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SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 Form 10-K
 (Mark One)
 þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the fiscal year ended December 31, 2006
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from          to
 Commission File Number: 0-17995
 Zix Corporation
 (Exact Name of Registrant as Specified in its Charter)
 Texas
    
    75-2216818(State or Other Jurisdiction of
    
    (I.R.S. EmployerIncorporation or Organization)
    
    Identification Number)
 2711 N. Haskell Avenue, Suite 2200, LB 36, Dallas, Texas 75204-2960  (Address of Principal Executive Offices)
 (214) 370-2000  (Registrants Telephone Number, Including Area Code)
 Securities Registered Pursuant to Section 12(b) of the Act:
 Common Stock$0.01 Par Value
    
    NASDAQ
 o þ
 o þ
 þ o
 o
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##### Table of Contents



TABLE OF CONTENTS
 PART IItem 1.
    
    Business
    
    
    3Item 1A.
    
    Risk Factors
    
    
    13Item 1B.
    
    Unresolved Staff Comments
    
    
    19Item 2.
    
    Properties
    
    
    20Item 3.
    
    Legal Proceedings
    
    
    20Item 4.
    
    Submission of Matters to Vote of Security Holders
    
    
    21PART IIItem 5.
    
    Market for Registrants Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities
    
    
    21Item 6.
    
    Selected Financial Data
    
    
    22Item 7.
    
    Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    25Item 7A.
    
    Quantitative and Qualitative Disclosures About Market
Risk
    
    
    48Item 8.
    
    Financial Statements and Supplementary Data
    
    
    48Item 9.
    
    Changes in and Disagreements with Accountants on Accounting
and Financial Disclosures
    
    
    48Item 9A.
    
    Controls and Procedures
    
    
    48Item 9B.
    
    Other Information
    
    
    49PART IIIItem 10.
    
    Directors and Executive Officers of the Registrant
    
    
    49Item 11.
    
    Executive Compensation
    
    
    49Item 12.
    
    Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters
    
    
    49Item 13.
    
    Certain Relationships and Related Transactions
    
    
    50Item 14.
    
    Principal Accountant Fees and Services
    
    
    50PART IVItem 15.
    
    Exhibits and Financial Statement Schedules
    
    
    50Stock Option AgreementSeverance AgreementSubsidiariesConsent of Whitley Penn LLPConsent of Deloitte & Touche, LLPCertification Pursuant to Section 302Certification Pursuant to Section 302Certification Pursuant to Section 906
 2




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PART I
 
 Item 1. Business
   ®
  Business Segments
 Email Encryption
 Segment Overview:
   3




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Email Encryption Service and Solutions:
  
    
    Privacy with encryption
    
    Authentication
    
    Integrity of messages
    
    Non-repudiation  senders cannot deny sending, and recipients cannot deny receiving, messages
  
    
    Certified receipts
    
    Storage security
    
    Time stamps that cannot be repudiated
    
    Corporate policy enforcement
  ZixVPM®, ZixVPM Alliance, and ZixVPM Corporate
  4




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ZixAuditor®
  ZixMail®
  ZixPort® and ZixPort Corporate
 5




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ZixDirect®
  ZixConnect
  Email Encryption Competition:
  6




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e-Prescribing
 Segment Overview:
   e-Prescribing Services and Solutions
 PocketScript
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e-Prescribing Competition:
   Recent Developments
 2006 Reduction in Workforce
 
    
    The Company announced in 2006 that it was in the process of reducing its quarterly
spending through a reduction in workforce and reductions in non-headcount related areas and
that the targeted cost reductions would equal approximately 25% reduction in quarterly
spending when compared with the first quarter of 2006. At December 31, 2006, the Company
had implemented the majority of these cost reductions.
 Private Placement in April 2006 (see Note 15 to the consolidated financial statements)
 
    
    On April 5, 2006, the Company sold, in a private placement transaction, an aggregate of
9,930,000 units consisting of (i) one share of common stock of the Company, par value $0.01
per share and (ii) a related warrant to purchase 0.60 of one share of common stock or
5,958,000 warrants. The units were sold for a purchase price of $1.19 per unit. Net proceeds
from the transaction were $10,909,000.
 Warrant Activity and Redemption of 2004 Convertible Notes (see Note 14 to the consolidated
financial statements)
 
    
    In the first quarter 2006, and as a result of the amended convertible promissory notes
payable having certain anti-dilution clauses, the Company issued an additional 51,054
warrants to the remaining note holder and reduced the range of the exercise prices of the
warrants.
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
    
    In the second quarter 2006, and as a result of the Companys second quarter 2006 private
placement transaction and certain anti-dilution clauses contained in the amended convertible
promissory notes payable, the Company issued additional warrants to purchase 264,718 shares
of common stock and further reduced the range of the exercise prices of certain warrants.
    
    On June 23, 2006, the Company and the remaining holder of a Company convertible note
agreed on terms for early extinguishment of the remaining $5,000,000 convertible promissory
note payable, and as a result, the Company retired the full $5,000,000 using restricted cash
and paid a $200,000 early payment premium (plus accrued interest) for a total payoff amount
of $5,259,000. In accordance with the terms of the note, the Company issued warrants to the
note holder to purchase an additional 782,998 shares of common stock at $4.47 per share.
Further, upon repayment of the convertible promissory note payable, the Company wrote-off all
unamortized discounts and deferred financing costs against the loss on extinguishment of
debt. The total loss on extinguishment of debt was $871,000.
 Company History
      Regulatory Drivers for Market Growth
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®
 Sales and Marketing
    10




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Employees
  Research and Development; Patents and Trademarks
  Year Ended December 31,2006
    
    
    2005
    
    
    2004Email Encryption
    
    $
    2,837,000
    
    
    $
    2,001,000
    
    
    $
    3,072,000e-Prescribing
    
    
    3,248,000
    
    
    
    4,025,000
    
    
    
    1,933,000Corporate
    
    
    
    
    
    
    494,000
    
    
    
    4,326,000Total Research & Development
    
    $
    6,085,000
    
    
    $
    6,520,000
    
    
    $
    9,331,000
   Availability of Raw Material; Working Capital Items
  Compliance with Environmental Regulations
  11




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Governmental Contracts
  Significant Customers
  Sales Backlog
  December 31, 2006
    
    
    December 31, 2005Email Encryption
    
    $
    22,552,000
    
    
    $
    19,849,000e-Prescribing
    
    
    3,961,000
    
    
    
    2,092,000Total backlog
    
    $
    26,513,000
    
    
    $
    21,941,000
   Seasonality
  Geographic Information
  Available Information
    12




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www.sec.gov.
 www.zixcorp.com.
 
 Item 1A. Risk Factors
 (In these risk factors, we, us, our, and ZixCorp refer to Zix Corporation and its
wholly-owned subsidiaries.)
 An investment in our common stock involves a high degree of risk. You should carefully
consider the following risk factors in evaluating an investment in our common stock. If any of the
following risks actually occurs, our business, financial condition, results of operations or cash
flow could be materially and adversely affected. In such case, the trading price of our common
stock could decline, and you could lose all or part of your investment. You should also refer to
the other information set forth in this report, including our consolidated financial statements and
the related notes.
 We have incurred significant operating losses in previous years and we continue to use
significant amounts of cash for our business operations, which could result in us having
insufficient cash to fund our operations under our current business plan.
  The market may not broadly accept our Email Encryption and PocketScript e-Prescribing
services, which would prevent us from operating profitably. End-users of our PocketScript service may not
continue to use the service under risk factors below.
 Failure to enter into additional or to maintain existing sponsorship agreements for our
PocketScript e-Prescribing service and generate other revenue sources from our PocketScript service
could harm our business.
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Healthcare providers may fail to adopt our PocketScript service.
 End-users of our PocketScript service may not continue to use the service. The market may not broadly accept our Email
Encryption and PocketScript e-Prescribing services, which would prevent us from operating
profitably in risk factors above)
 Failure to significantly increase our base of PocketScript users or obtain significant
prescription transaction fees, or other fees may result in failure to achieve the critical mass of
physicians and revenue to build a successful business.
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Competition in our businesses is expected to increase, which could cause our business to fail.
    Our inability to successfully execute timely development and introduction of new Email
Encryption and e-Prescribing services and related services and to implement technological changes
could harm our business.
  Future asset impairments could affect our financial results.
 Capacity limits on our technology and network hardware and software may be difficult to
project, and we may not be able to expand and/or upgrade our systems to meet increased use, which
would result in reduced revenues.
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Security interruptions to our data centers could disrupt our business, and any security
breaches could expose us to liability and negatively impact customer demand for our solutions and
services.
    Pending litigation could have a material impact on our operating results and financial
condition.
   16




