 2000.From January 1997 to February 2000, Ms. Goodrum served as ChiefFinancial Officer for COMPS.Com, Inc., a provider of commercial real estateinformation services.  Ms. Goodrumreceived her B.A. in Education from the University of Maryland, College Park,and her M.B.A. from San Diego State University.

 

Michael A. Newman has served as our Vice President& General Counsel since September 2002.  From April 1999 to September 2002,he served in various capacities in the legal department of Gateway, Inc., apublicly traded PC manufacturer, most recently as Senior Staff Counsel,Securities, Finance and Corporate Development. From February 1996 to April 1999, he practiced as an attorneyin the San Diego office of Cooley Godward, LLP, a law firm specializing in therepresentation of high-growth information technology and life sciencescompanies.  Mr. Newman received his B.S.in Business Administration from Georgetown University, and a J.D. from HarvardLaw School.

 

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

 

**Item 2. Properties**

 

Our corporate headquarters and principal offices arelocated in San Diego, California, where we leased approximately 105,000 squarefeet as of December 31, 2004. This lease expires in December 2008,with an option to extend the lease for an additional five years. We believethat our current space is adequate for our current needs and sufficient spaceis available to meet our identified future needs. We lease office space in theUK, Ireland, Japan and France in executive suite arrangements on an annualbasis.

 

**Item 3. Legal Proceedings**

 

We are not a party to anymaterial legal proceedings.

 

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

 

There were no matterssubmitted to a vote of the security holders during the fourth quarter of thefiscal year-ended December 31, 2004.

 

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##### **Part II**

 

**Item 5. Market for Registrant’s Common Equity, RelatedStockholder Matters****and Issuer Purchases of EquitySecurities**

 

Our common stock istraded on the Nasdaq National Market (Nasdaq) under the symbol “WBSN.” Thefollowing table sets forth the range of high and low closing prices on Nasdaqof our common stock for the periods indicated, as reported by Nasdaq. Suchquotations represent inter-dealer prices without retail markup, markdown orcommission and may not necessarily represent actual transactions.

 

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

 

| **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   |       |
|                                       |            |          |            |         |            |  |  |

 

To date, we have neitherdeclared nor paid any dividends on the common stock. We currently intend toretain all future earnings, if any, for use in the operation and development ofour business and, therefore, do not expect to declare or pay any cash dividendson the common stock in the foreseeable future. As of February 28, 2005,there were approximately 5,500 holders of record of the common stock.  See Item 12 — “Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters” forinformation regarding our equity compensation plans.

 

**Use of Proceeds**

 

**On March 28,2000, we completed our initial public offering for the sale of 4,000,000 sharesof common stock at a price to the public of $18 per share, which resulted innet proceeds of $65.7 million after payment of the underwriters’ commissionsand deductions of offering expenses.  Theregistration statement (No. 333-95619) relating to our initial public offeringwas declared effective on March 28, 2000. Subsequent to our initial public offering, a portion of the offeringproceeds were used to repay the $1.5 million balance of our fixed term loanagreements with financial institutions. The remaining proceeds have conformed with our intended use outlined inthe prospectus related to such offering. We currently have approximately $64.2 million remaining from our IPOproceeds.**

 

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**Issuer Purchases of Equity Securities**

 

On April 3, 2003, we announced that our Boardof Directors authorized a stock repurchase program of up to 2 million shares ofour common stock.  The following tableprovides information regarding our stock repurchases in the quarter ended December 31,2004:

 
| **Month**                                | ** ** | **Number of  shares  purchased  during month(1)** | ** ** | **Average  price paid per  share** | ** ** | **Cumulative  number of shares  purchased as part  of publicly  announced plan(2)** | ** ** | **Maximum number  of shares that may  yet be purchased  under the plan** | ** ** |
|------------------------------------------|------------|---------------------------------------------------|------------|------------------------------------|------------|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| October 1st  through 31st  of 2004  |       | —                                            |       | —                             |       | 898,500                                                                             |       | 1,101,500                                                                |       |
| November 1st  through 30th  of 2004 |       | 15,000                                            |       | $                                  | 46.03      |                                                                                | 913,500    |                                                                     | 1,086,500  |   |
| December 1st  through 31st  of 2004 |       | 92,500                                            |       | $                                  | 51.15      |                                                                                | 1,006,000  |                                                                     | 994,000    |   |
| Total                                    |       | 107,500                                           |       | $                                  | 50.44      |                                                                                | 1,006,000  |                                                                     | 994,000    |   |

 

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**(1)**          The purchases were made in open-market transactions.

 

**(2)**          On April 3, 2003, we announced that our Board ofDirectors authorized a stock repurchase program of up to 2 million shares ofour common stock.

 

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**Item 6. SelectedFinancial Data**

 

You should read thefollowing selected financial data in conjunction with our financial statementsand related notes and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” appearing elsewhere in this annual report.We derived the income statement data for the years ended December 31,2004, 2003 and 2002 and the balance sheet data as of December 31, 2004 and2003 from our financial statements audited by Ernst & Young LLP, whichappear elsewhere in this report. We derived the income statement data for theyears ended December 31, 2001 and 2000 and the balance sheet data as of December 31,2002, 2001 and 2000 from our financial statements audited by Ernst & YoungLLP, which are not included in this annual report. Our historical results arenot necessarily indicative of operating results to be expected in the future.

 
| ** **                                | ** ** | **Years Ended December 31,**               | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                | ** ** | **2004**                                        | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                | ** ** | **(In thousands, except for per  share data )** | ** ** |
| **Income  Statement Data:**               | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                  |       | $                                               | 111,859    |   | $ | 81,734 |   | $ | 60,965 |   | $ | 35,893 |   | $ | 17,441 |   |
|                                      |       |                                            |       |   |   |   |   |   |   |   |   |
| Cost of  revenues                         |       | 7,769                                           |       | 5,523 |   | 4,170 |   | 3,602 |   | 2,707 |   |
|                                      |       |                                            |       |   |   |   |   |   |   |   |   |
| Gross margin                              |       | 104,090                                         |       | 76,211 |   | 56,795 |   | 32,291 |   | 14,734 |   |
| Operating  expenses:                      |       |                                            |       |   |   |   |   |   |   |   |   |
| Selling and  marketing                    |       | 42,625                                          |       | 31,845 |   | 26,201 |   | 19,707 |   | 12,726 |   |
| Research and  development                 |       | 14,509                                          |       | 12,843 |   | 10,957 |   | 7,642 |   | 6,287 |   |
| General and  administrative               |       | 8,200                                           |       | 6,649 |   | 5,960 |   | 5,358 |   | 3,491 |   |
| Amortization  of stock-based compensation |       | —                                          |       | 83 |   | 448 |   | 860 |   | 1,938 |   |
| Total  operating expenses                 |       | 65,334                                          |       | 51,420 |   | 43,566 |   | 33,567 |   | 24,442 |   |
| Income  (loss) from operations            |       | 38,756                                          |       | 24,791 |   | 13,229 |   | (1,276 | ) | (9,708 | ) |
| Other  income, net                        |       | 2,226                                           |       | 2,292 |   | 2,711 |   | 4,500 |   | 3,761 |   |
| Income  (loss) before income taxes        |       | 40,982                                          |       | 27,083 |   | 15,940 |   | 3,224 |   | (5,947 | ) |
| Provision  (benefit) for income taxes     |       | 14,806                                          |       | 10,395 |   | (797 | ) | 108 |   | — |   |
| Net income  (loss)                        |       | $                                               | 26,176     |   | $ | 16,688 |   | $ | 16,737 |   | $ | 3,116 |   | $ | (5,947 | ) |
|                                      |       |                                            |       |   |   |   |   |   |   |   |   |
| Net income  (loss) per share:             |       |                                            |       |   |   |   |   |   |   |   |   |
| Basic                                     |       | $                                               | 1.13       |   | $ | 0.76 |   | $ | 0.79 |   | $ | 0.16 |   | $ | (0.35 | ) |
| Diluted                                   |       | $                                               | 1.09       |   | $ | 0.73 |   | $ | 0.72 |   | $ | 0.14 |   | $ | (0.35 | ) |
| Weighted  average shares – basic     |       | 23,080                                          |       | 22,038 |   | 21,211 |   | 20,082 |   | 16,882 |   |
| Weighted  average shares – diluted   |       | 24,114                                          |       | 22,976 |   | 23,338 |   | 22,780 |   | 16,882 |   |

 
| ** **                                           | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                           | ** ** | **2004**                    | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                           | ** ** | **(In thousands)**          | ** ** |
| **Balance  Sheet Data:**                             | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                           | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and  cash equivalents and marketable securities |       | $                           | 243,788    |   | $ | 182,859 |   | $ | 140,466 |   | $ | 103,108 |   | $ | 81,259 |   |
| Working  capital                                     |       | 195,635                     |       | 145,322 |   | 114,459 |   | 79,846 |   | 69,019 |   |
| Total assets                                         |       | 315,293                     |       | 233,613 |   | 180,188 |   | 119,812 |   | 92,454 |   |
| Deferred  revenue                                    |       | 132,317                     |       | 93,960 |   | 64,679 |   | 43,478 |   | 24,487 |   |
| Debt                                                 |       | —                      |       | — |   | — |   | — |   | — |   |
| Total  stockholders’ equity                     |       | 167,944                     |       | 128,929 |   | 106,711 |   | 70,680 |   | 64,064 |   |
|                                                      |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

** **

The following discussion and analysis shouldbe read in conjunction with the financial statements and related notescontained elsewhere in this report. See “Risks and Uncertainties” regardingcertain factors known to us that could cause reported financial information notto be necessarily indicative of future results.

 

**Forward Looking Statements**

** **

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

 

•                  anticipatedtrends in revenue;

•                  growthopportunities in domestic and international markets;

•                  customeracceptance and satisfaction with our products;

•                  expectedtrends in operating and other expenses;

•                  anticipatedcash and intentions regarding usage of cash;

•                  changesin effective tax rates; and

•                  anticipatedproduct enhancements or releases.

 

**These forward-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 provide employee internetmanagement (EIM) software products that enable organizations to analyze, reportand manage 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 organizations the ability to enhance security,improve employee productivity, conserve network bandwidth and mitigatepotential legal liability by identifying potential risks and rapidlyconfiguring and implementing policies to manage their employees’ internetaccess and use of software applications. In 1996, we released our firstsoftware product, Websense Internet Screening System, and since that time, wehave focused our business on developing and selling employee internetmanagement solutions.  WebsenseEnterprise now serves as a platform for related Websense add-on modules, suchas the Premium Groupsä, Real Time Security UpdatesTM, BandwidthOptimizerTM, Instant Messaging (IM) Attachment ManagerTM, and Client PolicyManagerTM. Websense Enterprise supports a variety of reporting options thatallow organizations to document and analyze patterns of employees’ use ofcomputing resources. We currently derive all of our revenue from subscriptionsto the Websense Enterprise solution (including add-on modules), and expect thistrend to continue in the future as more offerings are added to the WebsenseEnterprise platform.

 

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During 2004, we derived 32%of revenue from international sales compared with 31% for 2003, with the UnitedKingdom comprising approximately 9% of our total revenue in both years. Webelieve international markets represent a significant growth opportunity and weare continuing to expand our international operations, particularly in selectedcountries in the European, Asia/Pacific and Latin American markets.

 

**We sell Websense Enterprise throughboth indirect and direct channels. Sales through indirect channels currentlyaccount for more than 80% of our revenue, and our strategy is to continue torely on indirect sales channels for a significant majority of our sales.**

 

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

 

**Critical Accounting Policies**

 

**We believe the following criticalaccounting policies affect our more significant judgments and estimates used inthe preparation of our consolidated financial statements.**

 

***RevenueRecognition.***When a purchase decision is made for Websense Enterprise,customers enter into a subscription agreement, which is generally 12, 24 or 36months in duration and for a fixed number of users. Other services such asupgrades/enhancements and standard post-contract technical support services aresold together with Websense Enterprise and provided throughout the subscriptionterm. We recognize revenue on a monthly straight-line basis, commencing withthe month the subscription begins, over the term of the subscription agreementprovided collectibility is reasonably assured. Upon entering into asubscription arrangement for a fixed or determinable fee, we electronicallydeliver access codes to users and then promptly invoice customers for the fullamount of their subscriptions. Payment is due for the full term of thesubscription, generally within 30 days of the invoice. We record amounts billedto customers in excess of recognizable revenue as deferred revenue on ourbalance sheet. Upon expiration of the subscription, customers who wish tore-subscribe typically must do so at then current rates to continue usingWebsense Enterprise. Our revenue is significantly influenced by new and renewalsubscriptions, and a decrease in subscription amounts could negatively impactour future revenue.

 

***Allowance forDoubtful Accounts.***We maintain an allowance for doubtful accounts forestimated losses resulting from the inability or unwillingness of our customersto pay their invoice(s). If the financial condition of our customers were todeteriorate, resulting in an impairment of their ability to make payments,additional allowances may be required.

 

*Deferred Tax Assets.* As required by Statement ofFinancial Accounting Standards No. 109 (“FAS 109”), we recognize tax assets onthe balance sheet if it is “more likely than not” that they will be realized onfuture tax returns.  At December 31,2004, we had deferred tax assets of $18.1 million.  We believe that it is more likely than notthat our deferred tax assets will be realized. Factors considered by usincluded: our earnings history, projected earnings based on current operations,and projected future taxable income in excess of stock option deductions.However, should we determine that we would not be able to realize all or partof our deferred tax assets in the future, an adjustment to the deferred taxassets would be charged against income in the period such determination wasmade. See Note 8 of Notes to the Consolidated Financial Statements for furtherexplanation of our deferred tax assets.

 

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*Tax Contingency Reserve.*Significant judgment is required indetermining our consolidated income tax provision and evaluating our U.S. andforeign tax positions. It is our policy to maintain tax contingency reservesfor tax audit issues that are likely to occur and can reasonably be estimated. Wereview the reserves as circumstances warrant and adjust the reserves as eventsoccur that affect our potential liability for additional taxes, such as lapsingof applicable statutes of limitations, conclusion of tax audits, additionalexposure based on current calculations, identification of new issues orrendering of court decisions affecting a particular tax issue. Tax reservecontingencies and changes to the reserves are evaluated and recorded in our taxprovision in the period in which the above noted events occur.

