**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

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

**Forthe fiscal year ended December 31, 2006**

**OR**

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

**Forthe Transition Period from                to                **

**CommissionFile Number 000-30093**

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**Websense, Inc.**

(Exact name of registrantas specified in its charter)

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

 

**10240 Sorrento Valley Road**

**San Diego, California 92121**

**858-320-8000**

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

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**Securitiesregistered pursuant to section 12(b) of the Act:**

| Title of Each Class            | ** ** | **Name of Each Exchange on  Which Registered** |
|--------------------------------|------------|------------------------------------------------|
| Common stock,  $0.01 par value |       | NASDAQ Global  Select Market                   |

 

**Securities registered pursuant to Section 12(g) ofthe Act:**

**None**

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

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

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

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

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

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

The aggregate market valueof the voting stock held by non-affiliates of the registrant, as of June 30,2006 was approximately $968 million (based on the closing price for shares ofthe registrant’s Common Stock as reported by the Nasdaq Global Select Marketfor that date). Shares of Common Stock held by each officer, director andholder of 10% or more of the outstanding Common Stock have been excluded inthat such persons may be deemed affiliates. Exclusion of shares held by anyperson should not be construed to indicate that such person possesses thepower, direct or indirect, to direct or cause the direction of management orpolicies of the registrant, or that such person is controlled by or undercommon control with the registrant.

The number of sharesoutstanding of the registrant’s Common Stock, $.01 par value, as of February 15,2007 was 44,821,417.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the definitiveProxy Statement to be delivered to stockholders in connection with the AnnualMeeting of Stockholders to be held June 5, 2007 are incorporated byreference into Part III.

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

 

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**Websense, Inc.**

**Form 10-K**

**Forthe Fiscal Year Ended December 31, 2006**

**TABLEOF CONTENTS**
|               | ** ** | ** **                                                                                                              | ** ** | **Page** |
|---------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Part I   |       |                                                                                                                    |       |     |   |
| Item 1.       |       | Business                                                                                                                |       | 3        |   |
| Item 1A.      |       | Risk Factors                                                                                                            |       | 15       |   |
| Item 1B.      |       | Unresolved  Staff Comments                                                                                              |       | 26       |   |
| Item 2.       |       | Properties                                                                                                              |       | 27       |   |
| Item 3.       |       | Legal  Proceedings                                                                                                      |       | 27       |   |
| Item 4.       |       | Submission  of Matters to a Vote of Security Holders                                                                    |       | 27       |   |
| Part II  |       |                                                                                                                    |       |     |   |
| Item 5.       |       | Market  for the Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |       | 28       |   |
| Item 6.       |       | Selected  Financial Data                                                                                                |       | 29       |   |
| Item 7.       |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                             |       | 30       |   |
| Item 7A.      |       | Quantitative  and Qualitative Disclosures About Market Risk                                                             |       | 40       |   |
| Item 8.       |       | Financial  Statements and Supplementary Data                                                                            |       | 42       |   |
| Item 9.       |       | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                                   |       | 70       |   |
| Item 9A.      |       | Controls  and Procedures                                                                                                |       | 70       |   |
| Item 9B.      |       | Other  Information                                                                                                      |       | 72       |   |
| Part III |       |                                                                                                                    |       |     |   |
| Item 10.      |       | Directors  and Executive Officers and Corporate Governance of the Registrant                                            |       | 72       |   |
| Item 11.      |       | Executive  Compensation                                                                                                 |       | 72       |   |
| Item 12.      |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                        |       | 72       |   |
| Item 13.      |       | Certain  Relationships and Related Transactions and Director Independence                                               |       | 73       |   |
| Item 14.      |       | Principal  Accountant Fees and Services                                                                                 |       | 73       |   |
| Part IV  |       |                                                                                                                    |       |     |   |
| Item 15.      |       | Exhibits,  Financial Statements and Schedules                                                                           |       | 74       |   |
|          |       | Signatures                                                                                                              |       | 76       |   |

 

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**PART I**

**Forward-LookingStatements**

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

·       anticipatedtrends in revenue;

·       growthopportunities in domestic and international markets;

·       newchannels of distribution;

·       customeracceptance and satisfaction with our products;

·       expectedtrends in operating and other expenses;

·       anticipatedcash and intentions regarding usage of cash;

·       changesin effective tax rates; and

·       anticipatedproduct enhancements or releases.

These forward-lookingstatements are subject to risks and uncertainties, including those risks anduncertainties described herein under Part I, Item 1A “Risk Factors”, whichcould cause actual results to differ materially from those anticipated as ofthe date of this report. We assume no obligation to update any forward-lookingstatements to reflect events or circumstances arising after the date of thisreport.

**Item 1.**                        Business

**Overview**

Our products help organizations manage their networksand computing resources to provide a secure and productive computingenvironment. We provide Web filtering and Web security software products thatenable organizations to protect employees and confidential information fromexternal Web-based attacks, such as spyware and phishing, as well as analyze,report and manage how employees use computing resources and the Internet. In January 2007,we acquired PortAuthority Technologies, Inc. (PortAuthority), ourtechnology development partner for information leak prevention solutions. As aresult, in addition to our Web filtering and Web security software products, weoffer software that helps prevent the loss of confidential information frominternal threats, such as ineffective business process controls, employee errorand malfeasance.

Since we released our first software product in 1996,our products have evolved from preventing access to unacceptable Internetcontent to products that proactively manage employees use of computingresources and the Internet to maximize productivity and prevent access to themost undesirable and dangerous elements on the Web, such as Web sites thatcontain or will download viruses, spyware, keyloggers, phishing exploits and anever-increasing variety of malicious code.

At the foundation of our Web filtering and Websecurity product offering is the Websense Enterprise® software application,which serves as a management and reporting platform for our Web filtering andrelated add-on Web security products. Websense Enterprise gives organizationsthe ability to enhance network security, improve employee productivity,mitigate potential legal liability and conserve network bandwidth by allowingorganizations to identify potential risk areas and implement and automate 

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Web access and applicationusage policies that reduce these risks. When combined with our Web securityproducts that utilize our ThreatSeekerTM technology including SecurityFiltering, Remote Filtering and Client Policy ManagerTM, Websense Enterpriseallows organizations to further enhance network and content security byblocking access to malicious Web sites and by preventing the transmission ofdata to known spyware destination sites. To simplify the purchase process forour value-added resellers and customers, we have created a suite of WebsenseEnterprise and our most popular add-on security products and services, known asthe Websense® Web Security SuiteTM.

Our Web filteringand Web security software operates in conjunction with our proprietarydatabases which encompass:

·       Approximately20 million Web site universal resource locators (URLs) organized into more than90 categories, including specific categories for sites containing spyware,viruses and other malware, and phishing destination sites.

·       Morethan two million software applications and executable files classified in 50categories such as productivity applications and games, including anever-increasing database of malicious code, spyware, hacking tools and viruses.

·       Commonlyused network and Internet protocols, such as http, instant messaging protocolsand peer-to-peer protocols.

Our databases are updated continuously each businessday using a proprietary process of automated content assessment andclassification, with manual verification. In 2005, we increased the resourcesfocused on identifying and classifying adware, spyware, keylogging and othermalicious code located on Internet sites and created Websense Security LabsTM.Researchers in the Websense Security Labs use our patent-pending ThreatSeekertechnology to scan nearly 600 million Web sites each week to identify andinvestigate advanced Internet threats in order to deliver timely product and informationupdates to the security community and Websense customers.****Subscribers to our Web security add-onproducts and the Websense Web Security Suite receive updates of thesecurity risk categories of the URL and application databases in real time asnew malicious or high-risk URLs and executable files are identified andcategorized.

We have been developing Web content filtering andsecurity solutions to protect Internet users from receiving and accessingunwanted or illegal content on their mobile phones and personal digitalassistants (PDAs). We have engaged in discussions regarding mobile filteringsolutions with several third parties, and we expect to close our firsttransaction for the mobile filtering and security products in 2007.

In January 2007, we acquired PortAuthority and inFebruary 2007, we introduced our first information leak prevention (ILP)solution, the Websense Content Protection SuiteTM, based on products receivedthrough the acquisition of PortAuthority, including the patented andpatent-pending Precise IDTM digital fingerprinting technology. The ContentProtection Suite consists of the Websense Content AuditorTM, asoftware-based monitoring and reporting solution that identifies andcategorizes different types of data whether it is data-in-motion ordata-at-rest, and the Content EnforcerTM, a software-based policy engine thatautomates pre-set policies regarding the use and distribution of differenttypes of data and information.

We expect that we will continue to derive the majorityof our revenue from Websense Enterprise-based products for several years. Themarkets for information leak prevention solutions and Web filtering on mobilehandsets are still in the early phases of development, and therefore will onlycomprise a small percentage of our revenues in 2007.

We operate in one industry segment, as defined bygenerally accepted accounting principles.

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

**Industry Background**

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

Additionally, as organizations create collaborativenetworks with their customers, suppliers, technology partners and otherstakeholders, they increase the amount of confidential and sensitive data thattravels across these networks. Securing this data from internal threats, suchas inadequate business process controls, employee error and malfeasance andundetected malicious code, has become a top priority for information technologyexecutives.

Traditionally, organizations have sought to protectagainst external security risks with a combination of firewalls, intrusiondetection/prevention software and anti-virus software. With the growth inspyware, key logging applications, and phishing sites, and the proliferation ofblended attacks on computing networks, combined with the rapid increase inemployee use of instant messaging and peer-to-peer file sharing, organizationsare finding that existing security measures leave significant time andtechnology gaps in their protection. Firewalls can provide protection againstexternal threats such as hacking, but do little to prevent employees fromhacking into their own organization’s data from inside the corporate firewall.Anti-virus software provides protection from e-mail borne viruses, but does notprevent the possible theft or corruption of corporate data by spyware, andoffers only limited protection against viruses that proliferate viapeer-to-peer networks and instant messaging. Existing anti-virus andanti-spyware software also requires time for the vendor to identify and reverseengineer the new virus or spyware application before they can be remediated andremoved from infected systems. According to a 2006 FBI study, approximately 65percent of organizations that deploy these traditional security measures stillhave their networks or data compromised by viruses and other malicious attacks.

Technology efforts to protect against internal threatsto confidential data have been even less effective than security solutions forexternal threats. While organizations have had some success protecting againstemployee malfeasance and malicious code attacks, there have been fewertechnology solutions to protect against inadvertent or deliberate outbounddisclosure of an organization’s confidential information. Recent changes in theregulatory environment, designed to protect individual privacy, have alsocreated specific requirements for regulated industries such as banks and creditunions to implement data security measures.

Given the necessity ofcorporate Internet access and the continuing worldwide adoption of the Web as amass communication, entertainment, information and commerce medium, we believethere is a significant opportunity for Web filtering, Web security andinformation leak prevention solutions that effectively address the needs oforganizations to protect themselves from Web-based threats and manage 

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employeeusage of the computing environment and confidential data. Additionally,although the Web and e-mail are the primary drivers of Internet traffic today,the rapid emergence of Internet-enabled applications creates the need forsoftware that applies management and security policies to different data types,applications, and protocols, as well as Web pages, at multiple points in theinformation technology infrastructure and across multiple communicationtechnologies. Software tools are needed to protect against internal andexternal threats to data security and implement granular policy-based securitymeasures that are user, content and destination aware.

**Our Products andServices**

We offer products that protect data and users fromthreats to information security and productivity loss. Our Web filtering andrelated services mitigate risks associated with inappropriate Web content andloss of productivity due to unmanaged Web surfing. Our add-on Web securityproducts protect from Web-based malicious attacks by blocking access to compromisedand malicious Web sites. Our information leak prevention products protectagainst the loss, or leakage, of confidential information due to internalthreats, such as inadequate business process controls, employee error andmalfeasance, and undetected malicious code.

We sell subscriptions to our products based on thenumber of seats or devices to be managed. Revenues from sales of subscriptionsto Websense Enterprise and related add-on products accounted for all of ourrevenues in 2006, 2005 and 2004.

*WebsenseEnterprise.*   Websense Enterprise is the softwareapplication that serves as the management and reporting platform for our Webfiltering and Web security products, including Security Filtering, RemoteFiltering and Client Policy Manager. It allows organizations to manageemployees’ use of corporate computing resources by filtering access to Websites, applications, and protocols while providing multiple options foridentifying, analyzing and reporting on Internet activity and the risksassociated with employee computing. The Websense Enterprise application worksin conjunction with our proprietary URL, protocol and application databases togive business managers the ability to automate the enforcement of highlycustomized Internet and application access and use policies for different usersand groups within the business. By automating the enforcement of thesepolicies, Websense Enterprise and the related add-on Web security productssupport an organization’s efforts to enhance network security, improve employeeproductivity, mitigate potential legal liability, and conserve networkbandwidth.

To address specific customer needs, such as the needfor enhanced network security, we offer Websense Web Security Suite, whichincludes Websense Enterprise and a select group of add-on security products andservices as a combined solution.

*Web Filtering.*   WebsenseEnterprise enables employers to proactively analyze, report and manage employeeaccess to Web sites based on the content of the requested Web site. Oursoftware application works in conjunction with a database of more than 20million business-relevant Web sites to provide patented flexibility formanagers when customizing, implementing and modifying Internet access policiesfor various groups, user types and individuals. A graphical interface enablesbusiness managers to define the categories of Web sites to which access will bemanaged. The filtering software examines each Internet access request,determines the category of the requested Web site and applies the policies thathave been defined by the company. Some examples of management options include:

·       Allow:   Therequest is allowed to proceed, because the organization has chosen not torestrict access to the category applicable to the Web site.

·       Block:   Therequested Web site is in a category that is not allowed to be accessedaccording to the policy in effect.

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

·       Continuewith Exception Report:   The user is reminded about the organization’sInternet usage policy, but can choose to access the requested Web site.

·       Timeof Day:   Filtering options can be managed by time of day. For example,access to shopping sites could be blocked during business hours and permittedat all other times.

The breadth and specificity of Web site 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. There are currently more than 90 categories in thebasic Web filtering product.

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

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

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

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

*Deployment Options.*   WebsenseEnterprise integrates with an organization’s network server, proxy server,switch, router or firewall and is designed to work in networks of virtually anysize and configuration. Websense Enterprise can support up to 50,000 users on asingle server. We currently offer three deployment options:

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

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

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

*Add-OnSecurity Products.**  *Thereare two primary types of add-on products that extend and enhance the policyenforcement capabilities of Websense Enterprise: additional database categoriesand products that enforce policies at the desktop and on mobile devices, suchas laptop computers. These add-on products rely on the application framework ofthe Websense Enterprise platform and our proprietary databases of softwareapplications and protocols.

Our product thatprovides additional database categories is:

·       *Security Filtering.*   The SecurityFiltering add-on product includes specialized database categories that augmentthe categories included with basic Web filtering solution and provideadditional policy 

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enforcement options at theInternet gateway. We continually update our security-specific filteringcategories as new malicious or compromised Web sites are identified by ourThreatSeeker technology.

Our mobile anddesktop policy management add-on products are:

·       *Remote Filtering.  *Remote Filteringextends the corporate Web filtering policies to laptop computers and othermobile devices when they are disconnected from the corporate network. By usingremote filtering, IT administrators can enforce security policies, such asblocking access to sites containing spyware, even when a laptop computer isaccessing the Internet from an unmanaged server. This enables the networkmanager to reduce the risk that mobile devices will infect the network withmalicious code when the device again connects to the network.

·       *Client Policy Manager*.   The ClientPolicy Manager (CPM) product 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 security threats from hacking and spyware applications. It can alsobe used to create lists of allowable applications and block the launch ofothers, enhancing security by preventing the launch of certain categories ofexecutables such as hacking tools or spyware. CPM utilizes the applicationframework of Websense Enterprise and references our database of over twomillion software applications and executable files.

*Websense Web SecuritySuite.*   The Websense Web Security Suite combinesWebsense Enterprise, Security Filtering and several additional services,including Real Time Security UpdatesTM and Websense Web Protection ServicesTM,for a single price. The Websense Web Security Suite was created tosimplify the sales process for our value-added resellers and simplify thepurchase process for our customers.

·       *Real Time Security Updates.  *RealTime Security Updates allow subscribing organizations to receive databaseupdates for Web-based and application-based threats in real time as they areidentified and categorized by the Websense Security Labs. Websense SecurityLabs scans nearly 600 million Web sites weekly to identify new Web-basedthreats. This service is available only as part of the Websense Web SecuritySuite.

·       *Websense Web Protection Services:   SiteWatcher*TM,*BrandWatcher*TM*and ThreatWatcher*****TM*Services*. The SiteWatcher andBrandWatcher services monitor our customer’s Web sites and brands,respectively, for malicious code or illegal use in a phishing attack and notifythe customer if either occurs. The ThreatWatcher service helps customersprevent malicious attacks on their Web servers by identifying securityvulnerabilities. These products are available only as part of the Websense WebSecurity Suite.

*Websense ContentProtection Suite.**  *WebsenseContent Protection Suite is based on the information leak preventiontechnology acquired through the purchase of PortAuthority in January 2007.Websense Content Protection Suite is an integrated information leakprevention solution that protects against information leaks and data loss byidentifying and categorizing sensitive or confidential data based on itscharacteristics, monitoring the movement of sensitive data throughout thenetwork and enforcing pre-determined usage and movement policies. The Websense ContentProtection Suite:

·       discoversand accurately identifies data stored on a network-connected device(data-at-rest);

·       monitorsand prevents sensitive data from unauthorized distribution in outgoing andinternal communications, including email, instant messaging, Internet (FTP andhttp) and Web-based mail;

·       automatesenforcement of policies for data-in-motion to authorized recipients;

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·       monitorsand prevents unauthorized copying of highly sensitive files to USB drives andother portable media; or being printed to hardcopy paper; and

·       auditsand reports the distribution and use of confidential data against regulatoryand internal security policy requirements.

The Websense Content Protection Suite includesmore than 140 pre-built policy templates and a sophisticated policy engine toaddress the most common compliance requirements for United States federal andstate regulations, as well as industry regulations such as the Payment CardIndustry Data Security Standard (PCI DSS) and Check 21 Act, Canada’s PersonalInformation Protection and Electronic Documents Act (PIPEDA) and internationalgovernment and banking regulations for the European Union, United Kingdom,Israel, South Africa, Australia and Singapore. These templates areautomatically updated as regulations change.

Our products thatcomprise the Websense Content Protection Suite are:

·       *Content Auditor.  *Content Auditoridentifies and classifies sensitive data based on management-defined criteria,discovers its location within the organization, and identifies who is using it,how it is being used and where it is being sent within or outside the organization.By tracking and reporting on the location of data stored anywhere in thenetwork (data at rest) and the movement (data in motion) and use of data (datain use), Content Auditor allows organizations to identify gaps in informationsecurity and compliance processes, uncover policy and process risks based onfederal, state and industry regulations, and identify and report on informationsecurity practices and policies.

·       *Content Enforcer.  *Content Enforcerincludes Content Auditor and augments its identification and monitoringcapabilities by automating the enforcement of user and content-based datasecurity policies for both internal and outbound data. Content Enforcerprevents internal leaks through the use of server agents installed on MicrosoftExchange, Lotus Notes, Microsoft ISA and Microsoft Print servers that enforcepolicies on data that is transmitted by these applications. Content Enforcerprovides outbound leak prevention by examining outbound data traffic at thenetwork egress points and applying policies such as block, allow, quarantine,monitor and archive sensitive data through the use of real-time filters.Content Enforcer can effectively monitor, secure, filter, quarantine and blockoutbound content contained in email, instant messaging, file transfers, Webpostings and other types of messaging traffic copying to portable media devicesand printing to hardcopy paper. In addition, Content Enforcer can enforcepolicies for sensitive data being sent to authorized recipients throughautomated encryption via integration with third-party message encryptiongateways.

Additional Websense products and services include:

·       *Platinum Support*.   Platinum Supportgives customers experienced, personalized service, plus proactive support andcontinuing education, to ensure the performance, reliability, and availabilityof each Websense solution.

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

·       *Content Filtering for Mobile Devices.  *Wehave been developing Web content filtering and security solutions to protect Internetusers from receiving and accessing unwanted or illegal content on their mobilephones and personal digital assistants (PDAs). We have engaged in thediscussions regarding mobile filtering solutions with several third parties,and we expect to close our first transaction for the mobile filtering andsecurity products in 2007.

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**TechnologyIntegrations**

Websense solutions integrate with a wide variety ofinformation technology platforms. Our objective is for Websense products to beavailable for virtually any network environment desired by a customer.

In 2005, we implemented the Websense Web SecurityEcosystemTM—a comprehensive ecosystem of world class security and networkingtechnology providers that enable easy deployment and integration of Websensesolutions in enterprise environments. The Websense Web Security Ecosystemprovides interoperability of joint solutions with vendors from leading securityand networking markets, including: network access control, Internet gateways,certified appliance platforms, security event management and identitymanagement.

Thetable below lists many of the platforms with which Websense products operate:
| Firewall Solutions:                                                              |   | Cache/Proxy Solutions:                                                                  |
|----------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------|
| ·       Check Point Software                  |   | ·       Blue Coat Systems                            |
| ·       Cisco PIX                             |   | ·       Cisco Content Engine                         |
| ·       CP Secure                             |   | ·       Citrix Presentation Server                   |
| ·       Juniper Networks/NetScreen            |   | ·       Inktomi Traffic Server                       |
| ·       Microsoft ISA Server                  |   | ·       Microsoft Proxy Server                       |
| ·       SonicWall                             |   | ·       Network Appliance NetCache                   |
|                                                                             |   | ·       Squid Proxy                                  |
| Appliance Solutions:                                                             |   | ·       Stratacache Flyer                            |
| ·       Blue Coat Systems                     |   | ·       Sun ONE Web Proxy Server (formerly  iPlanet) |
| ·       Celestix MSA                          |   | ·       Websense Content Gateway                     |
| ·       Cisco Systems Content Engine          |   |                                                                                    |
| ·       Crossbeam Systems C-Series            |   | Switch/Router Solutions:                                                                |
| ·       Crossbeam Systems X-Series            |   | ·       Cisco Catalyst Switches                      |
| ·       Network Engines NS                    |   | ·       Cisco Routers                                |
| ·       Resilience NetSquad                   |   | ·       ADTRAN Net Vanta                             |
| ·       Stratacache Flyer                     |   |                                                                                    |
|                                                                             |   | Security Event Management Solutions:                                                    |
| Identity Management Solutions:                                                   |   | ·       Arcsight                                     |
| ·       HP Open View                          |   | ·       Network Intelligence                         |
| ·       IBM Tivoli                            |   |                                                                                    |
| ·       Microsoft Identity Integration Server |   | Network Access Control Solutions:                                                       |
| ·       Novell Nsure                          |   | ·       Cisco Network Admission Control              |
| ·       Sun Microsystems Identity Manager     |   |                                                                                    |

 

In 2006,PortAuthority, our new subsidiary, formed the DATASEC Alliance, a strategicpartnership program designed to bring together best-of-breed products to enableenterprises to control their sensitive information. These partnerships fosterinteroperability with complementary technology vendors, allowing customers todeploy comprehensive data protection and compliance solutions. DATASEC Alliancemembers include Internet gateway platform vendors, securemessaging/communication vendors, endpoint security solution vendors andsecurity analysis vendors, such as: 
| ·       BlueCoat   |   | ·       Safend          |
|-------------------------------------------------------|--------|------------------------------------------------------------|
| ·       Checkpoint |   | ·       LogLogic        |
| ·       FaceTime   |   | ·       PostX           |
| ·       Tumbleweed |   | ·       PGP Corporation |

 

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**Customers**

Our more than 24,000 Webfiltering and Web security customers range from companies with as few as 50employees to members of the Global 1000 and to government agencies andeducational institutions. In total, these customers have subscribed toapproximately 25 million seats as of December 31, 2006. No customeraccounted for more than 10% of our total revenues in 2006, 2005 or 2004.

**Sales, Marketingand Distribution**

*Sales.***  **Our sales strategy is to increasesales to new customers and increase the renewal rate on subscriptions toexisting customers by increasing the number and productivity of the resellersand distributors that sell our products. To accomplish this, we sell ourproducts and services primarily through indirect channels. For 2006, indirectchannel sales comprised over 85% of total revenues. As we move toward a pureindirect sales model our revenue will be derived almost entirely from sales throughindirect channels, including distributors and value-added resellers that sellour products to end-users, distributors that sell our products to value-addedresellers and providers of managed Internet and other services.

We historically have sold our products in the UnitedStates through a network of approximately 1,000 value-added resellers. In August 2006,we announced a new two-tier distribution strategy in North America and enteredinto a relationship with Ingram Micro to distribute, market and support our Websecurity and Web filtering software in North America. Through joint marketingprograms with Websense, Ingram Micro will focus its efforts on recruiting newresellers, especially resellers focused on selling to small and medium-sizedbusinesses (SMB), and on building awareness and demand within our existingNorth America channel partner base. During the second half of 2006, we added200 value-added resellers to end the year with 1,200 in North America.

Internationally, we sell our products through amulti-tiered distribution network of more than 250 distributors andresellers in over 80 countries, who sell to customers located in over 150countries. 

Our channel sales efforts are coordinated worldwidethrough a sales team of approximately 250 individuals. Customers that buydirect from us are typically large organizations that insist on a directrelationship.