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We may have to defend our rights in intellectual property that we use in our services, which
could be disruptive and expensive to our business.
 Defects or errors in our services could harm our business.
 Public key cryptography technology is subject to risks.
 We depend on key personnel.
 We rely on third parties.
  17




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We could be affected by government regulation.
    Our stock price may be volatile.
 We have a significant amount of stock options and warrants outstanding and may issue
additional equity securities in the future. Exercise of the outstanding options and warrants, and
future issuances of other securities will dilute the ownership
interests of existing shareholders.
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The Company may be required to pay liquidated damages in the event one or more of the
registration statements it has filed with the SEC for the benefit of third parties ceases to be
effective.
 We may have liability for indemnification claims arising from the sale of our Web Inspector,
Message Inspector, and Dr. Chart ® product lines.
  NOTE ON FORWARD-LOOKING STATEMENTS AND RISK FACTORS
 Item 7. Managements Discussion and Analysis
of Financial
Condition and Results of Operations, NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
  
 Item 1B. Unresolved Staff Comments
  19




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Item 2. Properties
  
 Item 3. Legal Proceedings
     20




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Item 4. Submission of Matters to Vote of Security Holders
  
 PART II
 
 Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of
Equity Securities
  2006
    
    2005Quarter Ended
    
    High
    
    Low
    
    High
    
    LowMarch 31
    
    $
    2.53
    
    
    $
    1.30
    
    
    $
    5.34
    
    
    $
    2.67June 30
    
    $
    1.48
    
    
    $
    0.84
    
    
    $
    3.92
    
    
    $
    2.50September 30
    
    $
    1.15
    
    
    $
    0.51
    
    
    $
    3.84
    
    
    $
    1.94December 31
    
    $
    1.42
    
    
    $
    0.55
    
    
    $
    2.50
    
    
    $
    1.50
     The stock price performance depicted on the graph below is not necessarily indicative of
future stock price performance. The graph will not be deemed incorporated by reference in any
filing by us under the Securities Act or the Exchange Act, except to the extent that we
specifically incorporate the graph by reference.
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COMPARISON
OF 5 YEAR CUMULATIVE TOTAL RETURN*
 
 
 *
    
    $ 100 invested on 12/31/01 in stock or index-including reinvestment of dividends.Fiscal year ending December 31. 
 Item 6. Selected Financial Data
  22




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Year Ended December 31,2006
    
    2005
    
    2004
    
    2003
    
    2002(In thousands, except per share data)Statement of Operations Data:Revenues(1)
    
    $
    18,358
    
    
    $
    13,964
    
    
    $
    14,127
    
    
    $
    5,840
    
    
    $
    1,672Cost of revenues(2)
    
    
    (12,552
    )
    
    
    (14,194
    )
    
    
    (15,878
    )
    
    
    (8,211
    )
    
    
    (8,999
    )Research and development expenses(2)
    
    
    (6,085
    )
    
    
    (6,520
    )
    
    
    (9,331
    )
    
    
    (5,896
    )
    
    
    (6,180
    )Selling, general and administrative expenses(2)
    
    
    (23,188
    )
    
    
    (26,358
    )
    
    
    (29,399
    )
    
    
    (19,907
    )
    
    
    (19,335
    )Customer deposit forfeiture(3)
    
    
    1,000
    
    
    
    960
    
    
    
    
    
    
    
    
    
    
    
    Net gain (loss) on sale of product lines(4)
    
    
    53
    
    
    
    (3,716
    )
    
    
    
    
    
    
    
    
    
    
    Loss on extinguishment of convertible debt(5)
    
    
    (871
    )
    
    
    (1,283
    )
    
    
    
    
    
    
    
    
    
    
    Asset impairment charge(6)
    
    
    (125
    )
    
    
    (288
    )
    
    
    (675
    )
    
    
    
    
    
    
    Interest expense(7)
    
    
    (1,126
    )
    
    
    (6,848
    )
    
    
    (801
    )
    
    
    (13
    )
    
    
    (2,141
    )Gain on derivatives (8)
    
    
    4,043
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loss from continuing operations
    
    
    (19,508
    )
    
    
    (43,596
    )
    
    
    (42,040
    )
    
    
    (27,667
    )
    
    
    (34,299
    )Basic and diluted loss per common share from
continuing operations(9)
    
    
    (0.34
    )
    
    
    (1.20
    )
    
    
    (1.33
    )
    
    
    (1.23
    )
    
    
    (2.07
    )Shares used in computing basic and diluted
loss per common share
    
    
    57,068
    
    
    
    36,452
    
    
    
    31,533
    
    
    
    23,525
    
    
    
    18,129Balance Sheet Data:Working capital(10)
    
    
    (897
    )
    
    
    9,348
    
    
    
    4,913
    
    
    
    7,283
    
    
    
    13,668Total assets
    
    
    20,366
    
    
    
    34,115
    
    
    
    52,242
    
    
    
    26,419
    
    
    
    21,000Debt obligations(11)
    
    
    2,916
    
    
    
    7,063
    
    
    
    19,252
    
    
    
    
    
    
    
    Convertible preferred stock(12)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,653Stockholders equity
    
    
    927
    
    
    
    10,397
    
    
    
    14,765
    
    
    
    17,919
    
    
    
    11,545
 
   (1)
    
    Revenues were insignificant during 2002. The respective increases in revenue were mainly
due to the nature of the Companys subscription-based secure e-messaging business, which is
experiencing renewal rates of 95% combined with continued additions of new customers.
Revenue growth was further bolstered by the acquisitions of MyDocOnline in January 2004 and
PocketScript and Elron Software in July and September 2003. Increased revenues resulting
from these acquisitions totaled $4.0 million, $4.2 million and $1.3 million in 2005, 2004,
and 2003, respectively. On March 11, 2005, the MI/WI product lines, which were acquired in
the Elron acquisition, were sold to CyberGuard. During 2005, the MI/WI product lines
contributed $0.6 million to total revenues (see Note 6 to the consolidated financial
statements) versus revenues in 2004 and 2003 of $4.1 million and $1.3 million respectively.
On September 30, 2005, the Dr. Chart product line was sold to MITEM. During 2005, this
product line contributed $0.3 million to total revenues (see Note 6 to the consolidated
financial statements) versus revenues in 2004 of $0.5 million.(2)
    
    In 2006, 2005, 2004, 2003, and 2002, expenses associated with continuing operations
include non-cash stock-based compensation of $2.8 million, $1.1 million, $4.1 million, $1.0
million, and $2.5 million, respectively. On January 1, 2006, the Company adopted Statement
of Financial Accounting Standards (SFAS) 123(R), Share Based Payment, which resulted in
the incremental stock-based compensation costs. For the preceding years, these non-cash
expenses were often in association with reductions in force and related severance
agreements. Selling, general, and administrative expenses include advertising costs of $0.6
million, $0.8 million, $0.7 million, $1.4 million, and $2.9 million for 2006, 2005, 2004,
2003, and 2002, respectively.(3)
    
    A Master Services Agreement was entered into with Aventis for $4.0 million on January 30,
2004, for the Companys performance of various future services. The services were to be
delivered in minimum amounts of $1.0 million, $1.0 million, and $2.0 million prior to
January 30, 2005, January 30, 2006, and January 30, 2007, respectively. The services are to
be defined on an ongoing basis over the life of the agreement and valued in accordance with
pricing for similar services rendered by the Company for other customers. Aventis paid the
$4.0 million upon execution of the Master Services Agreement. Subsequent to the MyDocOnline
acquisition, Aventis merged with Sanofi and the rights under this agreement were transferred
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to the new company, sanofi-aventis. sanofi-aventis has expressed to ZixCorp that after the
merger, the combined company would have other focuses and they forfeited the $1.0 million
deposit for 2006, as well as the remaining 2005 element of the deposit for that year
totaling $0.96 million (see Note 13 to the consolidated financial statements).(4)
    
    On September 30, 2005, the Company sold its Dr. Chart product line to MITEM. In addition
to cash and an exercisable warrant, ZixCorp also received a promissory note of $540,000 from
MITEM. Because collectability of the note was not assured, the note was fully reserved. The
note has since been restructured, and any payments received against the note are recorded as
a gain. In 2006 those payments totaled $0.05 million. The net loss recognized in 2005 on
the sale of Dr. Chart was $4.8 million. On March 11, 2005, the Company sold its MI/WI
product lines to CyberGuard. The net gained realized on the sale was $1.0 million. The
combined impact of these transactions is a net loss of $3.7 million for 2005 (see Note 6 to
the consolidated financial statements).(5)
    