 

**Results of Operations**

 

The following tablesummarizes our operating results as a percentage of total revenues for each ofthe periods shown.

 
| ** **                                | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|
| ** **                                | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                  |       | 100                               | %          | 100 | % | 100 | % |
|                                      |       |                              |       |   |   |   |   |
| Cost of  revenues                         |       | 7                                 |       | 7 |   | 7 |   |
|                                      |       |                              |       |   |   |   |   |
| Gross margin                              |       | 93                                |       | 93 |   | 93 |   |
|                                      |       |                              |       |   |   |   |   |
| Operating  expenses:                      |       |                              |       |   |   |   |   |
| Selling and  marketing                    |       | 38                                |       | 39 |   | 43 |   |
| Research and  development                 |       | 13                                |       | 16 |   | 18 |   |
| General and  administrative               |       | 7                                 |       | 8 |   | 9 |   |
| Amortization  of stock-based compensation |       | —                            |       | — |   | 1 |   |
| Total  operating expenses                 |       | 58                                |       | 63 |   | 71 |   |
|                                      |       |                              |       |   |   |   |   |
| Income from  operations                   |       | 35                                |       | 30 |   | 22 |   |
|                                      |       |                              |       |   |   |   |   |
| Other  income, net                        |       | 2                                 |       | 3 |   | 4 |   |
|                                      |       |                              |       |   |   |   |   |
| Income  before income taxes               |       | 37                                |       | 33 |   | 26 |   |
|                                      |       |                              |       |   |   |   |   |
| Provision  (benefit) for income taxes     |       | 14                                |       | 13 |   | (1 | ) |
|                                      |       |                              |       |   |   |   |   |
| Net income                                |       | 23                                | %          | 20 | % | 27 | % |

 

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

 

# **Revenue**

 

# **Revenue increased to $111.9 million in2004 from $81.7 million in 2003. The increase was primarily a result of theaddition of new, renewed and upgraded subscriptions from our customers.Approximately 65% of subscription revenue recognized in 2004 was derived fromrenewal business. We expect total**

 

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# **revenue growth amounts in 2005 toexceed total revenue growth in 2004, although the percentage revenue growthrate may be lower in 2005 than in 2004 as a result of the increasing overallrevenue base.**

 

# **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 $7.8 million in 2004from $5.5 million in 2003. 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 2004 and 2003. 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 $104.1 millionin 2004 from $76.2 million in 2003. The increase was due to increased revenue.As a percentage of revenue, gross margin remained unchanged at 93% for theyears-ended 2004 and 2003. We expect that gross margin, as a percentage ofrevenue, will remain in excess of 90% of revenue for the foreseeable future.**

 

# **Operating Expenses**

 

# ***Selling andmarketing***. Selling and marketing expenses consist primarily ofsalaries, commissions and benefits related to personnel engaged in selling,marketing and customer support functions, along with costs related to publicrelations, advertising, promotions and travel as well as allocated facilitiescosts and depreciation expenses.  Sellingand marketing expenses increased to $42.6 million in 2004 from $31.8 million in2003. The increase in selling and marketing expenses of $10.8 million wasprimarily due to increased headcount costs and related travel and allocatedcosts as well as higher commission and co-op marketing expenses related tohigher sales levels. We expect selling and marketing expenses to increase inabsolute dollars in the future as more personnel are added to support ourexpanding selling and marketing efforts worldwide and as increased sales resultin higher overall sales commission expenses.

 

# ***Research and development***. Research and development expensesconsist primarily of salaries and benefits for software developers, contractprogrammers, allocated facilities costs and equipment depreciation.  Research anddevelopment expenses increased to $14.5 million in 2004 from $12.8 million in2003. The increase of $1.7 million in research and development expenses wasprimarily a result of increased compensation costs as well as allocated coststo support our expanding list of technology partners, the enhancements ofWebsense Enterprise and additional products. We expect research and developmentexpenses to increase in absolute dollars in future periods as a result of ourcontinued enhancements of Websense Enterprise and additional products.

 

*General and administrative*. General and administrative expenses consistprimarily of salaries, benefits and related expenses for our executive,finance, human resources and administrative personnel, third party professionalservice fees and allocated facilities and depreciation expenses.  General and administrative expenses increasedto $8.2 million in 2004 from $6.6 million in 2003. The $1.6 million increase ingeneral and administrative expenses was primarily a result of an increase inprofessional accounting fees driven primarily by compliance with theSarbanes-Oxley Act of 2002, and allocated costs and additional personnel neededto support our growing operations. We expect general and administrativeexpenses to increase in absolute dollars in future periods, reflecting growthin operations, increasing expenses associated with being a public company andexpansion of our international

 

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operations.  We may also incur increased general andadministrative expense in connection with our announced search for a chiefexecutive officer to succeed Mr. Carrington.

 

# **Other Income, Net**

 

# **Net other income decreased to $2.2million in 2004 from $2.3 million in 2003. The decrease is due primarily tolower interest rates realized on our cash, cash equivalents and marketablesecurities despite increased balances as of December 31, 2004 as comparedwith December 31, 2003. The lower interest rates are substantially theresult of our strategy beginning in the second quarter of 2003 to purchaselower interest tax-exempt investments in order to maximize the after-tax returnon our investments. Also contributing to the decrease were realized losses fromsettled foreign currency forward contracts. The majority of our total cash andcash equivalents and marketable securities are tax-exempt. We expect themajority of our cash and cash equivalents and marketable securities willcontinue to be held in tax-exempt investments during the foreseeable future.**

 

# **Provision for Income Taxes**

 

In 2004, United States and foreign income taxexpense was $14.8 million as compared to $10.4 million for 2003. The annualeffective income tax rate for 2004 was 36.1% compared to 38.4% for 2003. Theannual effective tax rate for 2004 was lower than the 2003 effective tax rateprimarily due to an increase in foreign earnings taxed at less than the UnitedStates federal income tax rate, an increase in tax exempt interest income andan increase in federal and state research and development tax credits.

 

In 2005 and thereafter, we anticipate that oureffective tax rate may decrease due to benefits derived from lower tax ratesassociated with foreign income.

 

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# ** **

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

# ** **

# **Revenue**

# ** **

# **Revenueincreased to $81.7 million in 2003 from $61.0 million in 2002. This increasewas primarily a result of the addition of new customers and increased sales toexisting customers. Approximately 60% of subscription revenue recognized in2003 was derived from renewal business.**

 

# **Cost of Revenue**

# ** **

# **Cost ofrevenue increased to $5.5 million in 2003 from $4.2 million in 2002. Theincrease was primarily due to the costs associated with additional personnel inour technical support and database groups. As a percentage of revenue, cost of revenue remained unchanged at 7%during the years-ended 2003 and 2002.**

# ** **

# **Gross Margin**

# ** **

# **Grossmargin increased to $76.2 million in 2003 from $56.8 million in 2002. Theincrease was primarily due to increased revenue. As a percentage of revenue,gross margin remained unchanged at 93% during the years-ended 2003 and 2002.**

# ** **

# **Operating Expenses**

# ** **

# ***Selling and marketing***. 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 commissionexpenses related to higher sales levels.

# ** **

# ***Research and development***. Researchand development expenses increased to $12.8 million in 2003 from $11.0 millionin 2002. The increase of $1.8 million in research and development expenses wasprimarily a result of personnel added during 2003 to support our expanded listof technology partners, the enhancements of Websense Enterprise, including thedevelopment and launch of Websense Enterprise v5.0, and additional products.

# ** **

*General andadministrative*. General and administrative expensesincreased to $6.6 million in 2003 from $6.0 million in 2002. The $0.6 millionincrease in general and administrative expenses in 2003 was primarily due tothe addition of personnel to support our growing operations, both domesticallyand internationally.

 

# ***Amortization of stock-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**

# ** **

# **Netother income decreased to $2.3 million in 2003 from $2.7 million in 2002. Thedecrease was due primarily to lower interest rates realized on our cash andcash equivalents and marketable securities despite increased balances as of December 31,2003 as compared with December 31, 2002. The lower interest rates were substantiallythe result of the lower interest rate environment combined with our strategy tomaximize the after-tax return on our investments by purchasing lower interesttax-exempt**

 

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# **investmentsbeginning in the second quarter of 2003. As of December 31, 2003, themajority of our total cash and cash equivalents and marketable securities weretax-exempt, compared to no such investments at December 31, 2002.**

# ** **

# **Provision for IncomeTaxes**

# ** **

# **In 2002,we recorded an income tax benefit of $0.8 million, primarily attributable tothe release of the valuation allowance against our deferred tax assets. Therelease of our valuation allowance offset these taxes as well as the provisionfor federal and California income taxes, which resulted in an effective netbenefit rate of 5% for 2002.  During2003, we recorded a provision for income taxes of $10.4 million, for aneffective tax rate of 38.4%.**

# ** **

**Liquidity and Capital Resources**

 

As of December 31, 2004, we had cash andcash equivalents of $38.9 million, investments in marketable securities of $204.9million and retained earnings of $17.7 million.

 

**Net cashprovided by operating activities was $65.2 million in 2004 compared with $46.0million in 2003. The $19.2 million increase in cash provided by operatingactivities in 2004 was primarily due to an increase in our net income and anincrease in deferred revenue (subscription amounts in excess of recognizablerevenue are recorded as deferred revenue). Our operating cash flow and revenueare significantly influenced by subscription renewals and a decrease insubscription renewals would negatively impact our operating cash flow andrevenue.**

** **

Net cash used in investing activities was $61.1million in 2004 compared with net cash used in investing activities of $38.8million in 2003. The $22.3 million increase in cash used by investingactivities in 2004 was primarily due to more purchases of marketable securitiesoffset by maturities and sales of marketable securities.

 

Net cash used by financing activities was $0.6million in 2004 compared with net cash used by financing activities of $1.1million in 2003.  The $0.5 million decreasein net cash used by financing activities in 2004 was primarily due to anincrease in proceeds received from the exercise of stock options as well as theissuance of common stock pursuant to our employee stock purchase program whichoffset the use of $23.0 million in 2004 for the repurchase of 610,000 shares ofour common stock.

 

We have operating lease and software licensecommitments of approximately $1.9 million in 2005, $2.1 million in 2006, $2.0million in 2007 and $0.3 million in 2008. A significant majority of ouroperating lease commitments are related to our corporate headquarters lease,which was renewed in April 2002, and was most recently amended in July 2004to add additional space for our corporate headquarters and to extend the leasethrough 2008. The lease renewal incentives resulted in no rent payments in thethird and fourth quarters of 2002 and escalating rent payments from 2004 to2008. The rent expense related to our corporate headquarters lease renewal isrecorded monthly on a straight-line basis in accordance with generally acceptedaccounting principles.

 

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Future minimum annual payments undernon-cancelable operating leases and software licenses at December 31, 2004are as follows (in thousands):

 
| ** ** | ** ** | **Operating  Leases** | ** ** | **Software  Licenses** | ** ** | **Total** | ** ** |
|------------|------------|-----------------------|------------|------------------------|------------|-----------|------------|
| 2005       |       | $                     | 1,741      |                   | $          | 184       |       | $ | 1,925 |   |
| 2006       |       | 1,889                 |       | 184                    |       | 2,073     |       |
| 2007       |       | 1,937                 |       | 46                     |       | 1,983     |       |
| 2008       |       | 325                   |       | —                 |       | 325       |       |
|       |       | $                     | 5,892      |                   | $          | 414       |       | $ | 6,306 |   |

 

Asof December 31, 2004 and 2003, we did not have any relationships withunconsolidated entities or financial partners, such as entities often referredto as structured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. As such, we are not materiallyexposed to any financing, liquidity, market or credit risk that could arise ifwe had engaged in such relationships.

 

On April 3, 2003, we announced that our Board of Directors authorized a stock repurchase program of up to 2 million shares of our common stock. The repurchases will be made from time to time on the open market at prevailing market prices or in privately negotiated transactions. Depending on market conditions and other factors, purchases under this program may be commenced or suspended at any time, or from time to time, without prior notice. As of December 31, 2004, we had repurchased 1,006,000 shares of our common stock under this program, for an aggregate of $30.7 million at an average price of $30.48 per share.

 

We believe that our cash and cash equivalents balances and investments in marketable securities will be sufficient to satisfy our cash requirements for the foreseeable future. We intend to continue to invest our cash in excess of current operating requirements in interest-bearing, investment-grade securities.

 

26

 

**Summarized Quarterly Data (Unaudited)**

 

Thefollowing tables present unaudited quarterly financial information for theeight quarters ended December 31, 2004. We believe this informationreflects all adjustments (consisting only of normal recurring adjustments) thatwe consider necessary for a fair presentation of such information in accordancewith generally accepted accounting principles. The results for any quarter arenot necessarily indicative of results for any future period.

 
| ** **                    | ** ** | **1st Quarter**                            | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|
| ** **                    | ** ** | **(In thousands, except per share  data)** | ** ** |
| **2004**                      |       |                                       |       |            |       |            |       |            |       |
| Revenue                       |       | $                                          | 24,611     |            | $          | 26,643          |       | $               | 28,917     |   | $ | 31,688 |   |
| Gross margin                  |       | 22,920                                     |       | 24,869          |       | 26,914          |       | 29,387          |       |
| Income from  operations       |       | 7,718                                      |       | 8,753           |       | 10,678          |       | 11,607          |       |
| Income  before income taxes   |       | 8,131                                      |       | 9,209           |       | 11,276          |       | 12,366          |       |
| Net income                    |       | 5,127                                      |       | 5,807           |       | 7,106           |       | 8,136           |       |
| Basic income  per share (1)   |       | $                                          | 0.23       |            | $          | 0.25            |       | $               | 0.31       |   | $ | 0.35 |   |
| Diluted  income per share (1) |       | $                                          | 0.22       |            | $          | 0.24            |       | $               | 0.29       |   | $ | 0.33 |   |
|                          |       |                                       |       |            |       |            |       |            |       |
| **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 |   |

 

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**(1) Basic and diluted net income per sharecomputations for each quarter are independent and may not add up to the netincome per share computation for the respective year. See Note 1 of Notes tothe Consolidated Financial Statements for an explanation of the determinationof basic and diluted net income per share.**

 

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** **

**Risksand Uncertainties**

 

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

 

*Because we expect to derive a substantialportion of our future revenue from subscription fees for Websense Enterpriseand related add-on products, any failure of this product to satisfy customerdemands or to achieve more widespread market acceptance will seriously harm ourbusiness.*

 

A substantial portion of our revenue comesfrom subscriptions to Websense Enterprise and its related Premium Groups and weexpect this trend will continue for the foreseeable future. As a result, if forany reason revenue from Websense Enterprise or the add-on products**declines or does not grow as rapidly as we anticipate, ouroperating results and our business will be significantly impaired. If WebsenseEnterprise or the add-on products**fail to meetthe needs of our existing and target customers, or if they do not compare favorablyin price and performance to competing products, our growth will be limited. Ourfuture financial performance also will depend, in part, on our ability todiversify our offerings by successfully developing, introducing and gainingcustomer acceptance of new products and enhanced versions of WebsenseEnterprise, including add-on application modules such as Client Policy Manager,Real-Time Security Updates, Bandwidth Optimizer and Instant MessagingAttachment Manager. We may not be successful in achieving market acceptance ofany new products that we develop or of enhanced versions of WebsenseEnterprise. Moreover, increased emphasis on the sale of our add-on productscould distract us from sales of our core Websense Enterprise offering,negatively impacting our overall sales. Any failure or delay in diversifying our existing offerings, ordiversification at the detriment to our core Websense Enterprise offering,could harm our business, results of operations and financial condition.