In 2006, we generated 36% of our total revenue fromcustomers outside of the United States. Revenue generated in the United Kingdomrepresented approximately 10% of our total revenue. See Note 4 of Notes tothe Consolidated Financial Statements for further explanation of our revenuebased on geography. Our current international efforts are focused on expandingour indirect sales channels in Europe, Latin America, Asia/Pacific, andAustralia. Our continuing reliance on sales in international markets exposes usto risks attendant to foreign sales. See “Item 1A. Risk Factors - Sales tocustomers outside the United States have accounted for a significant portion ofour revenue, which exposes us to risks inherent in international sales.”

*Marketing.*   Ourmarketing efforts are designed to raise awareness of the potential risksassociated with unmanaged use of corporate computing resources and confidentialdata, generate qualified sales leads for our channel partners, and increaserecognition of Websense as a provider of Web filtering, Web securityinformation leak prevention solutions. 

Our marketing activities are targeted toward businessexecutives, including information technology professionals, chief executives,upper level management and human resource personnel. We actively manage ourpublic relations programs, communicating directly with technology professionalsand the media, in an effort to promote greater awareness of the growingproblems caused by viruses, spyware, phishing sites, and key logging, as wellas employee misuse of the Internet and other computing resources at work. 

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We also providepotential customers and channel partners with free trials of WebsenseEnterprise, Websense Web Security Suite and Websense Content ProtectionSuite, typically for 30-day periods. Our additional marketing initiativesinclude:

·       jointmarketing programs with our distributors to recruit additional value-addedresellers and drive awareness for Websense solutions with existing resellers;

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

·       participationin and sponsorship of trade shows and industry events; 

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

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

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

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

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

**Customer Service,Training and Support**

We believe that superior customer support is criticalto retaining and expanding our customer base. Our technical support groupprovides dependable and timely resolution of customer technical inquiries andis available to customers by telephone, e-mail and over the Web. We alsoproactively update customers on a variety of topics, including release dates ofnew products and updates to existing products. 

Our training servicesgroup delivers education, training and pre-sales support to our resellers andcustomers. We also offer online training to our customers and resellers toprovide them with the knowledge and skills to successfully deploy, use andmaintain our products.

**Research andDevelopment**

We maintain research and development facilities in SanDiego and Israel, and are commencing research and development activities inChina. Our research and development department is divided into several groups,which include content operations, security research, software development, qualityand assurance, and documentation. Individuals in different locations aregrouped along product lines and work as part of cross-disciplined teamsdesigned to provide a framework for defining and addressing the activitiesrequired to bring product concepts and development projects to marketsuccessfully. In connection with our increased focus on the SMB market, we areworking to develop products specifically targeted at that market.

Research and developmentexpenses totaled $22.7 million in 2006, $16.3 million in 2005 and $14.5 millionin 2004. Research and development expenses as a percentage of revenue were 12%in 2006, 11% in 2005, and 13% in 2004.

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**Competition**

The market for ourproducts is fragmented, highly and increasingly competitive, quickly evolvingand subject to rapid technological change. Increased competition and pricingpressures generally could result in reduced sales, reduced renewals and/or seatgrowth from existing customers, reduced margins or failure of our products toachieve or maintain more widespread market acceptance,. Competitors vary insize and in the scope and breadth of the products and services they offer. Ourcurrent principal competitors include:

·       companiesoffering Web security solutions, such as Microsoft, Symantec, McAfee, JuniperNetworks, Message Labs and Trend Micro;

·       companiesoffering Web filtering products, such as SurfControl, Secure Computing,Symantec, Digital Arts, Computer Associates, Microsoft, St. Bernard Software,Finjan, Barracuda, ScanSafe, Cisco Systems and Trend Micro;

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

·       companiesoffering information leak protection solutions, such as Vontu, Verdasys,Vericept, Tablus, Symantec, Secure Computing, Reconnex, Provilla, Proofpoint,Palisade Systems, Orchstria, Oakley Networks, McAfee, Intrusion, Fidelis, Checkpointand Code Green Networks;

·       companiesoffering desktop security solutions such as Check Point Software, CiscoSystems, McAfee, Microsoft and Symantec; and

·       companiesoffering proxy based solutions such as Blue Coat Systems and Cisco Systems.

We also face current and potential competition in Webfiltering and Web security from vendors of Internet servers, operating systemsand networking hardware, many of which now, or may in the future, developand/or bundle Web filtering, Web security or other competitive products withtheir offerings. We compete against and expect increased competition fromanti-virus software developers, traditional network management softwaredevelopers and Web management service providers. In the information leakprevention market, we may face competition from anti-virus software developers,e-mail filtering and security vendors, and providers of other software-basedcompliance solutions. 

We believe that theprincipal competitive factors affecting the markets for our products include,but are not limited to:
| ·       performance                  |   | ·       innovation                        |
|-------------------------------------------------------------------------|--------|------------------------------------------------------------------------------|
| ·       quality                      |   | ·       customer support                  |
| ·       introduction of new products |   | ·       frequency of upgrades and updates |
| ·       brand name recognition       |   | ·       reduction of production costs     |
| ·       price                        |   | ·       manageability of products         |
| ·       functionality                |   | ·       reputation                        |

 

We believe that we competeeffectively against our competitors in each of these areas. However, many ofour current and potential competitors, such as Symantec Corporation, McAfee, Inc.,Trend Micro, Cisco Systems and Microsoft Corporation, have longer operatinghistories and significantly greater financial, technical, marketing or otherresources. They may have significantly greater name recognition, establishedmarketing and channel relationships both in the United States andinternationally, better access to the SMB market, and access to a largerinstalled base of customers. In addition, current and potential competitorshave established or may establish cooperative relationships among themselves orwith third 

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partiesto increase the functionality of their products to address customer needs.Accordingly, new competitors or alliances among competitors may emerge andrapidly acquire significant market share. 

**IntellectualProperty Rights**

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

We currently have three patents issued in the UnitedStates, one patent issued in an international market, ten patent applicationspending in the United States and sixteen pending international patentapplications that seek to protect our proprietary database and filteringtechnologies, including issued patents and pending patent applications relatingto our flexible filtering management options and WebCatcher and AppCatchertechnologies, and pending patent applications relating to our ThreatSeekertechnology. We also have one patent issued in the United States, one patentissued in an international market, twenty-five pending patent applications inthe United States and thirteen pending international patent applications thatseek to protect information leakage prevention and content distribution,including our PreciseID digital fingerprinting technology. No assurance can begiven that any pending patent applications will result in issued patents.

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

**Employees**

As of February 15,2007, we had 728 employees. None of our employees are represented by a laborunion, and we have never experienced a work stoppage. We believe that ourrelations with our employees are good.

**Web Site Access toSEC Filings**

We maintain an InternetWeb site at *www.websense.com*. Thecontent of our Web site is not part of this report. We make available, free ofcharge, through our Internet Web site our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K, andamendments to those reports filed or furnished pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934, as amended, or the ExchangeAct, as soon as reasonably practicable after we electronically file suchmaterial with, or furnish it to, the SEC.

**Executive Officers**

Ourexecutive officers and their ages as of February 15, 2007 are as follows: 
| Name              | ** ** | ** ** | ** ** | **Age**                                   | ** ** | **Position(s)** |
|-------------------|------------|------------|------------|-------------------------------------------|------------|-----------------|
| Gene Hodges       |       | 55         |       | Chief Executive Officer  and President    |
| Douglas C. Wride  |       | 53         |       | Chief Financial Officer  and Secretary    |
| Michael A. Newman |       | 37         |       | Vice President & General Counsel |

 

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

Douglas C. Wride has served as our Chief FinancialOfficer and Secretary since June 1999. Mr. Wride served as ChiefFinancial Officer of Artios, Inc., a provider of hardware and softwaredesign solutions to companies in the packaging industry, from March 1997until it was acquired by BARCO n.a. in December 1998. Mr. Wride alsoserved as Chief Operating Officer of Artios from July 1997 to December 1998.From April 1996 to March 1997, Mr. Wride served as ChiefOperating Officer and Chief Financial Officer of NetCount, LLC, a provider ofInternet measurement and research services. Mr. Wride is a C.P.A. andreceived his B.S. in Business/Accounting from the University of SouthernCalifornia.

Michael A. Newman hasserved as our Vice President & General Counsel since September 2002.From April 1999 to September 2002, he served in various capacities inthe legal department of Gateway, Inc., a publicly traded PC manufacturer,most recently as Senior Staff Counsel, Securities, Finance and CorporateDevelopment. From February 1996 to April 1999, he practiced as anattorney in the San Diego office of Cooley Godward, LLP, a law firmspecializing in the representation of high-growth information technology andlife sciences companies. Mr. Newman received his B.S. in BusinessAdministration from Georgetown University, and a J.D. from Harvard Law School.

**Item 1A.**                RiskFactors

You should carefullyconsider the following information in addition to other information in thisreport before you decide to purchase our common stock. The risks anduncertainties described below are those that we currently deem to be materialand that we believe are specific to our company and our industry. In additionto these risks, our business may be subject to risks currently unknown to us.If any of these or other risks actually occur, our business may be adverselyaffected, the trading price of our common stock could decline, and you may loseall or part of your investment in Websense.

*We have experienced declining growth rates,particularly for Web filtering sales to large enterprises in North America andWestern Europe, and therefore need to increase our sales to small and mediumsized business customers.*

During the first half of2006, we were unable to sustain our growth rates for sales of Web filteringproducts to large enterprises, particularly for new sales to this marketsegment. During the second half of 2006, we expanded our focus on increasingsales to small and medium sized business (SMB) customers in North America andWestern Europe while sales growth rates in the large enterprise market segmentslowed down. Our growth plans for new sales in North America and Western Europein 2007 are largely dependent on our ability to increase sales in the SMBspace. To be successful, we must develop products specifically targeted at theSMB market. We are scheduled to release the first such product inJuly 2007. We will also need to increase our reliance on our new two-tierdistribution channel in North America and establish similar two-tierdistribution arrangements in Western Europe that target SMB customers. Numerouscompetitors target the SMB space for Web filtering sales, many of whom aredifferent competitors from our primary competitors in the large enterprisespace. If we cannot develop new products for the SMB market or competeeffectively for volume business through our existing or a newly establishedtwo-tier distribution model, our financial results will be negatively affected.

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*We are moving towards a two-tier distribution channelin North America which is intended to increase the quantity of our indirectsales.*

As wemove toward a two-tier indirect sales model in North America, our revenue willbe derived almost entirely from sales through indirect channels, includingvalue-added resellers, distributors that sell our products to end-users,providers of managed Internet services and other resellers. Currently, IngramMicro is our only broad-line distributor in North America, so the success ofour North American sales efforts is reliant on Ingram Micro’s success inselling our products to their reseller network. Our indirect sales modelinvolves a number of additional risks, including:

·       ourresellers and distributors, including Ingram Micro, are not subject to minimumsales requirements or any obligation to market our products to their customers;

·       wecannot control the level of effort our resellers and distributors expend or theextent to which any of them will be successful in marketing and selling ourproducts;

·       wecannot assure that our channel partners will market and sell our new productofferings such as our security-oriented offerings and our new information leakprevention offerings;

·       ourreseller and distributor agreements are generally nonexclusive and may beterminated at any time without cause; and

·       ourresellers and distributors frequently market and distribute competing productsand may, from time to time, place greater emphasis on the sale of theseproducts due to pricing, promotions, and other terms offered by ourcompetitors.

Our ability tomeaningfully increase the amount of our products sold through our saleschannels also depends on our ability to adequately and efficiently supportthese channel partners with, among other things, appropriate financialincentives to encourage pre-sales investment and sales tools, such as salestraining, technical training and product collateral needed to support theircustomers and prospects. Additionally, we are continually evaluating thechanges to our internal ordering and partner management systems in order to effectivelyexecute our new two-tier distribution strategy. Any failure to properly andefficiently support our sales channels will result in lost sales opportunities.

*Ourfuture success depends on our ability to sell new, renewal and upgraded Webfiltering and Web security subscriptions.*

Substantially all of ourrevenue in 2006 was derived from new and renewal subscriptions to our Webfiltering and Web security products. We expect that a significant majority ofour sales in 2007 will continue to be derived from our Web filtering andsecurity products and that sales of our newly acquired information leakprevention products and other products under development will comprise only avery small portion of our overall sales in 2007. If our Web filtering andsecurity products fail to meet the needs of our existing and target customers,or if they do not compare favorably in price, features and performance tocompeting products, our operating results and our business will besignificantly impaired. If we cannot sufficiently increase our customer basewith the addition of new customers, particularly in the SMB space, and increaseseats under subscriptions from existing customers, we will not be able to growour business to meet expectations.

Subscriptions for our Webfiltering and security products typically have durations of 12, 24 or 36months. Our customers have no obligation to renew their subscriptions uponexpiration. Our revenue also depends upon maintaining a high rate of sales ofrenewal subscriptions and in selling further subscriptions to existingcustomers in order to add additional seats or product offerings within theirrespective organizations. This may require increasingly costly sales effortstargeting senior management and other management personnel associated with ourcustomers’ Internet and security infrastructure. We may not be able to maintainor continue to generate increasing revenue from existing customers*.*

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*Failure of our security products, including ourinformation leak prevention products, to achieve more widespread marketacceptance will seriously harm our business.*

Our future financialperformance depends on our ability to diversify our offerings by successfullydeveloping, introducing and gaining customer acceptance of our new products andservices, particularly our security offerings. On January 8, 2007, weacquired PortAuthority Technologies, Inc., and as a result of thatacquisition, we now sell information leak prevention products in the contentsecurity market. We also sell our WebBlazer proxy product and other securityofferings with our traditional Web filtering products. We may not be successfulin achieving market acceptance of these or any new products that we develop.Moreover, our recent increased emphasis on the development, marketing and saleof our security offerings and information leak prevention products coulddistract us from sales of our core Web filtering and Web security offerings,negatively impacting our overall sales. Any failure or delay in diversifyingour existing offerings, or diversification at the detriment to our core Webfiltering and Web security offerings, could harm our business, results ofoperations and financial condition.

*We face increasing competition from much largersoftware and hardware companies, which places pressure on our pricing and whichcould prevent us from increasing revenue or maintaining profitability. Inaddition, as we increase our emphasis on our security-oriented products, weface competition from better-established security companies that havesignificantly greater resources.*

The market for our products is intensely competitiveand is likely to become even more so in the future, within both the Webfiltering market as well as the Web security market. Our current principal Webfiltering 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 Webfiltering and Web security products. 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 Webfiltering or other competitive products with their products. Increasedcompetition may cause price reductions or a loss of market share, either ofwhich could have a material adverse effect on our business, results ofoperations and financial condition. If we are unable to maintain the currentpricing on sales of our products or increase our pricing in the future, ourprofitability could be negatively impacted. Even if our products providegreater functionality and are more effective than certain other competitiveproducts, potential customers might accept this limited functionality in lieuof purchasing our products. In addition, our own indirect sales channels maydecide to develop or sell competing products instead of our products. Pricingpressures and increased competition generally could result in reduced sales,reduced margins or the failure of our products to achieve or maintain morewidespread market acceptance, any of which could have a material adverse effecton our business, results of operations and financial condition.

Our currentprincipal competitors include:

·       companiesoffering Web security solutions, such as Microsoft, Symantec, McAfee, JuniperNetworks, Message Labs and Trend Micro;

·       companiesoffering Web filtering products, such as SurfControl, Secure Computing,Symantec, Digital Arts, Computer Associates, Microsoft, St. Bernard Software,Finjan, Barracuda, ScanSafe, Cisco Systems and Trend Micro;

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

·       companiesoffering information leak protection solutions, such as Vontu, Verdasys,Vericept, Tablus, Symantec, Secure Computing, Reconnex, Provilla, Proofpoint,Palisade Systems, Orchstria, Oakley Networks, McAfee, Intrusion, Fidelis,Checkpoint and Code Green Networks;

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

·       companiesoffering proxy based solutions such as BlueCoat Systems and Cisco Systems.

As we develop andmarket our products with an increasing security-oriented emphasis, we also faceincreasing competition from security solutions providers. Many of ourcompetitors within the Web security market, such as Symantec Corporation,McAfee, Inc., Trend Micro, Cisco Systems and Microsoft Corporation enjoysubstantial competitive advantages, including:

·       greatername recognition and larger marketing budgets and resources;

·       establishedmarketing relationships and access to larger customer bases; and

·       substantiallygreater financial, technical and other resources.

As a result, we may beunable to gain sufficient traction as a provider of Web security solutions, andour competitors may be able to respond more quickly and effectively than we canto new or emerging technologies and changes in customer requirements, or devotegreater resources to the development, marketing, promotion and sale of theirproducts than we can. Current and potential competitors have established or mayestablish cooperative relationships among themselves or with third parties toincrease the functionality and market acceptance of their products. In addition,our competitors may be able to replicate our products, make more attractiveoffers to existing and potential employees and strategic partners, develop newproducts or enhance existing products and services more quickly. Accordingly,new competitors or alliances among competitors may emerge and rapidly acquiresignificant market share. In addition, we also expect that competition willincrease as a result of industry consolidation. For all of the foregoingreasons, we may not be able to compete successfully against our current andfuture competitors.

*Our international operations involve risks that couldincrease our expenses, adversely affect our operating results, and requireincreased time and attention of our management.*

We have significant operations outside of the UnitedStates, including research and development, sales and customer support. Werecently established engineering operations in Beijing, China, and acquiredPortAuthority Technologies, Inc., whose engineering efforts are based inIsrael. We intend to maintain our principal engineering efforts for ourinformation leak prevention products in Israel.

We plan to continueto expand our international operations, but such expansion is contingent uponthe financial performance of our existing international operations as well asour identification of growth opportunities. Our international operations aresubject to risks in addition to those faced by our domestic operations,including:

·       difficultiesassociated with managing a distributed organization located on multiplecontinents in greatly varying time zones;

·       potentialloss of proprietary information due to misappropriation or laws that may beless protective of our intellectual property rights;

·       requirementsof foreign laws and other governmental controls, including trade and laborrestrictions and related laws that reduce the flexibility of our businessoperations;

·       politicalunrest, war or terrorism, particularly in areas in which we have facilities;

·       difficultiesin staffing, managing, and operating our international operations, includingdifficulties related to administering our stock plans in some foreigncountries;

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·       difficultiesin coordinating the activities of our geographically dispersed and culturallydiverse operations;

·       seasonalreductions in business activity in the summer months in Europe and in otherperiods in other countries;

·       restrictionson our ability to repatriate cash from our international subsidiaries or toexchange cash in international subsidiaries into cash available for use in theUnited States; and

·  costs and delays associated with developingsoftware in multiple languages.

All of our foreignsubsidiaries’ operating expenses are incurred in foreign currencies. As aresult, should the dollar weaken, our foreign operating expenses wouldincrease. Should foreign currency exchange rates fluctuate, our earnings andnet cash flows from international operations may be adversely affected,especially if international sales continue to grow as a percentage of our totalsales.

*Salesto customers outside the United States have accounted for a significant portionof our revenue, which exposes us to risks inherent in international sales.*

Wemarket and sell our products outside the United States through value-addedresellers, distributors and other resellers. International sales representedapproximately 36% of our total revenue generated during our fiscal year ended December 31,2006 compared with 33% of our total revenue during our fiscal year ended December 31,2005. As a key component of our business strategy to generate new businesssales, 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:

·       ourability to adapt to sales and marketing practices and customer requirements indifferent cultures;

·       ourability to successfully localize software products for a significant number ofinternational markets;

·       thesignificant presence of some of our competitors in some international markets;

·       lawsand business practices favoring local competitors;

·       dependenceon foreign distributors and their sales channels;

·       longerpayment cycles for sales in foreign countries and difficulties in collectingaccounts receivable;

·       compliancewith multiple, conflicting and changing governmental laws andregulations, including tax laws and regulations and consumer protectionand privacy laws; and

·       regionaleconomic and political conditions.

These factors could have amaterial adverse effect on our international sales. Any reduction ininternational sales, or our failure to further develop our internationaldistribution channels, could have a material adverse effect on our business,results of operations and financial condition.

Our international revenueis currently primarily denominated in U.S. dollars. As a result, fluctuationsin the value of the U.S. dollar and foreign currencies may make our productsmore expensive for international customers, which could harm our business. Wecurrently bill certain international customers in Euros. This may increase ourrisks associated with fluctuations in foreign currency exchange rates since wecannot be assured of receiving the same U.S. dollar equivalent as when we billexclusively in U.S. dollars. We engage in currency hedging activities withthe intent of limiting the risk of exchange rate fluctuation. Our hedgingactivities also involve inherent risks that could result in an unforeseen loss.If we fail to properly forecast rate fluctuations these activities could have anegative impact.

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*Acquired companies or technologies can be difficult tointegrate, disrupt our business, dilute stockholder value and adversely affectour operating results.*

In January 2007, we acquired PortAuthorityTechnologies, Inc., and we may acquire additional companies, services andtechnologies in the future as part of our efforts to expand and diversify ourbusiness. Although we review the records of companies or businesses we areinterested in acquiring, even an in-depth review may not reveal existing orpotential problems or permit us to become familiar enough with a business toassess fully its capabilities and deficiencies. Integration of acquiredcompanies may disrupt or slow the momentum of the activities of our business.

Acquisitionsinvolve numerous risks, including:

·       difficultiesin integrating operations, technologies, services and personnel of the acquiredcompany;

·       diversionof financial and management resources from existing operations;

·       riskof entering new markets;

·       potentialloss of key employees of the acquired company;

·       integratingpersonnel with diverse business and cultural backgrounds;

·       preservingthe development, distribution, marketing and other important relationships ofthe companies;

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

·       inabilityto generate sufficient revenue to offset acquisition costs.

Acquisitions mayalso cause us to:

·       issueequity securities that would dilute our current stockholders’ percentageownership;

·       assumecertain liabilities;

·       incuradditional debt;

·       makelarge and immediate one-time write-offs and restructuring and other relatedexpenses;

·       becomesubject to intellectual property or other litigation; and

·       creategoodwill or other intangible assets that could result in significantamortization expense.

As a result, if we fail toproperly evaluate, execute and integrate acquisitions such as PortAuthority,our business and prospects may be seriously harmed.

*We may not be able to develop acceptable new productsor enhancements to our existing products at a rate required by our rapidlychanging market.*

Our future success depends on our ability to developnew products or enhancements to our existing products that keep pace with rapidtechnological developments and that address the changing needs of ourcustomers. Although our products are designed to operate with a variety ofnetwork hardware and software platforms, we will need to continuously modifyand enhance our products to keep pace with changes in Internet-related hardware,software, communication, browser and database technologies. We may not besuccessful in either developing such products or introducing them to the marketin a timely fashion. In addition, uncertainties about the timing and nature ofnew network platforms or technologies, or modifications to existing platformsor technology could increase our research and development expenses. The failureof our products to operate effectively with the existing and future networkplatforms 

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and technologies willlimit or reduce the market for our products, result in customer dissatisfactionand seriously harm our business, results of operations and financial condition.

We may spend significanttime and money on research and development to design and develop ourinformation leak prevention products. If these products fail to achieve broadmarket acceptance in our target markets, we may be unable to generatesignificant revenue from our research and development efforts. Moreover, evenif we are able to develop information prevention products, they may not beaccepted in our target markets. As a result, our business, results ofoperations and financial condition would be adversely impacted.

*Our products may fail to keep pace with the rapidgrowth and technological change of the Internet in accordance with ourcustomers’ expectations.*

The ongoing evolution of the Internet and computingenvironments will require us to continually improve the functionality, featuresand reliability of our databases. Because our products primarily manage accessto URLs and software applications included in our databases, if our databasesdo not contain a meaningful portion of relevant content, the effectiveness ofour Web filtering products will be significantly diminished. Any failure of ourdatabases to keep pace with the rapid growth and technological change of theInternet, such as the increasing amount of multimedia content on the Internetthat is not easily classified, will impair the market acceptance of ourproducts.

We rely upon a combinationof automated filtering technology and human review to categorize URLs andsoftware applications in our proprietary databases. Our customers may not agreewith our determinations that particular URLs and software applications shouldbe included or not included in specific categories of our databases. Inaddition, it is possible that our filtering processes may place objectionableor security risk material in categories that are generally unrestricted by ourusers’ Internet and computer access policies, which could result in suchmaterial not being blocked from the network. Any miscategorization could resultin customer dissatisfaction and harm our reputation. Any failure to effectivelycategorize and filter URLs and software applications according to our customers’expectations will impair the growth of our business. Our databases and databasetechnologies may not be able to keep pace with the growth in the number of URLsand software applications, especially the growing amount of content utilizingforeign languages and the increasing sophistication of malicious code and thedelivery mechanisms associated with spyware, phishing and other hazardsassociated with the Internet.

*Failure of our products to work properly or misuse ofour products could impact sales, increase costs, and create risks of potentialnegative publicity and legal liability.*

Our products are complex and are deployed in a widevariety of complex network environments. Our products may have errors ordefects that users identify after deployment, which could harm our reputationand our business. In addition, products as complex as ours frequently containundetected errors when first introduced or when new versions or enhancementsare released. We have from time to time found errors in versions of ourproducts, and we may find such errors in the future. Because customers rely onour products to manage employee behavior to protect against security risks andprevent the loss of sensitive data, any significant defects or errors in ourproducts may result in negative publicity or legal claims. For example, anactual or perceived breach of network or computer security at one of ourcustomers, regardless of whether the breach is attributable to our products,could adversely affect the market’s perception of our security products.Moreover, parties whose Web sites or software applications are placed insecurity-risk categories or other categories with negative connotations mayseek redress against us for falsely labeling them or for interfering with theirbusiness. The occurrence of errors could adversely affect sales of ourproducts, divert the attention of engineering personnel from our productdevelopment efforts and cause significant customer relations or legal problems.