    On June 23, 2006, the Company agreed to an early extinguishment of the final $5.0 million
convertible note payable. The total loss on the extinguishment of the debt was $0.9 million.
On December 30, 2005, the Company transacted an early extinguishment of 50%, or $5.0
million, of the then-outstanding balance of the convertible notes payable (see Note 14 to
the consolidated financial statements). The total loss on the extinguishment of debt was
$1.3 million.(6)
    
    The Company recorded a $0.1 million and a $0.3 million asset impairment charge in 2006
and 2005, respectively, on certain fixed assets that were not being utilized and had no
identifiable value to the Company (see Note 10 to the consolidated financial statements). In
2004, the Company shutdown all activity associated with its Connect product. As a result, an
impairment of the developed technology asset was recognized for $0.7 million (see Notes 6
and 11 to the consolidated financial statements).(7)
    
    In 2006, interest expense charges included $0.7 million related to the Companys
convertible notes, which were also retired. In 2005, interest expense includes charges of
$6.4 million related to the Companys $20 million in convertible notes and related warrants
issued on November 2, 2004. The interest expense from the initial purchase agreement
included amortization of the warrants value as a discount on the notes, deferred finance
charges and stated interest. In 2005, the Company restructured the notes and created a
beneficial conversion feature which was valued at $2.5 million and fully amortized in 2005
(see Note 14 to the consolidated financial statements).In 2004, interest expense also included charges of $0.5 million, which relates to the $20
million aggregate convertible notes. In 2002, interest expense included a charge of $1.7
million representing the beneficial conversion feature resulting from the issuance of notes
payable convertible into shares of common stock at an effective price less than the fair
market value of the common stock on the date the notes were issued.(8)
    
    Due to certain terms of the April 2006 private placement, some elements of the
transaction were recorded as derivative liabilities and were revalued each quarter with the
change in value being recorded as a gain or loss. The 2006 gain was primarily from a change
in the fair value of warrants as compared to the value on the date of closing. On December
21, 2006, the Financial Accounting Standards Board (FASB) issued Staff Position Emerging
Issues Task Force (EITF) 00-19-2,
Accounting for Registration Payment Arrangementswhich resulted in the Company prospectively
adjusting the remaining balance of the derivative liabilities relating to the private
placement directly to retained earnings as of October 1, 2006 (see Note 15 to the consolidated
financial statements).(9)
    
    In calculating the basic and diluted loss per common share for 2003 and 2002, the
Companys loss from continuing operations and net loss have been increased by $1.4 million
and $3.2 million, respectively, representing the preferred stock dividends associated with
the Series A and Series B convertible preferred stocks.(10)
    
    Working capital includes customer deposits and deferred revenue totaling $10.4 million,
both as of December 31, 2006.(11)
    
    Debt obligations at December 31, 2006, consist of promissory notes payable totaling $2.7
million and a short-term promissory note totaling $0.3 million. Debt obligations at December
31, 2005, consist of convertible promissory notes payable totaling $4.4 million, promissory
notes payable totaling $2.2 million, a short-term promissory note totaling $0.3 million and
capital leases totaling $0.2 million. All notes payable are shown net of unamortized
discounts. December 31, 2004, balance consisted of convertible promissory notes payable
totaling $17.2 million (see Note 14 to the consolidated financial statements,
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promissory note
payable totaling $1.8 million (see Note 14 to the consolidated financial statements), and
capital leases totaling $0.2 million.(12)
    
    With regards to the outstanding shares in 2002, all of these shares and related accrued
dividends were converted throughout 2003 into shares of the Companys common stock.
 
 Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
 Overview
      25




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
    
    Rate of new subscriptions (termed new first year orders) for the Email Encryption Service
    
    Renewal rates for the Email Encryption Service
    
    New insurance payor sponsorships of the PocketScript service to physicians
    
    Successful adoption and usage of the PocketScript service by physicians
    
    Retention of the users (physicians) of the PocketScript service
    
    Future transaction fees (or related fees) associated with the use of the PocketScript service
    
    The ability to increase the business volume with reasonable cost increases
   Critical Accounting Policies and Estimates
  Inventory
 Property and Equipment, Long-Lived and Other Intangible Assets, Depreciation and Amortization
  26




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Goodwill
 Goodwill and Other Intangible Assets
   Deferred Tax Assets
 27




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Revenue Recognition Software Revenue Recognition, Modification of SOP 97-2, Software Revenue
Recognition, With respect to Certain Transactions, Revenue Arrangements
with Multiple Deliverables, Revenue Recognition in Financial Statements,
      28




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Deferred Cost of Revenue
 Stock-based compensation Share-Based
Payment Accounting for Stock Issued to
Employees
  Share
Based Payment,
 Year Ended December 31,2006
    
    2005
    
    2004Risk-free interest rate
    
    
    4.59
    %
    
    
    3.41
    %
    
    
    1.86
    %Expected option life
    
    5.8 years
    
    
    3.6 years
    
    
    2.5 yearsExpected stock price volatility
    
    
    93
    %
    
    
    96
    %
    
    
    108
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    Fair value of options granted
    
    $
    1.03
    
    
    $
    2.31
    
    
    $
    4.23
   29




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Year Ended December 31,2005
    
    
    2004Net loss, as reported
    
    $
    (43,596,000
    )
    
    $
    (42,040,000
    )Add employee stock compensation expense recorded under the intrinsic value method
    
    
    
    
    
    
    1,115,000Deduct pro forma stock compensation expense computed under the fair value method
    
    
    (6,166,000
    )
    
    
    (9,214,000
    )Pro forma net loss
    
    $
    (49,762,000
    )
    
    $
    (50,139,000
    )Basic and diluted loss per common share:As reported
    
    $
    (1.20
    )
    
    $
    (1.33
    )Pro forma
    
    $
    (1.37
    )
    
    $
    (1.59
    )
 Full Year 2006 Summary of Operations
 Financial
 
    
    Revenue for the year 2006 was $18,358,000 from all products compared with $13,964,000 in
2005 and $14,127,000 in 2004.
    
    Revenue from the two core products of Email Encryption and e-Prescribing was $18,358,000
in 2006 compared with $12,988,000 in 2005 and $9,603,000 in 2004 for the same two products.
    
    Gross Margin for 2006 was $5,806,000 or 32% of revenues compared to a loss of $230,000 or
a negative 2% of revenues in 2005.
 
    
    Email Encryption  gross margin for this segment was $8,727,000 or 62% of revenues
compared to $4,744,000 or 47% of revenues in 2005.
    
    E-Prescribing  gross loss for this segment was $2,921,000 or a negative 69% of
revenues compared to a loss of $4,344,000 or a negative 146% of revenues in 2005.
 
    
    Net loss for the year 2006 was $19,508,000 compared with $43,596,000 in 2005 and
$42,040,000 in 2004.
    
    Ending unrestricted cash balance was $12,783,000 and the balance in restricted accounts
was $35,000 on December 31, 2006.
    
    The Company continued to pay down its debt utilizing both restricted and non-restricted
cash resources. As a result, total debt was reduced from $7,063,000 at December 31, 2005, to
$2,916,000 at December 31, 2006.
 Cost Reductions
 
    
    The Company announced in 2006 that it was in the process of reducing its quarterly
spending through a reduction in workforce and reductions in non-headcount related areas and
that the targeted cost reductions would equal approximately 25% reduction in quarterly
spending when compared with the first quarter of 2006. At December 31, 2006, the Company
had implemented the majority of these cost reductions.
    