 

*Our future success depends on our existingcustomers renewing and purchasing additional subscriptions to WebsenseEnterprise and the related add-on products.*

 

Our future success depends on achievingsubstantial revenue from customer renewals for subscriptions to WebsenseEnterprise and the related add-on products. Subscriptions for WebsenseEnterprise typically have durations of 12, 24 or 36 months. Our customers haveno obligation to renew their subscriptions upon expiration. We may be unable togenerate significant revenue from renewals. In order to maintain our revenue wemust be successful in selling renewal subscriptions.

 

Our future success also depends on ourability to sell further subscriptions to existing customers in order to addadditional seats or product offerings within their respective organizations. Asa result, to increase our revenue we must sell our existing customersadditional subscriptions for Websense Enterprise and the add-on products to getgreater coverage of their workforces. This may require increasingly costlysales efforts targeting senior management and other management personnelassociated with our customers’ internet infrastructure.

 

*We face increasing competition, which placespressure on our pricing and which could prevent us from increasing revenue ormaintaining profitability. In addition, we may face competition frombetter-established companies that have significantly greater resources.*

 

The market for our products is intenselycompetitive and is likely to become even more so in the future. Our currentprincipal competitors frequently offer their products at a significantly lowerprice than our products, which has resulted in pricing pressures on sales ofour product and potentially could result in the commoditization of employeeinternet management, or EIM, products. We also face increasing

 

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competition from security solutions providers who may add EIM modulesor features to their product offerings. If we are unable to maintain the current pricing on sales of ourproducts 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 of ourproducts to achieve or maintain more widespread market acceptance, any of whichcould have a material adverse effect on our business, results of operations andfinancial condition. Our current principal competitors include:

 

•                  companiesoffering web filtering products, such as SurfControl plc, Secure Computing,Symantec Corporation, CyberGuard Corporation, Computer Associates and Trend Micro;

•                  companiesintegrating web filtering into specialized security appliances, such asSonicWALL, 8e6 Technologies, Blue Coat Systems and Internet Security Systems;

•                  companiesoffering web security solutions, such as Symantec Corporation; and

•                  companiesoffering desktop security solutions such as Microsoft Corporation, CiscoSystems, Internet Security Systems, and Check Point Software.

 

We also face current and potentialcompetition from vendors of internet servers, operating systems and networkinghardware, many of which now, or may in the future, develop and/or bundle EIM orother competitive products with their products. We compete against, and expectincreased competition from, anti-virus software developers, traditional networkmanagement software developers and Web management service providers. We mayface new competition from companies offering quality of service solutions, suchas Packeteer, companies with a direct presence on computer desktops, such asMicrosoft, and companies offering desktop management solutions, such asAltiris. If EIM functions become standard features of internet-related hardwareor software, the demand for our products will decrease. Furthermore, even ifour products provide greater functionality and are more effective than certainother competitive products, potential customers might accept this limitedfunctionality in lieu of purchasing our products. In addition, our own indirectsales channels may decide to develop or sell competing products instead of ourproducts. Many of our potential competitors enjoy substantial competitiveadvantages, such as:

 

•                                          greatername recognition and larger marketing budgets and resources;

•                                          establishedmarketing relationships and access to larger customer bases; and

•                                          substantiallygreater financial, technical and other resources.

 

As a result, they may be able to respond morequickly and effectively than we can to new or changing opportunities,technologies, standards or customer requirements. For all of the foregoingreasons, we may not be able to compete successfully against our current andfuture 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 theUnited States through value-added resellers, distributors and other resellers.International sales represented approximately 32% of our total revenue in 2004and approximately 31% in 2003, and international sales increased 41% inabsolute dollars in 2004 compared with 2003. As a key component of our businessstrategy, we intend to expand our international sales, but success cannot beassured. In addition to the risks associated with our domestic sales, ourinternational sales are subject to the following risks:

 

•                                          dependenceon foreign distributors and their sales channels;

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

•                                          lawsand business practices favoring local competitors;

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

•                                          foreigncurrency fluctuations;

 

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•                                          longeraccounts receivable payment cycles and other collection difficulties; and

•                                          regionaleconomic and political conditions.

 

Such factors could have a material adverseeffect on our future international sales. Any reduction in international sales,or our failure to further develop our international distribution channels,could have a material adverse effect on our business, results of operations and financialcondition. Our international revenue is currently denominated in U.S. dollars.As a result, fluctuations in the value of the U.S. dollar and foreigncurrencies may make our products more expensive for international customers,which could harm our business. Beginning in 2005, we anticipate billing certaininternational customers in foreign currencies. This may increase our risks associated with fluctuations in foreigncurrency exchange rates since we cannot be assured of receiving the same U.S.dollar equivalent as when we bill exclusively in U.S. dollars.  We engage in currency hedging activitieswith the intent of limiting the risk of exchange rate fluctuation.  If we fail to properly forecast ratefluctuations these activities could have a negative impact.

 

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

 

Based on our experience with potentialcustomers, we believe that many corporations do not recognize or acknowledgethe existence or scope of problems caused by misuse or abuse of the internet orof network computers. In addition, there may be a time-limited opportunity toachieve and maintain a significant share of the market for EIM and our otherproducts due in part to the emerging nature of these markets and thesubstantial resources available to our existing and potential competitors. Ifemployers do not recognize or acknowledge these problems, then the market forour products may develop more slowly than we expect, which could adverselyaffect our operating results. Developing and maintaining awareness of ourWebsense brand is critical to achieving widespread acceptance of our existingand future products. Furthermore, we believe that the importance of brandrecognition will increase as competition in our market develops. Successfulpromotion of our Websense brand will depend largely on the effectiveness of ourmarketing efforts and on our ability to develop reliable and useful products atcompetitive prices. If we fail to successfully promote our Websense brand, orif our expenses to promote and maintain our Websense brand are greater thananticipated, our results of operations and financial condition could suffer.

 

*Because we recognize revenue fromsubscriptions for our products ratably over the term of the subscription,downturns in sales may not be immediately reflected in our revenue.*

 

We expect that nearly all of our revenue forthe foreseeable future will come from subscriptions to Websense Enterprise andadd-on application modules. Upon execution of a subscription agreement, weinvoice our customers for the full term of the subscription agreement. We thenrecognize revenue from customers monthly over the terms of their subscriptionagreements, which typically have durations of 12, 24 or 36 months. As a result,a majority of the revenue we report in each quarter is deferred revenue fromsubscription agreements entered into and paid for during previous quarters.Because of this financial model, the revenue we report in any quarter or seriesof quarters may mask significant downturns in sales and the market acceptanceof our products.

 

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

 

Our future success depends on our ability todevelop new products or enhancements to our existing products that keep pacewith rapid technological developments and that address the changing needs ofour customers. Although our products are designed to operate with a variety ofnetwork hardware and software platforms, we will need to continuously modifyand enhance our products to keep pace with changes in internet-relatedhardware, software, communication, browser and database technologies. We maynot be successful in either developing such products or timely introducing themto the market. In

 

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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.

 

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

 

Our success depends largely upon thecontinued services of our executive officers and other key management anddevelopment personnel. We are also substantially dependent on the continuedservice of our existing engineering personnel because of the complexity of ourproducts and technologies. We do not have employment agreements with a majorityof our executive officers, key management or development personnel and,therefore, they could terminate their employment with us at any time withoutpenalty. In January 2005, John Carrington, our chief executive officer,and our Board of Directors initiated a succession process to identify a newchief executive officer for Websense before January 2006.  There is no deadline for this process and ourintention is for Mr. Carrington to retain his current role as chief executiveofficer until a successor is identified, and to retain his role as Chairman ofthe Board following the transition. We do not maintain key person lifeinsurance policies on any of our employees. The loss of one or more of our keyemployees 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.

 

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

 

Our quarterly operating results have variedsignificantly in the past, and will likely vary in the future primarily as theresult of fluctuations in our billings, revenues and operating expenses. Weexpect that our operating expenses will increase substantially in the future aswe expand our selling and marketing activities, increase our research anddevelopment efforts and hire additional personnel. In addition, our operatingexpenses historically have fluctuated, and may continue to fluctuate in thefuture, as the result of the factors described below and elsewhere in thisquarterly report:

 

•                                          concentrationof marketing expenses for activities such as trade shows and advertisingcampaigns;

•                                          concentrationof general and administrative expenses, such as recruiting expenses andprofessional services fees;

•                                          concentrationof research and development costs; and

•                                          concentrationof expenses associated with commissions paid on sales of subscriptions to ourproducts.

 

As a result, our results of operations maynot meet the expectations of current or potential investors. If this occurs,the price of our common stock may decline.

 

*The market price of our common stock islikely to be highly volatile and subject to wide fluctuations.*

 

The market price of our common stock has beenand likely will continue to be highly volatile and could be subject to widefluctuations in response to a number of factors that are beyond our control,including:

 

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

•                                          demandfor our products, including fluctuations in subscription renewals;

•                                          fluctuationsin revenue from our indirect sales channels;

•                                          changesin the pricing policies of our competitors; and

•                                          changesin government regulations.

 

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In addition, the market price of our commonstock could be subject to wide fluctuations in response to:

 

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

•                                          changesin our pricing 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 experiencedsignificant price and volume fluctuations that have particularly affected themarket price of the stock of many internet-related companies, and that oftenhave been unrelated or disproportionate to the operating performance of thesecompanies. A number of publicly traded internet-related companies have currentmarket prices below their initial public offering prices. Market fluctuationssuch as these may seriously harm the market price of our common stock. In thepast, securities class action suits have been filed following periods of marketvolatility in the price of a company’s securities. If such an action wereinstituted, we would incur substantial costs and a diversion of managementattention and resources, which would seriously harm our business, results ofoperations and financial condition.

 

*If we acquire any companies or technologiesin the future, they could prove difficult to integrate, disrupt our business,dilute stockholder value and adversely affect our operating results.*

 

We may acquire or make investments incomplementary companies, services and technologies in the future. We have notmade any acquisitions or investments to date, and therefore our ability as anorganization to make acquisitions or investments is unproven.  Although we review the records of companiesor businesses we are interested in acquiring, even an in-depth review may notreveal existing or potential problems or permit us to become familiar enoughwith a business to assess fully its capabilities and deficiencies.

 

Acquisitions and investments involve numerousrisks, including:

 

•                                          difficultiesin integrating operations, technologies, services and personnel;

•                                          diversionof financial and management resources from existing operations;

•                                          riskof entering new markets;

•                                          potentialloss of key employees; and

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

 

In addition, if we finance acquisitions byissuing convertible debt or equity securities, our existing stockholders may bediluted which could affect the market price of our stock. As a result, if wefail to properly evaluate and execute acquisitions or investments, our businessand prospects may be seriously harmed.

 

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

 

We currently sell a significant majority ofour products indirectly. We intend to continue to rely on our indirect saleschannels for a significant majority of revenue. We depend on our indirect saleschannels, including value-added resellers, distributors, and providers ofmanaged internet services, to offer our products to a larger customer base thancan be reached through a direct sales effort. We will need to expand ourexisting relationships and enter into new relationships to increase our currentand future market share and revenue. We may be unable to maintain and expandour existing relationships or enter into new relationships on commercially reasonableterms or at all. If we are unable to maintain and

 

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expand our existing relationships or enter into new relationships, wewould lose customer introductions and co-marketing benefits and our operatingresults could suffer.

 

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

 

Our indirect sales channels accounted formore than 80% of our revenue in 2004 and 2003. We anticipate that sales fromour 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 Policy Manager, Real-Time Security Updates,Bandwidth Optimizer and IM Attachment 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.Some of our indirect sales channels also market and sell products that competewith our products or may decide to do so in the future. We may not be able toprevent these parties from devoting greater resources to support ourcompetitors’ products and/or eliminating their efforts to sell our products.

 

*Any failure to protect our intellectualproperty rights could impair our ability to protect our proprietary technologyand establish our Websense brand.*

 

Intellectual property is critical to oursuccess, and we rely upon trademark, copyright and trade secret laws in theUnited States and other jurisdictions as well as confidentiality procedures andcontractual provisions to protect our proprietary technology and our Websensebrand. Any of our trademarks may be challenged by others or invalidated throughadministrative process or litigation. We currently have only two issued patentsin the United States and one corresponding issued patent internationally, andwe may be unable to obtain further patent protection in the future. Inaddition, any issued patents may not provide us with any competitiveadvantages, or may be challenged by third parties. Furthermore, legal standardsrelating to the validity, enforceability and scope of protection ofintellectual property rights are uncertain. Effective patent, trademark,copyright and trade secret protection may not be available to us in everycountry in which our products are available. The laws of some foreign countriesmay not be as protective of intellectual property rights as United States laws,and mechanisms for enforcement of intellectual property rights may beinadequate. As a result our means of protecting our proprietary technology andbrands may not be adequate. Furthermore, despite our efforts, we may be unableto prevent third parties from infringing upon or misappropriating ourintellectual property, including the misappropriation or misuse of the contentof our proprietary database of websites. Any such infringement ormisappropriation could have a material adverse effect on our business, resultsof operations and financial condition.