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Our products may also bemisused or abused by customers or non-customer third parties who obtain accessand use of our products. These situations may arise where an organization usesour products in a manner that impacts their end users’ or employees’ privacy orwhere our products are misappropriated to censor private access to theInternet. Any of these situations could result in negative press coverage andnegatively affect our reputation.

*We face risksrelated to customer outsourcing to system integrators.*

Some of our customers haveoutsourced the management of their information technology departments to largesystem integrators. If this trend continues, our established customerrelationships could be disrupted and our products could be displaced byalternative system and network protection solutions offered by systemintegrators. Significant product displacements could impact our revenue andhave a material adverse effect on our business.

*Other vendors may include products similar to ours intheir hardware or software and render our products obsolete.*

In the future, vendors ofhardware and of operating system software or other software may continue toenhance their products or bundle separate products to include functions thatare currently provided primarily by network security software. If networksecurity functions become standard features of computer hardware or ofoperating system software or other software, our products may become obsoleteand unmarketable, particularly if the quality of these network securityfeatures is comparable to that of our products. Furthermore, even if thenetwork security and/or management functions provided as standard features byhardware providers or operating systems or other software is more limited thanthat of our products, our customers might accept this limited functionality inlieu of purchasing additional software. Sales of our products would suffermaterially if we were then unable to develop new Web filtering, security andinformation leak prevention products to further enhance operating systems orother software and to replace any obsolete products.

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

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

From time to time, we arealso audited by various state, federal and international authorities relatingto tax matters. We fully cooperate with all audits. Our audits are in variousstages of completion; however, no outcome for a particular audit can bedetermined with certainty prior to the conclusion of the audit and appealsprocess. As each audit is concluded, adjustments, if any, are appropriately recordedin our financial statements in the period determined. To provide for potentialtax exposures, we maintain allowances for tax contingencies based on reasonableestimates of our potential exposure with respect to the tax liabilities thatmay result from such audits. However, if the reserves are insufficient upon 

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completionof any audits, there could be an adverse impact on our financial position andresults of operations.

*Any failure toprotect our proprietary technology would negatively impact our business.*

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

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

We currently haveonly four issued patents in the United States and two patents issuedinternationally, and we may be unable to obtain further patent protection inthe future. We have several pending patent applications in the United Statesand in other countries. We cannot ensure that:

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

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

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

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

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

·       wewill develop additional proprietary technologies that are patentable; or

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

Furthermore, legalstandards relating 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 U.S. laws, andmechanisms for enforcement of intellectual property rights may be inadequate.As a result our means of protecting our proprietary technology and brands maynot be adequate. Furthermore, despite our efforts, we may be unable to preventthird parties from infringing upon or misappropriating our intellectualproperty, including the misappropriation or misuse of the content of ourproprietary databases of universal resource locators (URLs) and softwareapplications. Any such infringement or misappropriation could have a materialadverse effect on our business, results of operations and financial condition.

*Third parties claiming that we infringe theirproprietary rights could cause us to incur significant legal expenses andprevent us from selling our products.*

The software and Internetindustries are characterized by the existence of a large number of patents,trademarks and copyrights and by frequent litigation based on allegations ofpatent infringement or other 

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violationsof intellectual property rights. As we expand our product offerings in the dataleakage and security area where larger companies with large patent portfolioscompete, the possibility of an intellectual property claim against us grows. Wecould receive claims that we have infringed the intellectual property rights ofothers, including claims regarding patents, copyrights, and trademarks. Anysuch claim, with or without merit, could result in costly litigation anddistract management from day-to-day operations. If we are not successful indefending such claims, we could be required to stop selling our products, paymonetary amounts as damages, enter into royalty or licensing arrangements, orsatisfy indemnification obligations that we have with some of our customers.

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

We expect that nearly allof our revenue for the foreseeable future will come from subscriptions to WebsenseEnterprise and our add-on products. Upon execution of a subscription agreement,we invoice our customers for the full term of the subscription agreement. Wethen recognize revenue from customers daily over the terms of theirsubscription agreements, which typically have durations of 12, 24 or 36 months.As a result, a majority of the revenue we report in each quarter is derivedfrom deferred revenue from subscription agreements entered into and paid forduring previous quarters. Because of this financial model, the revenue wereport in any quarter or series of quarters may mask significant downturns insales and the market acceptance of our products before these downturns resultin declining revenues.

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

Our quarterly operating results have variedsignificantly in the past, and will likely vary in the future primarily as theresult of fluctuations in our billings, revenues, operating expenses and taxprovisions. Although a significant portion of our revenue in any quarter comesfrom previously deferred revenue, a meaningful portion of our revenue in anyquarter depends on subscriptions to our products that are sold in that quarter.The risk of quarterly fluctuations is increased by the fact that a significantportion of our quarterly sales have historically been generated during the lastmonth of each fiscal quarter, with many of the largest enterprise customerspurchasing subscriptions to our products nearer to the end of the last month ofeach quarter. Due to the unpredictability of these end-of-period buyingpatterns, forecasts may not be achieved.

We expect that ouroperating expenses will increase substantially in the future as we expand ourselling and marketing activities, increase our research and development effortsand hire additional personnel which could impact our gross margins. Inaddition, our operating expenses historically have fluctuated, and may continueto fluctuate in the future, as the result of the factors described below andelsewhere in this quarterly report:

·       timingof marketing expenses for activities such as trade shows and advertisingcampaigns;

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

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

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

Consequently, our resultsof operations may not meet the expectations of current or potential investors.If this occurs, the price of our common stock may decline.

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

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

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

·       demandfor our products, including fluctuations in subscription renewals;

·       changesin the pricing policies of our competitors; and

·       changesin government regulations.

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

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

·       changesin our pricing policies; and

·       quarterlyvariations in our revenues and operating expenses.

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

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

Our success dependslargely upon the continued services of our executive officers and other keymanagement 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. We do not maintain key person life insurance policies on any of ouremployees. The loss of one or more of our key employees could seriously harmour business, results of operations and financial condition. In such an eventwe may be unable to recruit personnel to replace these individuals in a timelymanner, or at all, on acceptable terms.

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

To execute our growthplan, we must attract and retain highly qualified personnel. We need to hireadditional personnel in virtually all operational areas, including selling andmarketing, research and development, operations and technical support, customerservice and administration. Competition for these personnel is intense,especially for engineers with high levels of experience in designing anddeveloping software and Internet-related products. We may not be successful inattracting and retaining qualified personnel. We have from time to time in thepast experienced, and we expect to continue to experience in the future,difficulty in hiring and retaining highly skilled employees with appropriate 

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qualifications.In order to attract and retain personnel in a competitive marketplace, webelieve that we must provide a competitive compensation package, including cashand equity based compensation. The volatility of our stock price may from timeto time adversely affect our ability to recruit or retain employees. Many ofthe companies with which we compete for experienced personnel have greaterresources than we have. If we fail to attract new personnel or retain andmotivate our current personnel, our business and future growth prospects couldbe severely harmed.

*Compliance with changing regulation of corporate governance,accounting principles and public disclosure may result in additional expenses.*

Changing laws, regulationsand standards relating to corporate governance, accounting principles andpublic disclosure, including the Sarbanes-Oxley Act of 2002, new SECregulations and NASDAQ Global Select Market rules, are creating uncertainty forcompanies such as ours. These new or changed laws, regulations and standardsare subject to varying interpretations in many cases due to their lack ofspecificity and, as a result, their application in practice may evolve overtime. Further guidance by regulatory and governing bodies can result incontinuing uncertainty regarding compliance matters and higher costs related tothe ongoing revisions to accounting, disclosure and governance practices. Ourefforts to comply with evolving laws, regulations and standards have resultedin, and are likely to continue to result in, increased general andadministrative expenses and a diversion of management time and attention fromrevenue-generating activities to compliance activities. In particular, ourefforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 andthe related regulations regarding our required assessment of our internalcontrols over financial reporting and our external auditors’ audit of thatassessment has required the commitment of significant financial and managerialresources. If our efforts to comply with new or changed laws, regulations andstandards differ from the activities intended by regulatory or governing bodiesdue to ambiguities related to practice, our reputation may be harmed.

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

Some provisions of ourcertificate of incorporation and bylaws, as well as some provisions of Delawarelaw, may discourage, delay or prevent third parties from acquiring us, even ifdoing so would be beneficial to our stockholders. For example, our certificateof incorporation provides for a classified board, with each board memberserving a staggered three-year term. It also provides that stockholders may notfill board vacancies, call stockholder meetings or act by written consent. Ourbylaws further provide that advance written notice is required prior to stockholderproposals. Each of these provisions makes it more difficult for stockholders toobtain control of our board or initiate actions that are opposed by the thencurrent board. Additionally, we have authorized preferred stock that isundesignated, making it possible for the board to issue up to 5,000,000 sharesof preferred stock with voting or other rights and preferences that couldimpede the success of any attempted change of control. Delaware law also couldmake it more difficult for a third party to acquire us. Section 203 of theDelaware General Corporation Law has 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 topay dividends.*

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

**Item 1B.**               UnresolvedStaff Comments

None.

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**Item 2.**                        Properties

Our corporate headquartersand principal offices are located in San Diego, California, where we leased approximately105,000 square feet as of December 31, 2006. This lease expires in December 2013with an option to extend the lease for an additional five years. We leaseadditional office space in Palo Alto, California, Ra’anana, Israel and Beijing,China and have executive suite arrangements on monthly, annual or two-yeararrangements, depending on the local market, relating to office space inIreland, the United Kingdom, Australia, China, Brazil, France, Germany, HongKong, Italy and Japan. We believe that our current space is adequate for ourcurrent needs and sufficient space is available to meet our identified futureneeds.

**Item 3.**                        LegalProceedings

On September 29, 2006, Jason Tauber filed apurported class action against us and other unidentified individuals inCalifornia Superior Court for the County of San Diego, captioned Tauber v.Websense. The complaint alleges that the plaintiff and a putative class ofcertain software engineers and computer professionals who worked for us asexempt employees during the period from September 15, 2002 through thepresent should have been classified as non-exempt employees under Californialaw and should have been paid for overtime. The complaint also alleges relatedwage and hour violations of the California Labor Code arising from the allegedmisclassification and that the failure to pay overtime constitutes an unfairbusiness practice under California Business and Professions Code § 17200. Thecomplaint seeks unspecified damages for unpaid overtime, prejudgment interest,attorneys’ fees and other costs, statutory penalties for alleged violations,and other proper relief. The case is at a very early stage. We deny allmaterial allegations and intend to defend the action vigorously.

We are involved in variouslegal actions in the normal course of business. Based on current information,including consultation with our lawyers, we believe that any ultimate liabilitythat may result from these actions, including Tauber v. Websense, would notmaterially affect our consolidated financial positions, results of operation orcash flows. Our evaluation of the likely impact of these actions could changein the future and unfavorable outcomes and/or defense costs, depending upon theamount and timing, could have a material adverse effect on our results ofoperations or cash flows in a future period.

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

There were no matters submitted to a vote of thesecurity holders during the fourth quarter of the fiscal year-ended December 31,2006.

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**Part II**

**Item5.**                        Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities

Ourcommon stock is traded on the NASDAQ Global Select Market (Nasdaq) under thesymbol “WBSN.” The following table sets forth the range of high and low closingprices on Nasdaq of our common stock for the periods indicated, as reported byNasdaq. Such quotations represent inter-dealer prices without retail markup,markdown or commission and may not necessarily represent actual transactions.

| **Year Ended December 31, 2006** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------------------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter                                        |       | $          | 33.85      |     | $          | 25.46   |       |
| Second Quarter                                       |       | 28.06      |       | 19.99    |       |
| Third Quarter                                        |       | 22.64      |       | 18.01    |       |
| Fourth Quarter                                       |       | 28.05      |       | 21.31    |       |
|                                                      |            |            |            |          |            |         |            |  |  |

 

| **Year Ended  December 31, 2005** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------------------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter                          |       | $          | 30.76      |     | $          | 22.50   |       |
| Second Quarter                         |       | 28.19      |       | 22.91    |       |
| Third Quarter                          |       | 27.11      |       | 23.11    |       |
| Fourth Quarter                         |       | 33.98      |       | 25.54    |       |
|                                        |            |            |            |          |            |         |            |  |  |

 

To date, we have neitherdeclared nor paid any cash dividends on our common stock. We currently intendto retain all future earnings, if any, for use in the operation and developmentof our business and for stock repurchases and, therefore, do not expect todeclare or pay any cash dividends on our common stock in the foreseeablefuture. As of February 15, 2007, there were approximately 6,500 holders ofrecord of our common stock. See Item 12—“Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters” forinformation regarding our equity compensation plans.

On January 31, 2006,we announced that the Board of Directors authorized a two-for-one stock splitof our common stock, to be effected in the form of a special dividend of oneshare of our common stock for each share of our common stock outstanding. Theadditional shares issued as a result of the stock split were distributed on March 17,2006 to stockholders of record at the close of business on February 13,2006. All prior year share and per share data (including any data relating tooptions) presented in this report, including the accompanying consolidatedfinancial statements and related notes have been restated to reflect the stocksplit.

**Use of Proceeds**

On March 28, 2000, wecompleted our initial public offering for the sale of 8,000,000 shares ofcommon stock at a price to the public of $9 per share, which resulted in netproceeds of $65.7 million after payment of the underwriters’ commissions anddeductions of offering expenses (the “Proceeds”). The registration statement (No. 333-95619)relating to our initial public offering was declared effective on March 28,2000. Subsequent to our initial public offering, a portion of the Proceeds wereused to repay the $1.5 million balance of our fixed term loan agreements withfinancial institutions. We used all of the remaining Proceeds consistent withour intended use outlined in the prospectus related to such offering andtowards the acquisition of PortAuthority Technologies, Inc. in January 2007.As of January 31, 2007, we had cash, cash equivalents and marketable securitiesof $249.0 million.

**Issuer Purchases of Equity Securities**

On April 3, 2003, weannounced that our Board of Directors authorized a stock repurchase program ofup to 4 million shares of its common stock. On August 15, 2005, weannounced that our Board of Directors increased the size of the stockrepurchase program by an additional 4 million shares, for a total program sizeof up to 8 million shares. On July 25, 2006, we announced that our Boardof Directors increased the size of the stock repurchase program by anadditional 4 million shares, for a total program 

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size ofup to 12 million shares. The repurchases will be made from time to time on theopen market at prevailing market prices or in privately negotiatedtransactions. Depending on market conditions and other factors, purchases underthis program may commence or be suspended at any time, or from time to time,without prior notice. We repurchased 4.3 million shares in 2006, bringing thetotal number of shares repurchased as part of our stock repurchase program to8,170,060 and leaving 3,829,940 as the maximum number of shares that may yet berepurchased under our stock repurchase program. We made no stock repurchases inthe quarter ended December 31, 2006.

**Item6.**                        SelectedFinancial Data

Youshould read the following selected financial data in conjunction with ourfinancial statements and related notes and “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” appearing elsewherein this annual report. We derived the income statement data for the years endedDecember 31, 2006, 2005 and 2004 and the balance sheet data as of December 31,2006 and 2005 from our financial statements audited by Ernst & YoungLLP, an independent registered accounting firm, which appear elsewhere in thisreport. We derived the income statement data for the years ended December 31,2003 and 2002 and the balance sheet data as of December 31, 2004, 2003 and2002 from our financial statements audited by Ernst & Young LLP, anindependent registered accounting firm, which are not included in this annualreport. Our historical results are not necessarily indicative of operatingresults to be expected in the future.

| ** **                                | ** ** | **Years Ended December 31,**                                 | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                | ** ** | **(In thousands, except for per share data)** | ** ** |
| **Income Statement Data:**                |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Revenues                                  |       | $                                                                           | 178,814    |   | $ | 148,636 |   | $ | 111,859 |   | $ | 81,734 |   | $ | 60,965 |   |
| Cost of revenues                          |       | 15,274                                                                      |       | 10,642 |   | 7,769 |   | 5,523 |   | 4,170 |   |
| Gross margin                              |       | 163,540                                                                     |       | 137,994 |   | 104,090 |   | 76,211 |   | 56,795 |   |
| Operating expenses:                       |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Selling and marketing                     |       | 80,135                                                                      |       | 55,288 |   | 42,625 |   | 31,845 |   | 26,201 |   |
| Research and development                  |       | 22,663                                                                      |       | 16,277 |   | 14,509 |   | 12,843 |   | 10,957 |   |
| General and  administrative               |       | 21,279                                                                      |       | 11,729 |   | 8,200 |   | 6,649 |   | 5,960 |   |
| Amortization of  stock-based compensation |       | —                                                                      |       | — |   | — |   | 83 |   | 448 |   |
| Total operating expenses                  |       | 124,077                                                                     |       | 83,294 |   | 65,334 |   | 51,420 |   | 43,566 |   |
| Income from operations                    |       | 39,463                                                                      |       | 54,700 |   | 38,756 |   | 24,791 |   | 13,229 |   |
| Other income, net                         |       | 11,287                                                                      |       | 5,411 |   | 2,226 |   | 2,292 |   | 2,711 |   |
| Income before income  taxes               |       | 50,750                                                                      |       | 60,111 |   | 40,982 |   | 27,083 |   | 15,940 |   |
| Provision (benefit) for  income taxes     |       | 18,657                                                                      |       | 21,343 |   | 14,806 |   | 10,395 |   | (797 | ) |
| Net income                                |       | $                                                                           | 32,093     |   | $ | 38,768 |   | $ | 26,176 |   | $ | 16,688 |   | $ | 16,737 |   |
| Net income per share:                     |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Basic                                     |       | $                                                                           | 0.69       |   | $ | 0.82 |   | $ | 0.57 |   | $ | 0.38 |   | $ | 0.39 |   |
| Diluted                                   |       | $                                                                           | 0.68       |   | $ | 0.79 |   | $ | 0.54 |   | $ | 0.36 |   | $ | 0.36 |   |
| Weighted average  shares—basic       |       | 46,494                                                                      |       | 47,491 |   | 46,161 |   | 44,076 |   | 42,422 |   |
| Weighted average  shares—diluted     |       | 47,116                                                                      |       | 49,196 |   | 48,228 |   | 45,952 |   | 46,676 |   |

 

| ** **                                          | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------------|------------|
| ** **                                          | ** ** | **2006**                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                          | ** ** | **(In thousands)**          | ** ** |
| **Balance  Sheet Data:**                            | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash equivalents and marketable securities |       | $                           | 326,905    |   | $ | 320,389 |   | $ | 243,788 |   | $ | 182,859 |   | $ | 140,466 |   |
| Working capital                                     |       | 230,039                     |       | 255,103 |   | 195,635 |   | 145,322 |   | 114,459 |   |
| Total assets                                        |       | 424,257                     |       | 403,675 |   | 315,293 |   | 233,613 |   | 180,188 |   |
| Deferred revenue                                    |       | 220,343                     |       | 179,925 |   | 132,317 |   | 93,960 |   | 64,679 |   |
| Total stockholders’ equity                     |       | 180,725                     |       | 205,811 |   | 167,944 |   | 128,929 |   | 106,711 |   |
|                                                     |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

The following discussionand analysis should be read in conjunction with the financial statements andrelated notes contained elsewhere in this report. See “Risk Factors” under Item1A above regarding certain factors known to us that could cause reportedfinancial information not to be necessarily indicative of future results. Alsonote that because our acquisition of PortAuthority Technologies, Inc. wascompleted in January 2007, there was no financial impact on our financialcondition and results of operation for our year ended December 31, 2006.

**Overview**

Our products help organizations manage their networksand computing resources to provide a secure and productive computingenvironment. We provide Web filtering and Web security software products thatenable organizations to protect employees and confidential information fromexternal Web-based attacks such as spyware, and phishing, as well as analyze, reportand manage how employees use computing resources and the Internet. In January 2007,we acquired our technology development partner for information leak preventionsolutions, PortAuthority Technologies, Inc. (PortAuthority). As a result,in addition to our Web filtering and Web security software products, we offersoftware that helps prevent the loss of confidential information from internalthreats, such as ineffective business process controls, employee error andmalfeasance.

We focus our business on developing and selling Webfiltering and Web security products that automate organizations’ Internet andapplication use policies as well as information leak protection solutions.Websense Enterprise is our core Web filtering solution, providing fully featuredWeb filtering and serving as management platforms for related Websense add-onmodules, such as our Security Filtering, Remote Filtering and Client PolicyManagerTM. We have also created the Websense Web Security SuiteTM to addressspecific customer needs. We currently derive all of our revenue fromsubscriptions to the Websense Enterprise-based solutions and expect this tocontinue in the future as more offerings are added to the Websense Enterpriseplatforms.

Since we released our first software product in 1996,our products have evolved from preventing the download of unacceptable contentto products that proactively manage employee computing resources and theInternet to maximize productivity and prevent access to the most undesirableand dangerous elements on the Web, such as Web sites that contain or willdownload viruses, spyware, keyloggers, phishing exploits and an ever-increasingvariety of malicious code.

At the foundation of our Web filtering and Websecurity product offering is the Websense Enterprise® software application,which serves as a central policy engine and management and reporting platformfor our Web filtering and related add-on Web security products. WebsenseEnterprise gives organizations the ability to enhance network security, improveemployee productivity, mitigate potential legal liability and conserve networkbandwidth by allowing organizations to identify potential risk areas andimplement and automate Web access and application usage policies that reducethese risks. When combined with our Web security products that utilize ourThreatSeekerTM technology including Security Filtering, Remote Filtering andClient Policy ManagerTM, Websense Enterprise allows organizations to enhancenetwork and content security by blocking access to malicious Web sites andpreventing the transmission of data to known spyware destination sites. Tosimplify the purchase process for our value-added resellers and customers, wehave created a suite of Websense Enterprise and our most popular add-on securityproducts and services, known as the Websense® Web Security SuiteTM.

We have been developing Web content filtering andsecurity solutions to protect Internet users from receiving and accessingunwanted or illegal content on their mobile phones and personal digitalassistants (PDAs). We have engaged in discussions regarding mobile filteringsolutions with several third parties, and we expect to close our firsttransaction for the mobile filtering and security products in 2007.

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During 2006, we derived 36% of revenue frominternational sales, compared with 33% for 2005, with the United Kingdomcomprising approximately 10% of our total revenue in both years. We believeinternational markets continue to represent a significant growth opportunityand we are continuing to expand our international operations, particularly inselected countries in the European, Asia/Pacific and Latin American markets.

We sell Websense Enterprise through both indirectchannels and directly, and are transitioning to a two tier distributionstrategy in North America. Sales through indirect channels currently accountfor more than 85% of our revenue, and we plan to increase the percentage of ourrevenue obtained through indirect channels. Our strategy is to increase new andrenewal customer sales through independent software distributors and resellersand increase the focus of our internal sales and marketing force on supportingour channel strategy. As a result, we expect to increase the proportion of oursales made through indirect channels. In August 2006, we announced a newtwo-tier distribution strategy in North America and entered into a relationshipwith Ingram Micro to distribute, market and support our Web security and Webfiltering software in North America. Through joint marketing programs withWebsense, Ingram Micro will focus its efforts on recruiting new resellers,especially resellers focused on selling to small and medium-sized businesses(SMB), and on building awareness and demand within our existing North Americachannel partner base.

As described elsewhere inthis report, we recognize revenue from subscriptions to our products, includingadd-on modules, on a daily straight line basis commencing on the day the termof the subscription begins, over the term of the subscription agreement. Werecognize the operating expenses related to these sales as they are incurred.These operating expenses include sales commissions, which are based on thetotal amount of the subscription contract and are fully expensed in the periodthe product is delivered. Operating expenses have continued to increase ascompared with prior periods due to expanded selling and marketing efforts,continued product research and development and investments in administrativeinfrastructure to support subscription sales that we will recognize as revenuein subsequent periods.

**Critical AccountingPolicies**

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

*RevenueRecognition.*   When a purchase decision is madefor our products, customers enter into a subscription agreement, which isgenerally 12, 24 or 36 months in duration and for a fixed number of users.Other services such as upgrades/enhancements and standard post-contract technicalsupport services are sold together with our product subscription and providedthroughout the subscription term.

Prior to January 1, 2006, we recognized revenue on amonthly straight line basis, commencing with the month the subscription began. Effectiveas of January 1, 2006, we recognize revenue on a daily straight line basiscommencing on the date the term of the subscription begins, and continuing overthe term of the subscription agreement, provided collectability is reasonablyassured. During 2006, we re-evaluated our revenue recognition policy inaccordance with the provisions of SOP 97-2 and determined that our priorpractice resulted in a material cummulative difference in our deferred revenue.Upon entering into a subscription arrangement for a fixed or determinable fee,we electronically deliver access codes to users and then promptly invoicecustomers for the full amount of their subscriptions. Payment is due for thefull term of the subscription, generally within 30 to 60 days of the invoice.We record amounts billed to customers in excess of recognizable revenue asdeferred revenue on our balance sheet. In connection with the change in revenuerecognition policy, we adopted Staff Accounting Bulletin No. 108 (SAB No. 108),*Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements*, and applied the special cumulative effect transitionprovision to our 2006 financial statements. 