    The Company had full-time headcount of 156 on December 31, 2006 compared to 215 on
December 31, 2005.
 Private Placement in April 2006 (see Note 15 to the consolidated financial statements)
 
    
    On April 5, 2006, the Company sold, in a private placement transaction, an aggregate of
9,930,000 units consisting of (i) one share of common stock of the Company, par value $0.01
per share and (ii) a related warrant to purchase 0.60 of one share of common stock or
5,958,000 warrants. The units were sold for a purchase price of $1.19 per unit. Net proceeds
were $10,909,000.
 Redemption of 2004 Convertible Notes (see Note 14 to the consolidated financial statements)
 
    
    On June 23, 2006, the Company and the remaining holder of a Company convertible note
agreed on terms for early extinguishment of the remaining $5,000,000 convertible promissory
note payable, and as a result, the Company retired the full $5,000,000 using restricted cash
and paying a $200,000 early payment premium plus accrued interest for a total payoff amount
of $5,259,000. In accordance with the terms of the note, the Company issued warrants to the
note holder to purchase an additional 782,998 shares of common stock at $4.47 per share. As
a result of the repayment, the Company wrote-off all
 30




---



##### Table of Contents



unamortized discounts and deferred
financing costs against the loss on extinguishment of debt. The total loss on extinguishment
of debt was $871,000.
 Results of Operations
 Revenues
   Variance
    
    
    VarianceYear Ended December 31,
    
    
    2006 vs. 2005
    
    
    2005 vs. 20042006
    
    
    2005
    
    
    2004
    
    
    $
    
    
    %
    
    
    $
    
    
    %Services
    
    $
    18,358,000
    
    
    $
    13,412,000
    
    
    $
    11,282,000
    
    
    $
    4,946,000
    
    
    
    37
    %
    
    $
    2,130,000
    
    
    
    19
    %Hardware
    
    
    
    
    
    
    443,000
    
    
    
    1,519,000
    
    
    
    (443,000
    )
    
    
    (100
    %)
    
    
    (1,076,000
    )
    
    
    (71
    %)Software
    
    
    
    
    
    
    109,000
    
    
    
    1,326,000
    
    
    
    (109,000
    )
    
    
    (100
    %)
    
    
    (1,217,000
    )
    
    
    (92
    %)Total revenues
    
    $
    18,358,000
    
    
    $
    13,964,000
    
    
    $
    14,127,000
    
    
    $
    4,394,000
    
    
    
    31
    %
    
    $
    (163,000
    )
    
    
    (1
    %)
   Variance
    
    
    VarianceYear Ended December 31,
    
    
    2006 vs. 2005
    
    
    2005 vs. 20042006
    
    
    2005
    
    
    2004
    
    
    $
    
    
    %
    
    
    $
    
    
    %Email Encryption
    
    $
    14,094,000
    
    
    $
    10,007,000
    
    
    $
    7,071,000
    
    
    $
    4,087,000
    
    
    
    41
    %
    
    $
    2,936,000
    
    
    
    42
    %e-Prescribing
    
    
    4,264,000
    
    
    
    2,981,000
    
    
    
    2,532,000
    
    
    
    1,283,000
    
    
    
    43
    %
    
    
    449,000
    
    
    
    18
    %Subtotal before divested
products or services
    
    
    18,358,000
    
    
    
    12,988,000
    
    
    
    9,603,000
    
    
    
    5,370,000
    
    
    
    41
    %
    
    
    3,385,000
    
    
    
    35
    %MI/WI Products
    
    
    
    
    
    
    646,000
    
    
    
    4,073,000
    
    
    
    (646,000
    )
    
    
    (100
    %)
    
    
    (3,427,000
    )
    
    
    (84
    %)Dr. Chart and Connect
    
    
    
    
    
    
    330,000
    
    
    
    451,000
    
    
    
    (330,000
    )
    
    
    (100
    %)
    
    
    (121,000
    )
    
    
    (27
    %)Subtotal divested products
or services
    
    
    
    
    
    
    976,000
    
    
    
    4,524,000
    
    
    
    (976,000
    )
    
    
    (100
    %)
    
    
    (3,548,000
    )
    
    
    (78
    %)Total revenues
    
    $
    18,358,000
    
    
    $
    13,964,000
    
    
    $
    14,127,000
    
    
    $
    4,394,000
    
    
    
    31
    %
    
    $
    (163,000
    )
    
    
    (1
    %)
 Email Encryption 
 31




---



##### Table of Contents



e-Prescribing 
   Divested Products:
 Revenue Outlook:
 Backlog, Orders, and Deployments
 Company-wide backlog 
  32




---



##### Table of Contents



Email Encryption Orders 
  2006
    
    
    2005Three month period ending:December 31,
    
    $
    1,089,000
    
    
    $
    1,032,000September 30,
    
    
    1,234,000
    
    
    
    1,135,000June 30,
    
    
    1,372,000
    
    
    
    1,761,000March 31,
    
    
    970,000
    
    
    
    1,402,000Total new first year orders for the twelve months ending December 31,
    
    $
    4,665,000
    
    
    $
    5,330,000
  e-Prescribing 
  33




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##### Table of Contents



Cost of Revenues
  Variance
    
    
    VarianceYear Ended December 31,
    
    
    2006 vs. 2005
    
    
    2005 vs. 20042006
    
    
    2005
    
    
    2004
    
    
    $
    
    
    %
    
    
    $
    
    
    %Email Encryption
    
    $
    5,367,000
    
    
    $
    5,263,000
    
    
    $
    6,091,000
    
    
    $
    104,000
    
    
    
    2
    %
    
    $
    (828,000
    )
    
    
    (14
    %)e-Prescribing
    
    
    7,185,000
    
    
    
    7,325,000
    
    
    
    5,549,000
    
    
    
    (140,000
    )
    
    
    (2
    %)
    
    
    1,776,000
    
    
    
    32
    %Subtotal
    
    
    12,552,000
    
    
    
    12,588,000
    
    
    
    11,640,000
    
    
    
    (36,000
    )
    
    
    (0
    %)
    
    
    948,000
    
    
    
    8
    %Divested Products:MI/WI & Dr Chart
    
    
    
    
    
    
    1,606,000
    
    
    
    4,238,000
    
    
    
    (1,606,000
    )
    
    
    (100
    %)
    
    
    (2,632,000
    )
    
    
    (62
    %)Total Cost of Revenues
    
    $
    12,552,000
    
    
    $
    14,194,000
    
    
    $
    15,878,000
    
    
    $
    (1,642,000
    )
    
    
    (12
    %)
    
    $
    (1,684,000
    )
    
    
    (11
    %)
  34




---



##### Table of Contents



Email Encryption 
 e-Prescribing 
 Divested Products 
  35




---



##### Table of Contents



Research and Development Expenses
  Variance
    
    VarianceYear Ended December 31,
    
    2006 vs. 2005
    
    2005 vs. 20042006
    
    2005
    
    2004
    
    $
    
    %
    
    $
    
    %Total research and
development
expenses
    
    $
    6,085,000
    
    
    $
    6,520,000
    
    
    $
    9,331,000
    
    
    $
    (435,000
    )
    
    
    (7
    %)
    
    $
    (2,811,000
    )
    
    
    (30
    %)
    Selling, General and Administrative Expenses
  36




---



##### Table of Contents



Variance
    
    VarianceYear Ended December 31,
    
    2006 vs. 2005
    
    2005 vs. 20042006
    
    2005
    
    2004
    
    $
    
    %
    
    $
    
    %Total selling,
general and
administrative
expenses
    
    $
    23,188,000
    
    
    $
    26,358,000
    
    
    $
    29,399,000
    
    
    $
    (3,170,000
    )
    
    
    (12
    %)
    
    $
    (3,041,000
    )
    
    
    (10
    %)
   Customer Deposit Forfeiture
   Gain/Loss on Sale of Product Lines
   
    
    On March 11, 2005, the Company sold its Web Inspector and Message Inspector product
lines to CyberGuard Corporation. The total sales price was $3,626,000 consisting of
$2,126,000 in cash and a $1,500,000 note receivable due in three equal payments in 2005,
which was subsequently paid in full. The net gain recognized on the sale of the Web
Inspector and Message Inspector product lines was $1,035,000.
 37




---



##### Table of Contents




    
    On September 30, 2005, the Company sold its Dr. Chart product line to MITEM. The total
sales price was $700,000 consisting of $150,000 in cash and a note receivable in the
original principal amount of $550,000, which was subject to adjustments at closing. The
note was fully reserved due to the Companys determination that collection was not assured
given MITEMs financial position, its early stages of its product development and the
extended payment terms of the note. The net loss recognized on the sale of Dr. Chart was
$4,751,000. The note receivable at closing was reduced to $540,000.
  Asset Impairment Charge
   Interest Expense
  Stated
    
    
    
    
    
    
    
    
    
    
    Financing
    
    
    
    
    
    
    TotalInterest on
    
    
    Discount
    
    
    Premium
    
    
    Cost
    
    
    Warrants
    
    
    InterestNotes
    
    
    Amortization
    
    
    Accretion
    
    
    Amortization
    
    
    Issued
    
    
    Expense2006Convertible promissory
notes payable
    
    $
    185,000
    
    
    $
    354,000
    
    
    $
    
    
    