 

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

 

The software and internet industries arecharacterized by the existence of a large number of patents, trademarks andcopyrights and by frequent litigation based on allegations of patentinfringement or other violations of intellectual property rights. As the numberof entrants into our market increases, the possibility of an intellectualproperty claim against us grows. Our technologies and products may not be ableto withstand any third-party claims or rights against their use. Anyintellectual property claims, with or without merit, could be time-consumingand expensive to litigate or settle, and could divert management attention fromexecuting our business plan.

 

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

 

We may not succeed in accurately categorizinginternet and application content to meet our customers’ expectations. We relyupon a combination of automated filtering technology and human review tocategorize websites and software applications in our proprietary databases. Ourcustomers may not agree with our determinations that particular websites andsoftware applications should be included or not included in specific categoriesof our databases. In addition, it is possible that our filtering processes mayplace objectionable material in categories that are generally unrestricted byour users’ internet and computer access policies, which could result inemployees having access to such material in the workplace. Anymiscategorization could result in customer dissatisfaction and harm ourreputation. Furthermore, we select our categories based on content we believeemployers want to manage. We may not now, or in the future, succeed in properlyidentifying the categories of content that employers want to manage. Anyfailure to effectively categorize and filter websites and software applicationsaccording to our customers’ expectations will impair the growth of our businessand our efforts to increase brand acceptance.

 

*Failure of our products to work properlycould impact sales, increase costs, and create risks of potential negativepublicity and legal liability.*

 

Because our products are complex and are deployedin a wide variety of complex network environments, they may have errors ordefects that users identify after deployment, which could harm our reputationand our business. In addition, products as complex as ours frequently containundetected errors when first introduced or when new versions or enhancementsare released. We have from time to time found errors in versions of ourproducts, and we may find such errors in the future. The occurrence of errorscould 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 ourproducts to manage employee behavior, any significant defects or errors in ourproducts may result in negative publicity or legal claims. Negative publicityor legal claims could seriously harm our business, results of operations andfinancial condition. In addition, the capability of our products to reportinternet data retrieval requests and software application execution requestsalong with the workstations from which they originated may result in negativepublicity or legal claims based on potential privacy violations.

 

*Our databases may fail to keep pace with therapid growth and technological change of the internet.*

 

The success of our products depends on thebreadth and accuracy of our databases. Although our databases currently catalogmore than 8 million websites and over 650,000 software applications andexecutable files, they contain only a portion of such material that exists. Inaddition, the total number of websites and software applications is growingrapidly, and we expect this rapid growth rate to continue in the future. Ourdatabases and database technologies may not be able to keep pace with thegrowth in the number of websites and software applications, especially thegrowing amount of content utilizing foreign languages. Further, the ongoingevolution of the internet and computing environments will require us to continuallyimprove the functionality, features and reliability of our databases. Becauseour products primarily can only manage access to websites and softwareapplications included in our databases, if our databases do not contain ameaningful portion of relevant content, the effectiveness of WebsenseEnterprise will be significantly diminished. Any failure of our databases tokeep pace with the rapid growth and technological change of the internet willimpair the market acceptance of our products, which in turn will harm ourbusiness, results of operations and financial condition.

 

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*Our worldwide income tax provisions and othertax accruals may be insufficient if any taxing authorities assume taxingpositions that are contrary to the company’s positions.*

 

**Significantjudgment is required in determining our worldwide provision for income taxesand for our accruals for other state, federal and international taxes such assales and VAT taxes. In the ordinary course of a global business, there aremany transactions for which the ultimate tax outcome is uncertain. Some ofthese uncertainties arise as a consequence of intercompany arrangements toshare revenue and costs. In such arrangements there are uncertainties about theamount and manner of such sharing, which could ultimately result in changesonce the arrangements are reviewed by taxing authorities. Although we believethat our approach to determining the amount of such arrangements is reasonable,no assurance can be given that the final exposure of**these matters will not be materially different than that which isreflected in our historical income tax provisions and other tax accruals. Suchdifferences could have a material effect on our income tax provisions or benefits,or other tax accruals, in the period in which such determination is made, andconsequently, on our net income for such period.

** **

**From time to time, we are alsoaudited by various state, federal and international authorities relating to taxmatters.  We fully cooperate with allaudits, but defend our positions vigorously. Our audits are in various stages of completion; however, no outcome fora particular audit can be determined with certainty prior to the conclusion ofthe audit and appeals process.  As eachaudit is concluded, adjustments, if any, are appropriately recorded in ourfinancial statements in the period determined. To provide for potential tax exposures, we maintain allowances for taxcontingencies based on reasonable estimates of our potential exposure withrespect to the tax liabilities that may result from such audits.  However, if the reserves are insufficientupon completion of any audits, there could be an adverse impact on ourfinancial position and results of operations.**

 

*We are subject to changes in financial accounting standards, which mayadversely affect our reported financial results or the way we conduct business.*

 

Accountingpolicies affecting software revenue recognition have been the subject offrequent interpretations, significantly affecting the way we sell our products.Future changes in financial accounting standards, including pronouncementsrelating to revenue recognition, may have a significant effect on our reportedresults, including reporting of transactions completed before the effectivedate of the changes.

 

In December 2004,FASB issued statement of Financial Accounting standards No. 123 (revised2004), Share-Based Payment (SFAS 123R), which will be effective in ourthird quarter of fiscal 2005. SFAS 123R will result in our recognition ofsubstantial compensation expense relating to our employee stock options andemployee stock purchase plans. We currently use the intrinsic value method tomeasure compensation expense for stock-based awards to our employees. Underthis standard, we generally do not recognize any compensation related to stockoption grants we issue under our stock option plans or the discounts we provideunder our employee stock purchase plans. Under the new rules, we are requiredto adopt a fair value-based method for measuring the compensation expenserelated to employee stock awards; this will lead to substantial additionalcompensation expense. This change will have a material adverse effect on ourreported results of operations. Note 1 to our Consolidated FinancialStatements in this report provides our pro forma net income and earnings pershare as if we had used a fair value-based method similar to the methodsrequired under SFAS 123R to measure the compensation expense for employee stockawards during fiscal 2004, 2003 and 2002. In addition, the adoption of this standard could limit our ability tocontinue to use stock options as an incentive and retention tool, which could,in turn, hurt our ability to recruit employees and retain existing employees.

 

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*Our systems may be vulnerable to securityrisks or service disruptions that could harm our business.*

 

Although wehave taken measures to secure our systems against security risks and other causesof disruption of electronic services, our servers are vulnerable to physical orelectronic break-ins and service disruptions, which could lead to interruptions,delays, loss of data or the inability to process customer requests. Such eventscould be very expensive to remedy, could damage our reputation and coulddiscourage existing and potential customers from using our products.

 

*Evolving regulation of the internet mayaffect us adversely.*

 

As internet commerce continues to evolve,increasing regulation by federal, state or foreign agencies becomes morelikely. Such regulation is likely in the areas of user privacy, pricing,content and quality of products and services. Taxation of internet use or othercharges imposed by government agencies or by private organizations foraccessing the internet may also be imposed. Laws and regulations applying tothe solicitation, collection or processing of personal or consumer informationcould affect our activities. Furthermore, any regulation imposing fees for internetuse could result in a decline in the use of the internet and the viability ofinternet commerce, which could have a material adverse effect on our business,results of operations and financial condition.

 

*Our growth could strain our personnel and infrastructureresources, and if we are unable to implement appropriate controls andprocedures to manage our growth, we may not be able to successfully implementour business plan.*

 

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

 

*Because competition for our target employeesis intense, we may not be able to attract and retain the highly skilledemployees we need to support our planned growth.*

 

To execute our growth plan, we must attractand retain highly qualified personnel. We need to hire additional personnel invirtually all operational areas, including selling and marketing, research anddevelopment, operations and technical support, customer service and administration.Competition for these personnel is intense, especially for engineers with highlevels of experience in designing and developing software and internet-relatedproducts. We may not be successful in attracting and retaining qualifiedpersonnel. We have from time to time in the past experienced, and we expect tocontinue to experience in the future, difficulty in hiring and retaining highlyskilled employees with appropriate qualifications. Many of the companies withwhich we compete for experienced personnel have greater

 

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resources than we have. If we fail to attract new personnel or retainand motivate our current personnel, our business and future growth prospectscould be severely harmed.

 

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

 

Some provisions of our certificate ofincorporation and bylaws, as well as some provisions of Delaware law, maydiscourage, delay or prevent third parties from acquiring us, even if doing sowould be beneficial to our stockholders. For example, our certificate ofincorporation provides for a classified board, with each board member serving astaggered three-year term. It also provides that stockholders may not fillboard vacancies, call stockholder meetings or act by written consent. Ourbylaws further provide that advance written notice is required prior tostockholder proposals. Each of these provisions makes it more difficult forstockholders to obtain control of our board or initiate actions that areopposed by the then current board. Additionally, we have authorized preferredstock that is undesignated, making it possible for the board to issue preferredstock with voting or other rights and preferences that could impede the successof any attempted change of control. Delaware law also could make it moredifficult for a third party to acquire us. Section 203 of the DelawareGeneral Corporation Law may have an anti-takeover effect with respect totransactions not approved in advance by our board, including discouragingattempts that might result in a premium over the market price of the shares ofcommon stock held by our stockholders.

 

*We do not intend to pay dividends.*

 

We have not declared or paid any cashdividends on our common stock since we have been a publicly traded company. Wecurrently intend to retain any future cash flows from operations to fund growthand, do not expect to pay any dividends in the foreseeable future.

 

**Item 7A. Quantitative and Qualitative Disclosures About Market Risk**

** **

**Our market risk exposures are related to our cash,cash equivalents and investments. We invest our excess cash in highly liquidshort-term investments, municipal securities, commercial paper and corporatebonds. 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 at December 31,2004. Changes in interest rates over time will, however, affect our interestincome.

 

For the year-ended December 31, 2004, all ofour billings, including those billed by our operations in Ireland, weredenominated in our functional currency, which is the U.S. dollar. Working fundsnecessary to facilitate the short-term operations of our subsidiaries are keptin the local currencies in which they do business. Beginning in 2005, weanticipate billing certain international customers in foreign currencies,however we do not expect the foreign currency billings to represent more than10% of our total billings during 2005.

 

We utilize foreign currency forward contracts to hedge foreign currency market exposures of underlying assets and liabilities. Our objective is to reduce the risk to earnings and cash flows associated with changes in foreign currency exchange rates. We do not use foreign currency forward contracts for speculative or trading purposes. As of December 31, 2004, we had committed to six foreign 

 

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currencyforward contracts to purchase Euro and British Pounds for $1.0 million.Our Euro commitment represents 300,000 Euros at a weighted average forward rateof 1.329. Our British Pound commitment represents 300,000 British Pounds at aweighted average forward rate of 1.912. The fair value of these foreign currency forward contracts was $1.0million at December 31, 2004. All of the foreign currency forward contracts will be settled before March 31,2005.

 

38

 

**Item 8. Financial Statements and Supplementary Data**

 

**Report ofIndependent Registered Public Accounting Firm**

 

The Board of Directors andStockholders

Websense, Inc. 

 

We have audited theaccompanying consolidated balance sheets of Websense, Inc. as of December 31,2004 and 2003, and the related consolidated statements of income, stockholders’equity, and cash flows for each of the three years in the period ended December31, 2004.  Our audits also included thefinancial statement schedule listed in the Index at Item 15(a).  These financial statements and schedule arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements and schedule based on ouraudits. 

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion. 

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Websense, Inc. at December 31,2004 and 2003, and the results of its operations and its cash flows for each ofthe three years in the period ended December 31, 2004, in conformity with U. S.generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, whenconsidered in relation to the basic financial statements taken as a whole,presents fairly in all material respects the information set forth therein.

 

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Websense Inc.’s internal control overfinancial reporting as of December 31, 2004, based on the criteria establishedin Internal Control-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated February 25, 2005expressed an unqualified opinion thereon.

 
|                  | /s/  Ernst & Young LLP |   |
|-----------------------|----------------------------|--------|
|                  |                       |
|                  |                       |
| San Diego, California |                       |
| February 25, 2005     |                       |

 

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**Websense,Inc.**

**Consolidated Balance Sheets**

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

 
| ** **                                                                                                                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Assets**                                                                                                                                      |       |                  |       |   |   |
| Current  assets:                                                                                                                                |       |                  |       |   |   |
| Cash and  cash equivalents                                                                                                                      |       | $                     | 38,878     |   | $ | 35,324 |   |
| Marketable  securities                                                                                                                          |       | 204,910               |       | 147,535 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $1,140 and $525 at December 31,  2004 and 2003                             |       | 44,309                |       | 27,999 |   |
| Income taxes  receivable                                                                                                                        |       | 3,201                 |       | 664 |   |
| Deferred  income taxes                                                                                                                          |       | 8,530                 |       | 8,733 |   |
| Other  current assets                                                                                                                           |       | 1,525                 |       | 1,271 |   |
| Total  current assets                                                                                                                           |       | 301,353               |       | 221,526 |   |
|                                                                                                                                            |       |                  |       |   |   |
| Property and  equipment, net                                                                                                                    |       | 3,955                 |       | 2,997 |   |
| Deferred  income taxes, less current portion                                                                                                    |       | 9,523                 |       | 8,672 |   |
| Deposits and  other assets                                                                                                                      |       | 462                   |       | 418 |   |
| Total assets                                                                                                                                    |       | $                     | 315,293    |   | $ | 233,613 |   |
|                                                                                                                                            |       |                  |       |   |   |
| **Liabilities  and stockholders’ equity**                                                                                                  |       |                  |       |   |   |
| Current  liabilities:                                                                                                                           |       |                  |       |   |   |
| Accounts  payable                                                                                                                               |       | $                     | 1,100      |   | $ | 743 |   |
| Accrued  payroll and related benefits                                                                                                           |       | 7,163                 |       | 5,241 |   |
| Other  accrued expenses                                                                                                                         |       | 5,011                 |       | 3,835 |   |
| Income taxes  payable                                                                                                                           |       | 1,758                 |       | 905 |   |
| Current  portion of deferred revenue                                                                                                            |       | 90,686                |       | 65,480 |   |
| Total  current liabilities                                                                                                                      |       | 105,718               |       | 76,204 |   |
|                                                                                                                                            |       |                  |       |   |   |
| Deferred  revenue, less current portion                                                                                                         |       | 41,631                |       | 28,480 |   |
|                                                                                                                                            |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                                     |       |                  |       |   |   |
| Common stock  - $0.01 par value; 100,000 shares authorized; 23,526 and 22,445 shares issued  and outstanding at December 31, 2004 and 2003 |       | 235                   |       | 228 |   |
| Additional  paid-in capital                                                                                                                     |       | 150,447               |       | 120,639 |   |
| Treasury  stock                                                                                                                                 |       | —                |       | (7,684 | ) |
| Retained  earnings                                                                                                                              |       | 17,681                |       | 15,731 |   |
| Accumulated  other comprehensive income (loss)                                                                                                  |       | (419                  | )          | 15 |   |
| Total  stockholders’ equity                                                                                                                |       | 167,944               |       | 128,929 |   |
| Total  liabilities and stockholders’ equity                                                                                                |       | $                     | 315,293    |   | $ | 233,613 |   |

 

Seeaccompanying notes.