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The cumulative net resultis an increase in deferred revenue and a reduction in retained earnings, beforetax impact, as of January 1, 2006 by $8.7 million. For 2006, the impact ofdaily revenue recognition on subscriptions was to reduce revenue recognized by$1.7 million, reduce net income by $1.1 million, and increase deferred revenueby an additional $1.7 million to a total increase of $10.4 million whencompared to what these amounts would have been under the monthly revenuerecognition policy.

We record distributor marketing payments and channelrebates as an offset to revenue. We recognize distributor marketing payments asan offset to revenue as the marketing service is provided. We recognize channelrebates as an offset to revenue on a straight-line basis over the term of thesubscription agreement.

*Accountingfor Share-Based Compensation.**  *Through December 31, 2005, weaccounted for share-based employee compensation plans under the measurement andrecognition provisions of Accounting Principles Board (APB) No. 25 (APB No. 25),and related Interpretations, as permitted by Financial Accounting StandardsBoard (FASB) Statement of Financial Accounting Standards (SFAS) No. 123*Accounting for Stock-Based Compensation*(SFAS No. 123). Accordingly, we recorded no share-based employeecompensation expense for options granted under our Amended and Restated 2000Stock Incentive Plan (2000 Plan) or predecessor plans (or options granted asnon-plan inducement options) during the twelve months ended December 31,2005 as all other options granted had exercise prices equal to the fair marketvalue of the common stock on the date of grant. We also recorded nocompensation expense in connection with the Employee Stock Purchase Plan as thepurchase price of the stock was not less than 85% of the lower of the fairmarket value of the common stock at the beginning of each offering period or atthe end of each purchase period. In accordance with SFAS No. 123 and SFAS No. 148,*Accounting for Stock-Based Compensation—Transitionand Disclosure* (SFAS No. 148), we disclosed net income or lossand net income or loss per share as if the fair value-based method was appliedin measuring compensation expense for share-based incentive programs.

Effective January 1, 2006, we adopted the fairvalue recognition provisions of SFAS No. 123(R), using the modifiedprospective transition method. Under that transition method, compensationexpense that we recognized beginning on that date includes: (a) compensationexpense for all share-based payments granted prior to, but not yet vested as ofJanuary 1, 2006, based on the grant date fair value estimated inaccordance with the original provisions of SFAS No. 123, and (b) compensationexpense for all share-based payments granted on or after January 1, 2006,based on the grant date fair value estimated in accordance with the provisionsof SFAS No. 123(R). Results for prior periods will not be restated. Theresults for the twelve months ended December 31, 2006 include share-basedcompensation expense of $20.4 million (excluding tax effects). Compensationexpense related to share-based awards is generally amortized over the vestingperiod in the related expense categories of the consolidated statement ofincome.

At December 31, 2006, there was$62.6 million of total unrecognized compensation cost related toshare-based compensation arrangements granted under all equity compensationplans (excluding tax effects). That total unrecognized compensation cost willbe adjusted for estimated forfeitures as well as for future changes inestimated forfeitures. We expect to recognize that cost over a weighted averageperiod of approximately three years.

We estimate the fair value of options granted usingthe Black-Scholes option valuation model and the assumptions described below.We estimate the expected term of options granted based on the history of grantsand exercises in our option database. We estimate the volatility of our commonstock at the date of grant based on both the historical volatility as well asthe implied volatility of publicly traded options on our common stock,consistent with SFAS No. 123(R) and Securities and ExchangeCommission Staff Accounting Bulletin No. 107 (SAB No. 107). We basethe risk-free interest rate that is used in the Black-Scholes option valuationmodel on the implied yield in effect at the time of option grant on U.S.Treasury zero-coupon issues with equivalent remaining terms. We have never paidany cash dividends on our 

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common stock and do notanticipate paying any cash dividends in the foreseeable future. Consequently,we use an expected dividend yield of zero in the Black-Scholes option valuationmodel. We amortize the fair value ratably over the vesting period of theawards, which is typically four years. We use historical data to estimatepre-vesting option forfeitures and record share-based expense only for thoseawards that are expected to vest. For purposes of calculating pro formainformation under SFAS No. 123 for periods prior to January 1, 2006,we accounted for forfeitures as they occurred. We may elect to use differentassumptions under the Black-Scholes option valuation model in the future orselect a different option valuation model altogether, which could materiallyaffect our net income or loss and net income or loss per share in the future.

We determine the fair value of share-based paymentawards on the date of grant using an option-pricing model that is affected byour stock price as well as assumptions regarding a number of complex andsubjective variables. These variables include, but are not limited to ourexpected stock price volatility over the term of the awards, and actual andprojected employee stock option exercise behaviors. Option-pricing models weredeveloped for use in estimating the value of traded options that have novesting or hedging restrictions and are fully transferable. Because ouremployee stock options have certain characteristics that are significantlydifferent from traded options, and because changes in the subjectiveassumptions can materially affect the estimated value, in management’s opinion,the existing valuation models may not provide an accurate measure of the fairvalue of our employee stock options. Although the fair value of employee stockoptions is determined in accordance with SFAS No. 123(R) and SAB No. 107using an option-pricing model, that value may not be indicative of the fairvalue observed in a willing buyer/willing seller market transaction.

*DeferredTax Assets.*   As required by SFAS No. 109, werecognize tax assets on the balance sheet if it is “more likely than not” thatthey will be realized on future tax returns. At December 31, 2006, we haddeferred tax assets of $32.0 million. We believe that it is more likely thannot that 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. However, should we determine that we wouldnot be able to realize all or part of our deferred tax assets in the future, anadjustment to the deferred tax assets would be charged against income in theperiod such determination was made.

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

*Allowance for DoubtfulAccounts.**  *Wemaintain an allowance for doubtful accounts for estimated losses resulting fromthe inability or unwillingness of our customers to pay their invoices. If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired.

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**Results ofOperations**

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

| ** **                 | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------|------------|---------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                   |       |                                        | 100        | % |   |   | 100 | % |   |   | 100 | % |   |
| Cost of revenues           |       |                                        | 9          | * |   |   | 7 |   |   |   | 7 |   |   |
| Gross margin               |       |                                        | 91         | * |   |   | 93 |   |   |   | 93 |   |   |
| Operating expenses:        |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Selling and marketing      |       |                                        | 45         | * |   |   | 37 |   |   |   | 38 |   |   |
| Research and development   |       |                                        | 12         | * |   |   | 11 |   |   |   | 13 |   |   |
| General and administrative |       |                                        | 12         | * |   |   | 8 |   |   |   | 7 |   |   |
| Total operating expenses   |       |                                        | 69         | * |   |   | 56 |   |   |   | 58 |   |   |
| Income from operations     |       |                                        | 22         | * |   |   | 37 |   |   |   | 35 |   |   |
| Other income, net          |       |                                        | 6          |   |   |   | 3 |   |   |   | 2 |   |   |
| Income before income taxes |       |                                        | 28         | * |   |   | 40 |   |   |   | 37 |   |   |
| Provision for income taxes |       |                                        | 10         |   |   |   | 14 |   |   |   | 14 |   |   |
| Net income                 |       |                                        | 18         | %* |   |   | 26 | % |   |   | 23 | % |   |

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*                    Theresults for the year ended December 31, 2006 include share-based compensationexpense of $20.4 million (excluding tax effects) or 11% of revenues, inthe following expense categories of the consolidated statement of income (inthousands):

| Share-based  compensation in:                        |   |   |   |
|------------------------------------------------------|--------|--------|--------|
| Cost of revenue                                      |   | $      | 1,476  |   |
| Total share-based compensation in cost of revenue    |   | 1,476  |   |
| Selling and marketing                                |   | 8,264  |   |
| Research and development                             |   | 3,573  |   |
| General and administrative                           |   | 7,045  |   |
| Total share-based compensation in operating expenses |   | 18,882 |   |
| Total share-based  compensation                      |   | $      | 20,358 |   |

 

**Years ended December 31,2006 and 2005**

**Revenue**

Revenue increased to$178.8 million in 2006 from $148.6 million in 2005. The increase was primarilya result of the addition of new, renewed and upgraded subscriptions from ourcustomers that resulted in a 1.1 million increase in the number of seats undersubscription from December 31, 2005 to December 31, 2006. Our changein our revenue recognition policy to daily revenue recognition resulted in areduction of revenue by $1.7 million in 2006 relative to revenue that wouldhave been recognized under the monthly revenue recognition policy that we usedprior to 2006. Approximately 65% of subscription revenue recognized in 2006 andin 2005 was derived from renewal business. We expect our 2007 revenue toincrease over 2006 revenue levels, as a result of our deferred revenue underexisting subscriptions, our renewal business, and expected worldwide growth, partiallyoffset by increased distributor marketing payments and channel payments.

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**Cost of Revenue**

Cost of revenue consistsof the costs of content review, technical support and infrastructure costsassociated with maintaining our databases. Cost of revenue increased to $15.3million in 2006 from $10.6 million in 2005. The increase was primarily due tothe costs associated with share-based compensation expense relating to ouradoption of SFAS No. 123(R) on January 1, 2006, as well asadditional personnel in our technical support and database groups and allocatedcosts. We allocate the total costs for human resources, employee benefits,payroll taxes, information technology, facilities, fixed asset depreciation andlegal costs to each of our functional areas based on salaries and headcountdata. We expect cost of revenue to increase in the future to support the growthand maintenance of our databases as well as the technical support needs of ourcustomers. As a percentage of revenue, cost of revenue increased to 9% during2006 from 7% in 2005. We expect that cost of revenue, as a percentage ofrevenue, will remain below 10% of revenue for the foreseeable future.

**Gross Margin**

Gross margin increased to$163.5 million in 2006 from $138.0 million in 2005. The increase was due toincreased revenue. As a percentage of revenue, gross margin decreased to 91% in2006 from 93% in 2005. We expect thatgross margin, as a percentage of revenue, will remain in excess of 90% ofrevenue for the foreseeable future.

**Operating Expenses**

*Sellingand marketing.*   Selling and marketing expensesconsist primarily of salaries, commissions and benefits related to personnelengaged in selling, marketing and customer support functions, including costsrelated to public relations, advertising, promotions and travel as well asallocated costs. Selling and marketing expenses increased to $80.1 million in2006 from $55.3 million in 2005. The increase in selling and marketing expensesof $24.8 million was primarily due to share-based compensation expensesrelating to our adoption of SFAS No. 123(R) on January 1, 2006,as well as additional expenses associated with our new channel strategy,increased personnel costs and related travel, and allocated costs. We expectselling and marketing expenses to increase in absolute dollars in the future asmore personnel are added to support our expanding selling and marketing effortsworldwide, including for our new information leak prevention products, and asincreased sales result in higher overall sales commission expenses.

*Researchand development.*   Research and developmentexpenses consist primarily of salaries and benefits for software developers andallocated costs. Research and development expenses increased to $22.7 millionin 2006 from $16.3 million in 2005. The increase of $6.4 million in researchand development expenses was primarily due to share-based compensation expenserelating to our adoption of SFAS No. 123(R) on January 1, 2006,as well as increased personnel needed to support our expanding list oftechnology partners, the enhancements of Websense Enterprise and additionalproducts, and allocated costs. We expect research and development expenses toincrease in absolute dollars in future periods due to our acquisition ofPortAuthority and its engineering team, and as more personnel are added tosupport our continued enhancements of our products, our recently acquiredinformation leak prevention products from PortAuthority, as well as thedevelopment of new products.

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*General andadministrative.*   General and administrativeexpenses consist primarily of salaries, benefits and related expenses for ourexecutive, finance, and administrative personnel, third party professionalservice fees and allocated costs. General and administrative expenses increasedto $21.3 million in 2006 from $11.7 million in 2005. The $9.6 million increasein general and administrative expenses was primarily a result of share-basedcompensation expense relating to our adoption of SFAS No. 123(R) on January 1,2006, as well as additional personnel needed to support our growing operations,and allocated costs. We expect general and administrative expenses to increasein absolute dollars in future periods reflecting growth in operations, increasingexpenses associated with being a public company and expansion of ourinternational operations.

**Other Income, Net**

Net other income increasedto $11.3 million in 2006 from $5.4 million in 2005. The increase was dueprimarily to higher interest rates realized on our increased balances of cash,cash equivalents and marketable securities during 2006 compared with 2005. Themajority of our investments of cash and cash equivalents and marketablesecurities are tax-exempt. We expect that the majority of our cash and cashequivalents and marketable securities will continue to be held in tax-exemptinvestments during the foreseeable future. Our acquisition of PortAuthority forapproximately $90 million, on January 8, 2007, will reduce our balance ofcash, cash equivalents and marketable securities from which we generateinterest income.

**Provision forIncome Taxes**

In 2006, United States andforeign income tax expense was $18.7 million as compared to $21.3 million for2005. The annual effective income tax rate for 2006 was 36.8% compared to 35.5%for 2005. The increase in the tax rate is primarily related to an increase inthe provision for state income taxes and the impact of SFAS 123(R) on stockcompensation that does not result in a tax deduction. The increase in tax rateis partially offset by an increase in tax exempt income. Our effective tax ratemay change in future periods due to the composition of taxable income betweendomestic and international operations, the magnitude of our tax-exempt income,and any future changes or interpretations in tax rules and legislation, orcorresponding accounting rules. We are presently analyzing the impact of ouracquisition of PortAuthority on our 2007 effective tax rate.

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

**Revenue**

Revenue increased to$148.6 million in 2005 from $111.9 million in 2004. The increase was primarilya result of the addition of new, renewed and upgraded subscriptions from ourcustomers that resulted in a 4.1 million increase in the number of seats undersubscription from December 31, 2004 to December 31, 2005.Approximately 65% of subscription revenue recognized in 2005 and 2004 wasderived from renewal business. 

**Cost of Revenue**

Cost of revenue increasedto $10.6 million in 2005 from $7.8 million in 2004. The increase was primarilydue to the costs associated with additional personnel in our technical supportand database groups, as well as allocated costs. As a percentage of revenue,cost of revenue remained unchanged at 7% during the years ended 2005 and 2004. 

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**Gross Margin**

Gross margin increased to$138.0 million in 2005 from $104.1 million in 2004. The increase was due toincreased revenue. As a percentage of revenue, gross margin remained unchangedat 93% for the years ended 2005 and 2004. 

**Operating Expenses**

*Sellingand marketing.*   Selling and marketing expensesincreased to $55.3 million in 2005 from $42.6 million in 2004. The increase inselling and marketing expenses of $12.7 million was primarily due to increasedpersonnel costs and related travel and allocated costs as well as highercommissions related to higher sales levels. 

*Researchand development.*   Research and development expenses increased to $16.3 million in 2005from $14.5 million in 2004. The increase of $1.8 million in research anddevelopment expenses was primarily a result of increased personnelneeded to support our expanding list of technology partners, the enhancementsof Websense Enterprise and additional products as well as increased allocatedcosts. 

*General andadministrative.*   General and administrativeexpenses increased to $11.7 million in 2005 from $8.2 million in 2004. The $3.5million increase in general and administrative expenses was primarily a resultof additional personnel needed to support our growing operations, increasedallocated costs and an increase in professional accounting fees driven bycompliance with the Sarbanes-Oxley Act of 2002. 

**Other Income, Net**

Net other income increasedto $5.4 million in 2005 from $2.2 million in 2004. The increase was dueprimarily to higher interest rates realized on our increased balances of cash,cash equivalents and marketable securities during 2005 compared with 2004. 

**Provision forIncome Taxes**

In 2005, United States andforeign income tax expense was $21.3 million as compared to $14.8 million for2004. The annual effective income tax rate for 2005 was 35.5% compared to 36.1%for 2004. The annual effective tax rate for 2005 was lower than the 2004effective tax rate primarily due to an increase in foreign earnings taxed atless than the United States federal income tax rate, an increase in tax-exemptinterest income and an increase in federal and state research and developmenttax credits.

**Liquidity andCapital Resources**

As of December 31, 2006, we had cash and cashequivalents of $83.5 million, investments in marketable securities of $243.4million, and retained earnings of $82.7 million. As of December 31, 2005,we had cash and cash equivalents of $61.6 million, investments in marketablesecurities of $258.8 million and retained earnings of $56.4 million.

Net cash provided by operating activities was $83.7million in 2006 compared with net cash provided by operating activities of$100.7 million in 2005. The $17.0 million decrease in cash provided byoperating activities in 2006 was primarily due to decreased tax benefits fromfewer exercises of stock options and decreased growth in deferred revenue(subscription amounts in excess of recognizable revenue are recorded asdeferred revenue) compared to 2005. Our operating cash flow is significantlyinfluenced by subscription renewals and accounts receivable collections, anddeferred revenue. A decrease in subscription renewals or accounts receivablecollections, or a lower deferred revenue balance, will negatively impact ouroperating cash flow. 

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Net cash provided by investing activities was $10.5million in 2006 compared with net cash used in investing activities of $57.6million in 2005. The $68.1 million increase of net cash provided by investingactivities for 2006 was primarily due to fewer purchases to offset thematurities and sales of marketable securities.

Net cash used by financing activities was $72.3million in 2006 compared with net cash used by financing activities of $20.4million in 2005. The $51.9 million increase in net cash used by financing activitiesin 2006 was primarily due to share repurchases of 4,300,000 shares of ourcommon stock for $91.4 million, compared with share repurchases of 1,858,060shares for $48.3 million in 2005, and the reduction of proceeds from exercisesof employee stock options in 2006.

A majority of our operating lease commitments arerelated to our worldwide office space leases, which expire at various datesthrough December 2013. The rent expense related to our worldwide officespace leases are recorded monthly on a straight-line basis in accordance withgenerally accepted accounting principles. Future minimum annual payments undernon-cancelable operating leases at February 15, 2007 are as follows (inthousands):

| **Years Ending December 31:** | ** ** | ** ** | ** ** | **Operating  Leases** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|------------|------------|-----------------------|------------|-----------|------------|
| 2007                                         |       |       | $          | 4,835                 |       |      | $          | 4,835 |   |
| 2008                                         |       |       | 2,375      |                  |       | 2,375     |       |
| 2009                                         |       |       | 2,209      |                  |       | 2,209     |       |
| 2010                                         |       |       | 2,285      |                  |       | 2,285     |       |
| 2011                                         |       |       | 2,361      |                  |       | 2,361     |       |
| 2012                                         |       |       | 2,450      |                  |       | 2,450     |       |
| 2013                                         |       |       | 2,539      |                  |       | 2,539     |       |
|                                         |       |       | $          | 19,054                |       |      | $          | 19,054 |   |

 

As of December 31, 2006 and 2005, we did not haveany relationships with unconsolidated entities or financial partners, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. As such,we are not materially exposed to any financing, liquidity, market or creditrisk that could arise if we had engaged in such relationships.

On April 3, 2003, we announced that our Board ofDirectors authorized a stock repurchase program of up to 4 million shares ofour common stock. On August 15, 2005, we announced that our Board ofDirectors increased the size of the stock repurchase program by an additional 4million shares, for a total program size of up to 8 million shares. On July 25,2006, we announced that our Board of Directors increased the size of the stockrepurchase program by an additional 4 million shares, for a total program sizeof up to 12 million shares. Repurchases may be made from time to time on theopen market at prevailing market prices or in privately negotiatedtransactions. Depending on market conditions and other factors, purchases underthis program may be commenced or suspended at any time, or from time to time,without prior notice. As of December 31, 2006, we had repurchased8,170,060 shares of our common stock under this program, for an aggregate of$170.4 million at an average price of $20.86 per share. 

We believe that our cashand cash equivalents balances, investments in marketable securities and ourongoing cash flow from operations will be sufficient to satisfy our cashrequirements, including our capital expenditures and stock repurchases, if any,for at least the next 12 months. In January 2007, we used approximately$92 million of our cash to acquire 100% of PortAuthority Technologies, Inc.as well as to repay the indebtedness of PortAuthority. Our cash requirementsmay increase for reasons we do not currently foresee or we may makeacquisitions as part of our growth strategy that increase our cash requirements.We may elect to raise funds for these purposes through capital marketstransactions or debt 

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orprivate equity transactions as appropriate. We intend to continue to invest ourcash in excess of current operating requirements in interest-bearing,investment-grade securities.

**SummarizedQuarterly Data (Unaudited)**

Thefollowing tables present unaudited quarterly financial information “as adjusted”amounts resulting from the adjustment to our revenue recognition policy for thefirst three quarters of the year ended December 31, 2006. All of thequarters for the year ended December 31, 2005 reflect amounts previouslyreported (see Note 11 to the Consolidated Financial Statements). We believethis information reflects all adjustments (which, except as discussed in thetable below, consisting only of normal recurring adjustments) that we considernecessary for a fair presentation of such information in accordance with generallyaccepted accounting principles. The results for any quarter are not necessarilyindicative of results for any future period. 

| ** **                                              | ** ** | **1st Quarter**                                               | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                              | ** ** | **(In thousands, except per share data)** | ** ** |
| **2006**                                                |       |                                                               |       |                 |       |                 |       |                 |       |   |   |   |   |   |   |   |   |
| Revenue—as  previously reported                    |       |                                                               | $          | 42,434               |       |                 |       | $                    | 44,149     |   |   |   | $ | 46,068 |   |   |   | $ |   |   |   |
| Impact of  adjustment                                   |       |                                                               | (374       | )                    |       |                 | (462       | )                    |       |   | (326 | ) |   |   |   |   |   |
| Revenue—as  adjusted/reported                      |       |                                                               | 42,060     |                 |       |                 | 43,687     |                 |       |   | 45,742 |   |   |   | 47,325 |   |   |
| Gross margin—as previously reported                |       |                                                               | 39,056     |                 |       |                 | 40,445     |                 |       |   | 42,195 |   |   |   |   |   |   |
| Impact of  adjustment                                   |       |                                                               | (374       | )                    |       |                 | (462       | )                    |       |   | (326 | ) |   |   |   |   |   |
| Gross margin—as  adjusted/reported                 |       |                                                               | 38,682     |                 |       |                 | 39,983     |                 |       |   | 41,869 |   |   |   | 43,006 |   |   |
| Income from operations—as previously reported      |       |                                                               | 10,391     |                 |       |                 | 10,763     |                 |       |   | 9,397 |   |   |   |   |   |   |
| Impact of adjustment                                    |       |                                                               | (374       | )                    |       |                 | (462       | )                    |       |   | (326 | ) |   |   |   |   |   |
| Income from  operations—as adjusted/reported       |       |                                                               | 10,017     |                 |       |                 | 10,301     |                 |       |   | 9,071 |   |   |   | 10,074 |   |   |
| Income before income taxes—as previously reported  |       |                                                               | 13,026     |                 |       |                 | 13,584     |                 |       |   | 12,181 |   |   |   |   |   |   |
| Impact of  adjustment                                   |       |                                                               | (374       | )                    |       |                 | (462       | )                    |       |   | (326 | ) |   |   |   |   |   |
| Income before  income taxes—as adjusted/reported   |       |                                                               | 12,652     |                 |       |                 | 13,122     |                 |       |   | 11,855 |   |   |   | 13,121 |   |   |
| Net income—as previously reported                  |       |                                                               | 8,199      |                 |       |                 | 8,368      |                 |       |   | 8,534 |   |   |   |   |   |   |
| Impact of  adjustment                                   |       |                                                               | (255       | )                    |       |                 | (301       | )                    |       |   | (229 | ) |   |   |   |   |   |
| Net income—as  adjusted/reported                   |       |                                                               | 7,944      |                 |       |                 | 8,067      |                 |       |   | 8,305 |   |   |   | 7,777 |   |   |
| Basic income per share(1)—as previously reported   |       |                                                               | $          | 0.17                 |       |                 |       | $                    | 0.18       |   |   |   | $ | 0.19 |   |   |   |   |   |   |
| Impact of  adjustment                                   |       |                                                               | $          | 0.00                 |       |                 |       | ($0.01               | )          |   |   | ($0.01 | ) |   |   |   |   |   |
| Basic income per  share(1)—as adjusted/reported    |       |                                                               | $          | 0.17                 |       |                 |       | $                    | 0.17       |   |   |   | $ | 0.18 |   |   |   | $ | 0.17 |   |   |
| Diluted income per share(1)—as previously reported |       |                                                               | $          | 0.17                 |       |                 |       | $                    | 0.17       |   |   |   | $ | 0.18 |   |   |   |   |   |   |
| Impact of  adjustment                                   |       |                                                               | ($0.01     | )                    |       |                 | $          | 0.00                 |       |   |   | $ | 0.00 |   |   |   |   |   |   |
| Diluted income per  share(1)—as adjusted/reported  |       |                                                               | $          | 0.16                 |       |                 |       | $                    | 0.17       |   |   |   | $ | 0.18 |   |   |   | $ | 0.17 |   |   |

 

39

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| ** **                   | ** ** | **1st Quarter**                                               | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|------------------------------|------------|--------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| ** **                   | ** ** | **(In thousands, except per share data)** | ** ** |
| **2005**                     |       |                                                               |       |                 |       |                 |       |                 |       |   |   |   |   |   |   |   |   |
| Revenue                      |       |                                                               | $          | 34,182               |       |                 |       | $                    | 36,026     |   |   |   | $ | 38,300 |   |   |   | $ | 40,128 |   |   |
| Gross margin                 |       |                                                               | 31,682     |                 |       |                 | 33,525     |                 |       |   | 35,471 |   |   |   | 37,316 |   |   |
| Income from operations       |       |                                                               | 12,459     |                 |       |                 | 12,708     |                 |       |   | 14,465 |   |   |   | 15,068 |   |   |
| Income before income taxes   |       |                                                               | 13,413     |                 |       |                 | 13,909     |                 |       |   | 16,000 |   |   |   | 16,789 |   |   |
| Net income                   |       |                                                               | 8,612      |                 |       |                 | 8,934      |                 |       |   | 10,111 |   |   |   | 11,111 |   |   |
| Basic income per share(1)    |       |                                                               | $          | 0.18                 |       |                 |       | $                    | 0.19       |   |   |   | $ | 0.21 |   |   |   | $ | 0.23 |   |   |
| Diluted income  per share(1) |       |                                                               | $          | 0.17                 |       |                 |       | $                    | 0.18       |   |   |   | $ | 0.21 |   |   |   | $ | 0.23 |   |   |

----

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

**Item 7A.**                Quantitativeand 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 bonds, government agency obligations, andcorporate bonds. These investments are not held for trading or otherspeculative purposes. Changes in interest rates affect the investment income weearn on our investments and therefore impact our cash flows and results ofoperations.