    $
    122,000
    
    
    $
    10,000
    
    
    $
    671,000Promissory note
payable
    
    
    
    
    
    
    435,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    435,000Short-term promissory
notes
    
    
    11,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,000Capital leases and other
    
    
    9,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,000Total interest
expense
    
    $
    205,000
    
    
    $
    789,000
    
    
    $
    
    
    
    $
    122,000
    
    
    $
    10,000
    
    
    $
    1,126,0002005Convertible promissory
notes payable
    
    $
    1,152,000
    
    
    $
    3,909,000
    
    
    $
    500,000
    
    
    $
    816,000
    
    
    $
    47,000
    
    
    $
    6,424,000Promissory note
payable
    
    
    
    
    
    
    386,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    386,000Short-term promissory
notes
    
    
    7,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,000Capital leases
    
    
    31,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    31,000Total interest
expense
    
    $
    1,190,000
    
    
    $
    4,295,000
    
    
    $
    500,000
    
    
    $
    816,000
    
    
    $
    47,000
    
    
    $
    6,848,0002004Convertible promissory
notes payable
    
    $
    178,000
    
    
    $
    200,000
    
    
    $
    
    
    
    $
    107,000
    
    
    $
    
    
    
    $
    485,000Promissory note
payable
    
    
    
    
    
    
    315,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    315,000Short-term promissory
notes
    
    
    1,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,000Total interest
expense
    
    $
    179,000
    
    
    $
    515,000
    
    
    $
    
    
    
    $
    107,000
    
    
    $
    
    
    
    $
    801,000
 38




---



##### Table of Contents



Investment and Other Income
  Recovery of Previously Impaired Investment
  Gain on Valuation of Derivative Liabilities
  Accounting for Registration
Payment Arrangements
 Income Taxes
  39




---



##### Table of Contents



Loss from Continuing Operations
   Year Ended December 31,2006
    
    
    2005
    
    
    2004Unusual Items:(Gain) or Loss on sale of product lines:Gain on sale of MI/WI
    
    $
    
    
    
    $
    (1,035,000
    )
    
    $
    Loss on sale of Dr. Chart
    
    
    
    
    
    
    4,751,000
    
    
    
    Customer deposit forfeiture
    
    
    (1,000,000
    )
    
    
    (960,000
    )
    
    
    Asset impairment charge
    
    
    125,000
    
    
    
    288,000
    
    
    
    675,000Recovery of previously impaired asset
    
    
    
    
    
    
    
    
    
    
    (70,000
    )Gain on derivatives
    
    
    (4,043,000
    )
    
    
    
    
    
    
    Loss on extinguishment of convertible debt
    
    
    871,000
    
    
    
    1,283,000
    
    
    
    Total unusual items
    
    $
    (4,047,000
    )
    
    $
    4,327,000
    
    
    $
    605,000
  Liquidity and Capital Resources
 Overview
     
    
    In June 2006, the Company retired its outstanding $5,000,000 convertible promissory
note prior to maturity by using restricted cash paying an early payment premium of
$200,000 (plus accrued interest). The total payoff amount was $5,259,000. As a result,
debt was reduced to $2,916,000 at the end of 2006.
 40




---



##### Table of Contents




    
    On April 5, 2006, the Company sold, in a private placement transaction, an aggregate
of 9,930,000 units consisting of (i) one share of common stock of the Company, par value
$0.01 per share and (ii) a related warrant to purchase 0.60 of one share of common stock
or 5,958,000 warrants. These were sold for a purchase price of $1.19 per unit. Net
proceeds from the transaction were $10,909,000.
    
    The Company announced in 2006 that it was in the process of reducing its quarterly
spending through a reduction in workforce and reductions in non-headcount related areas
and that the targeted cost reductions would equal approximately 25% reduction in
quarterly spending when compared with the first quarter of 2006. At December 31, 2006,
the Company had implemented the majority of these cost reductions.
     
    
    Rate of new subscriptions (termed new first-year orders) for the Email Encryption Service
    
    Renewal rates for the Email Encryption Service
    
    New insurance payor sponsorships of the e-Prescribing service to physicians
    
    Successful adoption and usage of the e-Prescribing service by physicians
 41




---



##### Table of Contents




    
    Retention of the users (physicians) of the e-Prescribing service
    
    Future transaction fees (or related fees) associated with the use of the e-Prescribing service
    
    The ability to increase the business volume with reasonable cost increases
 Email Encryption
 e-Prescribing
     42




---



##### Table of Contents



Sources and Uses of Cash Summary
   Twelve Months
    
    
    Twelve MonthsEnded
    
    
    Ended
    
    
    Variance forDecember 31,
    
    
    December 31,
    
    
    the twelve2006
    
    
    2005
    
    
    month periodOperating Cash Receipts (Products existing
on December 31, 2006)
    
    $
    20,551,000
    
    
    $
    15,412,000
    
    
    $
    5,139,000Operating Cash Receipts (Products divested
in 2005)
    
    
    5,000
    
    
    
    1,760,000
    
    
    
    (1,755,000
    )Customer Deposit Received
    
    
    
    
    
    
    (8,000
    )
    
    
    8,000Net Operating Cash Spending
    
    
    (37,234,000
    )
    
    
    (42,065,000
    )
    
    
    4,831,000Net Cash Used by Operating Activities
    
    $
    (16,678,000
    )
    
    $
    (24,901,000
    )
    
    $
    8,223,000
   43




---



##### Table of Contents



Cash Sources
  
    
    contractual backlog
    
    Email Encryption growth and retention
    
    e-Prescribing growth and retention
    
    e-Prescribing transaction and performance-based fees
 Backlog
 44




---



##### Table of Contents



Email Encryption growth and retention
 e-Prescribing growth and retention
 e-Prescribing transaction and performance-based fees
   Cash Requirements
   45




---



##### Table of Contents



Liquidity Summary
  
    
    As of December 31, 2006, unrestricted cash on hand was $12,783,000.
    
    Cash receipts for the next twelve months are projected to be approximately
$26,500,000 based on current contracted billings and estimated contract renewals and
new business.
    
    Operating spending plus capital asset purchases for the next twelve months is
projected to be approximately $32,250,000 based upon the Companys organization, cost
reduction actions previously mentioned and order and deployment rates as of December 31,
2006,
   Options and Warrants of ZixCorp Common Stock
  Summary of Outstanding Options and WarrantsVested SharesTotal Value of
    
    
    (included inOutstanding
    
    
    Outstanding
    
    
    outstanding
    
    
    Total Value ofExercise Price Range
    
    Shares
    
    
    Shares
    
    
    shares)
    
    
    Vested Shares$1.42 - $1.92
    
    
    8,365,390
    
    
    $
    12,813,000
    
    
    
    6,643,264
    
    
    $
    10,229,000$1.93 - $3.50
    
    
    5,729,891
    
    
    
    16,691,000
    
    
    
    4,522,371
    
    
    
    13,439,000$3.51 - $4.99
    
    
    3,791,995
    
    
    
    16,452,000
    
    
    
    3,210,396
    
    
    
    14,063,000$5.00 - $5.99
    
    
    1,679,468
    
    
    
    8,683,000
    
    
    
    1,679,468
    
    
    
    8,683,000$6.00 - $8.99
    
    
    1,081,715
    
    
    
    6,984,000
    
    
    
    923,382
    
    
    
    6,010,000$9.00 - $19.99
    
    
    1,437,348
    
    
    
    15,639,000
    
    
    
    1,337,502
    
    
    
    14,612,000$20.00 - $57.60
    
    
    1,137,695
    
    
    
    60,547,000
    
    
    
    1,137,695
    
    
    
    60,547,000Total
    
    
    23,223,502
    
    
    $
    137,809,000
    
    
    
    19,454,078
    
    
    $
    127,583,000
 46




---



##### Table of Contents



Off-Balance Sheet Arrangements
  Contractual Obligations and Contingent Liabilities and Commitments
  Payments Due by PeriodTotal
    
    
    < 1 Year
    
    
    2-3 Years
    
    
    4-5 Years
    
    
    > 5 YearsDebt (long-term and
short-term)
    
    $
    1,855,000
    
    
    $
    255,000
    
    
    $
    1,400,000
    
    
    $
    200,000
    
    
    $
    Operating leases
    
    
    7,938,000
    
    
    
    1,321,000
    
    
    
    2,218,000
    
    
    
    1,960,000
    
    
    