 

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**Websense,Inc.**

**Consolidated Income Statements**

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

 
| ** **                                                                                                                                                                                        | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                                                                        | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Revenues                                                                                                                                                                                          |       | $                                 | 111,859    |   | $ | 81,734 |   | $ | 60,965 |   |
|                                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Cost of  revenues                                                                                                                                                                                 |       | 7,769                             |       | 5,523 |   | 4,170 |   |
|                                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Gross margin                                                                                                                                                                                      |       | 104,090                           |       | 76,211 |   | 56,795 |   |
|                                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Operating  expenses:                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Selling and  marketing (exclusive of $0, $32 and $121 for the years ended December 31,  2004, 2003 and 2002, respectively, reported below as amortization of  stock-based compensation)      |       | 42,625                            |       | 31,845 |   | 26,201 |   |
| Research and  development (exclusive of $0, $17 and $73 for the years ended December 31,  2004, 2003 and 2002, respectively, reported below as amortization of  stock-based compensation)    |       | 14,509                            |       | 12,843 |   | 10,957 |   |
| General and  administrative (exclusive of $0, $34 and $254 for the years ended December 31,  2004, 2003 and 2002, respectively, reported below as amortization of  stock-based compensation) |       | 8,200                             |       | 6,649 |   | 5,960 |   |
| Amortization  of stock-based compensation                                                                                                                                                         |       | —                            |       | 83 |   | 448 |   |
| Total  operating expenses                                                                                                                                                                         |       | 65,334                            |       | 51,420 |   | 43,566 |   |
|                                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Income from  operations                                                                                                                                                                           |       | 38,756                            |       | 24,791 |   | 13,229 |   |
|                                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Other  income, net                                                                                                                                                                                |       | 2,226                             |       | 2,292 |   | 2,711 |   |
|                                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Income  before income taxes                                                                                                                                                                       |       | 40,982                            |       | 27,083 |   | 15,940 |   |
|                                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Provision  (benefit) for income taxes                                                                                                                                                             |       | 14,806                            |       | 10,395 |   | (797 | ) |
|                                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Net income                                                                                                                                                                                        |       | $                                 | 26,176     |   | $ | 16,688 |   | $ | 16,737 |   |
|                                                                                                                                                                                              |       |                              |       |   |   |   |   |
| Net income  per share:                                                                                                                                                                            |       |                              |       |   |   |   |   |
| Basic net  income per share                                                                                                                                                                       |       | $                                 | 1.13       |   | $ | 0.76 |   | $ | 0.79 |   |
| Diluted net  income per share                                                                                                                                                                     |       | $                                 | 1.09       |   | $ | 0.73 |   | $ | 0.72 |   |
| Weighted  average shares – basic                                                                                                                                                             |       | 23,080                            |       | 22,038 |   | 21,211 |   |
| Weighted  average shares – diluted                                                                                                                                                           |       | 24,114                            |       | 22,976 |   | 23,338 |   |

 

See accompanying notes.

 

41

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**Websense,Inc.**

**ConsolidatedStatements of Stockholders’ Equity**

**(Inthousands)**

 
| ** **                                                                                    | ** ** | **Common stock** | ** ** | **Additional** | ** ** | **Treasury**        | ** ** | **Deferred** | ** ** | **Retained  earnings** | ** ** | **Accumulated other   comprehensive** | ** ** | **Total  stockholders’** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------|------------|----------------|------------|---------------------|------------|--------------|------------|------------------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                    | ** ** | **Shares**       | ** ** | **Amount**     | ** ** | **paid-in capital** | ** ** | **stock**    | ** ** | **compensation**       | ** ** | **(deficit)**                         | ** ** | **Income  (loss)**            | ** ** | **equity** | ** ** |
| 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 |   |
| Issuance of common stock upon exercise of options                                             |       | 1,473            |       | 15             |       | 19,811              |       | —       |       | —                 |       | —                                |       | —                        |       | 19,826 |   |
| Issuance of common stock for stock purchase plan                                              |       | 190              |       | 2              |       | 2,531               |       | —       |       | —                 |       | —                                |       | —                        |       | 2,533 |   |
| Issuance of common stock upon exercise of warrant                                             |       | 28               |       | —         |       | —              |       | —       |       | —                 |       | —                                |       | —                        |       | — |   |
| Purchase of treasury stock                                                                    |       | (610             | )          | —         |       | —              |       | (22,980      | )          | —                 |       | —                                |       | —                        |       | (22,980 | ) |
| Retirement of treasury stock                                                                  |       |             |       | (10            | )          | (6,428              | )          | 30,664       |       |                   |       | (24,226                               | )          |                          |       | — |   |
| Tax benefit of stock options                                                                  |       | —           |       | —         |       | 13,894              |       | —       |       | —                 |       | —                                |       | —                        |       | 13,894 |   |
| Comprehensive income:                                                                         |       |             |       |           |       |                |       |         |       |                   |       |                                  |       |                          |       |   |   |
| Net income                                                                                    |       | —           |       | —         |       | —              |       | —       |       | —                 |       | 26,176                                |       | —                        |       | 26,176 |   |
| Net change in unrealized gain (loss) on marketable  securities                                |       | —           |       | —         |       | —              |       | —       |       | —                 |       | —                                |       | (442                          | )          | (442 | ) |
| Net change in unrealized loss on fair market  valuation of foreign currency forward contracts |       | —           |       | —         |       | —              |       | —       |       | —                 |       | —                                |       | 8                             |       | 8 |   |
| Comprehensive income                                                                          |       |             |       |           |       |                |       |         |       |                   |       |                                  |       |                          |       | 25,742 |   |
| Balance at December 31, 2004                                                             |       | 23,526           |       | $              | 235        |                | $          | 150,447      |       | $                      | —     |                                  | $          | —                        |       | $ | 17,681 |   | $ | (419 | ) | $ | 167,944 |   |

 

See accompanying notes.

 

42

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**Websense,Inc.**

**ConsolidatedStatements of Cash Flows**

**(Inthousands)**

 
| ** **                                                                         | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Operating  activities:**                                                         | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                 | 26,176     |   | $ | 16,688 |   | $ | 16,737 |   |
|                                                                               |       |                              |       |   |   |   |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                              |       |   |   |   |   |
| Depreciation                                                                       |       | 2,277                             |       | 2,016 |   | 1,929 |   |
| Amortization  of deferred compensation                                             |       | —                            |       | 83 |   | 448 |   |
| Deferred  revenue                                                                  |       | 38,357                            |       | 29,281 |   | 21,201 |   |
| Unrealized  loss on foreign currency forward contracts                             |       | 8                                 |       | — |   | — |   |
| Tax benefit  from exercise of stock options                                        |       | 13,894                            |       | 7,027 |   | 12,937 |   |
| Changes in  operating assets and liabilities:                                      |       |                              |       |   |   |   |   |
| Accounts  receivable                                                               |       | (16,310                           | )          | (8,159 | ) | (7,314 | ) |
| Income taxes  receivable                                                           |       | (2,537                            | )          | (664 | ) | — |   |
| Other  current assets                                                              |       | (254                              | )          | (87 | ) | (100 | ) |
| Deposits and  other assets                                                         |       | (44                               | )          | (119 | ) | 85 |   |
| Deferred  income taxes                                                             |       | (648                              | )          | (1,973 | ) | (15,432 | ) |
| Accounts  payable                                                                  |       | 357                               |       | (18 | ) | 121 |   |
| Accrued  payroll and related benefits                                              |       | 1,922                             |       | 1,614 |   | 877 |   |
| Other accrued  expenses                                                            |       | 1,176                             |       | 395 |   | 1,176 |   |
| Income taxes  payable                                                              |       | 853                               |       | (65 | ) | 970 |   |
| Net cash  provided by operating activities                                         |       | 65,227                            |       | 46,019 |   | 33,635 |   |
|                                                                               |       |                              |       |   |   |   |   |
| **Investing  activities:**                                                         |       |                              |       |   |   |   |   |
| Purchase of  property and equipment                                                |       | (3,235                            | )          | (2,046 | ) | (2,186 | ) |
| Purchases of  marketable securities                                                |       | (270,130                          | )          | (197,880 | ) | (112,763 | ) |
| Maturities  of marketable securities                                               |       | 161,520                           |       | 83,233 |   | 92,569 |   |
| Sales of  marketable securities                                                    |       | 50,793                            |       | 77,854 |   | — |   |
| Net cash  used in investing activities                                             |       | (61,052                           | )          | (38,839 | ) | (22,380 | ) |
|                                                                               |       |                              |       |   |   |   |   |
| **Financing  activities:**                                                         |       |                              |       |   |   |   |   |
| Proceeds  from exercise of stock options                                           |       | 19,826                            |       | 4,733 |   | 4,023 |   |
| Proceeds  from issuance of common stock for stock purchase plan                    |       | 2,533                             |       | 1,832 |   | 1,470 |   |
| Purchase of  treasury stock                                                        |       | (22,980                           | )          | (7,684 | ) | — |   |
| Net cash  (used in) provided by financing activities                               |       | (621                              | )          | (1,119 | ) | 5,493 |   |
|                                                                               |       |                              |       |   |   |   |   |
| Increase in  cash and cash equivalents                                             |       | 3,554                             |       | 6,061 |   | 16,748 |   |
|                                                                               |       |                              |       |   |   |   |   |
| Cash and  cash equivalents at beginning of year                                    |       | 35,324                            |       | 29,263 |   | 12,515 |   |
|                                                                               |       |                              |       |   |   |   |   |
| Cash and  cash equivalents at end of year                                          |       | $                                 | 38,878     |   | $ | 35,324 |   | $ | 29,263 |   |
|                                                                               |       |                              |       |   |   |   |   |
| **Supplemental  disclosures of cash flow information:**                            |       |                              |       |   |   |   |   |
| Income taxes  paid                                                                 |       | $                                 | 3,447      |   | $ | 6,211 |   | $ | 687 |   |

 

See accompanying notes.

 

43

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**Websense,Inc.**

**Notes toConsolidated Financial Statements**

**December 31,2004**

 

**1. Summary of SignificantAccounting Policies**

 

**Description of Business**

 

Websense, Inc. (“Websense”or the “Company”) was founded in 1994. The Company provides employee internetmanagement (EIM) software products that enable businesses to analyze, reportand manage how their employees use computing resources, including internetaccess, instant messaging (IM), peer-to-peer file sharing, network bandwidthand desktop applications. The Company’s Websense Enterprise solution supportsan organization’s efforts to enhance security, improve employee productivity,conserve network bandwidth and mitigate potential legal liability.

 

**Use of Estimates**

 

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

 

#### **Reclassifications**

#### ** **

Certainreclassifications have been made for consistent presentation.

 

#### **Principles of Consolidation**

#### ** **

The consolidated financial statements include theaccounts of the Company and its wholly owned subsidiaries in the UnitedKingdom, Japan, Ireland, Australia, France and Germany. Significantintercompany accounts and transactions have been eliminated in consolidation.Activities performed by the subsidiaries are a direct and integral extension ofthe Company’s primary business.

 

For the years ended December 31, 2004, 2003 and2002, the Company’s billings were denominated in its functional currency, whichis the U.S. dollar.  As such, the Companyhas not recorded foreign currency translation gains or losses.  However, the Company incurred foreigncurrency transaction losses of $76,000, $57,000 and $106,000 for the yearsended December 31, 2004, 2003 and 2002, respectively.

 

**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 as well asStaff Accounting Bulletin No. 104, RevenueRecognition, as issued by the Securities and Exchange Commission.  These statements and bulletin provide guidancefor recognizing revenue related to sales by software 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. Other services such asupgrades/enhancements and standard post-contract technical support services aresold together with Websense Enterprise and provided throughout the subscriptionterm.  The Company recognizes revenue ona monthly straight-line basis, commencing with the month the subscriptionbegins, over the term of the subscription agreement provided collectability isreasonably assured. Upon entering into a subscription arrangement for a fixedor determinable fee, the Company electronically delivers access codes to usersand then promptly invoices customers for the full amount of their subscriptions.Payment is due for the full term of the subscription, generally within 30 daysof invoicing. The Company records amounts billed to customers in excess of recognizablerevenue as deferred revenue in the accompanying balance sheets.

 

44

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**Cash and Cash Equivalents**

 

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

 

**Marketable Securities**

 

Marketable securities at December 31,2004 consist of tax-exempt auction rate notes and municipal bonds. The Companycurrently classifies all investment securities as available for sale.Securities classified as available for sale are reported at fair value,adjusted for other than temporary declines in value. The Company records otherthan temporary declines in value to earnings as realized losses. Unrealizedholding gains and losses on securities available for sale are reported as a netamount in a separate component of stockholders’ equity until realized. Realizedgains and losses are recorded based on the specific identification method.

 

Historically, the fair valuesof the Company’s tax-exempt auction rate notes have not changed due to the highcredit quality and short-term nature of these securities. However, if the fairvalue of its tax-exempt auction notes did change when interest rates and/ordividends reset at auction, the Company would recognize unrealized holdinggains and/or losses on these investments as a net amount in a separatecomponent of stockholders’ equity until realized. The Company would thenrecognize realized gains and/or losses based on the specific identificationmethod.