We are exposed to changes in interest rates primarilyfrom our short-term available-for-sale investments. Under our current policies,we do not use interest rate derivative instruments to manage exposure tointerest rate changes. A hypothetical 100 basis point adverse move in interestrates along the entire interest rate yield curve would not materially affectthe fair value of our interest sensitive financial instruments at December 31,2006. Changes in interest rates over time will, however, affect our interestincome.

We utilize foreign currency forward contracts andzero-cost collar contracts to hedge foreign currency market exposures ofunderlying assets and liabilities. We bill customers in Euro-denominatedcountries in the Euro. We also keep working funds necessary to facilitate theshort-term operations of our subsidiaries in the local currencies in which theydo business. Our objective is to reduce the risk to earnings and cash flowsassociated with changes in foreign currency exchange rates. We do not useforeign currency contracts for speculative or trading purposes.

 

Notionaland fair values of our hedging positions at December 31, 2006 and 2005 arepresented in the table below (in thousands):
|               | ** ** | **December 31, 2006**      | ** ** | **December 31, 2005** | ** ** |
|---------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**        | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | 1,350      |                            |       | $ | 1,705 |   |   |   | $ | 1,630 |   |   | € | 3,400 |   |   | $ | 4,027 |   |   |   | $ | 4,023 |   |   |
| British Pound |       | £                               | 1,200      |                            |       | 2,350 |   |   |   | 2,337 |   |   | £ | 2,425 |   |   | 4,300 |   |   |   | 4,215 |   |   |
| Total         |       |                                 |       |                            | $          | 4,055 |   |   |   | $ | 3,967 |   |   |   |   |   | $ | 8,327 |   |   |   | $ | 8,238 |   |   |

 

The $2.3 million notional decrease in our Euro hedgedposition is primarily due to our increased working capital requirements payablein Euros; which creates a natural hedge against the Euro-based billings. All ofthe Euro hedging contracts will be settled before February 28, 2007. For2005 and 2006, less 

40

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than 15% of our totalbillings were denominated in the Euro. We do not expect foreign currencybillings to represent more than 15% of our total billings during 2007.

The $2.0 million notional decrease in our BritishPound hedged position is primarily due to a shortening of the period hedged aswell as a decrease in the percentage of working funds hedged. All of theBritish Pound hedging contracts will be settled before March 31, 2007. In2007, we expect an increase in British Pound expenditures and our correspondinghedged commitments to be consistent with our increase in overall operatingexpenditures.

Given our foreign exchange position, a 10% change inforeign exchange rates upon which these foreign exchange contracts are basedwould result in exchange gains and losses. In all material aspects, theseexchange gains and losses would be fully offset by exchange gains and losses onthe underlying net monetary exposures for which the contracts are designated ashedges. We do not expect material exchange rate gains and losses from unhedgedforeign currency exposures.

41

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Item 8.                        FinancialStatements and Supplementary Data

**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and Stockholders ofWebsense, Inc.

We have audited the accompanying consolidated balancesheets of Websense, Inc. as of December 31, 2006 and 2005, and therelated consolidated statements of income, stockholders’ equity, and cash flowsfor each of the three years in the period ended December 31, 2006. Ouraudits also included the financial statement schedule listed in the Index atItem 15(a). These financial statements and schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Websense, Inc. at December 31, 2006 and 2005, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2006, in conformity with U.S.generally accepted accounting principles. Also, in our opinion, the relatedfinancial statement schedule, when considered in relation to the basicfinancial statements, taken as a whole, presents fairly in all materialrespects the information set forth therein.

As discussed in Note 1 to the consolidated financialstatements, Websense, Inc. changed its method of accounting forShare-Based Payments in accordance with Statement of Financial Accounting Standards No. 123 (revised2004) on January 1, 2006. Also, as described in Notes 1 and 11 tothe consolidated financial statements, during 2006, Websense, Inc. adoptedSecurities and Exchange Commission Staff Accounting Bulletin No. 108,“Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in the Current Year Financial Statements (“SAB 108”).” TheCompany used the one time special transition provisions of SAB 108 and recordedan adjustment to retained earnings effective January 1, 2006 forcorrection of prior period errors in recording revenue and deferred revenue.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness ofWebsense, Inc.’s internal control over financial reporting as ofDecember 31, 2006, based on criteria established in Internal Control-IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission and our report dated February 23, 2007 expressed an unqualifiedopinion thereon.
|                        | /s/ ERNST & YOUNG LLP |
|------------------------|--------------------------------|
| San Diego, California  |                           |
| February 23, 2007 |                           |

 

42

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**Websense, Inc.Consolidated Balance Sheets(In thousands, except par value amounts)**

| ** **                                                                                                                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                         |       |                  |       |   |   |
| Current assets:                                                                                                                                    |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                          |       | $                     | 83,523     |   | $ | 61,629 |   |
| Marketable securities                                                                                                                              |       | 243,382               |       | 258,760 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $1,425 and $1,460 at December 31, 2006 and 2005                               |       | 52,740                |       | 50,570 |   |
| Prepaid income taxes                                                                                                                               |       | —                |       | 1,962 |   |
| Current portion of deferred income taxes                                                                                                           |       | 18,179                |       | 15,772 |   |
| Other current assets                                                                                                                               |       | 3,943                 |       | 3,467 |   |
| Total current assets                                                                                                                               |       | 401,767               |       | 392,160 |   |
| Property and equipment, net                                                                                                                        |       | 5,793                 |       | 4,923 |   |
| Intangible assets, net                                                                                                                             |       | 1,067                 |       | — |   |
| Deferred income taxes, less current portion                                                                                                        |       | 13,806                |       | 6,043 |   |
| Deposits and other assets                                                                                                                          |       | 1,824                 |       | 549 |   |
| Total assets                                                                                                                                       |       | $                     | 424,257    |   | $ | 403,675 |   |
| **Liabilities  and stockholders’ equity**                                                                                                     |       |                  |       |   |   |
| Current liabilities:                                                                                                                               |       |                  |       |   |   |
| Accounts payable                                                                                                                                   |       | $                     | 2,712      |   | $ | 2,073 |   |
| Accrued payroll and related benefits                                                                                                               |       | 9,164                 |       | 8,476 |   |
| Other accrued expenses                                                                                                                             |       | 7,084                 |       | 5,085 |   |
| Income taxes payable                                                                                                                               |       | 4,229                 |       | 2,305 |   |
| Current portion of deferred revenue                                                                                                                |       | 148,539               |       | 119,118 |   |
| Total current liabilities                                                                                                                          |       | 171,728               |       | 137,057 |   |
| Deferred revenue, less current portion                                                                                                             |       | 71,804                |       | 60,807 |   |
| Stockholders’  equity:                                                                                                                        |       |                  |       |   |   |
| Common stock—$0.01 par value; 100,000 shares authorized;  44,785 and 47,942 shares issued and outstanding at December 31, 2006 and  2005 |       | 509                   |       | 500 |   |
| Additional paid-in capital                                                                                                                         |       | 237,302               |       | 197,826 |   |
| Treasury stock, at cost                                                                                                                            |       | (139,744              | )          | (48,340 | ) |
| Retained earnings                                                                                                                                  |       | 82,748                |       | 56,449 |   |
| Accumulated other comprehensive loss                                                                                                               |       | (90                   | )          | (624 | ) |
| Total stockholders’ equity                                                                                                                    |       | 180,725               |       | 205,811 |   |
| Total liabilities and stockholders’ equity                                                                                                    |       | $                     | 424,257    |   | $ | 403,675 |   |

 

See accompanying notes.

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

| ** **                            | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                              |       | $                                           | 178,814    |   | $ | 148,636 |   | $ | 111,859 |   |
| Cost of revenues                      |       | 15,274                                      |       | 10,642 |   | 7,769 |   |
| Gross margin                          |       | 163,540                                     |       | 137,994 |   | 104,090 |   |
| Operating  expenses:                  |       |                                        |       |   |   |   |   |
| Selling and marketing                 |       | 80,135                                      |       | 55,288 |   | 42,625 |   |
| Research and development              |       | 22,663                                      |       | 16,277 |   | 14,509 |   |
| General and administrative            |       | 21,279                                      |       | 11,729 |   | 8,200 |   |
| Total operating expenses              |       | 124,077                                     |       | 83,294 |   | 65,334 |   |
| Income from operations                |       | 39,463                                      |       | 54,700 |   | 38,756 |   |
| Other income, net                     |       | 11,287                                      |       | 5,411 |   | 2,226 |   |
| Income before income taxes            |       | 50,750                                      |       | 60,111 |   | 40,982 |   |
| Provision for income taxes            |       | 18,657                                      |       | 21,343 |   | 14,806 |   |
| Net income                            |       | $                                           | 32,093     |   | $ | 38,768 |   | $ | 26,176 |   |
| Net income per share:                 |       |                                        |       |   |   |   |   |
| Basic net income per share            |       | $                                           | 0.69       |   | $ | 0.82 |   | $ | 0.57 |   |
| Diluted net income per share          |       | $                                           | 0.68       |   | $ | 0.79 |   | $ | 0.54 |   |
| Weighted average shares—basic    |       | 46,494                                      |       | 47,491 |   | 46,161 |   |
| Weighted average  shares—diluted |       | 47,116                                      |       | 49,196 |   | 48,228 |   |

 

See accompanying notes.

44

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

| ** **                                                                                         | ** ** | **Common stock** | ** ** | **Additional** | ** ** | **Treasury**             | ** ** | **Retained** | ** ** | **Accumulated other  comprehensive** | ** ** | **Total  stockholders’** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------------------|------------|--------------|------------|-------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                         | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **paid-in capital** | ** ** | **stock**    | ** ** | **earnings**                              | ** ** | **Income (loss)**        | ** ** | **equity** | ** ** |
| Balance at  December 31, 2003                                                                 |       |                  | 44,890     |           |       |                     | $          | 228          |       |                                      |       | $                             | 120,639    |   |   | $ | (7,684 | ) |   | $ | 15,731 |   |   |   | $ | 15 |   |   |   | $ | 128,929 |   |   |
| Issuance of common  stock upon exercise of options                                                 |       |                  | 2,946      |           |       |                     | 15         |         |       |                                      | 19,811     |                          |       | — |   |   | — |   |   |   | — |   |   |   | 19,826 |   |   |
| Issuance of common  stock for ESPP Purchase                                                        |       |                  | 380        |           |       |                     | 2          |         |       |                                      | 2,531      |                          |       | — |   |   | — |   |   |   | — |   |   |   | 2,533 |   |   |
| Issuance of common  stock upon exercise of warrant                                                 |       |                  | 56         |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase of  treasury stock                                                                        |       |                  | (1,220     | )              |       |                     | —     |         |       |                                      | —     |                          |       | (22,980 | ) |   | — |   |   |   | — |   |   |   | (22,980 | ) |   |
| Retirement of  treasury stock                                                                      |       |                  |       |           |       |                     | (10        | )            |       |                                      | (6,428     | )                             |       | 30,664 |   |   | (24,226 | ) |   |   |   |   |   |   | — |   |   |
| Tax benefit of  stock options                                                                      |       |                  | —     |           |       |                     | —     |         |       |                                      | 13,894     |                          |       | — |   |   | — |   |   |   | — |   |   |   | 13,894 |   |   |
| Net income                                                                                         |       |                  | —     |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | 26,176 |   |   |   | — |   |   |   | 26,176 |   |   |
| Net change in  unrealized loss on marketable securities, net of tax                                |       |                  | —     |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | — |   |   |   | (442 | ) |   |   | (442 | ) |   |
| Net change in  unrealized gain on fair market valuation of foreign currency contracts, net  of tax |       |                  | —     |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | — |   |   |   | 8 |   |   |   | 8 |   |   |
| Comprehensive  income                                                                              |       |                  |       |           |       |                     |       |         |       |                                      |       |                          |       |   |   |   |   |   |   |   |   |   |   |   | 25,742 |   |   |
| Balance at  December 31, 2004                                                                 |       |                  | 47,052     |           |       |                     | 235        |         |       |                                      | 150,447    |                          |       | — |   |   | 17,681 |   |   |   | (419 | ) |   |   | 167,944 |   |   |
| Issuance of common  stock upon exercise of options                                                 |       |                  | 2,434      |           |       |                     | 12         |         |       |                                      | 24,594     |                          |       | — |   |   | — |   |   |   | — |   |   |   | 24,606 |   |   |
| Issuance of common  stock for ESPP Purchase                                                        |       |                  | 314        |           |       |                     | 2          |         |       |                                      | 3,356      |                          |       | — |   |   | — |   |   |   | — |   |   |   | 3,358 |   |   |
| Issuance of common  stock for Stock Dividend                                                       |       |                  | —     |           |       |                     | 251        |         |       |                                      | (251       | )                             |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase of  treasury stock                                                                        |       |                  | (1,858     | )              |       |                     | —     |         |       |                                      | —     |                          |       | (48,340 | ) |   | — |   |   |   | — |   |   |   | (48,340 | ) |   |
| Tax benefit of  stock options                                                                      |       |                  | —     |           |       |                     | —     |         |       |                                      | 19,680     |                          |       | — |   |   | — |   |   |   | — |   |   |   | 19,680 |   |   |
| Net income                                                                                         |       |                  | —     |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | 38,768 |   |   |   | — |   |   |   | 38,768 |   |   |
| Net change in  unrealized loss on marketable securities, net of tax                                |       |                  | —     |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | — |   |   |   | (112 | ) |   |   | (112 | ) |   |
| Net change in  unrealized loss on fair market valuation of foreign currency contracts net of  tax  |       |                  | —     |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | — |   |   |   | (93 | ) |   |   | (93 | ) |   |
| Comprehensive  income                                                                              |       |                  |       |           |       |                     |       |         |       |                                      |       |                          |       |   |   |   |   |   |   |   |   |   |   |   | 38,563 |   |   |
| Balance at  December 31, 2005                                                                 |       |                  | 47,942     |           |       |                     | 500        |         |       |                                      | 197,826    |                          |       | (48,340 | ) |   | 56,449 |   |   |   | (624 | ) |   |   | 205,811 |   |   |
| Revenue recognition  error—net of tax upon adoption of SAB 108 (See Note 11)                  |       |                  | —     |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | (5,794 | ) |   |   | — |   |   |   | (5,794 | ) |   |
| Balance at  January 1, 2006 upon adoption of SAB 108                                          |       |                  | 47,942     |           |       |                     | 500        |         |       |                                      | 197,826    |                          |       | (48,340 | ) |   | 50,655 |   |   |   | (624 | ) |   |   | 200,017 |   |   |
| Issuance of common  stock upon exercise of options                                                 |       |                  | 946        |           |       |                     | 7          |         |       |                                      | 11,573     |                          |       | — |   |   | — |   |   |   | — |   |   |   | 11,580 |   |   |
| Issuance of common  stock for ESPP Purchase                                                        |       |                  | 197        |           |       |                     | 2          |         |       |                                      | 3,978      |                          |       | — |   |   | — |   |   |   | — |   |   |   | 3,980 |   |   |
| Share-based  compensation expense                                                                  |       |                  | —     |           |       |                     | —     |         |       |                                      | 20,358     |                          |       | — |   |   | — |   |   |   | — |   |   |   | 20,358 |   |   |
| Excess tax benefit  of share-based compensation                                                    |       |                  | —     |           |       |                     | —     |         |       |                                      | 3,567      |                          |       | — |   |   | — |   |   |   | — |   |   |   | 3,567 |   |   |
| Purchase of  treasury stock                                                                        |       |                  | (4,300     | )              |       |                     | —     |         |       |                                      | —     |                          |       | (91,404 | ) |   | — |   |   |   | — |   |   |   | (91,404 | ) |   |
| Net income                                                                                         |       |                  | —     |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | 32,093 |   |   |   | — |   |   |   | 32,093 |   |   |
| Net change in  unrealized gain on marketable securities, net of tax                                |       |                  | —     |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | — |   |   |   | 458 |   |   |   | 458 |   |   |
| Net change in  unrealized gain on fair market valuation of foreign currency contracts, net  of tax |       |                  | —     |           |       |                     | —     |         |       |                                      | —     |                          |       | — |   |   | — |   |   |   | 76 |   |   |   | 76 |   |   |
| Comprehensive  income                                                                              |       |                  |       |           |       |                     |       |         |       |                                      |       |                          |       |   |   |   |   |   |   |   |   |   |   |   | 32,627 |   |   |
| Balance at  December 31, 2006                                                                 |       |                  | 44,785     |           |       |                     | $          | 509          |       |                                      |       | $237,302                      |       |   | $ | (139,744 | ) |   | $ | 82,748 |   |   |   | $ | (90 | ) |   |   | $ | 180,725 |   |   |

 

See accompanying notes.

45

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

| ** **                                                                         | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Operating activities                                                               |       |                                        |       |   |   |   |   |
| Net income                                                                         |       | $                                           | 32,093     |   | $ | 38,768 |   | $ | 26,176 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation                                                                       |       | 3,273                                       |       | 2,631 |   | 2,277 |   |
| Amortization of intangible assets                                                  |       | 133                                         |       | — |   | — |   |
| Share-based compensation                                                           |       | 20,358                                      |       | — |   | — |   |
| Deferred revenue net of cumulative impact upon  adoption of  SAB 108               |       | 34,624                                      |       | 47,608 |   | 38,357 |   |
| Deferred income taxes                                                              |       | (10,170                                     | )          | (3,762 | ) | (648 | ) |
| Unrealized gain (loss) on foreign exchange contracts                               |       | 76                                          |       | (93 | ) | 8 |   |
| Tax benefit from exercise of stock options                                         |       | —                                      |       | 19,680 |   | 13,894 |   |
| Excess tax benefit from share-based compensation                                   |       | (3,567                                      | )          | — |   | — |   |
| Changes in  operating assets and liabilities:                                      |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                |       | (2,170                                      | )          | (6,261 | ) | (16,310 | ) |
| Prepaid income taxes                                                               |       | 1,962                                       |       | 1,239 |   | (2,537 | ) |
| Other current assets                                                               |       | (476                                        | )          | (1,942 | ) | (254 | ) |
| Deposits and other assets                                                          |       | (1,275                                      | )          | (87 | ) | (44 | ) |
| Accounts payable                                                                   |       | 639                                         |       | 973 |   | 357 |   |
| Accrued payroll and related benefits                                               |       | 688                                         |       | 1,313 |   | 1,922 |   |
| Other accrued expenses                                                             |       | 1,999                                       |       | 74 |   | 1,176 |   |
| Income taxes payable                                                               |       | 5,491                                       |       | 547 |   | 853 |   |
| Net cash provided by operating activities                                          |       | 83,678                                      |       | 100,688 |   | 65,227 |   |
| **Investing  activities:**                                                         | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchase of intangible asset                                                       |       | (1,200                                      | )          | — |   | — |   |
| Purchase of property and equipment                                                 |       | (4,143                                      | )          | (3,599 | ) | (3,235 | ) |
| Purchases of marketable securities                                                 |       | (649,486                                    | )          | (477,282 | ) | (270,130 | ) |
| Maturities of marketable securities                                                |       | 665,322                                     |       | 422,278 |   | 211,120 |   |
| Sales of marketable securities                                                     |       | —                                      |       | 1,042 |   | 1,193 |   |
| Net cash provided by (used in) investing activities                                |       | 10,493                                      |       | (57,561 | ) | (61,052 | ) |
| **Financing  activities:**                                                         | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from exercise of stock options and warrants                               |       | 11,580                                      |       | 24,606 |   | 19,826 |   |
| Proceeds from issuance of common stock for stock  purchase plan                    |       | 3,980                                       |       | 3,358 |   | 2,533 |   |
| Excess tax benefit of share-based compensation                                     |       | 3,567                                       |       | — |   | — |   |
| Purchase of treasury stock                                                         |       | (91,404                                     | )          | (48,340 | ) | (22,980 | ) |
| Net cash used in financing activities                                              |       | (72,277                                     | )          | (20,376 | ) | (621 | ) |
| Increase in cash and cash equivalents                                              |       | 21,894                                      |       | 22,751 |   | 3,554 |   |
| Cash and cash equivalents at beginning of year                                     |       | 61,629                                      |       | 38,878 |   | 35,324 |   |
| Cash and cash equivalents at end of year                                           |       | $                                           | 83,523     |   | $ | 61,629 |   | $ | 38,878 |   |
| **Supplemental disclosures of  cash flow information:**                            | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income taxes paid                                                                  |       | $                                           | 17,493     |   | $ | 3,656 |   | $ | 3,447 |   |
| Unrealized gain  (loss) on marketable securities                                   |       | $                                           | 458        |   | $ | (112 | ) | $ | (442 | ) |

 

See accompanying notes.

46

----

**Websense, Inc. Notes to Consolidated Financial Statements December 31, 2006**

**1.**   Summaryof Significant Accounting Policies

**Description ofBusiness**

Websense, Inc. (“Websense”or the “Company”) commenced operations in 1994. The Company’s products helporganizations manage their networks and computing resources to provide a secureand productive computing environment. The Company provides Web filtering andWeb security software products that enable organizations to protect employeesand confidential information from external Web-based attacks, such as spywareand phishing, as well as analyze, report and manage how employees use computingresources and the Internet. In addition to the Company’s Web filtering and Websecurity software products, the Company offers software that helps prevent theloss of confidential information from internal threats, such as ineffectivebusiness process controls, employee error and malfeasance.

**Use of Estimates**

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

**Reclassifications**

Certain prior yearreclassifications have been made for consistent presentation.

**Principles ofConsolidation**

The consolidated financial statements include theaccounts of the Company and its wholly-owned subsidiaries in Australia, Brazil,Canada, France, Germany, India, Ireland, Italy, Japan, Mauritius and the UnitedKingdom. Significant intercompany accounts and transactions have beeneliminated in consolidation. Activities performed by the subsidiaries are adirect and integral extension of the Company’s primary business.

For the years ended December 31,2006, 2005 and 2004, the Company’s billings were primarily denominated in itsfunctional currency, which is the U.S. dollar. As such, the Company has notrecorded foreign currency translation gains or losses. However, the Companyincurred foreign currency transaction gains/(losses) of $96,000, ($32,000) and($76,000) for the years ended December 31, 2006, 2005 and 2004,respectively.

**Revenue Recognition**

The Company has adopted American Institute ofCertified Public Accountants Statement of Position No. 97-2, *Software Revenue Recognition* (SOP No. 97-2)as amended by SOP No. 98-9, as well as Staff Accounting Bulletin No. 104,Revenue Recognition, as issued by the Securities and Exchange Commission. Thesestatements and bulletin provide guidance for recognizing revenue related tosales by software vendors.

The Company sells itsproducts on a subscription basis. A subscription is generally 12, 24 or 36months in duration and for a fixed number of seats or devices. The Companyrecognizes revenue on a daily 

47

----

**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

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

The Company records amounts billed to customers inexcess of recognizable revenue as deferred revenue in the accompanying balancesheets. The Company amortizes deferred revenues over the term of thesubscription agreement commencing with the day the agreement is signed.

The Company records distributor marketing payments andchannel rebates in accordance with Emerging Issues Task Force Issue No. 01-09,*Accounting for Consideration Given by aVendor to a Customer (Including a Reseller of the Vendor’s Products),*whichstates these payments and rebates should be recorded as an offset when revenue.The Company recognizes distributor marketing payments as an offset to revenueas the marketing service is provided. The Company recognizes channel rebates asan offset to revenue on a straight-line basis over the term of the correspondingsubscription agreement.

**Cash and CashEquivalents**

The Company considers all highly liquid investmentswith a maturity of ninety days or less when purchased to be cash equivalents.The Company generally invests its excess cash in fixed income obligations withstrong credit ratings. Such investments are made in accordance with the Company’sinvestment policy, which establishes guidelines relative to diversification andmaturities designed to maintain safety and liquidity. These guidelines areperiodically reviewed and modified if necessary to take advantage of trends inyields and interest rates. The Company has not experienced any losses on itscash and cash equivalents.

**MarketableSecurities**

Marketable securities at December 31, 2006consist of auction rate notes, municipal bonds, corporate bonds and governmentagency obligations. The Company has the ability and intent, if necessary, toliquidate any of its investment securities in order to meet the liquidity needsof current obligations. Accordingly, investments with contractual maturitiesgreater than one year from December 31, 2006 have been classified as currentassets in the accompanying consolidated balance sheets. The Company currentlyclassifies all investment securities as available for sale. Securitiesclassified as available for sale are reported at fair value, adjusted for otherthan temporary declines in value. The Company records other than temporarydeclines in value to earnings as realized losses. The Company has not had anyinvestment security losses taken to date, related to other than temporarydeclines in value. Unrealized holding gains and losses on securities availablefor sale are reported as a net amount in a separate component of stockholders’equity until realized. Realized gains and losses are recorded based on thespecific identification method.