    2,439,000Consulting contract
    
    
    50,000
    
    
    
    50,000
    
    
    
    
    
    
    
    
    
    
    
    Total cash
obligations
    
    
    9,843,000
    
    
    
    1,626,000
    
    
    
    3,618,000
    
    
    
    2,160,000
    
    
    
    2,439,000Interest on
obligations
    
    
    163,000
    
    
    
    53,000
    
    
    
    108,000
    
    
    
    2,000
    
    
    
    Total
    
    $
    10,006,000
    
    
    $
    1,679,000
    
    
    $
    3,726,000
    
    
    $
    2,162,000
    
    
    $
    2,439,000
    Recent Accounting Pronouncements
 Considering the
Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial
Statements
 Fair Value Measurements
 Accounting for
Uncertainty in Income Taxesan interpretation of FASB Statement No. 109
 47




---



##### Table of Contents



Item 7A. Quantitative and Qualitative Disclosures About Market Risk
   
 Item 8. Financial Statements and Supplementary Data
  
 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
  
   
 Item 9A. Controls and Procedures
 Evaluation of Disclosure Controls and Procedure
 Annual Report on Form 10-K ,
 48




---



##### Table of Contents



Managements Report on Internal Control Over Financial Reporting
  Changes in Internal Controls over Financial Reporting
  
 Item 9B. Other Information
  
 PART III
 
 Item 10. Directors and Executive Officers of the Registrant
  www.zixcorp.com
 
 Item 11. Executive Compensation
  
 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters
  49




---



##### Table of Contents



Item 13. Certain Relationships and Related Transactions
  
 Item 14. Principal Accountant Fees and Services
  
 PART IV
 
 Item 15. Exhibits and Financial Statement Schedules
 Financial Statements
  Financial Statement Schedules
  Exhibits
 ExhibitNumber
    
    
    
    Description2.1
    
    
    
    Asset Purchase Agreement, dated as of January 30, 2004, by
and among Zix Corporation, MyDocOnline, Inc., Aventis
Pharmaceuticals Holdings Inc., and Aventis Pharmaceuticals
Inc. (excluding schedules and exhibits). Filed as Exhibit
2.1 to Zix Corporations Current Report on Form 8-K, dated
February 10, 2004, and incorporated herein by reference.2.2
    
    
    
    Asset Purchase Agreement, dated July 22, 2003, between Zix
Corporation and Pocket Script L.L.C. (excluding schedules
and exhibits). Filed as Exhibit 4.1 to Zix Corporations
Current Report on Form 8-K, dated July 23, 2003, and
incorporated herein by reference.2.3
    
    
    
    Asset Purchase Agreement, dated September 2, 2003, among Zix
Corporation, Zix Acquisition Corporation, Elron Software,
Inc., Elron Electronic Industries, Ltd., and Elron Software
(2000), Ltd. (excluding schedules and exhibits). Filed as
Exhibit 4.1 to Zix Corporations Current Report on Form 8-K,
dated September 4, 2003, and incorporated herein by
reference.2.4
    
    
    
    Asset Purchase Agreement, entered into as of March 11, 2005,
by and between CyberGuard Corporation and Zix SCM, Inc.
(excluding the Disclosure Schedule and Annexes). Filed as
Exhibit 2.1 to Zix Corporations Current Report on Form 8-K,
dated March 17, 2005, and incorporated herein by reference.2.5
    
    
    
    Asset Purchase Agreement, entered into as of September 30,
2005, among Mitem Corporation, Zix Corporation, and
MyDocOnline, Inc. (excluding the Disclosure Schedule and
Exhibits). Filed as Exhibit 2.1 to Zix Corporations Current
Report on Form 8-K, dated October 5, 2005, and incorporated
herein by reference.
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##### Table of Contents



ExhibitNumber
    
    
    
    Description3.1
    
    
    
    Restated Articles of Incorporation of Zix Corporation, as
filed with the Texas Secretary of State on November 10,
2005. Filed as Exhibit 3.1 to Zix Corporations Annual Report on
Form 10-K for the year ended December 31, 2005, and incorporated
herein by reference.3.2
    
    
    
    Restated Bylaws of Zix Corporation, dated October 30, 2002.
Filed as Exhibit 3.2 to Zix Corporations Quarterly Report
on Form 10-Q for the quarterly period ended September 30,
2002, and incorporated herein by reference.4.1
    
    
    
    Specimen certificate for common stock of Zix Corporation.
Filed as Exhibit 4.1 to Zix Corporations Annual Report on
Form 10-K for the year ended December 31, 1999, and
incorporated herein by reference.4.2
    
    
    
    Form of Warrant, dated June 24, 2003, to purchase shares of
common stock of Zix Corporation, issued by Zix Corporation (issued
in connection with a $5.25 million financing).
Filed as Exhibit 4.2 to Zix Corporations Current Report on
Form 8-K, dated June 25, 2003, and incorporated herein by
reference.4.3
    
    
    
    Warrant to purchase 166,667 shares of common stock of Zix
Corporation issued by Zix Corporation to Rodman & Renshaw,
LLC., dated as of November 2, 2004. Filed as Exhibit 4.1 to
Zix Corporations Quarterly Report on Form 10-Q for the
quarterly period ended March 31, 2005, and incorporated
herein by reference.4.4
    
    
    
    Warrant to purchase 108,964 shares of common stock of Zix
Corporation issued by Zix Corporation to Rodman & Renshaw, LLC.,
dated as of November 2, 2004. Filed as Exhibit 4.2 to Zix
Corporations Report on Form 8-K dated December 29, 2006, and
incorporated herein by reference.4.5
    
    
    
    Form of Common Stock Purchase Warrant, dated as of November
2, 2004, issued by Zix Corporation to Omicron Master Trust
and Amulet Limited. Filed as Exhibit 4.4 to Zix
Corporations Current Report on Form 8-K, dated November 4,
2004, and incorporated herein by reference.4.6
    
    
    
    Form of Amended and Restated Common Stock Purchase Warrant
to purchase shares of Zix Corporation issued to Omicron
Master Trust and Amulet Limited, dated as of July 22, 2005
(excluding exhibits). Filed as Exhibit 4.4 to Zix Corporations
Current Report on Form 8-K, dated April 14, 2005, and incorporated
herein by reference.4.7
    
    
    
    Form of Warrant, dated August 9, 2005, to purchase shares of
Common Stock of Zix Corporation (including appendices)
(issued in connection with a $26.3 million private
placement). Filed as Exhibit 4.2 to Zix Corporations
Current Report on Form 8-K, dated August 9, 2005, and
incorporated herein by reference.4.8
    
    
    
    Warrant, dated September 30, 2005, issued by Mitem
Corporation exercisable for 400,000 shares of common stock
of Mitem Corporation. Filed as Exhibit 2.3 to Zix
Corporations Current Report on Form 8-K, dated October 5,
2005, and incorporated herein by reference.4.9
    
    
    
    Form of Warrant, as of April 6, 2006, to purchase approximately
5.9 million shares of Common Stock of Zix Corporation (issued to
various purchasers in connection with an $11.8 million private
placement). Filed as Exhibit 4.2 to Zix Corporations Report on
Form 8-K dated April 5, 2006, and incorporated herein by
reference.
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##### Table of Contents



ExhibitNumber
    
    
    
    Description4.10
    
    
    
    Warrant, dated February 22, 2007, to purchase 145,853 shares of
Common Stock issued by Zix Corporation to sanofi-aventis, U.S.
Inc. Filed as Exhibit 4.3 to Zix Corporations Current Report on
Form 8-K, dated February 28, 2007, and incorporated herein by
reference.4.11
    
    
    
    Promissory Note, dated March 11, 2005, payable by CyberGuard
Corporation in the original principal amount of $1,500,000.
Filed as Exhibit 2.2 to Zix Corporations Current Report on
Form 8-K, dated March 17, 2005, and incorporated herein by
reference.4.12
    
    
    
    Secured Promissory Note, dated February 22, 2007, of Zix
Corporation issued to sanofi-aventis, U.S. Inc. Filed as Exhibit
4.2 to Zix Corporations Current Report on Form 8-K, dated
February 28, 2007, and incorporated herein by reference.4.13
    
    
    
    Registration Rights Agreement, dated June 24, 2003, by and
among Zix Corporation and the investors named therein
(issued in connection with the $5.75 million financing).
Filed as Exhibit 4.3 to Zix Corporations Current Report on
Form 8-K, dated June 25, 2003, and incorporated herein by
reference.4.14
    