 

#### **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.

 

**ForeignCurrency Cash Flow Hedges**

 

Statement of FinancialAccounting Standards (SFAS) No. 133, Accounting for Derivative Instruments andHedging Activities, as amended, established accounting and reporting standardsrequiring recognition of all derivatives as assets or liabilities in theconsolidated balance sheets and measurement of those instruments at fair value.Gains and losses resulting from changes in the fair values of those derivativeinstruments will be recorded to earnings or other comprehensive incomedepending on the use of the derivative instrument and whether it qualifies forhedge accounting.  The Company usesderivatives to manage foreign currency risk and not for speculative or tradingpurposes. The Company’s objective is to reduce the risk to earnings and cashflows associated with changes in foreign currency exchange rates.

 

45

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During 2004, the Company began to utilize foreign currency forward contracts. All such contracts entered into were designated as cash flow hedges and were considered effective, as defined by SFAS 133, as amended.  None of the contracts were terminated prior to settlement. Net realized losses related to these contracts settled during the year are included in other income, net in the accompanying consolidated income statements and amounted to $186,000 in 2004. As of December 31, 2004, the Company had committed to six foreign currency forward contracts to purchase Euro and British Pounds for $1.0 million. All of these contracts were designated as cash flow hedges and were determined effective as of December 31, 2004.  The fair value of these contracts was $1.0 million at December 31, 2004 and all of the foreign exchange contracts will be settled before March 31, 2005. Realized gains or losses related to the settlements, if any, will be recorded in other income, net at the time of settlement.

 

**Concentration of Credit Risk**

 

The Company sells itsproducts to customers primarily in the United States, Canada, Europe, Asia, Australia,and Latin America. The Company maintains a reserve for potential credit lossesand historically 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 SFAS No.86, Accounting for the Costs of Computer Software to be Sold, Leased, orOtherwise Marketed, costs are capitalized, when significant, in the developmentof specific computer software products after establishment of technologicalfeasibility and marketability. There have been no such costs capitalized todate as the costs incurred during the period between technological feasibilityto general release have not been significant.

 

The Company accounts forinternally developed computer software costs, incurred in the applicationstage, in accordance with SOP 98-1, Accounting for Costs of Computer SoftwareDeveloped or Obtained for Internal Use.

 

**Advertising Expenses**

 

Advertising costs areexpensed as incurred. Total advertising costs for the years ended December 31,2004, 2003 and 2002 were $4.1 million, $3.4 million and $3.5 million,respectively.

 

**Stock–Based Compensation**

 

The Company has elected tofollow Accounting Principles Board (APB) No. 25, Accounting for Stock Issued toEmployees, and related interpretations in accounting for its employee stockoptions because the alternative fair value accounting provided for under SFASNo. 123, Accounting for Stock-Based Compensation, as amended by SFAS148, Accounting for Stock-BasedCompensation – 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

 

46

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underlying the stock on the date of grant, nocompensation expense is recognized. At the time stock options were granted, theCompany believed that the exercise price was at a price not less than the fairvalue of the underlying common stock. In conjunction with the Company’s initialpublic offering, the Company reviewed its exercise prices and arrived at thedeemed fair value for each option grant during 1999. With respect to the3,220,500 options granted during 1999 and through March 27, 2000, theCompany recorded deferred compensation of $5.4 million for the differencebetween the exercise price per share and the deemed fair value per share at thegrant date. The approximate weighted-average exercise price per share and theapproximate weighted-average deemed fair value per share for the options was$1.64 and $3.31, respectively. Deferred stock compensation was recognized andamortized on an accelerated basis in accordance with Financial AccountingStandards Board Interpretation FIN No. 28 over the vesting period of therelated options, generally four years. Deferred stock compensation was fullyamortized as of December 31, 2003.

 

Proforma information regarding net income is required by SFAS 123, as amended bySFAS 148, and has been determined as if the Company has accounted for itsemployee stock options under the fair value method of SFAS 123, as amended bySFAS 148. The pro forma effects of stock-based compensation on net income andnet income per share have been estimated at the date of grant using theBlack-Scholes option pricing model based on the following weighted averageassumptions since the Company’s initial public offering in March of 2000:risk free interest rates of 2.36% to 6.0%, dividend yields of 0%, expectedvolatility of 48% to 132%, and life of 5 years.

 

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

 
| ** **                                                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                         | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net income  as reported                                                                                            |       | $                                 | 26,176     |   | $ | 16,688 |   | $ | 16,737 |   |
| Add:  Stock-based employee compensation cost included in net income as reported,  net of tax (1), (2)              |       | —                            |       | 51 |   | 448 |   |
| Deduct:  Total stock-based compensation expense determined under fair value method for  all awards, net of tax (2) |       | (11,300                           | )          | (9,185 | ) | (11,146 | ) |
| Pro forma  net income                                                                                              |       | $                                 | 14,876     |   | $ | 7,554 |   | $ | 6,039 |   |
|                                                                                                               |       |                              |       |   |   |   |   |
| Basic net  income per share as reported                                                                            |       | $                                 | 1.13       |   | $ | 0.76 |   | $ | 0.79 |   |
|                                                                                                               |       |                              |       |   |   |   |   |
| Pro forma  basic net income per share                                                                              |       | $                                 | 0.64       |   | $ | 0.34 |   | $ | 0.28 |   |
|                                                                                                               |       |                              |       |   |   |   |   |
| Diluted net  income per share as reported                                                                          |       | $                                 | 1.09       |   | $ | 0.73 |   | $ | 0.72 |   |
|                                                                                                               |       |                              |       |   |   |   |   |
| Pro forma  diluted net income per share                                                                            |       | $                                 | 0.62       |   | $ | 0.33 |   | $ | 0.26 |   |

 

47

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----

(1)          The Company wasrecognizing deferred stock-based compensation expense on the deemed fair valueof options granted prior to the initial public offering in March 2000.  This expense was amortized on an accelerated basis,in accordance with FIN 28, over approximately a four-year period, which beganin March 2000.

 

(2)          The Company had aneffective tax rate of 36%, 38% and (5%) in 2004, 2003 and 2002,respectively.  Because of the tax benefitof 5% in 2002, the additions and deductions were assumed to be unaffected.

 

For purposesof pro forma disclosures, the estimated fair value is amortized to expense overthe options vesting period.  The effectof applying SFAS 123, as amended by SFAS 148, for purposes of providing proforma disclosures may not be representative of the effects on our operatingresults in future years.

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment(SFAS 123R), which will be effective in the Company’s third quarter offiscal 2005.  As permitted by SFAS 123,the Company currently accounts for share-based payments to employees using APB25’s intrinsic value method and, as such, generally recognizes no compensationcost for employee stock option grants or the discounts the Company providesunder its employee stock purchase plans. Accordingly, the adoption of SFAS 123R’s fair value method willsignificantly increase the Company's recognized employee compensation expense,thereby reducing net income and earnings per share. The impact of adoption ofSFAS 123R cannot be predicted at this time because it will depend on levels ofshare-based payments granted in the future. However, had the Company adopted SFAS 123R in prior periods, the impactof that standard would have approximated the impact of SFAS 123 as described inthe preceding paragraphs.  SFAS 123R alsorequires the benefits of tax deductions in excess of recognized compensationcost to be reported as a financing cash flow, rather than as an operating cashflow as required under current guidance. This requirement will reduce the Company’s net operating cash flows andincrease net financing cash flows in periods after adoption.  The Company cannot estimate what thoseamounts will be in the future, however, the amount of operating cash flowsrecognized in 2004, 2003 and 2002 for such tax deductions were $13.9 million,$7.0 million and $12.9 million, respectively.

 

**Comprehensive Income**

 

The Companyhas adopted SFAS No. 130, Reporting Comprehensive Income, which requires thatall components of comprehensive income, including net income, be reported inthe financial statements in the period in which they are recognized.Comprehensive income is defined as the change in equity during a period fromtransactions and other events and circumstances from non-owner sources. Netincome and other comprehensive income, including foreign currency translationadjustments, and unrealized gains and losses on investments, shall be reported,net of their related tax effect, to arrive at comprehensive income.Comprehensive income for the years ended December 31, 2004, 2003 and 2002 was$25.7 million, $16.2 million and $17.2 million, respectively. The differencefrom reported net income is due to the changes in unrealized gain (loss) onmarketable securities of ($442,000) and to the changes in unrealized gain(loss) on the fair market valuation of foreign currency forward contracts of$8,000 for the year ended December 31, 2004. For the years ended December 31,2003 and 2002, the difference from reported net income is due to changes inunrealized gain (loss) on marketable securities of ($461,000) and $416,000,respectively.

 

48

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**Net Income Per Share**

 

Websense computes net incomeper share in accordance with SFAS No. 128, Earnings Per Share (EPS). Under theprovisions of SFAS No. 128, basic net income per share is computed by dividingthe net income for the period by the weighted average number of common sharesoutstanding during the period. Diluted net income per share is computed bydividing the net income for the period by the weighted average number of commonand common equivalent shares outstanding during the period. Common equivalentshares for all periods presented consist of dilutive stock options.

 

Dilutive securities includeoptions, warrants and preferred stock as if converted and restricted stocksubject to vesting. In 2004, the difference between the weighted average sharesused in determining basic EPS versus diluted EPS related to dilutive stockoptions totaled 1,034,000. Potentially dilutive securities totaling 201,000,1,376,000 and 1,413,000 for the years ended December 31, 2004, 2003 and2002, respectively, were excluded from historical basic and diluted earningsper share because of their anti-dilutive effect as a result of stock optionswhich have exercise prices greater than the average market price of the commonshares.

 

49

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

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

 

**Tax Matters**

 

From time to time, theCompany is audited by various state, federal and international authoritiesrelating to tax matters.  The Companyfully cooperates with all audits, but defends its positions vigorously.  The Company’s audits are in various stages ofcompletion; however, no outcome for a particular audit can be determined withcertainty prior to the conclusion of the audit and appeals process.  Adjustments, if any, are appropriatelyrecorded in the Company’s financial statements in the period determined.

 

**Recently Issued Accounting Standards**

 

In December 2004, the FASBissued FASB Staff Position No. FAS 109-2, “Accounting and Disclosure Guidancefor the Foreign Earnings Repatriation Provision within the American JobsCreation Act of 2004”. The American Jobs Creation Act of 2004 introduces aspecial one-time dividends received deduction on the repatriation of certainforeign earnings to a U.S. taxpayer (“repatriation provision”), providedcertain criteria are met. FAS 109-2 provides accounting and disclosure guidancefor the repatriation provision, and was effective immediately upon issuance. Anevaluation of the repatriation provision is dependent upon consideration ofvarious factors including cash payment requirement, base period limitation,domestic reinvestment plan, foreign country dividend limitations and issuanceof clarifying language on key elements of the provision by the U.S. Treasury.The Company does not believe that the adoption of FAS 109-2 will have asignificant effect on its financial statements.

 

**2. Marketable Securities**

 

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

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

 

50

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Investments in marketablesecurities consisted of the following at December 31, 2003 (in thousands):

 
| ** **         | ** ** | **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 |   |

** **

The amortizedcost and estimated fair value of the securities at December 31, 2004 and2003, by contractual maturity, are shown below (in thousands).

 
| ** **                 | ** ** | **2004**            | ** ** | **2003**                  | ** ** |
|----------------------------|------------|---------------------|------------|---------------------------|------------|
| ** **                 | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| ** **                 | ** ** | ** **          | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Due within 1  year         |       | $                   | 155,537    |                      | $          | 155,346 |   | $ | 104,189 |   | $ | 104,194 |   |
|                       |       |                |       |                      |       |   |   |   |   |
| Due between  1 and 3 years |       | 49,800              |       | 49,564                    |       | 43,331 |   | 43,341 |   |
|                       |       | $                   | 205,337    |                      | $          | 204,910 |   | $ | 147,520 |   | $ | 147,535 |   |

 

Realized gain(loss) from investments in marketable securities for the years ended 2004, 2003and 2002 were ($4,000), $194,000 and $8,000, respectively.

 

**3. Property and Equipment**

 

Property and equipmentconsist of the following (in thousands):

 
| ** **                      | ** ** | **Estimated  Useful Lives** | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-----------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | ** **                  | **2004**   | ** **            | **2003**   | ** ** |
|                            |       |                        |       |                  |       |   |   |
| Computer  hardware and software |       | 3 years                     |       | $                     | 11,563     |   | $ | 8,804 |   |
| Office  furniture and equipment |       | 3 years                     |       | 2,097                 |       | 1,853 |   |
| Other  equipment                |       | 3 years                     |       | 539                   |       | 307 |   |
|                            |       |                        |       | 14,199                |       | 10,964 |   |
|                            |       |                        |       |                  |       |   |   |
| Accumulated  depreciation       |       |                        |       | (10,244               | )          | (7,967 | )  |
|                            |       |                        |       |                  |       |   |   |
|                            |       |                        |       | $                     | 3,955      |   | $ | 2,997 |   |

 

Depreciation expensefor 2004, 2003 and 2002 was $2.3 million, $2.0 million and $1.9 million,respectively.

 

51

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**4. Geographic Information**

 

The following illustratesrevenues attributed to customers located in the Company’s country of domicile(the United States) and those attributed to foreign customers (in thousands):

 

 
| ** **                      | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------|------------|-----------------------------------|------------|
| ** **                      | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| United  States                  |       | $                                 | 75,891     |   | $ | 56,006 |   | $ | 41,456 |   |
| Europe,  Middle East and Africa |       | 23,831                            |       | 16,932 |   | 11,888 |   |
| Asia\Pacific                    |       | 4,861                             |       | 4,045 |   | 4,085 |   |
| Canada and  Latin America       |       | 7,276                             |       | 4,751 |   | 3,536 |   |
|                            |       | $                                 | 111,859    |   | $ | 81,734 |   | $ | 60,965 |   |

 

The United Kingdomrepresented $10.1 million, $7.4 million and $4.9 million of total revenue forthe years ended 2004, 2003 and 2002, respectively. No other foreign countryrepresented more than 5% of total revenue.