Historically, the fair values of the Company’stax-exempt auction rate notes have not changed due to the high credit qualityand short-term nature of these securities. However, if the fair value of itstax-exempt auction notes did change when interest rates and/or dividends resetat auction, the Company would recognize unrealized holding gains and/or losseson these investments as a net amount in a separate component of stockholders’equity until realized. The Company would then recognize realized gains and/orlosses based on the specific identification method.

48

----

**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

**Interest on Cash and Marketable Securities**

The Company’s interest oncash and cash equivalents and marketable securities, included as a component ofother income, net, is $11.2 million, $6.1 million and $2.5 million for theyears ended December 31, 2006, 2005 and 2004, respectively.

**Intangible Assets**

Intangibleassets are carried at cost less accumulated amortization. The Company amortizesintangible assets using the straight-line method over their economic usefullives, unless these lives are determined to be indefinite. In accordance withStatement of Financial Accounting Standards (SFAS) No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*, the Company reviews intangible assets forimpairment whenever events or changes in circumstances indicate that thecarrying value may not be recoverable. If the value of future undiscounted cashflows is less than the carrying amount of an asset, the Company records animpairment loss based on the excess of the carrying amount over the fair valueof the asset. No impairment losses were recorded in 2006, 2005 or 2004.

**Disclosures About Fair Value of Financial Instruments**

The fair values ofinvestment securities have been determined using values supplied by anindependent pricing service and are disclosed together with carrying amounts inNote 2. The carrying value of cash and cash equivalents, accounts receivable,accounts payable and accrued liabilities approximate their fair values.

**Foreign Currency Hedges**

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. Gains andlosses 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.

During 2005 and 2006, theCompany utilized Euro foreign currency forward contracts to hedge anticipatedEuro denominated accounts receivable. During 2005, the Company utilized BritishPound foreign currency forward contracts to hedge anticipated operating expenses. During2006, the Company utilized British Pound zero-cost collar contracts to hedgeanticipated operating expenses. All such contracts entered into weredesignated as either fair value hedges or cash flow hedges and were consideredeffective, if applicable, as defined by SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities* (SFAS No. 133), as amended. None of the contractswere terminated prior to settlement. Net realized losses related to thecontracts designated as fair value hedges settled during 2006 are included inother income, net, in the accompanying consolidated statements of income andamounted to approximately $191,000 for 2006. There were no such gains or lossesin 2005. Net realized gains related to the contracts designated as cash flowhedges settled during 2006 are included in the respective operating categoriesthe Company hedges its British Pound expenditures against. These net realizedgains amounted to approximately $117,000 in 2006. Net realized losses related tothe contracts designated as cash flow hedges 

49

----

**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

settledduring 2005 are included in other income, net, in the accompanying consolidatedstatements of income and amounted to approximately $195,000.

Notional and fair valuesof the Company’s hedging position at December 31, 2006 and 2005 arepresented in the table below (in thousands):

| ** **    | ** ** | **December 31, 2006**      | ** ** | **December 31, 2005** | ** ** |
|---------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**        | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       |                                 | €     | 1,350                           |       |   |   | $ | 1,705 |   |   |   | $ | 1,630 |   |   | € | 3,400 |   |   | $ | 4,027 |   |   |   | $ | 4,023 |   |   |
| British Pound |       |                                 | £     | 1,200                           |       |   |   | 2,350 |   |   |   | 2,337 |   |   | £ | 2,425 |   |   | 4,300 |   |   |   | 4,215 |   |   |
| Total         |       |                                 |       |                            |       |   | $ | 4,055 |   |   |   | $ | 3,967 |   |   |   |   |   | $ | 8,327 |   |   |   | $ | 8,238 |   |   |

 

Euro forward contracts at December 31,2006 were designated as fair value hedges and were not required to be testedfor effectiveness as hedge accounting was not selected. All Euro contracts willbe settled before February 28, 2007. Realized gains or losses related tothe settlements, if any, will be recorded in other income, net at the time ofsettlement.

All British Poundcontracts were designated as cash flow hedges and were determined to be effectiveas of December 31, 2006 and 2005. All British Pound contracts will besettled before March 31, 2007. Realized gains and losses related to thesettlements, if any, will be recorded in the respective operating categoriesthe Company hedges its British Pound expenditures against.

**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 potentialcredit losses and historically such losses have been within management’sestimates.

**Property and Equipment**

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

**Computer Software Costs**

In accordance with SFAS No. 86,*Accounting for the Costs of ComputerSoftware to be Sold, Leased, or Otherwise Marketed* (SFAS No. 86),costs are capitalized, when significant, in the development of specificcomputer software products after establishment of technological feasibility andmarketability. There have been no such costs capitalized to date as the costsincurred during the period between technological feasibility to general releasehave not been significant.

The Company accounts forinternally developed computer software costs, incurred in the applicationstage, in accordance with SOP No. 98-1, *Accounting for Costs of Computer Software Developed or Obtained forInternal Use*(SOP No. 98-1). There have been no suchcosts capitalized to date as the costs incurred for internally developedcomputer software have not been significant.

50

----

**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

**Advertising Expenses**

Advertising costs areexpensed as incurred. Total advertising costs for the years ended December 31,2006, 2005 and 2004 were $4.9 million, $4.8 million and $4.1 million, respectively.

**Share-Based Compensation**

Through December 31,2005, the Company accounted for share-based employee compensation plans underthe intrinsic value measurement and recognition provisions of AccountingPrinciples Board (APB) Opinion No. 25 *Accountingfor Stock Issued to Employees* (APB No. 25), and relatedInterpretations, as permitted by SFAS No. 123 *Accounting for Stock-Based Compensation*(SFAS No. 123). Accordingly, the Company recorded no share-based employeecompensation expense for options granted under its Amended and Restated 2000Stock Incentive Plan (2000 Plan) or its predecessor plans (or options grantedas non-plan inducement options) during 2005****asall other options granted had exercise prices equal to the fair market value ofthe common stock on the date of grant. The Company also recorded nocompensation expense in connection with the Employee Stock Purchase Plan during2005 as the purchase price of the stock was not less than 85% of the lower ofthe fair market value of the common stock at the beginning of each offeringperiod or at the end of each purchase period. Through December 31, 2005 inaccordance with SFAS No. 123 and SFAS No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure* (SFAS No. 148), the Company disclosed net incomeor loss and net income or loss per share as if the fair value-based method wasapplied in measuring compensation expense for share-based incentive programs.

Effective January 1, 2006, the Company adoptedthe fair value recognition provisions of SFAS No. 123(R), using themodified prospective transition method. Under that transition method,compensation expense that the Company recognized beginning on that dateincludes: (a) compensation expense for all share-based awards granted priorto, but not yet vested as of January 1, 2006, based on the grant date fairvalue estimated in accordance with the original provisions of SFAS No. 123,and (b) compensation expense for all share-based awards granted on orafter January 1, 2006, based on the grant date fair value estimated inaccordance with the provisions of SFAS No. 123(R). Results for priorperiods will not be restated.

EffectiveJanuary 1, 2006, the Company adopted FASB Staff Position FAS No. 123R-3,*Transition Election Related to Accounting for theTax Effects of Share-Based Payment Awards*, (FAS 123R-3). FAS 123R-3provides a practical exception when transitioning to the accountingrequirements in Statement No. 123R. The Company has used the simplifiedmethod to calculate the pool of excess tax benefits available to absorb taxdeficiencies recognized subsequent to adopting Statement No. 123R (termedthe “APIC Pool”). The adoption of FAS 123R-3 for the year endedDecember 31, 2006 did not have a material impact on our consolidatedfinancial statements.

51

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

The table below reflects thepro-forma net income and earnings per share for the years ended December 31,2005 and 2004 if the Company had applied the fair value recognition provisionsof SFAS No. 123 (in thousands, except per share amounts):

| ** **                                                                                                            | ** ** | **Years Ended December 31,**                                      | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **      2005      ** | ** ** | **      2004      ** | ** ** |
| Net income - as  reported for prior periods(1)                                                                        |       |                                                                             | $          | 38,768 |   |   |   | $ | 26,176 |   |   |
| Share-based  compensation expense related to employee stock options and employee  stock purchases, net of tax(2) |       |                                                                             | $          | (10,794 | ) |   |   | $ | (9,700 | ) |   |
| Net income,  including the effect of share-based compensation expense(3)                                         |       |                                                                             | $          | 27,974 |   |   |   | $ | 16,476 |   |   |
| Basic net income per share—as reported for prior  periods(1)                                                     |       |                                                                             | $          | 0.82 |   |   |   | $ | 0.57 |   |   |
| Basic net income  per share, including the effect of shared-based compensation expenses(3)                            |       |                                                                             | $          | 0.59 |   |   |   | $ | 0.36 |   |   |
| Diluted net income per share—as reported for prior  periods(1)                                                   |       |                                                                             | $          | 0.79 |   |   |   | $ | 0.54 |   |   |
| Diluted net income per  share, including the effect of share-based compensation expense(3)                            |       |                                                                             | $          | 0.57 |   |   |   | $ | 0.34 |   |   |

----

(1)          Net income and netincome per share did not include share-based compensation expense for employeestock options and employee stock purchases under SFAS No. 123 because theCompany did not adopt the recognition provisions of SFAS No. 123 prior to January 1,2006.

(2)          Share-based compensationexpense prior to January 1, 2006 is calculated based on pro formainformation based on SFAS 123.

(3)          Net income and netincome per share prior to January 1, 2006 represents pro forma informationbased on SFAS 123.

Theresults for the year ended December 31, 2006 include share-basedcompensation expense of $20.4 million (excluding tax effects) in the followingexpense categories of the consolidated statement of income.

| ** **                                           | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Share-based compensation  in:                        |       |                                        |       |   |   |   |   |   |   |   |   |
| Cost of revenue                                      |       | $                                           | 1,476      |   |   | $ | — |   |   |   | $ | — |   |   |
| Total share-based compensation in cost of revenue    |       | 1,476                                       |       |   | — |   |   |   | — |   |   |
| Selling and marketing                                |       | 8,264                                       |       |   | — |   |   |   | — |   |   |
| Research and development                             |       | 3,573                                       |       |   | — |   |   |   | — |   |   |
| General and administrative                           |       | 7,045                                       |       |   | — |   |   |   | — |   |   |
| Total share-based compensation in operating expenses |       | 18,882                                      |       |   | — |   |   |   | — |   |   |
| Total share-based compensation                       |       | $                                           | 20,358     |   |   | $ | — |   |   |   | $ | — |   |   |

 

52

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

**1.**   Summaryof Significant Accounting Policies (Continued)

At December 31, 2006,there was $62.6 million of total unrecognized compensation cost related toshare-based compensation arrangements granted under all equity compensationplans (excluding tax effects). That total unrecognized compensation cost willbe adjusted for estimated forfeitures as well as for future changes inestimated forfeitures. The Company expects to recognize that cost over aweighted average period of approximately three years.

The Company estimates thefair value of options granted using the Black-Scholes option valuation modeland the assumptions shown in the tables below. The Company estimates theexpected term of options granted based on the history of grants and exercises inthe Company’s option database. The Company estimates the volatility of itscommon stock at the date of grant based on both the historical volatility aswell as the implied volatility of publicly traded options on its common stock,consistent with SFAS No. 123(R) and Securities and ExchangeCommission Staff Accounting Bulletin No. 107 (SAB No. 107). TheCompany bases the risk-free interest rate that is used in the Black-Scholesoption valuation model on the implied yield in effect at the time of optiongrant on U.S. Treasury zero-coupon issues with equivalent remaining terms. TheCompany has never paid any cash dividends on its common stock and does notanticipate paying any cash dividends in the foreseeable future. Consequently,the Company uses an expected dividend yield of zero in the Black-Scholes optionvaluation model. The Company amortizes the fair value ratably over the vestingperiod of the awards, which is typically four years. The Company useshistorical data to estimate pre-vesting option forfeitures and recordsshare-based expense only for those awards that are expected to vest. Forpurposes of calculating pro forma information under SFAS No. 123 forperiods prior to January 1, 2006, the Company accounted for forfeitures asthey occurred.

The Company used thefollowing assumptions to estimate the fair value of stock options granted forthe years ended December 31, 2006, 2005 and 2004:

| ** **                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Average expected life (years)      |       | 3.13                                        |       | 4.88 |   | 5.00 |   |
| Average expected volatility factor |       | 40.18                                       | %          | 44.16 | % | 52.06 | % |
| Average risk-free interest rate    |       | 3.58                                        | %          | 3.99 | % | 3.39 | % |
| Average expected dividend yield    |       | —                                      |       | — |   | — |   |

 

The Company used thefollowing assumptions to estimate the fair value of the semi-annual employeestock purchase plan share grant during the years ended December 31, 2006,2005 and 2004:

| ** **                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Average expected life  (years)      |       | 1.25                                        |       | 1.25 |   | 1.25 |   |
| Average expected  volatility factor |       | 36.19                                       | %          | 44.57 | % | 59.30 | % |
| Average risk-free  interest rate    |       | 4.90                                        | %          | 3.63 | % | 2.15 | % |
| Average expected dividend yield     |       | —                                      |       | — |   | — |   |

 

The Company’sdetermination of fair value of share-based payment awards on the date of grantusing an option-pricing model is affected by the Company’s stock price as wellas assumptions regarding a number of complex and subjective variables. Thesevariables include, but are not limited to the Company’s expected stock pricevolatility over the term of the awards, and actual and projected employee stockoption 

53

----

**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

exercisebehaviors. Option-pricing models were developed for use in estimating the valueof traded options that have no vesting or hedging restrictions and are fullytransferable. Because the Company’s employee stock options have certaincharacteristics that are significantly different from traded options, andbecause changes in the subjective assumptions can materially affect theestimated value, in management’s opinion, the existing valuation models may notprovide an accurate measure of the fair value of the Company’s employee stockoptions. Although the fair value of employee stock options is determined inaccordance with SFAS No. 123(R) and SAB No. 107 using anoption-pricing model, that value may not be indicative of the fair valueobserved in a willing buyer/willing seller market transaction.

**Comprehensive Income**

The Company has adoptedSFAS No. 130 *Reporting ComprehensiveIncome* (SFAS No. 130), which requires that all components ofcomprehensive income, including net income, be reported in the financialstatements in the period in which they are recognized. Comprehensive income isdefined as the change in equity during a period from transactions and otherevents and circumstances from non-owner sources. Net income and othercomprehensive income, including foreign currency translation adjustments, andunrealized gains and losses on investments, shall be reported, net of theirrelated tax effect, to arrive at comprehensive income.

**Accumulated OtherComprehensive Loss**

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

| ** **                                                              | ** ** | **December 31,** | ** **   |
|-------------------------------------------------------------------------|------------|-----------------------|--------------|
| ** **                                                              | ** ** | **2006**              | ** **   | **2005** | ** ** |
| Unrealized loss on  marketable securities                               |       | $                     | (81  81 | ) | $ | (539 539 | ) |
| Unrealized loss on fair  market valuation of foreign currency contracts |       | (9                    | )            | (85 | ) |
|                                                                    |       | $                     | (90          | ) | $ | (624 | ) |

 

**Net Income PerShare**

Websense computes net income per share in accordancewith SFAS No. 128, *Earnings Per Share*(EPS). Under the provisions of SFAS No. 128, basic net income per share iscomputed by dividing the net income for the period by the weighted averagenumber of common shares outstanding during the period. Diluted net income pershare is computed by dividing the net income for the period by the weightedaverage number of common and common equivalent shares outstanding during theperiod. Common equivalent shares for all periods presented consist of dilutivestock options.

In 2006, the difference between the weighted averageshares used in determining basic EPS versus diluted EPS related to dilutivestock options which totaled 622,000. Potentially dilutive securities totaling4,666,000, 212,000 and 402,000 for the years ended December 31, 2006, 2005and 2004, respectively, were excluded from historical basic and dilutedearnings per share because of their anti-dilutive effect as a result of stockoptions which have exercise prices greater than the average market price of thecommon shares.

54

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

The following is a reconciliationof the numerator and denominator of Basic EPS to the numerator and denominatorof 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, 2006:**  | ** ** |                                                                  | ** ** | ** **                |       |                       | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Basic EPS                    |       |                                                                  | $          | 32,093                    | ** ** |                       |       | 46,494 | ** ** |   |   | $ | 0.69 |   |   |
| Effect of options            |       |                                                                  | —     | ** **                |       |                       | 622        | ** ** |   |   | (0.01 | ) |   |
| Diluted EPS                  |       |                                                                  | $          | 32,093                    | ** ** |                       |       | 47,116 | ** ** |   |   | $ | 0.68 |   |   |
| **December 31,  2005:** | ** ** |                                                                  | ** ** | ** **                |       |                       | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Basic EPS                    |       |                                                                  | $          | 38,768                    | ** ** |                       |       | 47,491 | ** ** |   |   | $ | 0.82 |   |   |
| Effect of options            |       |                                                                  | —     | ** **                |       |                       | 1,705      | ** ** |   |   | (0.03 | ) |   |
| Diluted EPS                  |       |                                                                  | $          | 38,768                    | ** ** |                       |       | 49,196 | ** ** |   |   | $ | 0.79 |   |   |
| **December 31,  2004:** | ** ** |                                                                  | ** ** | ** **                |       |                       | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Basic EPS                    |       |                                                                  | $          | 26,176                    | ** ** |                       |       | 46,161 | ** ** |   |   | $ | 0.57 |   |   |
| Effect of options            |       |                                                                  | —     | ** **                |       |                       | 2,067      | ** ** |   |   | (0.03 | ) |   |
| Diluted EPS                  |       |                                                                  | $          | 26,176                    | ** ** |                       |       | 48,228 | ** ** |   |   | $ | 0.54 |   |   |

 

**Tax Matters**

From time to time, theCompany is audited by various state, federal and international authoritiesrelating to tax matters. The Company fully cooperates with all audits, butdefends 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. As eachaudit is concluded, adjustments, if any, are appropriately recorded in theCompany’s financial statements in the period determined.

**Allowance forDoubtful Accounts**

The Company maintains anallowance for doubtful accounts for estimated losses resulting from theinability or unwillingness of the Company’s customers to pay their invoices. Ifthe financial condition of the Company’s customers were to deteriorate,resulting in an impairment of their ability to make payments, additionalallowances may be required.

**Recently IssuedAccounting Standards**

In July 2006, the FASB issued FASB InterpretationNo. 48 (FIN No. 48) *Accounting forUncertainty in Income Taxes*, an interpretation of SFAS No. 109,*Accounting for Income Taxes*,which prescribes a recognition threshold and measurement process for recordingin the financial statements uncertain tax positions taken or expected to betaken in a tax return. In addition, FIN No. 48 provides guidance on thederecognition, classification, interest and penalties, accounting in interimperiods and disclosure requirements for uncertain tax positions. The accountingprovisions of FIN No. 48 will be effective for the 

55

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

Company beginning January 1,2007. The Company is evaluating the impact of the provisions of FIN No. 48and currently cannot estimate the impact to the Company’s financial statements.

In September 2006, the FASBissued SFAS No. 157 *FairValue Measurement* (SFAS No. 157), which provides guidance forusing fair value to measure assets and liabilities. In addition, SFAS No. 157also provides guidance for expanded information about the extent to whichcompanies measure assets and liabilities at fair value, the information used tomeasure fair value, and the effect of fair value measurements on earnings. SFASNo. 157 applies whenever other standards require (or permit) assets orliabilities to be measured at fair value, but does not expand the use of fairvalue in any new circumstances. The accounting provisions of SFAS No. 157will be effective for the Company beginning January 1, 2008. The Companyis in the process of determining the effect the adoption of SFAS No. 157will have on its financial statements.

In September 2006,the SEC released Staff Accounting Bulletin No. 108, *Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements*(SAB No. 108). SAB No. 108 provides interpretive guidance on the SEC’sviews regarding the process of quantifying materiality of financial statementmisstatements. SAB No. 108 is effective for fiscal years ending after November 15,2006, with early application for the first interim period ending after November 15,2006. Effective the beginning of the fiscal year ended December 31, 2006,the Company had adopted SAB No. 108 (See Note 11).

**2.**   MarketableSecurities

Investments in marketablesecurities consisted of the following at December 31, 2006 (in thousands):

| ** **                    | ** ** | **Amortized  Cost** | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  (Losses)** | ** ** | **Estimated Fair  Value** | ** ** |
|-------------------------------|------------|---------------------|------------|-----------------------|------------|--------------------------|------------|--------------------------------|------------|
| Auction Rate Notes            |       | $                   | 46,260     |                  |       | $                        | —     |                           |       |   | $ | — |   |   |   | $ | 46,260 |   |   |
| Corporate Bonds               |       | 20,633              |       |                  | —     |                     |       |                           | (12        | ) |   |   | 20,621 |   |   |
| Government Agency Obligations |       | 10,524              |       |                  | —     |                     |       |                           | (6         | ) |   |   | 10,518 |   |   |
| Municipal Bonds               |       | 166,046             |       |                  | —     |                     |       |                           | (63        | ) |   |   | 165,983 |   |   |
|                          |       | $                   | 243,463    |                  |       | $                        | —     |                           |       |   | $ | (81 | ) |   |   | $ | 243,382 |   |   |

 

Investments in marketablesecurities consisted of the following at December 31, 2005 (in thousands):

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

 

56

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

**2.**   Marketable Securities (Continued)

The amortized cost andestimated fair value of the securities at December 31, 2006 and 2005, bycontractual maturity, are shown below (in thousands):

| ** **                 | ** ** | **2006**            | ** ** | **2005**                       | ** ** |
|----------------------------|------------|---------------------|------------|--------------------------------|------------|
| ** **                 | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Due within 1 year          |       | $                   | 197,992    |                           | $          | 197,905 |   | $ | 230,677 |   | $ | 230,299 |   |
| Due between 1 and 3  years |       | 45,471              |       | 45,477                         |       | 28,622 |   | 28,461 |   |
|                       |       | $                   | 243,463    |                           | $          | 243,382 |   | $ | 259,299 |   | $ | 258,760 |   |

 

Realized gains (losses)from investments in marketable securities for the years ended 2006, 2005 and2004 were $0, ($5,000) and $4,000, respectively.

**3.**   Propertyand Equipment

Propertyand equipment consist of the following (in thousands):

| ** **                      | ** ** | **Estimated**         | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **Useful Lives** | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Computer hardware  and software |       |                  | 3 years    |                  |       | $ | 18,245 |   | $ | 14,756 |   |
| Office furniture  and equipment |       |                  | 3-7 years  |                  |       | 3,037 |   | 2,452 |   |
| Other equipment                 |       |                  | 3 years    |                  |       | 659 |   | 590 |   |
|                            |       |                  |       |                  |       | 21,941 |   | 17,798 |   |
| Accumulated  depreciation       |       |                  |       |                  |       | (16,148 | ) | (12,875 | ) |
|                            |       |                  |       |                  |       | $ | 5,793 |   | $ | 4,923 |   |

 

Depreciationexpense for 2006, 2005 and 2004 was $3.3 million, $2.6 million and $2.3million, respectively.

**4.**   IntangibleAssets

Intangibleassets consist of the following (in thousands):

| ** **            | ** ** | ** **                                   | ** ** | **December 31, 2006** | ** ** |
|-----------------------|------------|----------------------------------------------|------------|---------------------------------|------------|
| ** **            | ** ** | **Weighted Average  Useful Lives** | ** ** | **Cost**                        | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| Purchased  technology |       |                                         | 3 years    |                            |       | $ | 1,200 |   |   | $ | (133 | ) |   | $ | 1,067 |   |
|                  |       |                                         |       |                            |       | $ | 1,200 |   |   | $ | (133 | ) |   | $ | 1,067 |   |

 

57

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

**4.**   Intangible Assets (Continued)

Amortization expense isexpected to be as follows (in thousands):

| **Years  Ending December 31:** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------|------------|
| 2007                                |       | $          | 400        |   |
| 2008                                |       | 400        |       |
| 2009                                |       | 267        |       |
|                                |       | $          | 1,067      |   |

 

**5.**   GeographicInformation

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

| ** **                      | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States                   |       | $                                           | 113,941    |   | $ | 99,589 |   | $ | 75,891 |   |
| Europe, Middle  East and Africa |       | 44,354                                      |       | 33,429 |   | 23,831 |   |
| Asia/Pacific                    |       | 7,704                                       |       | 6,124 |   | 4,861 |   |
| Canada and Latin  America       |       | 12,815                                      |       | 9,494 |   | 7,276 |   |
|                            |       | $                                           | 178,814    |   | $ | 148,636 |   | $ | 111,859 |   |

 

The United Kingdomrepresented $17.7 million, $14.2 million and $10.1 million of total revenue forthe years ended 2006, 2005 and 2004, respectively. No other foreign countryrepresented more than 5% of total revenue.