    
    
    Registration Rights Agreement, dated July 22, 2003, between
Zix Corporation and Pocket Script, L.L.C. Filed as Exhibit
4.2 to Zix Corporations Current Report on Form 8-K, dated
July 23, 2003, and incorporated herein by reference.4.15
    
    
    
    Registration Rights Agreement, dated September 2, 2003,
between Zix Corporation and Elron Software, Inc. Filed as
Exhibit 4.3 to Zix Corporations Current Report on Form 8-K,
dated September 4, 2003, and incorporated herein by
reference.4.16
    
    
    
    Registration Rights Agreement, dated January 30, 2004, by
and among Zix Corporation, Aventis Inc., a Pennsylvania
corporation, and Aventis Holdings Inc., a Delaware
corporation. Filed as Exhibit 4.2 to Zix Corporations
Current Report on Form 8-K, dated February 10, 2004, and
incorporated herein by reference.4.17
    
    
    
    Form of Registration Rights Agreement, dated as of November
2, 2004, by and between Zix Corporation and the Investors
named therein (issued in connection with a $20 million convertible
note private placement). Filed as Exhibit 4.5 to Zix
Corporations Current Report on Form 8-K, dated November 4,
2004, and incorporated herein by reference.4.18
    
    
    
    Form of Amended and Restated Registration Rights Agreement
by and between Zix Corporation and the Investors (excluding
exhibits) (issued in connection with a $20 million convertible note
private placement). Filed as Exhibit 4.5 to Zix Corporations
Current Report on Form 8-K, dated April 14, 2005, and
incorporated herein by reference.4.19
    
    
    
    Securities Purchase Agreement, dated June 24, 2003, by and
among Zix Corporation and the investors named therein
(including schedules but excluding exhibits) in connection
with a $5.75 million financing). Filed as Exhibit 4.1
to Zix Corporations Current Report on Form 8-K,
dated June 25, 2003, and incorporated herein by reference.4.20
    
    
    
    Securities Purchase Agreement, dated as of August 9, 2005,
by and between Zix Corporation and the Purchasers listed on
Schedule A thereto (including schedules, appendices and
exhibits) (issued in connection with a $26.3 million
private placement). Filed as Exhibit 4.1 to Zix
Corporations Current Report on Form 8-K/A, dated October
 52




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##### Table of Contents



ExhibitNumber
    
    
    
    Description21, 2005, and incorporated herein by reference.4.21
    
    
    
    Securities Purchase Agreement, dated as of April 4, 2006, by and
between Zix Corporation and the Purchasers listed on Schedule A
thereto (in connection with an $11.8 million private placement).
Filed as Exhibit 4.1 to Zix Corporations Report on Form 8-K dated
April 5, 2006, and incorporated herein by reference.4.22
    
    
    
    Purchase Agreement, dated as of November 1, 2004, by and
between Zix Corporation and Omicron Master Trust (excluding
schedules and exhibits). Filed as Exhibit 4.1 to Zix
Corporations Current Report on Form 8-K, dated November 4,
2004, and incorporated herein by reference.4.23
    
    
    
    Amendment No. 1 to Purchase Agreement, dated as of April 13,
2005, by and between Zix Corporation and Omicron Master
Trust (excluding schedules and exhibits). Filed as Exhibit
4.1 to Zix Corporations Current Report on Form 8-K, dated
April 14, 2005, and incorporated herein by reference.4.24
    
    
    
    Purchase Agreement, dated as of November 1, 2004, by and
between Zix Corporation and Amulet Limited (excluding
schedules and exhibits). Filed as Exhibit 4.2 to Zix
Corporations Current Report on Form 8-K, dated November 4,
2004, and incorporated herein by reference.4.25
    
    
    
    Amendment No. 1 to Purchase Agreement, dated as of April 13,
2005, by and between Zix Corporation and Amulet Limited
(excluding schedules and exhibits). Filed as Exhibit 4.2 to
Zix Corporations Current Report on Form 8-K, dated April
14, 2005, and incorporated herein by reference.4.26
    
    
    
    Agreement, dated February 22, 2007, between Zix Corporation and
sanofi-aventis, U.S. Inc. Filed as Exhibit 4.1 to Zix
Corporations Current Report on Form 8-K, dated February 28, 2007,
and incorporated herein by reference.10.1
    
    
    
    1990 Stock Option Plan of Zix Corporation (Amended and
Restated as of September 1999). Filed as Exhibit 10.1 to Zix
Corporations Quarterly Report on Form 10-Q for the
quarterly period ended September 30, 1999, and incorporated
herein by reference.10.2
    
    
    
    1992 Stock Option Plan of Zix Corporation (Amended and
Restated as of August 2000). Filed as Exhibit 10.2 to Zix
Corporations Annual Report on Form 10-K for the year ended
December 31, 2003, and incorporated herein by reference.10.3
    
    
    
    1995 Long-Term Incentive Plan of Zix Corporation (Amended
and Restated as of September 20, 2000). Filed as Exhibit
10.3 to Zix Corporations Quarterly Report on Form 10-Q for
the quarterly period ended September 30, 2000, and
incorporated herein by reference.10.4
    
    
    
    1996 Employee Stock Purchase Plan of Zix Corporation
(Amended and Restated as of July 1, 2000). Filed as Exhibit
10.2 to Zix Corporations Quarterly Report on Form 10-Q for
the quarterly period ended June 30, 2000, and incorporated
herein by reference.10.5
    
    
    
    Zix Corporation 1999 Directors Stock Option Plan (Amended
and Restated as of August 1, 2002). Filed as Exhibit 10.1 to
Zix Corporations Quarterly Report on Form 10-Q for the
quarterly period ended June 30, 2002, and incorporated
herein by reference.10.6
    
    
    
    Zix Corporation 2001 Employee Stock Option Plan, dated May
4, 2001. Filed as Exhibit 10.1 to Zix Corporations
Quarterly Report on Form 10-Q for the quarterly period ended
March 31, 2001, and incorporated herein by reference.
 53




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##### Table of Contents



ExhibitNumber
    
    
    
    Description10.7
    
    
    
    Zix Corporations 2001 Stock Option Plan (Amended and
Restated as of May 6, 2003). Filed as Exhibit 10.7 to Zix
Corporations Annual Report on Form 10-K for the year ended
December 31, 2003, and incorporated herein by reference.10.8
    
    
    
    Zix Corporation 2003 Stock Compensation Plan (Amended and
Restated in October 2003). Filed as Exhibit 10.1 to Zix
Corporations Quarterly Report on Form 10-Q for the
quarterly period ended September 30, 2003, and incorporated
herein by reference.10.9
    
    
    
    Zix Corporations 2003 New Employee Stock Option Plan, dated
October 1, 2003. Filed as Exhibit 10.9 to Zix Corporations
Annual Report on Form 10-K for the year ended December 31,
2003, and incorporated herein by reference.10.10
    
    
    
    Zix Corporation 2004 Stock Option Plan, dated May 6, 2004.
Filed as Exhibit 10.1 to Zix Corporations Quarterly Report
on Form 10-Q for the quarterly period ended March 31, 2004,
and incorporated herein by reference.10.11
    
    
    
    Zix Corporation 2004 Stock Option Plan (Amended and Restated
as of May 25, 2005). Filed as Exhibit 10.1 to Zix
Corporations Registration Statement on Form S-8
(Registration No. 333-126576), dated July 13, 2005, and
incorporated herein by reference.10.12
    
    
    
    Zix Corporation 2004 Directors Stock Option Plan, dated May 6,
2004. Filed as Exhibit 10.2 to Zix Corporations
Quarterly Report on Form 10-Q for the quarterly period ended
March 31, 2004, and incorporated herein by reference.10.13
    
    
    
    Zix Corporation 2006 Directors Stock Option Plan, dated June 13,
2006. Filed as Exhibit 10.1 to Zix Corporations Report on Form
8-K filed June 14, 2006, and incorporated herein by reference.10.14
    
    
    
    Zix Corporation 2005 Stock Compensation Plan (Amended and Restated
as of June 13, 2006) Filed as Exhibit 10.2 to Zix
Corporations Current Report on Form 8-K, filed June 14, 2006,
and incorporated herein by reference.10.15
    
    
    
    Form of Stock Option Agreement (with no change in control
provision) for Zix Corporation 2004 Stock Option Plan. Filed
as Exhibit 10.2 to Zix Corporations Registration Statement
on Form S-8 (Registration No. 333-126576), dated July 13,
2005, and incorporated herein by reference.10.16
    