 

**5. Deferred Revenue**

 

The Company expects torecognize revenues related to subscriptions in existence as of December 31,2004 as follows (in thousands):

 
| **Years Ending  December 31:** | ** ** |   |    |   |
|--------------------------------|------------|--------|---------|--------|
| 2005                           |       | $      | 90,686  |   |
| 2006                           |       | 29,814 |    |
| 2007 and thereafter            |       | 11,817 |    |
|                           |       | $      | 132,317 |   |

 

**6. Commitments and Guarantees**

 

The Company leases itsfacilities and certain equipment under non-cancelable operating leases, whichexpire at various dates through December 2008. The facilities leasescontain renewal options and are subject to cost increases.

 

Future minimum annualpayments under non-cancelable operating leases and software licenses at December 31,2004 are as follows (in thousands):

 
| **Years Ending  December 31:** | ** ** | ** ** | **Operating  Leases** | ** ** | **Software  Licenses** | ** ** | **Total** | ** ** |
|--------------------------------|------------|------------|-----------------------|------------|------------------------|------------|-----------|------------|
| 2005                           |       | $          | 1,741                 |       | $                      | 184        |      | $          | 1,925 |   |
| 2006                           |       | 1,889      |                  | 184        |                   | 2,073      |      |
| 2007                           |       | 1,937      |                  | 46         |                   | 1,983      |      |
| 2008                           |       | 325        |                  | —     |                   | 325        |      |
|                           |       | $          | 5,892                 |       | $                      | 414        |      | $          | 6,306 |   |
|                                |            |            |                       |            |                        |            |           |            |  |  |  |  |  |  |

 

Rent expense totaled $2.8million, $2.3 million and $2.0 million for the years ended December 31,2004, 2003 and 2002, respectively.

 

52

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Guarantees of Indebtednessof Others (FIN 45) elaborates on previously existing disclosure requirementsfor most guarantees, including loan guarantees such as standby letters ofcredit. It also clarifies that at the time a company issues a guarantee, thecompany must recognize an initial liability for the fair value, or marketvalue, of the obligations it assumes under the guarantee and must disclose thatinformation in its interim and annual financial statements. The provisionsrelated to recognizing a liability at inception of the guarantee for the fairvalue of the guarantor’s obligations does not apply to product warranties,indemnifications or to guarantees accounted for as derivatives.

 

We provide indemnificationsof varying scope and size to certain customers against claims of intellectualproperty infringement made by third parties arising from the use of ourproducts. We evaluate estimated losses for such indemnifications under SFAS 5,Accounting for Contingencies, as interpreted by FIN 45. We consider suchfactors as the degree of probability of an unfavorable outcome and the abilityto make a reasonable estimate of the amount of loss. To date, we have notencountered material costs as a result of such obligations and have not accruedany liabilities related to such indemnifications in our financial statements.

 

**7. Stockholders’ Equity**

 

**Warrants**

 

In connection with theCompany’s Series B convertible preferred stock offering between June and September 1999,the Company issued warrants to purchase 62,500 shares of common stock for $3.00per share to financial consultants. The warrants were exercisable in whole orin part at any time and from time to time until their expiration in June 2004.In April 2000, warrants to purchase 4,688 shares of common stock wereexercised. In November 2001, warrants to purchase 23,437 shares of commonstock were exercised. In July 2003, April 2004 and July 2004,warrants to purchase 4,000, 9,375 and 21,000 shares of common stock wereexercised, which resulted in 3,406, 8,467 and 19,287 shares of common stockbeing issued, respectively, due to the cashless exercise of these warrants. Atthe end of 2004, all warrants have been exercised.

 

**Stock Option Plan**

 

In May 1998, the Board ofDirectors elected to replace the 1997 Stock Option/Stock Issuance Plan with the1998 Stock Option/Stock Issuance Plan (1998 Stock Plan) under which 4,600,000shares of the Company’s common stock were authorized for future issuance, andreserved for purchase upon exercise of options granted. The 1998 Stock Planprovides for the grant of incentive and non-statutory options and issuances ofcommon stock to employees and directors.

 

In February 2000, theBoard of Directors replaced the 1998 Stock Plan with the 2000 Stock IncentivePlan (2000 Plan) under which 4,500,000 shares of the Company’s common stockwere initially authorized for future issuance, and reserved for purchase uponexercise of options granted. In addition, the 2000 Plan provides for automaticannual increases in the number of shares authorized and reserved for issuancethereunder (beginning in 2001) equal to the lesser of (i) 4% of the Company’soutstanding shares on the last business day in December of the calendaryear immediately preceding or (ii) 1,500,000 shares. At December 31, 2004,7,879,206 shares were authorized and reserved for issuance under the 2000 Plan.

 

53

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The 2000 Plan provides for the grant of options to the Company’sdirectors, officers, employees and consultants. The 2000 Plan provides for thegrant of incentive and non-statutory stock options and rights to purchase stockto employees, directors or consultants of the Company. The 2000 Plan providesthat incentive stock options will be granted only to employees and are subjectto certain limitations as to fair value during a calendar year.

 

The exercise price ofincentive stock options must equal at least the fair value on the date of grantand the exercise price of non-statutory stock options and the issuance price ofcommon stock under the stock issuance program may be no less than 85% of thefair value on the date of grant or issuance. The options are exercisable for aperiod of up to ten years after the date of grant and generally vest 25% oneyear from date of grant and ratably each month thereafter for a period of 36months. Unvested common shares obtained through early exercise of options aresubject to repurchase by the Company at the original issue price. To date onlynon-statutory options have been granted under the 2000 Plan.

 

In 2002, the Company issuedoptions as an incentive for certain persons to commence employment that werenot covered under the 2000 Plan.  Inaccordance with Section 4350(i) of the NASD Marketplace Rules for theNasdaq Stock Market, the Company issued 177,000 such options, which havesubstantially the same terms as options issued under the 2000 Plan.

 

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

 
| ** **                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|
| Balance at December 31,  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      |   |
| Granted                            |       | 976,000               |       | $                                      | 37.26      |   |
| Exercised                          |       | (1,473,028            | )          | $                                      | 13.46      |   |
| Cancelled                          |       | (321,468              | )          | $                                      | 22.28      |   |
| Balance at December 31,  2004 |       | 3,116,580             |       | $                                      | 24.18      |   |

 

54

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The following tablesummarizes all options outstanding and exercisable by price range as of December 31,2004:

 
| ** **                    | ** **   | **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-$14.98  |                    | 974,159    |                                                         | 6.89       |   | $ | 11.95 |   | 605,507 |   | $ | 10.67 |   |
| $                             | 15.00-$27.15 |                    | 713,668    |                                                         | 7.52       |   | $ | 20.69 |   | 325,940 |   | $ | 20.26 |   |
| $                             | 27.17-$32.27 |                    | 684,003    |                                                         | 7.70       |   | $ | 29.04 |   | 308,084 |   | $ | 28.18 |   |
| $                             | 32.30-$43.30 |                    | 625,750    |                                                         | 9.53       |   | $ | 37.25 |   | 7,291 |   | $ | 32.30 |   |
| $                             | 43.45-$52.66 |                    | 119,000    |                                                         | 9.90       |   | $ | 48.66 |   | — |   | $ | — |   |
|                          |         |                    |       |                                                         |       |   |   |   |   |   |   |
|                          |         | 3,116,580               |       | 7.86                                                         |       | $ | 24.18 |   | 1,246,822 |   | $ | 17.63 |   |

 

The weighted average fairvalue of options granted during 2004, 2003 and 2002 was $37.26, $17.45 and $24.28per share, respectively.

 

**Employee Stock Purchase Plan**

 

In February 2000, theCompany adopted the 2000 Employee Stock Purchase Plan. The purchase planprovides for automatic annual increases in the number of shares reserved forissuance thereunder (beginning in 2001) equal to the lesser of (i) 1% of theCompany’s outstanding shares on the last business day in December of thecalendar year immediately preceding or (ii) 375,000 shares. The purchase planis intended to qualify as an employee stock purchase plan within the meaning ofSection 423 of the Internal Revenue Code. Under the purchase plan, theBoard of Directors may authorize participation by eligible employees, includingofficers, in periodic offerings following commencement of the purchase plan.Shares issued and available for issuance are as follows:

 
| 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  |   |
| Shares  reserved for issuance during 2004 based on the automatic increase in shares  authorized |   | 224,449  |   |
| Shares issued  during 2004                                                                      |   | (189,988 | )      |
| Shares  reserved for issuance at December 31, 2004                                         |   | 521,745  |   |

 

55

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Unless otherwise determinedby the Board, employees are eligible to participate in the purchase planprovided they are employed for at least 20 hours per week and are customarilyemployed for at least five months per calendar year. Employees who participatein an offering may have up to 15% of their earnings withheld pursuant to thepurchase plan. The amount withheld is then used to purchase shares of commonstock on specified dates. The price of common stock purchased pursuant to theplan will be equal to 85% of the lower of the fair market value of the commonstock at the commencement date of each offering period or the relevant purchasedate. Employees may end their participation in the offering at any time duringthe offering period, and participation ends automatically on termination ofemployment.

 

**Shares Reserved for Future Issuance**

 

The following shares of commonstock are reserved for future issuance as of December 31, 2004:

 
| Stock  options:                |   |      |   |
|--------------------------------|--------|-----------|--------|
| Granted and  outstanding       |   | 3,116,580 |   |
| Reserved for  future grants    |   | 560,737   |   |
| Employee  Stock Purchase Plan: |   |      |   |
| Reserved for  future issuance  |   | 521,745   |   |
| Total:                         |   | 4,199,062 |   |

 

**Treasury Stock**

 

On April 3, 2003, theCompany announced that its Board of Directors authorized a stock repurchaseprogram of up to 2 million shares of our common stock. The repurchases will bemade from time to time on the open market at prevailing market prices or inprivately negotiated transactions. Depending on market conditions and otherfactors, purchases under this program may be commenced or suspended at anytime, or from time to time, without prior notice. As of December 31, 2004,1,006,000 shares of common stock had been repurchased under this program, foran aggregate of $30.7 million at an average price of $30.48 per share.

 

During 2004, the Companyretired the 1,006,000 shares of common stock that had been repurchased.  In accordance with APB 6, Status of AccountingResearch Bulletins, the treasury stock retirement was effected by reducing thefollowing:  treasury stock by $30.7million, common stock by $0.1 million, additional paid-in capital by $6.4million and retained earnings by $24.2 million on the Consolidated BalanceSheets.  There was no effect to theCompany’s overall equity position as a result of the retirement.

 

**8. Income Taxes**

 

For financial reportingpurposes, income before income taxes includes the following components:

 
| ** **                  | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                  | ** ** | **(In  thousands)**   | ** ** |
| Income  before income taxes |       |                  |       |   |   |   |   |
| United States               |       | $                     | 36,712     |   | $ | 26,551 |   | $ | 19,450 |   |
| Foreign                     |       | 4,270                 |       | 532 |   | (3,510 | ) |
| Total                       |       | $                     | 40,982     |   | $ | 27,083 |   | $ | 15,940 |   |

 

56

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The provision (benefit) forincome taxes is as follows:

 
| ** **                    | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------|------------|----------------------------------|------------|
| ** **                    | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                    | ** ** | **(In thousands)**               | ** ** |
| Current                       |       |                             |       |   |   |   |   |
| Federal                       |       | $                                | 12,535     |   | $ | 10,103 |   | $ | 7,255 |   |
| Foreign                       |       | 759                              |       | 401 |   | 557 |   |
| State                         |       | 2,160                            |       | 1,864 |   | 1,792 |   |
|                          |       | 15,454                           |       | 12,368 |   | 9,604 |   |
| Deferred                      |       |                             |       |   |   |   |   |
| Federal                       |       | (367                             | )          | (1,735 | ) | (7,685 | ) |
| Foreign                       |       | —                           |       | — |   | — |   |
| State                         |       | (281                             | )          | (238 | ) | (2,716 | ) |
|                          |       | (648                             | )          | (1,973 | ) | (10,401 | ) |
|                          |       |                             |       |   |   |   |   |
| Income tax expense  (benefit) |       | $                                | 14,806     |   | $ | 10,395 |   | $ | (797 | ) |

 

The reconciliation of income tax computed at thefederal statutory rate to the provision (benefit) for income taxes is asfollows:

 
| ** **           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------|------------|----------------------------------|------------|
| ** **           | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
|                 |       |                             |       |   |   |   |   |
| Statutory  Rate      |       | 35.0                             | %          | 35.0 | % | 35.0 | % |
| Foreign tax          |       | (0.9                             | )          | 0.1 |   | 7.3 |   |
| State tax            |       | 5.5                              |       | 5.9 |   | 8.1 |   |
| Valuation  allowance |       | (0.9                             | )          | (0.1 | ) | (54.6 | ) |
| Credits              |       | (1.7                             | )          | (1.2 | ) | (0.8 | ) |
| Tax-exempt  interest |       | (2.1                             | )          | (0.8 | ) | — |   |
| Other                |       | 1.2                              |       | (0.5 | ) | — |   |
|                 |       | 36.1                             | %          | 38.4 | % | (5.0 | )% |

 

Significant components of the Company’s deferred taxassets and liabilities as of December 31, are as follows:

 
| ** **                                   | ** ** | **2004**           | ** ** | **2003** | ** ** |
|----------------------------------------------|------------|--------------------|------------|----------|------------|
| ** **                                   | ** ** | **(In thousands)** | ** ** |
| Deferred tax  assets                         |       |               |       |     |       |
| Net  operating loss carryforwards            |       | $                  | —     |     | $          | 184 |   |
| Tax credit  carryforwards                    |       | 2,306              |       | —   |       |
| Deferred  revenue                            |       | 14,415             |       | 16,395   |       |
| Foreign  deferred taxes                      |       | 103                |       | 464      |       |
| Other                                        |       | 1,332              |       | 826      |       |
| Total  deferred tax assets                   |       | 18,156             |       | 17,869   |       |
| Valuation  allowance for deferred tax assets |       | (103               | )          | (464     | )          |
| Net deferred  taxes                          |       | $                  | 18,053     |     | $          | 17,405 |   |

 

57

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A valuation allowance isrequired when it is more likely than not that all or a portion of a deferredtax asset will not be realized. Periodically, management reassesses the need for a valuation allowance.  At December 31, 2004, the valuationallowance related to net operating losses generated in 2002 by the Company’swholly-owned subsidiary in Ireland. During 2002, the Company released the valuation allowance against itsU.S. deferred tax assets.