**6.   Deferred Revenue**

The Company expects torecognize revenues related to subscriptions in existence as ofDecember 31, 2006 as follows (in thousands):

| **Years Ending December 31:** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2007                               |       | $          | 148,539    |   |
| 2008                               |       | 51,736     |       |
| 2009 and thereafter                |       | 20,068     |       |
|                               |       | $          | 220,343    |   |

 

**7.**   Commitments and Guarantees

The Company leases its facilities and certain equipmentunder non-cancelable operating leases, which expire at various dates throughDecember 2008. The facilities leases contain renewal options and aresubject to cost increases.

58

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

**7.**   Commitments and Guarantees (Continued)

Future minimum annual payments under non-cancelableoperating leases at December 31, 2006 are as follows (in thousands):

**Years Ending December 31:**

| ** ** | ** ** | ** ** | ** ** | **Operating  Leases** | ** ** | **Total** | ** ** |
|------------|------------|------------|------------|-----------------------|------------|-----------|------------|
| 2007       |       |       | $          | 4,835                 |       |      | $          | 4,835 |   |
| 2008       |       |       | 697        |                  |       | 697       |       |
|       |       |       | $          | 5,532                 |       |      | $          | 5,532 |   |

 

Rent expense totaled $4.2 million, $3.9 million and$2.8 million for the years ended December 31, 2006, 2005 and 2004,respectively.

FIN No. 45*,Guarantees of Indebtedness of Others* (FIN No. 45), elaborateson previously existing disclosure requirements for most guarantees, includingloan guarantees such as standby letters of credit. It also clarifies that atthe time a company issues a guarantee, the company must recognize an initialliability for the fair value, or market value, of the obligations it assumesunder the guarantee and must disclose that information in its interim and annualfinancial statements. The provisions related to recognizing a liability atinception of the guarantee for the fair value of the guarantor’s obligationsdoes not apply to product warranties, indemnifications or to guaranteesaccounted for as derivatives.

The Company providesindemnifications of varying scope and size to certain customers against claimsof intellectual property infringement made by third parties arising from theuse of its products. The Company evaluates estimated losses for such indemnificationsunder SFAS No. 5, *Accounting forContingencies*, as interpreted by FIN No. 45. The Companyconsiders such factors as the degree of probability of an unfavorable outcomeand the ability to make a reasonable estimate of the amount of loss. To date,the Company has not encountered material costs as a result of such obligationsand has not accrued any liabilities related to such indemnifications in itsfinancial statements.

**Litigation**

On September 29, 2006, Jason Tauber filed apurported class action against the Company and other unidentified individualsin California Superior Court for the County of San Diego, captioned Tauber v.Websense. The complaint alleges that the plaintiff and a putative class ofcertain software engineers and computer professionals who worked for theCompany as exempt employees during the period from September 15, 2002through the present should have been classified as non-exempt employees underCalifornia law and should have been paid for overtime. The complaint alsoalleges related wage and hour violations of the California Labor Code arisingfrom the alleged misclassification and that the failure to pay overtimeconstitutes an unfair business practice under California Business andProfessions Code § 17200. The complaint seeks unspecified damages forunpaid overtime, prejudgment interest, attorneys’ fees and other costs,statutory penalties for alleged violations, and other proper relief. The caseis at a very early stage. The Company denies all material allegations and intendsto defend the action vigorously.

The Company is involved invarious legal actions in the normal course of business. Based on currentinformation, including consultation with the Company’s lawyers, the Companybelieves that any ultimate 

59

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

**7.**   Commitments and Guarantees (Continued)

liabilitythat may result from these actions, including Tauber v. Websense, would notmaterially affect the Company’s consolidated financial positions, results ofoperation or cash flows. The Company’s evaluation of the likely impact of theseactions could change in the future and unfavorable outcomes and/or defensecosts, depending upon the amount and timing, could have a material adverseeffect on the Company’s results of operations or cash flows in a future period.

**8.**   Stockholders’Equity

**Warrants**

In connection with theCompany’s Series B convertible preferred stock offering between June andSeptember 1999, the Company issued warrants to purchase 125,000 shares ofcommon stock for $1.50 per share to financial consultants. The warrants wereexercisable in whole or in part at any time and from time to time until theirexpiration. In April 2000, warrants to purchase 9,376 shares of commonstock were exercised. In November 2001, warrants to purchase 46,874 sharesof common stock were exercised. In July 2003, April 2004 and July 2004,warrants to purchase 8,000, 18,750 and 42,000 shares of common stock wereexercised, which resulted in 6,812, 16,934 and 38,574 shares of common stockbeing issued, respectively, due to the cashless exercise of these warrants. Atthe end of 2004, all warrants had been exercised.

**Stock Split**

On January 31, 2006, the Company announced that theBoard of Directors authorized a two-for-one stock split of its common stock, tobe effected in the form of a special dividend of one share of the Company’scommon stock for each share of the Company’s common stock outstanding. Theadditional shares issued as a result of the stock split were distributed onMarch 17, 2006 to stockholders of record at the close of business on February13, 2006. All prior year share and per share data (including any data relatingto options) presented in this report, including the accompanying consolidatedfinancial statements and related notes have been restated to reflect the stocksplit.

60

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

**Stock Option Plan**

*Employee StockPurchase Plan*

In February 2000, theCompany adopted the 2000 Employee Stock Purchase Plan (Purchase Plan). ThePurchase Plan provides for automatic annual increases in the number of shares reservedfor issuance thereunder (beginning in 2001) equal to the lesser of (i) 1%of the Company’s outstanding shares on the last business day in December ofthe calendar year immediately preceding or (ii) 750,000 shares. ThePurchase Plan is intended to qualify as an employee stock purchase plan withinthe meaning of Section 423 of the Internal Revenue Code. Under thePurchase Plan, the Board of Directors may authorize participation by eligibleemployees, including officers, in periodic offerings following commencement ofthe Purchase Plan. Shares issued and available for issuance are as follows:

| Shares reserved  for issuance at December 31, 2003                                        |   | 974,567   |   |
|------------------------------------------------------------------------------------------------|--------|-----------|--------|
| Shares reserved  for issuance during 2004 based on the automatic increase in shares authorized |   | 448,898   |   |
| Shares issued  during 2004                                                                     |   | (379,976  | )      |
| Shares reserved  for issuance at December 31, 2004                                        |   | 1,043,489 |   |
| Shares reserved  for issuance during 2005 based on the automatic increase in shares authorized |   | 470,514   |   |
| Shares issued  during 2005                                                                     |   | (313,598  | )      |
| Shares reserved  for issuance at December 31, 2005                                        |   | 1,200,405 |   |
| Shares reserved  for issuance during 2006 based on the automatic increase in shares authorized |   | 479,424   |   |
| Shares issued  during 2006                                                                     |   | (196,588  | )      |
| Shares reserved for  issuance at December 31, 2006                                        |   | 1,483,241 |   |

 

Unless otherwise determined by the Board or precludedby laws of foreign jurisdictions, employees are eligible to participate in thePurchase Plan provided they are employed for at least 20 hours per week and arecustomarily employed for at least five months per calendar year. Employees whoparticipate in an offering may have up to 15% of their earnings withheldpursuant to the Purchase Plan. The amount withheld is then used to purchaseshares of common stock on specified dates. The price of common stock purchasedpursuant to the Purchase Plan will be equal to 85% of the lower of the fairmarket value of the common stock at the commencement date of each offeringperiod or the relevant purchase date. Employees may end their participation inthe offering at any time during the offering period, and participation endsautomatically on termination of employment.

During 2006 and 2005, theCompany issued 196,588 and 313,598 shares, respectively, under the PurchasePlan.

*Employee StockOption Plan*

The Amended and Restated 2000 Stock Incentive Plan(2000 Plan) provides for the grant of stock options to the Company’s directors,officers, employees and consultants. The 2000 Plan provides for the 

61

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

grant of incentive andnon-statutory stock options, restricted stock units and rights to purchasestock to employees, directors or consultants of the Company. The 2000 Planprovides that incentive stock options will be granted only to employees and aresubject to certain limitations as to fair value during a calendar year.

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 theCompany’s outstanding shares on the last business day in December of thecalendar year immediately preceding or (ii) 3,000,000 shares. At December 31,2006, a total of 19,558,162 shares have been authorized for issuance under the2000 Plan, of which 615,060 remain available for grant.

The exercise price of both incentive and non-statutorystock options and the issuance price of common stock under the 2000 Plan mustequal at least the fair value on the date of grant or issuance, as the case maybe. Through April 2005, the option grants were generally exercisable for aperiod of ten years, and beginning in May 2005, the option grants aregenerally exercisable for a period of seven years after the date of grant andgenerally vest 25% one year from date of grant and ratably each monththereafter for a period of 36 months. Unvested common shares obtained throughearly exercise of stock options are subject to repurchase by the Company at theoriginal issue price. Restricted stock units are subject to vesting and theholders of the restricted stock units are entitled to delivery of theunderlying common stock on the applicable vesting date without any payment. Todate, the Company has awarded restricted stock units as part of competitivehiring packages to replace foregone compensation. The vesting schedules,including acceleration events, for restricted stock units may vary in theindividual cases. To date, only non-statutory stock options and restrictedstock units have been granted under the 2000 Plan. Through December 31,2006, the Company granted 120,000 restricted stock units. The unvestedrestricted stock units have a weighted average grant date fair value of $29.39and an aggregate intrinsic value of $2.7 million as of December 31, 2006.

In 2002, the Company issued stock options as anincentive for certain persons to commence employment that were not coveredunder the 2000 Plan. In accordance with Section 4350(i) of the NASDMarketplace Rules for the Nasdaq Global Select Market, the Company issued354,000 such stock options, which have substantially the same terms as stockoptions issued under the 2000 Plan.

In January 2006, the Company entered into anemployment agreement with Gene Hodges to serve as the Company’s President andChief Executive Officer, reporting to the Company’s Board of Directors, withemployment commencing on January 9, 2006 and continuing “at will” untileither party gives notice of termination. On January 9, 2006, Mr. Hodgeswas granted non-qualified stock options to purchase an aggregate of 1,200,000shares of the Company’s common stock outside the Company’s 2000 Plan (the “Options”)with an exercise price per share equal to the fair market value of the Company’scommon stock on that date. On April 13, 2006, at the request of theCompany, Mr. Hodges agreed to the cancellation of the Options and theimmediate re-grant under the 2000 Plan of non-qualified stock options topurchase an aggregate of 1,200,000 shares of the Company’s common stock withidentical option terms, exercise prices, vesting schedules and vestingcommencement dates as the original Options. The Company requested thecancellation and re-grant to bring the Options under the 2000 Plan for U.S.federal income tax reasons. Mr. Hodges received no income tax or other personalbenefit from the cancellation and re-grant.

62

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

The following tablesummarizes stock option activity both under the 2000 Plan and the 1,554,000stock options issued in 2002 and January 2006 not covered under a formalplan and related information: 

| ** **                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|
| Balance at  December 31, 2003 |       | 7,870,158                  |       |                                   | $          | 8.39 |   |   |
| Granted                            |       | 1,952,000                  |       |                                   | 18.63      |   |   |
| Exercised                          |       | (2,946,056                 | )          |                                   | 6.73       |   |   |
| Cancelled                          |       | (642,936                   | )          |                                   | 11.14      |   |   |
| Balance at  December 31, 2004 |       | 6,233,166                  |       |                                   | 12.09      |   |   |
| Granted                            |       | 2,039,000                  |       |                                   | 26.20      |   |   |
| Exercised                          |       | (2,435,512                 | )          |                                   | 10.11      |   |   |
| Cancelled                          |       | (621,952                   | )          |                                   | 17.77      |   |   |
| Balance at  December 31, 2005 |       | 5,214,702                  |       |                                   | 17.86      |   |   |
| Granted                            |       | 4,792,930                  |       |                                   | 28.16      |   |   |
| Exercised                          |       | (945,553                   | )          |                                   | 12.25      |   |   |
| Cancelled                          |       | (2,023,820                 | )          |                                   | 28.35      |   |   |
| Balance at  December 31, 2006 |       | 7,038,259                  |       |                                   | 22.61      |   |   |

 

The weighted average fair value of stock optionsgranted during the year ended December 31, 2006 was $12.84 per sharebased on the grant date fair value of the stock options estimated in accordancewith the provisions of SFAS No. 123(R), excluding Mr. Hodges’ April 2006re-granted stock options described above. The fair value of the April 2006re-granted stock options to Mr. Hodges was less than the original stockoption grants in January 2006 as the market price of the Company’s commonstock declined from January 2006 to April 2006. The Company willcontinue to amortize the higher fair value associated with Mr. Hodges’original stock option grants in January 2006 rather than the lower fairvalue associated with the April 2006 re-granted stock options.

The total intrinsic value of stock options exercisedduring the year ended December 31, 2006 was $12.6 million.

63

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

The following tablesummarizes all stock options outstanding and exercisable by price range as of December 31,2006: 

| ** **               | ** ** | **Options Outstanding** | ** ** | ** **                | ** ** | ** **        | ** ** |
|--------------------------|------------|------------------------------|------------|---------------------------|------------|-------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted**              | ** ** | ** **        | ** ** | **Options Exercisable** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Average**               | ** ** | ** **        | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Remaining**             | ** ** | **Weighted**      | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**        | ** ** | **Number of**           | ** ** | **Contractual Life** | ** ** | **Average**       | ** ** | **Number of** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | ** **                   | ** ** | **Shares**                | ** ** | **In Years** | ** ** | **Exercise Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| $0.25-$16.38             |       | 1,516,614                    |       |                      | 5.25       |              |       |   | $ | 10.55 |   |   | 1,309,053 |   |   | $ | 10.08 |   |   |
| $16.45-$21.77            |       | 1,801,519                    |       |                      | 6.54       |              |       |   | 20.46 |   |   | 233,382 |   |   | 19.11 |   |   |
| $21.81-$25.80            |       | 1,431,196                    |       |                      | 5.86       |              |       |   | 24.74 |   |   | 392,297 |   |   | 25.02 |   |   |
| $25.84-$32.24            |       | 2,110,530                    |       |                      | 7.07       |              |       |   | 30.78 |   |   | 197,809 |   |   | 27.72 |   |   |
| $32.42-$33.85            |       | 178,400                      |       |                      | 6.46       |              |       |   | 33.15 |   |   | 18,790 |   |   | 33.14 |   |   |
|                     |       | 7,038,259                    |       |                      | 6.28       |              |       |   | 22.61 |   |   | 2,151,331 |   |   | 15.61 |   |   |
|                          |            |                              |            |                           |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company defines in-the-money stock options at December 31,2006 as stock options that had exercise prices that were lower than the $22.83market price of the Company’s common stock at that date. The weighted-averageremaining contractual term of options currently exercisable is 5.52 years. Theaggregate intrinsic value of all exercisable and non-exercisable stock optionsoutstanding and in-the-money at December 31, 2006 was $23.0 million. Theaggregate intrinsic value of only exercisable stock options outstanding andin-the-money at December 31, 2006 was $17.6 million. There were 3.5million stock options in-the-money at December 31, 2006, of which 1.6million stock options were exercisable.

Thefollowing table summarizes the shares reserved for future grants:

| Shares reserved  for future grants at December 31, 2003                                         |   | 634,940    |   |
|------------------------------------------------------------------------------------------------------|--------|------------|--------|
| Shares reserved  for future grants during 2004 based on the automatic increase in shares  authorized |   | 1,795,592  |   |
| Shares granted  during 2004                                                                          |   | (1,952,000 | )      |
| Shares cancelled  during 2004                                                                        |   | 642,936    |   |
| Shares reserved  for future grants at December 31, 2004                                         |   | 1,121,468  |   |
| Shares reserved  for future grants during 2005 based on the automatic increase in shares  authorized |   | 1,882,054  |   |
| Shares granted  during 2005                                                                          |   | (2,039,000 | )      |
| Shares cancelled  during 2005                                                                        |   | 621,952    |   |
| Shares reserved  for future grants at December 31, 2005                                         |   | 1,586,474  |   |
| Shares reserved  for future grants during 2006 based on the automatic increase in shares  authorized |   | 1,917,696  |   |
| Shares granted  during 2006                                                                          |   | (4,912,930 | )      |
| Shares cancelled  during 2006                                                                        |   | 2,023,820  |   |
| Shares reserved for  future grants at December 31, 2006                                         |   | 615,060    |   |

 

64

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

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

**Shares Reserved forFuture Issuance**

Thefollowing shares of common stock are reserved for future issuance as of December 31,2006:

| Stock options:                 |   |      |   |
|--------------------------------|--------|-----------|--------|
| Granted and outstanding        |   | 7,038,259 |   |
| Reserved for future grants     |   | 615,060   |   |
| Employee Stock Purchase  Plan: |   |      |   |
| Reserved for future issuance   |   | 1,483,241 |   |
| Total:                         |   | 9,136,560 |   |

 

**Treasury Stock**

On April 3, 2003, the Company announced that itsBoard of Directors authorized a stock repurchase program of up to 4 millionshares of its common stock. On August 15, 2005, the Company announced thatits Board of Directors increased the size of the stock repurchase program by anadditional 4 million shares, for a total program size of up to 8 millionshares. On July 25, 2006, the Company announced that its Board ofDirectors increased the size of the stock repurchase program by an additional 4million shares, for a total program size of up to 12 million shares. Therepurchases will be made from time to time on the open market at prevailingmarket prices or in privately negotiated transactions. Depending on marketconditions and other factors, purchases under this program may commence or besuspended at any time, or from time to time, without prior notice. As of December 31,2006, the Company had repurchased 8,170,060 shares of its common stock underthis program, for an aggregate of $170.4 million at an average price of $20.86per share.

As of December 31,2004, the Company had retired all 1,006,000 shares of its common stock that hadbeen repurchased prior to that date. No shares of common stock that wererepurchased during 2005 or 2006 were retired. In accordance with APB No. 6,Status of Accounting Research Bulletins, the treasury stock retirement waseffected by reducing the following on the Company’s Consolidated BalanceSheets:  treasury stock by $30.7 million,common stock by $0.1 million, additional paid-in capital by $6.4 million andretained earnings by $24.2 million. There was no effect to the Company’soverall equity position as a result of the retirement.

**9.**   IncomeTaxes

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

| ** **                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                  | ** ** | **(In thousands)**                    | ** ** |
| Income before income  taxes |       |                                       |       |   |   |   |   |
| United States               |       | $                                          | 40,269     |   | $ | 50,321 |   | $ | 36,712 |   |
| Foreign                     |       | 10,481                                     |       | 9,790 |   | 4,270 |   |
| Total                       |       | $                                          | 50,750     |   | $ | 60,111 |   | $ | 40,982 |   |

 

65

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

**9.**   Income Taxes (Continued)

The provision for incometaxes is as follows:

| ** **                 | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                 | ** ** | **(In thousands)**                    | ** ** |
| **Current**                | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal                    |       | $                                          | 19,685     |   | $ | 19,590 |   | $ | 12,535 |   |
| Foreign                    |       | 2,579                                      |       | 1,909 |   | 759 |   |
| State                      |       | 4,147                                      |       | 2,945 |   | 2,160 |   |
|                       |       | 26,411                                     |       | 24,444 |   | 15,454 |   |
| **Deferred**               | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal                    |       | (6,727                                     | )          | (2,750 | ) | (367 | ) |
| Foreign                    |       | (159                                       | )          | (232 | ) | — |   |
| State                      |       | (868                                       | )          | (119 | ) | (281 | ) |
|                       |       | (7,754                                     | )          | (3,101 | ) | (648 | ) |
| Provision for income taxes |       | $                                          | 18,657     |   | $ | 21,343 |   | $ | 14,806 |   |

 

Thereconciliation of income tax computed at the federal statutory rate to theprovision for income taxes is as follows:

| ** **                | ** ** | **Year Ended December 31,**   | ** ** |
|---------------------------|------------|----------------------------------------------|------------|
| ** **                | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| Statutory Rate            |       |                                         | 35.0       | % |   |   | 35.0 | % |   |   | 35.0 | % |   |
| Foreign tax               |       |                                         | (2.6       | ) |   |   | (2.3 | ) |   |   | (0.9 | ) |   |
| State tax                 |       |                                         | 6.6        |   |   |   | 4.8 |   |   |   | 5.5 |   |   |
| Valuation  allowance      |       |                                         | (0.0       | ) |   |   | (0.4 | ) |   |   | (0.9 | ) |   |
| Credits                   |       |                                         | (0.6       | ) |   |   | (0.4 | ) |   |   | (1.7 | ) |   |
| Tax-exempt  interest      |       |                                         | (4.2       | ) |   |   | (2.9 | ) |   |   | (2.1 | ) |   |
| Share-based  compensation |       |                                         | 1.8        |   |   |   | (0.0 | ) |   |   | (0.0 | ) |   |
| Other                     |       |                                         | 0.8        |   |   |   | 1.7 |   |   |   | 1.2 |   |   |
|                      |       |                                         | 36.8       | % |   |   | 35.5 | % |   |   | 36.1 | % |   |

 

66

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

**9.**   Income Taxes (Continued)

Significant components ofthe Company’s deferred tax assets are as follows:

| ** **                                   | ** ** | **Year Ended December 31,**                                       | ** **                                                    |
|----------------------------------------------|------------|----------------------------------------------------------------------------------|---------------------------------------------------------------|
| ** **                                   | ** ** | **      2006      ** | ** **                                                    | **      2005      ** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                                          | ** **                                                    |
| Deferred tax assets                          |       |                                                                             |                                                          |   |   |   |   |   |   |
| Deferred revenue                             |       |                                                                             | $23,205                                                       |   |   |   | $17,410 |   |   |
| Share-based compensation                     |       |                                                                             | 5,662                                                         |   |   |   | — |   |   |
| State tax                                    |       |                                                                             | 454                                                           |   |   |   | — |   |   |
| Foreign deferred taxes                       |       |                                                                             | 921                                                           |   |   |   | 778 |   |   |
| Tax credit carryforwards                     |       |                                                                             |           — |   |   |   |     2,516 |   |   |
| Other                                        |       |                                                                             | 2,273                                                         |   |   |   | 1,658 |   |   |
| Total deferred tax assets                    |       |                                                                             | 32,515                                                        |   |   |   | 22,362 |   |   |
| Valuation allowance  for deferred tax assets |       |                                                                             | (530                                                          | ) |   |   | (547 | ) |   |
| Net deferred taxes                           |       |                                                                             | $                                                             | 31,985 |   |   |   | $ | 21,815 |   |   |
|                                              |            |                                                                                  |                                                               |  |  |  |  |  |  |  |  |

 

A valuation allowance is required when it is morelikely than not that all or a portion of a deferred tax asset will not berealized. Periodically, management reassesses the need for a valuationallowance. At December 31, 2006, the valuation allowance related to netoperating losses generated in 2004 and 2005 by the Company’s wholly-ownedsubsidiary in the United Kingdom. These losses are the result of stock optiondeductions accounted for under APB No. 25 and therefore, when the lossesare utilized in the future, the tax benefit will be credited to paid in capitalrather than the provision for income taxes.

As of December 31, 2005, the Company had federaland California research and development tax credit carryforwards ofapproximately $1.7 million and $1.3 million, respectively. During the yearended December 31, 2006, the Company utilized these tax credits.

Pursuant to Internal Revenue Code (IRC) Sections 382 and383, use of the Company’s tax credit carryforwards may be limited if acumulative change in ownership of more than 50% occurs within a three yearperiod. Based on IRC Sections 382 and 383, management believes that a priorchange in ownership may have occurred. However, management does not believethat such change would have a significant impact on the Company’s ability toutilize its tax credit carryforwards.

As of December 31, 2006, the Company hadapproximately $11.2 million of undistributed earnings related to its foreignsubsidiaries. Management believes that these earnings will be indefinitelyreinvested in foreign jurisdictions; accordingly, the Company has not providedfor U.S. federal income taxes related to these earnings. However, upon distributionof these earnings in the form of dividends or otherwise, the Company would besubject to both U.S. income taxes and withholding taxes payable to the variousforeign countries. It is estimated that the total tax liability, reduced byanticipated foreign tax credits, upon such a distribution would beapproximately $2.4 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 

67

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

**9.**   Income Taxes (Continued)

expenseapplied to temporary differences. The tax reserves are analyzed regularly andadjustments are made as events occur to warrant adjustment to the reserves.

**10.**   EmployeeRetirement Plan

Effective May 1,1997, the Company established a 401(k) defined contribution retirementplan (401(k) Plan) covering substantially all employees. The 401(k) Planprovides for voluntary employee contributions from 1% to 50% of annualcompensation, as defined, and did not provide for matching contributions fromthe Company as of December 31, 2003. In January 2004, the Company’sBoard of Directors approved a discretionary employer matching contribution of25% for each employee deferral contribution made during the plan year, up to 6%of the participant’s compensation. The amount of employer expenses includingthe employer match contributed to the 401(k) Plan during the years ended December 31,2006, 2005 and 2004 were $460,000, $430,000 and $369,000, respectively.

**11.**   StaffAccounting Bulletin No. 108

TheCompany reviewed its revenue recognition policy in consideration of guidance providedin SOP 97-2 and concluded that its prior accounting policy(effective since 1997) to recognize revenue on a monthly straight-line basis,commencing with the month the subscription begins is not consistent with SOP 97-2.As a result, the Company has adjusted revenue as recognized on a dailystraight-line basis, commencing on the day rather than the month thesubscription begins. The Company does not believe the net effects of this adjustment,when applied retroactively to prior years, was material either quantitively orqualitatively. The following quantitative measure was considered in reachingits determination (in thousands):

| **Years Ended December 31,** | ** ** | ** ** | ** ** | **Net after-tax  effect of  adjustment** | ** ** | **Reported  net income** | ** ** | **Percent of  reported net  income** | ** ** |
|---------------------------------------------|------------|------------|------------|----------------------------------------------------|------------|-------------------------------|------------|------------------------------------------------|------------|
| 2005                                        |       |       | $          | 1,259                                              |       |                          |       | $                                              | 38,768     |   |   |   | 3.25 | % |   |
| 2004                                        |       |       | 1,375      |                                               |       |                          | 26,176     |                                           |       |   | 5.25 | % |   |
| 2003                                        |       |       | 770        |                                               |       |                          | 16,688     |                                           |       |   | 4.62 | % |   |
| 2002                                        |       |       | 824        |                                               |       |                          | 16,737     |                                           |       |   | 4.92 | % |   |
| Total                                       |       |       | $          | 4,228                                              |       |                          |       | $                                              | 98,369     |   |   |   | 4.30 | % |   |

 

The cumulative impact on deferred revenue would havebeen material if not corrected in the Company’s financial statements for 2006.

As discussed underRecently Issued Accounting Standards in Note 1, in September 2006, the SECreleased SAB No. 108. The transition provisions of SAB No. 108 permitthe Company to adjust for the cumulative effect on retained earnings ofimmaterial errors relating to prior years. The adjustments to the 2006consolidated balance sheet includes: an increase of $8.7 million to current andlong-term portions of deferred revenue, a decrease of $5.8 million to retainedearnings, a decrease of $2.3 million to current and long term portions ofdeferred income taxes and an increase of $0.6 million to income taxes payable.SAB No. 108 also requires the adjustment of any prior quarterly financialstatements within the fiscal year of adoption for the effects of such errors onthe quarters when the information is next presented.

68

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**Websense, Inc. Notes to Consolidated Financial Statements (Continued) December 31, 2006**

**12.**   SubsequentEvents

**Acquisition ofPortAuthority**

On January 8, 2007,the Company acquired 100% of PortAuthority Technologies, Inc, a privately heldcompany that specialized in information leak prevention, for approximately $90million in cash (less PortAuthority transaction expenses of $493,300and carve-out payments to certain employees of PortAuthority who continueto be employed by the Company or its affiliates for 12—18 months following theeffectiveness of the merger of an aggregate of $1.8 million (including employertaxes)), subject to an escrow whereby $5.0 million was contributed to an escrowfund which will be available for 12 months to indemnify the Company for certainmatters, including breaches of representations and warranties and covenants inthe definitive merger agreement. In addition to the payment of the mergerconsideration, the Company assumed outstanding unvested PortAuthority stockoptions and converted those stock options into options to purchase 74,871shares of the Company’s common stock, under the 2007 Stock Incentive AssumptionPlan. The Company also assumed approximately $4.0 million in PortAuthorityindebtedness, which was extinguished subsequent to the acquisition date. TheCompany used its existing cash resources to fund the acquisition and theretirement of the assumed indebtedness. The results of operations ofPortAuthority will be included in the Company’s consolidated financialstatements beginning January 8, 2007. The Company is currently in theprocess of determining the purchase price allocation of the net tangible andintangible assets acquired.

**CorporateHeadquarters Office Lease**

Effective February 12,2007, The Company agreed to extend its existing corporate headquarters leasethrough 2013. The Company has committed to minimum annual payments ofapproximately $2.0 million in 2008, $2.2 million in 2009, $2.3 million in 2010,$2.4 million in 2011, $2.5 million in 2012 and $2.5 million in 2013, on thisnon-cancelable operating lease.

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

None

**Item 9A.   Controlsand Procedures**

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

Under the supervision and with the participation ofour management, including our CEO and CFO, an evaluation was performed on theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of the period covered by this annual report. Based onthat evaluation, our management, including the CEO and CFO, concluded that ourdisclosure controls and procedures were effective as of December 31, 2006.

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

**Management’s Reporton Internal Control Over Financial Reporting**

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

Under the supervision and with the participation ofour management, including our CEO and CFO, we conducted an evaluation of theeffectiveness of our internal control over financial reporting based on theframework in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission. Based on our evaluation under the framework in *Internal Control—Integrated Framework*, ourmanagement concluded that our internal control over financial reporting waseffective as of December 31, 2006.

Our management’s assessment of the effectiveness ofour internal control over financial reporting as of December 31, 2006 hasbeen audited by Ernst & Young LLP, an independent registered publicaccounting firm, as stated in their report which is included herein.

70

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**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and Stockholders ofWebsense, Inc.

We have audited management’s assessment, included inthe accompanying “Management’s Report on Internal Control Over FinancialReporting”, that Websense, Inc. maintained effective internal control overfinancial reporting as of December 31, 2006, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (the COSO criteria). Websense, Inc.’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. 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 thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining an understandingof internal control over financial reporting, evaluating management’sassessment, testing and evaluating the design and operating effectiveness ofinternal control, and performing such other procedures as we considerednecessary in the circumstances. We believe that our audit provides a reasonablebasis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. Acompany’s internal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the company; (2) provide reasonable assurance that transactionsare recorded 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 controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment thatWebsense, Inc. maintained effective internal control over financialreporting as of December 31, 2006, is fairly stated, in all materialrespects, based on the COSO criteria. Also, in our opinion, Websense, Inc.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2006, based on****the COSO criteria**.**

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theconsolidated balance sheets of Websense, Inc. as of December 31, 2006and 2005, and the related consolidated statements of income, stockholders’equity, and cash flows for each of the three years in the period endedDecember 31, 2006, and our report dated February 23, 2007 expressedan unqualified opinion thereon.
|                         | /s/ ERNST & YOUNG LLP |   |
|-------------------------|--------------------------------|--------|
| San Diego,  California  |                           |
| February 23,  2007 |                           |

 

71

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**Item 9B.**               OtherInformation.

None

**PART III**

**Item 10.**                 Directors,Executive Officers and Corporate Governance

(a)   Directors.Information concerning our directors is incorporated by reference from thesection captioned *“Proposal 1: Election ofDirectors”* contained in our Proxy Statement related to the AnnualMeeting of Stockholders to be held on June 5, 2007.

(b)   ExecutiveOfficers. Information concerning our executive officers is set forth under thesection captioned *“Executive Officers”*in Part I of this report.

(c)   Compliancewith Section 16(a) of the Exchange Act. Information concerningcompliance with Section 16(a) of the Exchange Act is incorporated byreference from the section captioned *“Section 16(a) BeneficialOwnership Reporting Compliance”* contained in our Proxy Statementrelated to the Annual Meeting of Stockholders to be held on June 5, 2007.

(d)   The Companyhas adopted a *Code of Business Conduct*which, together with the policies referred to therein, is applicable to alldirectors, officers and employees of the Company. In addition, the Company hasadopted a *Code of Ethics for the ChiefExecutive Officer, Senior Financial Officers and All Finance and AccountingDepartment Personnel* (“*Code ofEthics*”). The *Code of BusinessConduct* and the *Code of Ethics*cover all areas of professional conduct, including conflicts of interest,disclosure obligations, insider trading and confidential information, as wellas compliance with all laws, rules and regulations applicable to ourbusiness. The Company encourages all employees, officers and directors topromptly report any violations of any of the Company’s policies. In the eventthat 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 Web site. A copy of our *Codeof Business Conduct* and our *Codeof Ethics* can be obtained from our Web site at *www.websense.com*.

(e)   Audit Committee. Information concerning the audit committee of ourBoard of Directors and our designated “audit committee financial expert” isincorporated by reference from the section captioned “Audit Committee”contained in our Proxy Statement related to the Annual Meeting of Stockholdersto be held on June 5, 2007.

**Item 11.**                 ExecutiveCompensation

The information requiredby Item 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 5, 2007.

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

The information required by Item 12 of Form 10-Kconcerning security ownership of certain beneficial owners and management isincorporated by reference from the information contained in the sectioncaptioned *“Ownership of Securities”*in our Proxy Statement related to the Annual Meeting of Stockholders to be heldon June 5, 2007.

72

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Thefollowing table provides information as of December 31, 2006 with respectto the shares of the Company’s common stock that may be issued under theCompany’s existing equity compensation plans:

| **Plan Category**                                         | ** ** | ** ** | ** ** | **Number of securities  to be issued upon  exercise of outstanding  options, warrants and  rights** | ** ** | **Weighted-  average  exercise price  of outstanding  options,  warrants and  rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities subject to  outstanding options,  warrants and rights)** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders(1)     |       |       | 6,972,122  |                                                                                                                                             |       |                                                                                                  | $          | 22.76                                                                                                                                                                                                                                               |       |   |   | 2,098,301 | (3) |   |
| Equity compensation plans not approved by security  holders(2) |       |       | 66,137     |                                                                                                                                             |       |                                                                                                  | $          | 6.81                                                                                                                                                                                                                                                |       |   |   | — |   |   |
| Total                                                          |       |       | 7,038,259  |                                                                                                                                             |       |                                                                                                  | $          | 22.61                                                                                                                                                                                                                                               |       |   |   | 2,098,301 |   |   |

 

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

(2)          Consists of 354,000stock option grants made to certain new employees in 2002 in order to inducethem to commence employment with the company, of which 66,137 are outstanding. Theoutstanding stock options have substantially the same terms as stock optionsissued under the Amended and Restated 2000 Stock Incentive Plan and have aweighted average exercise price of $6.81 per share.

(3)          Consistsof shares available for future issuance under the Employee Stock Purchase Planand the Amended and Restated 2000 Stock Incentive Plan. As of December 31,2006, an aggregate of 1,483,241 shares of Common Stock were available forissuance under the Employee Stock Purchase Plan and 615,060 shares of CommonStock were available for issuance under the Amended and Restated 2000 StockIncentive Plan. The number of shares of Common Stock available for issuanceunder the Employee Stock Purchase Plan and the Amended and Restated 2000 StockIncentive Plan automatically increases on the first trading day of January eachcalendar year by an amount equal to 1% and 4%, respectively, of the totalnumber of shares of Common Stock outstanding on the last trading day of December inthe immediately preceding calendar year but in no event will any such increaseexceed 750,000 shares and 3,000,000 shares, respectively, of Common Stock.

**Item 13.**                 CertainRelationships and Related Transactions and Director Independence

The information requiredby Item 13 of Form 10-K is incorporated by reference from the informationcontained in the section captioned *“CertainRelationships and Related Transactions”* in the Company’s ProxyStatement related to the Annual Meeting of Stockholders to be held on June 5,2007.

**Item 14.**                 PrincipalAccounting Fees and Services

The information required by Item 14 of Form 10-Kis incorporated by reference from the information contained in the sectioncaptioned *“Proposal 2: Ratification ofSelection of Independent Auditors”* in the Company’s Proxy Statementrelated to the Annual Meeting of Stockholders to be held on June 5, 2007.

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**PART IV**

**Item 15.**                 Exhibits,Financial Statements and Schedules

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

1.Financial Statement Schedules.

Schedule II Valuation and Qualifying Accounts

Schedules not listed above have been omitted becausethey are not applicable, not required, or the information required to be setforth therein is included in the consolidated financial statements or notesthereto.

2.Exhibits
| Exhibit Number | ** ** | **Description of Document**                                                                                                                                                                                                                                                                                                                       |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(1)              |       | Agreement and Plan of Merger and Reorganization  among Websense, Inc., Leap Acquisition Corp., PortAuthority  Technologies, Inc., PortAuthority Technologies Israel Ltd., and Donald  Sullivan, as Stockholders’ Representative, dated December 20, 2006                                                                      |
| 3.1(2)              |       | Amended and Restated Certificate of Incorporation                                                                                                                                                                                                                                                                                                 |
| 3.2(2)              |       | Restated Bylaws                                                                                                                                                                                                                                                                                                                                   |
| 4.1(2)              |       | Specimen Stock Certificate of Websense, Inc.                                                                                                                                                                                                                                                                                                 |
| 10.1(2)*            |       | Employment Agreement by and between  Websense, Inc. and John B. Carrington, dated May 10, 1999                                                                                                                                                                                                                                          |
| 10.2(3)*            |       | Amendment to Employment Agreement by and between  Websense, Inc. and John B. Carrington, dated January 24, 2006                                                                                                                                                                                                                    |
| 10.3(2)*            |       | Employment Agreement by and between  Websense, Inc. and Douglas C. Wride, dated June 11, 1999                                                                                                                                                                                                                                           |
| 10.4(3)*            |       | Amendment to Employment Agreement by and between  Websense, Inc. and Douglas C. Wride, dated January 24, 2006                                                                                                                                                                                                                           |
| 10.5(4)*            |       | Employment Agreement by and between  Websense, Inc. and Gene Hodges, dated January 9, 2006                                                                                                                                                                                                                                              |
| 10.6(2)*            |       | 1998 Equity Incentive Plan                                                                                                                                                                                                                                                                                                                        |
| 10.7(2)*            |       | Standard Terms and Conditions Relating to Incentive  Stock Option Under the 1998 Equity Incentive Plan                                                                                                                                                                                                                                            |
| 10.8(3)*            |       | Amended and Restated 2000 Stock Incentive Plan                                                                                                                                                                                                                                                                                                    |
| 10.9(2)*            |       | 2000 Stock Incentive Plan, Notice of Grant of Stock  Option                                                                                                                                                                                                                                                                                       |
| 10.10(2)*           |       | 2000 Stock Incentive Plan, Form of Incentive  Stock Option Agreement                                                                                                                                                                                                                                                                         |
| 10.11(3)*           |       | 2000 Stock Incentive Plan, Form of Deferred  Issuance Stock Issuance Agreement                                                                                                                                                                                                                                                               |
| 10.14(2)*           |       | 2000 Employee Stock Purchase Plan                                                                                                                                                                                                                                                                                                                 |
| 10.15(1)*           |       | 2007 Stock Incentive Assumption Plan                                                                                                                                                                                                                                                                                                              |
| 10.16(1)*           |       | 2007 Stock Incentive Assumption Plan, Form of  Stock Option Agreement                                                                                                                                                                                                                                                                        |
| 10.17(2)            |       | Form of Indemnification Agreement between  Websense, Inc. and its directors                                                                                                                                                                                                                                                             |
| 10.18(2)            |       | Form of Indemnification Agreement between  Websense, Inc. and its officers                                                                                                                                                                                                                                                              |
| 10.19*              |       | Non-Employee Directors Compensation Term Sheet                                                                                                                                                                                                                                                                                                    |
| 10.20(5)            |       | Lease Agreement between Websense, Inc. and  Legacy-RECP Sorrento OPCO, LLC, dated April 19, 2002; First Amendment to  Lease between Websense, Inc. and Legacy-RECP Sorrento OPCO, LLC, dated  October 1, 2002; Second Amendment to Lease between Websense, Inc.  and Sorrento Valley Road LLC, dated April 30, 2003 |
| 10.21(6)            |       | Third Amendment to Lease between Websense, Inc.  and Sorrento Valley Road LLC, dated July 30, 2004                                                                                                                                                                                                                                      |

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| 10.22(3) |   | Fourth Amendment to Lease between  Websense, Inc. and Sorrento Valley Road LLC, dated March 24, 2005                                                                                 |
|----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.23(7) |   | Fifth Amendment to Lease between Websense, Inc.  and Arden Realty Limited Partnership, dated December 21, 2006                                                                       |
| 10.24(7) |   | Sixth Amendment to Lease between Websense, Inc.  and Arden Realty Limited Partnership, dated January 30, 2007                                                                        |
| 10.25(7) |   | Seventh Amendment to Lease between  Websense, Inc. and Arden Realty Limited Partnership, dated  February 12, 2007                                                                    |
| 10.26#   |   | Distribution Agreement by and between  Websense, Inc. and Ingram Micro Inc., dated August 3, 2006                                                                                    |
| 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 |

----

*                    Indicatesmanagement contract or compensatory plan or arrangement.

#                 Confidentialtreatment requested.

(1)          Previouslyfiled as an exhibit to our Form 8-K filed on January 12, 2007and incorporated herein by reference.

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

(3)          Previouslyfiled as an exhibit to our Form 10-K for the period ended December 31,2005 and incorporated herein by reference.

(4)          Previouslyfiled as an exhibit to our Form 8-K filed on January 11, 2006and incorporated herein by reference.

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

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

(7)          Previously filed as anexhibit to our Form 8-K filed on February 22, 2007 andincorporated herein by reference.

75

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**SIGNATURES**

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

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

|                        | **Signature** | ** **                             | ** **                               | ** ** | **Title**               | ** ** | ** ** | ** ** | **Date** | ** ** |
|------------------------|---------------|----------------------------------------|------------------------------------------|------------|-------------------------|------------|------------|------------|----------|------------|
| /s/ GENE HODGES        |          |                                   | Director,  President and Chief Executive |       | February 28,  2007 |
| Gene Hodges            |          | Officer (principal  executive officer) |                                     |       |
| /s/ DOUGLAS C. WRIDE   |          |                                   | Chief Financial  Officer (principal      |       | February 28,  2007 |
| Douglas C. Wride       |          | financial and accounting  officer)     |                                     |       |
| /s/ JOHN B. CARRINGTON |          |                                   | Chairman of the  Board                   |       | February 28,  2007 |
| John B. Carrington     |          |                                   |                                     |       |
| /s/ MARK ST.CLARE      |          |                                   | Director                                 |       | February 28,  2007 |
| Mark St.Clare          |          |                                   |                                     |       |
| /s/ BRUCE T. COLEMAN   |          |                                   | Director                                 |       | February 28,  2007 |
| Bruce T. Coleman       |          |                                   |                                     |       |
| /s/ JOHN SCHAEFER      |          |                                   | Director                                 |       | February 28,  2007 |
| John Schaefer          |          |                                   |                                     |       |
| /s/ GARY E. SUTTON     |          |                                   | Director                                 |       | February 28,  2007 |
| Gary E. Sutton         |          |                                   |                                     |       |
| /s/ PETER WALLER       |          |                                   | Director                                 |       | February 28,  2007 |
| Peter Waller           |          |                                   |                                     |       |
|                        |               |                                        |                                          |            |                         |            |            |            |          |            |  |

 

76

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**Schedule II—VALUATIONAND QUALIFYING ACCOUNTS**

**WEBSENSE,INC.(In thousands)**
| **A**                                                  | ** ** | **B**                                                   | ** ** | **C**                                              | ** ** | **D**         | ** ** | **E**                     | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------------------------|------------|---------------|------------|---------------------------|------------|
| **Description**                                        | ** ** | ** **                                              | ** ** | **Balance at beginning  of period** | ** ** | **Additions** | ** ** | **Deductions-  Describe** | ** ** | **Balance at End  of Period** | ** ** |
| **Charged to Costs  and Expenses**      | ** ** | **Charged to Other  Accounts- Describe** |
| YEAR ENDED DECEMBER 31,  2004                          |       |                                                    |       |                                               |       |          |       |                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Reserves and allowances  deducted from asset accounts: |       |                                                    |       |                                               |       |          |       |                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts                        |       |                                                    | $          | 525                                                |       |          |       | —                    |       |   |   | $  | 975 | (2) |   |   | $  | 360 | (1) |   |   | $ | 1,140 |   |   |
| YEAR ENDED DECEMBER 31,  2005                          |       |                                                    |       |                                               |       |          |       |                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Reserves and allowances  deducted from asset accounts: |       |                                                    |       |                                               |       |          |       |                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts                        |       |                                                    | $          | 1,140                                              |       |          |       | —                    |       |   |   | $  | 825 | (2) |   |   | $  | 505 | (1) |   |   | $ | 1,460 |   |   |
| YEAR ENDED DECEMBER 31,  2006                          |       |                                                    |       |                                               |       |          |       |                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Reserves and allowances  deducted from asset accounts: |       |                                                    |       |                                               |       |          |       |                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts                       |       |                                                    | $          | 1,460                                              |       |          |       | —                    |       |   |   | $  | 400 | (2) |   |   | $  | 435 | (1) |   |   | $ | 1,425 |   |   |

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(1)          Uncollectible accountswritten off, net of recoveries.

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

77

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**EXHIBITINDEX**

| Exhibit Number | ** ** | **Description of Document**                                                                                                                                                                                                                                                                                                                       |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(1)              |       | Agreement and Plan of Merger and Reorganization  among Websense, Inc., Leap Acquisition Corp., PortAuthority  Technologies, Inc., PortAuthority Technologies Israel Ltd., and Donald  Sullivan, as Stockholders’ Representative, dated December 20, 2006                                                                      |
| 3.1(2)              |       | Amended and Restated Certificate of Incorporation                                                                                                                                                                                                                                                                                                 |
| 3.2(2)              |       | Restated Bylaws                                                                                                                                                                                                                                                                                                                                   |
| 4.1(2)              |       | Specimen Stock Certificate of Websense, Inc.                                                                                                                                                                                                                                                                                                 |
| 10.1(2)*            |       | Employment Agreement by and between  Websense, Inc. and John B. Carrington, dated May 10, 1999                                                                                                                                                                                                                                          |
| 10.2(3)*            |       | Amendment to Employment Agreement by and between  Websense, Inc. and John B. Carrington, dated January 24, 2006                                                                                                                                                                                                                         |
| 10.3(2)*            |       | Employment Agreement by and between  Websense, Inc. and Douglas C. Wride, dated June 11, 1999                                                                                                                                                                                                                                           |
| 10.4(3)*            |       | Amendment to Employment Agreement by and between  Websense, Inc. and Douglas C. Wride, dated January 24, 2006                                                                                                                                                                                                                           |
| 10.5(4)*            |       | Employment Agreement by and between  Websense, Inc. and Gene Hodges, dated January 9, 2006                                                                                                                                                                                                                                              |
| 10.6(2)*            |       | 1998 Equity Incentive Plan                                                                                                                                                                                                                                                                                                                        |
| 10.7(2)*            |       | Standard Terms and Conditions Relating to Incentive  Stock Option Under the 1998 Equity Incentive Plan                                                                                                                                                                                                                                            |
| 10.8(3)*            |       | Amended and Restated 2000 Stock Incentive Plan                                                                                                                                                                                                                                                                                                    |
| 10.9(2)*            |       | 2000 Stock Incentive Plan, Notice of Grant of Stock  Option                                                                                                                                                                                                                                                                                       |
| 10.10(2)*           |       | 2000 Stock Incentive Plan, Form of Incentive  Stock Option Agreement                                                                                                                                                                                                                                                                         |
| 10.11(3)*           |       | 2000 Stock Incentive Plan, Form of Deferred  Issuance Stock Issuance Agreement                                                                                                                                                                                                                                                               |
| 10.14(2)*           |       | 2000 Employee Stock Purchase Plan                                                                                                                                                                                                                                                                                                                 |
| 10.15(1)*           |       | 2007 Stock Incentive Assumption Plan                                                                                                                                                                                                                                                                                                              |
| 10.16(1)*           |       | 2007 Stock Incentive Assumption Plan, Form of  Stock Option Agreement                                                                                                                                                                                                                                                                        |
| 10.17(2)            |       | Form of Indemnification Agreement between  Websense, Inc. and its directors                                                                                                                                                                                                                                                             |
| 10.18(2)            |       | Form of Indemnification Agreement between  Websense, Inc. and its officers                                                                                                                                                                                                                                                              |
| 10.19*              |       | Non-Employee Directors Compensation Term Sheet                                                                                                                                                                                                                                                                                                    |
| 10.20(5)            |       | Lease Agreement between Websense, Inc. and  Legacy-RECP Sorrento OPCO, LLC, dated April 19, 2002; First Amendment to  Lease between Websense, Inc. and Legacy-RECP Sorrento OPCO, LLC, dated  October 1, 2002; Second Amendment to Lease between Websense, Inc.  and Sorrento Valley Road LLC, dated April 30, 2003 |
| 10.21(6)            |       | Third Amendment to Lease between Websense, Inc.  and Sorrento Valley Road LLC, dated July 30, 2004                                                                                                                                                                                                                                      |
| 10.22(3)            |       | Fourth Amendment to Lease between  Websense, Inc. and Sorrento Valley Road LLC, dated March 24, 2005                                                                                                                                                                                                                                    |
| 10.23(7)            |       | Fifth Amendment to Lease between Websense, Inc.  and Arden Realty Limited Partnership, dated December 21, 2006                                                                                                                                                                                                                          |
| 10.24(7)            |       | Sixth Amendment to Lease between Websense, Inc.  and Arden Realty Limited Partnership, dated January 30, 2007                                                                                                                                                                                                                           |
| 10.25(7)            |       | Seventh Amendment to Lease between  Websense, Inc. and Arden Realty Limited Partnership, dated  February 12, 2007                                                                                                                                                                                                                       |
| 10.26#              |       | Distribution Agreement by and between  Websense, Inc. and Ingram Micro Inc., dated August 3, 2006                                                                                                                                                                                                                                       |
| 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 |

----

*                    Indicatesmanagement contract or compensatory plan or arrangement.

#                 Confidentialtreatment requested.

(1)          Previouslyfiled as an exhibit to our Form 8-K filed on January 12, 2007and incorporated herein by reference.

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

(3)          Previouslyfiled as an exhibit to our Form 10-K for the period ended December 31,2005 and incorporated herein by reference.

(4)          Previouslyfiled as an exhibit to our Form 8-K filed on January 11, 2006and incorporated herein by reference.

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

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

(7)          Previously filed as anexhibit to our Form 8-K filed on February 22, 2007 andincorporated herein by reference.

----