 

As of December 31,2004, the Company has federal and California research and development taxcredit carryforwards of approximately $1.4 million and $1.4 million,respectively.  These credits will beginto expire in 2022 unless previously utilized.

 

Pursuant to Internal RevenueCode (IRC) Sections 382 and 383, use of the Company’s tax loss and creditcarryforwards may be limited if a cumulative change in ownership of more than50% occurs within a three year period. Based on IRC Sections 382 and 383,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 of December 31,2004, the Company had approximately $2.3 million of undistributed earningsrelated to its foreign subsidiaries. Management believes that these earningswill be indefinitely reinvested in foreign jurisdictions; accordingly, theCompany has not provided for U.S. federal income taxes related to theseearnings. However, upon distribution of these earnings in the form of dividendsor otherwise, the Company would be subject to both U.S. income taxes andwithholding taxes payable to the various foreign countries. It is estimatedthat the total tax liability, reduced by anticipated foreign tax credits, uponsuch a distribution would be approximately $0.1 million.

 

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

 

**9. Employee Retirement Plan**

 

Effective May1, 1997, the Company established a 401(k) defined contribution retirement plan(401(k) Plan) covering substantially all employees. The 401(k) Plan providesfor voluntary employee contributions from 1% to 50% of annual compensation, asdefined, and did not provide for matching contributions from the Company as of December 31,2003.  In January 2004, the Company’sBoard of Directors approved a discretionary employer matching contribution of25% for each employee deferral contribution made during the plan year, up to 6%of the participant’s compensation.  Theamount of employer expenses including the employer match contributed to the401(k) Plan during the year ended December 31, 2004 was $369,000.

 

58

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**Item 9. Changes in and Disagreements with Accountants onAccounting and Financial Disclosure**

 

None

 

**Item 9A. Controls and Procedures**

 

**We maintain disclosure controls andprocedures which are designed to ensure that information required to bedisclosed in the reports we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s** rulesand forms, and that such information is accumulated and communicated to ourmanagement, including our chief executive officer, or CEO, and chief financialofficer, or CFO, as appropriate to allow timely decisions regarding requireddisclosure.

** **

**Under the supervision and withthe participation of our management, including our CEO and CFO, an evaluationwas performed on the effectiveness of the design and operation of ourdisclosure controls and procedures as of the end of the period covered by thisannual report. Based on that evaluation, our management, including the CEO andCFO, concluded that our disclosure controls and procedures were effective as ofDecember 31, 2004.**

** **

**An evaluation was also performedunder the supervision and with the participation of our management, includingour CEO and CFO, of any change in our internal controls over financialreporting that occurred during our last fiscal quarter and that has materiallyaffected, or is reasonably likely to materially affect, our internal controlsover financial reporting.  Thatevaluation did not identify any change in our internal controls over financialreporting that occurred during our latest fiscal quarter and that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrols over financial reporting.**

** **

**Management’s Report on Internal Control Over FinancialReporting**

** **

**Our management is responsible forestablishing and maintaining adequate internal control over financialreporting, as such term is defined in Exchange Act Rule 13a — 15(f) and 15d — 15(f).  All internal control systems, no matter howwell designed, have inherent limitations. Therefore even those systems determined to be effective can provide onlyreasonable assurance with respect to financial statement preparation and presentation.**

** **

**Under the supervision and withthe participation of our management, including our CEO and CFO, we conducted anevaluation of the effectiveness of our internal control over financialreporting based on the framework in *Internal Control – IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission.  Based on ourevaluation under the framework in *Internal Control*–*Integrated Framework*, our managementconcluded that our internal control over financial reporting was effective asof December 31, 2004.**

** **

Our management’s assessment of theeffectiveness of our internal control over financial reporting as of December 31,2004 has been audited by Ernst & Young LLP, an independent registeredpublic accounting firm, as stated in their report which is included herein.

 

59

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**Report of Independent Registered Public Accounting Firm on InternalControl over Financial Reporting**

 

The Board of Directors and StockholdersWebsense, Inc.

 

We have audited management’s assessment, included in the accompanying “Management’sReport on Internal Control Over Financial Reporting” that Websense, Inc.maintained effective internal control over financial reporting as ofDecember 31, 2004, based on criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria). Websense’smanagement is responsible for maintaining effective internal control over financialreporting and for its assessment of the effectiveness of internal control overfinancial reporting. Our responsibility is to express an opinion on management’sassessment and an opinion on the effectiveness of the company’s internalcontrol over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. Our audit included obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

A company’s internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. A company’s internalcontrol over financial reporting includes those policies and procedures that(1) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the company; (2) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements. Also, projections of anyevaluation of effectiveness to future periods are subject to the risk thatcontrols may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that Websense, Inc. maintainedeffective internal control over financial reporting as of December 31,2004, is fairly stated, in all material respects, based on the COSO criteria.Also, in our opinion, Websense, Inc. maintained, in all material respects,effective internal control over financial reporting as of December 31,2004, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the consolidated balancesheets as of December 31, 2004 and 2003, and the related consolidatedstatements of income, stockholders’ equity and cash flows for each of the threeyears in the period ended December 31, 2004 of Websense, Inc. and ourreport dated February 25, 2005 expressed an unqualified opinion thereon.

 

 
|                  | /s/  Ernst & Young LLP |   |
|-----------------------|----------------------------|--------|
|                  |                       |
| San Diego, California |                       |
| February 25, 2005     |                       |

 

60

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**PART III**

 

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

 

(a) Directors. Informationconcerning our directors is 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 7, 2005.

 

(b) Executive Officers.Information concerning our executive officers is set forth under the section captioned*“Executive Officers”* in Part I ofthis report.

 

(c) Compliance with Section 16(a)of the Exchange Act. Information concerning compliance with Section 16(a)of the Exchange Act is incorporated by reference from the section captioned*“Section 16(a) Beneficial OwnershipReporting Compliance”* contained in our Proxy Statement related tothe Annual Meeting of Stockholders to be held on June 7, 2005.

 

(d) The company has adopteda *Code of Business Conduct* which,together with the policies referred to therein, is applicable to all directors,officers and employees of the company. In addition, the company has adopted a *Codeof Ethics for the Chief Executive Officer, Senior Financial Officers and AllFinance and Accounting Department Personnel* (“*Code of Ethics*”).  The *Codeof Business Conduct* and the *Codeof Ethics* cover all areas of professional conduct, includingconflicts of interest, disclosure obligations, insider trading and confidentialinformation, as well as compliance with all laws, rules and regulationsapplicable to our business.  The companyencourages all employees, officers and directors to promptly report anyviolations of any of the company’s policies. In the event that an amendment to, or a waiver from, a provision of the *Code 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*.

 

**Item 11. Executive Compensation**

 

The information required byItem 11 of Form 10-K is incorporated by reference from the informationcontained in the section captioned *“ExecutiveCompensation and Other Information”* in our Proxy Statement relatedto the Annual Meeting of Stockholders to be held on June 7, 2005.

 

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

** **

**The information required by Item 12of Form 10-K concerning security ownership of certain beneficial owners andmanagement is incorporated by reference from the information contained in the section captioned*“Ownership of Securities”* in ourProxy Statement related to the Annual Meeting of Stockholders to be held on June 7,2005.**

** **

**61**

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**The following table providesinformation as of December 31, 2004 with respect to the shares of theCompany’s common stock that may be issued under the Company’s existing equitycompensation plans:**

 
| **Plan Category**                                               | ** ** | **Number of securities  to be issued upon  exercise of outstanding  options, warrants and  rights** | ** ** | **Weighted-  average  exercise price  of outstanding  options,  warrants and  rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities subject to  outstanding options,  warrants and rights)** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders (1)     |       | 2,999,785                                                                                           |       | $                                                                                      | 24.59      |                                                                                                                                                                               | 1,082,482  | (3) |
| Equity  compensation plans not approved by security holders (2) |       | 116,795                                                                                             |       | $                                                                                      | 13.79      |                                                                                                                                                                               | —     |   |
| Total                                                           |       | 3,116,580                                                                                           |       | $                                                                                      | 24.18      |                                                                                                                                                                               | 1,082,482  |   |

** **

----

**(1)**          Consists solely of the 2000 StockIncentive Plan and the Employee Stock Purchase Plan.

**(2)**          Consists of 177,000 stock optiongrants made to certain new employees in 2002 in order to induce them tocommence employment with the company, of which 116,795 are outstanding.  The outstanding stock options havesubstantially the same terms as stock options issued under the 2000 StockIncentive Plan and have a weighted average exercise price of $13.79 per share.

**(3)**          Consists of shares available forfuture issuance under the Employee Stock Purchase Plan and the 2000 StockIncentive Plan.  As of December 31,2004, an aggregate of 521,745 shares of Common Stock were available forissuance under the Employee Stock Purchase Plan and 560,737 shares of CommonStock were available for issuance under the 2000 Stock Incentive Plan.  The number of shares of Common Stockavailable for issuance under the Employee Stock Purchase Plan and the 2000Stock Incentive Plan automatically increases on the first trading day of January eachcalendar year by an amount equal to 1% and 4%, respectively, of the totalnumber of shares of Common Stock outstanding on the last trading day of December inthe immediately preceding calendar year but in no event will any such increaseexceed 375,000 shares and 1,500,000 shares, respectively, of Common Stock.

 

**Item 13. CertainRelationships and Related Transactions**

 

The information required by Item 13 of Form 10-K isincorporated by reference from the information contained in the section captioned*“Certain Relationships and RelatedTransactions”* in our Proxy Statement related to the Annual Meetingof Stockholders to be held on June 7, 2005.

 

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

** **

The information requiredby Item 14 of Form 10-K is incorporated by reference from the informationcontained 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 7,2005.

 

62

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**PART IV**

 

**Item 15. Exhibitsand Financial Statement Schedules**

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

 

Schedules not listed above havebeen omitted because they are not applicable, not required, or the informationrequired to be set forth therein is included in the consolidated financialstatements 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. |
| 10.19 (4)          |       | Third Amendment to Lease between Websense, Inc. and Sorrento Valley  Road LLC, dated July 30, 2004.                                                                                                                                                                                                                            |
| 10.20*             |       | Officers’ Bonus Term Sheet                                                                                                                                                                                                                                                                                                     |
| 10.21*             |       | President’s Bonus Term Sheet                                                                                                                                                                                                                                                                                                   |
| 10.22*             |       | Non-Employee Directors Compensation Term Sheet                                                                                                                                                                                                                                                                                      |
| 21.1               |       | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                                      |
| 23.1               |       | Consent of Independent Registered Public Accounting Firm                                                                                                                                                                                                                                                                            |

 

63

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

 

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*            Indicates management contract or compensatoryplan 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)          Previously filed as an exhibit to our Form 10-K for the period ended December 31,2000 and incorporated herein by reference.

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

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

 

64

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##### **SIGNATURES**

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 

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

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature**           | ** ** | **Title**                                                                        | ** ** | **Date**           |
|-------------------------|------------|----------------------------------------------------------------------------------|------------|--------------------|
| /s/  John B. Carrington |       | Chairman  of the Board and Chief Executive Officer (principal executive officer) |       | March 4, 2005 |
| John  B. Carrington     |       |                                                                             |       |
|                    |       |                                                                             |       |               |
| /s/  Douglas C. Wride   |       | Chief  Financial Officer (principal financial and accounting officer)            |       | March 4, 2005 |
| Douglas  C. Wride       |       |                                                                             |       |
|                    |       |                                                                             |       |               |
| /s/  Mark St.Clare      |       |                                                                             |       | March 4, 2005 |
| Mark  St.Clare          |       | Director                                                                         |       |               |
|                    |       |                                                                             |       |               |
| /s/  Bruce T. Coleman   |       |                                                                             |       | March 4, 2005 |
| Bruce  T. Coleman       |       | Director                                                                         |       |               |
|                    |       |                                                                             |       |               |
| /s/  John Schaefer      |       |                                                                             |       | March 4, 2005 |
| John  Schaefer          |       | Director                                                                         |       |               |
|                    |       |                                                                             |       |               |
| /s/  Gary E. Sutton     |       |                                                                             |       | March 4, 2005 |
| Gary  E. Sutton         |       | Director                                                                         |       |               |
|                    |       |                                                                             |       |               |
| /s/  Peter Waller       |       |                                                                             |       | March 4, 2005 |
| Peter  Waller           |       | Director                                                                         |       |               |

 

65

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##### **Schedule II –VALUATION AND QUALIFYING ACCOUNTS**

 

**WEBSENSE, INC.(In thousands)**

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

 

----

(1)          Uncollectible accounts written off, net of recoveries.

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

 

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**EXHIBITINDEX**

 
| **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. |
| 10.19 (4)  |       | Third Amendment to Lease between Websense, Inc. and Sorrento Valley  Road LLC, dated July 30, 2004.                                                                                                                                                                                                                            |
| 10.20*     |       | Officers’ Bonus Term Sheet                                                                                                                                                                                                                                                                                                     |
| 10.21*     |       | President’s Bonus Term Sheet                                                                                                                                                                                                                                                                                                   |
| 10.22*     |       | Non-Employee Directors Compensation Term Sheet                                                                                                                                                                                                                                                                                      |
| 21.1       |       | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                                      |
| 23.1       |       | Consent of Independent Registered Public Accounting Firm                                                                                                                                                                                                                                                                            |
| 31.1       |       | Certification of Principal Executive Officer pursuant to Exchange Act  Rules 13a-14(a) and 15d-14(a).                                                                                                                                                                                                                          |
| 31.2       |       | Certification of Principal Financial Officer pursuant to Exchange Act  Rules 13a-14(a) and 15d-14(a).                                                                                                                                                                                                                          |
| 32.1       |       | Certification of Principal Executive Officer pursuant to Exchange Act  Rules 13a-14(b) and 15d-14(b) and Section 1350 of Chapter 63 of  Title 18 of the United States Code.                                                                                                                                               |
| 32.2       |       | Certification of Principal Financial Officer pursuant to Exchange Act  Rules 13a-14(b) and 15d-14(b) and section 1350 of Chapter 63 of  Title 18 of the United States Code.                                                                                                                                               |

 

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*            Indicatesmanagement contract or compensatory plan or arrangement.

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

 

----

 

#### **(2)**          Previously filed as an exhibit toour Form 10-K for the period ended December 31, 2000 and incorporatedherein by reference.

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

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

 

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