    
    
    Form of Stock Option Agreement (with change in control
provision) for Zix Corporation 2004 Stock Option Plan. Filed
as Exhibit 10.3 to Zix Corporations Registration Statement
on Form S-8 (Registration No. 333-126576), dated July 13,
2005, and incorporated herein by reference.10.17
    
    
    
    Zix Corporation 401(k) Retirement Plan. Filed as Exhibit
10.10 to Zix Corporations Annual Report on Form 10-K for
the year ended December 31, 2003, and incorporated herein by
reference.10.18
    
    
    
    Adoption Agreement relating to Zix Corporation 401(k)
Retirement Plan. Filed as Exhibit 10.11 to Zix Corporations
Annual Report on Form 10-K for the year ended December 31,
2003, and incorporated herein by reference.10.19
    
    
    
    Stock Option Agreement, effective as of November 14, 2001,
between John Ryan and Zix Corporation. Filed as Exhibit 4.2
in Zix Corporations Registration Statement on Form S-8
(Registration No. 333-74890), dated December 11, 2001, and
incorporated herein by reference. Portions of this exhibit
 54




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##### Table of Contents



ExhibitNumber
    
    
    
    Descriptionwere omitted pursuant to a request for confidential
treatment that was filed with the SEC on November 26, 2001.
On December 5, 2001, the SEC approved the filing of this
exhibit omitting the portions for which confidential
treatment was requested. The omitted information has been
filed with the SEC.10.20
    
    
    
    Employment Agreement, entered into as of January 20, 2004,
between Zix Corporation and Richard D. Spurr. Filed as Exhibit
10.14 to Zix Corporations Annual Report on Form 10-K for
the year ended December 31, 2003, and incorporated herein by
reference.10.21
    
    
    
    Employment Offer Letter of Zix Corporation, dated March 23,
2005, to Richard D. Spurr. Filed as Exhibit 10.1 to Zix
Corporations Quarterly Report on Form 10-Q for the
quarterly period ended March 31, 2005, and incorporated
herein by reference.10.22
    
    
    
    Stock Option Agreement, dated February 24, 2004, between Zix
Corporation and Richard D. Spurr. Filed as Exhibit 10.15 to Zix
Corporations Annual Report on Form 10-K for the year ended
December 31, 2003, and incorporated herein by reference.10.23
    
    
    
    Stock Option Agreement, dated November 17, 2004, between Zix
Corporation and Richard D. Spurr. Filed as Exhibit 10.18 to
Zix Corporations Annual Report on Form 10-K for the year
ended December 31, 2004, and incorporated herein by
reference.10.24
    
    
    
    Stock Option Agreement, dated March 23, 2005, between Zix
Corporation and Richard D. Spurr. Filed as Exhibit 10.2 to
Zix Corporations Quarterly Report on Form 10-Q for the
quarterly period ended March 31, 2005, and incorporated
herein by reference.10.25*
    
    
    
    Stock Option Agreement, dated March 2, 2006, between Zix
Corporation and Richard D. Spurr.10.26
    
    
    
    Form of Zix Corporation Stock Option Agreement between Zix
Corporation and Brad Almond and Ronald A. Woessner. Filed as
Exhibit 10.19 to Zix Corporations Annual Report on Form
10-K for the year ended December 31, 2004, and incorporated
herein by reference.10.27
    
    
    
    Form of Outside Director Stock Option Agreement, dated
January 2, 2004, between Zix Corporation and James S.
Marston, Dr. Ben G. Streetman and Michael E. Keane. Filed as
Exhibit 10.3 to Zix Corporations Quarterly Report on Form
10-Q for the quarterly period ended June 30, 2004, and
incorporated herein by reference.10.28
    
    
    
    Outside Director Stock Option Agreement, dated May 6, 2004,
between Zix Corporation and Antonio R. Sanchez III. Filed as
Exhibit 10.4 to Zix Corporations Quarterly Report on Form
10-Q for the quarterly period ended June 30, 2004, and
incorporated herein by reference.10.29
    
    
    
    Severance Agreement, dated February 25, 2002, between Zix
Corporation and Ronald A. Woessner. Filed as Exhibit 10.18
to Zix Corporations Annual Report on Form 10-K for the year
ended December 31, 2001, and incorporated herein by
reference.10.30
    
    
    
    Form of Severance Agreement between Zix Corporation and
certain executive officers. Filed as Exhibit 10.2 to Zix
Corporations Quarterly Report on Form 10-Q for the
quarterly period ended March 31, 2002, and incorporated
herein by reference.
 55




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##### Table of Contents



ExhibitNumber
    
    
    
    Description10.31*
    
    
    
    Severance Agreement, dated November 10, 2006, between Zix
Corporation and Barry W. Wilson.10.32
    
    
    
    Description of Compensation for Members of Zix Corporation
Board of Directors. Filed as Exhibit 10.24 to Zix
Corporations Annual Report on Form 10-K for the year ended
December 31, 2004, and incorporated herein by reference.10.33
    
    
    
    Lease Agreement, dated December 29, 2003, between Zix
Corporation and 7-Eleven, Inc. (excluding exhibits)
(relating to Zix Corporations Dallas, Texas facilities).
Filed as Exhibit 10.24 to Zix Corporations Annual Report on
Form 10-K for the year ended December 31, 2003, and
incorporated herein by reference.10.34
    
    
    
    Office Lease Agreement, dated February 28, 2005, between
Gateway Rosewood, Inc. and Zix SCM, Inc. (relating to Zix
Corporations Burlington, Massachusetts facility). Filed as
Exhibit 10.26 to Zix Corporations Annual Report on Form
10-K for the year ended December 31, 2004, and incorporated
herein by reference.10.35
    
    
    
    Lease Agreement, dated November 27, 2000, between
MyDocOnline, Inc. and Ft. Round Rock Ltd. and related
Amendments No. 1 and No. 2 (excluding exhibits) (relating to
Zix Corporations Austin, Texas facility). Filed as Exhibit
10.27 to Zix Corporations Annual Report on Form 10-K for
the year ended December 31, 2003, and incorporated herein by
reference.10.36
    
    
    
    Amendment No. 3 to Lease Agreement, dated November 27, 2000,
between MyDocOnline, Inc. and Ft. Round Rock Ltd., as
amended (relating to Zix Corporations Austin, Texas
facility). Filed as Exhibit 10.28 to Zix Corporations
Annual Report on Form 10-K for the year ended December 31,
2004, and incorporated herein by reference.10.37
    
    
    
    Facilities Service Agreement, entered into as of June 25,
2003, by and between Collocation Solutions, LLC and Zix
Corporation (excluding schedule and exhibit). Filed as
Exhibit 10.33 to Zix Corporations Annual Report on Form
10-K for the year ended December 31, 2003, and incorporated
herein by reference.10.38
    
    
    
    Lease, dated March 9, 2004, between Duke Realty Ohio and
PocketScript, Inc. (excluding exhibits) (relating to Zix
Corporations Mason, Ohio facility). Filed as Exhibit 10.34
to Zix Corporations Annual Report on Form 10-K for the year
ended December 31, 2003, and incorporated herein by
reference.10.39
    
    
    
    Sublease Agreement between ZixCorp Canada, Inc. and
Intelligent Photonics Control Corp., dated May 20, 2005
(relating to Zix Corporations Ontario, Canada facility).
Filed as Exhibit 10.1 to Zix Corporations Quarterly Report
on Form 10-Q for the quarterly period ended June 30, 2005,
and incorporated herein by reference.10.40
    
    
    
    Amendment and Confirmation of Sublease, dated February 27,
2006, amongst Elk Property Management Limited (Landlord),
Intelligent Photonics Control Corp. (Tenant), 6447309 Canada
Inc. (Assignee), ZixCorp Canada, Inc. and Zix Corporation
(excluding schedules). Filed as Exhibit 10.40 to Zix Corporations
Annual Report on Form 10-K for the year ended December 31, 2005,
and incorporated herein by reference.
 56




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##### Table of Contents



ExhibitNumber
    
    
    
    Description10.41
    
    
    
    Sublease, dated as of July 20, 2006, between ZixCorp Canada, Inc.,
as Tenant, and Peleton Photonic Systems, Inc., as Subtenant. Filed
as Exhibit 10.1 to Zix Corporations Quarterly Report on Form 10-Q
for the period ended September 30, 2006, and incorporated herein
by reference.10.42
    
    
    
    Letter of Agreement dated September 12, 2006 between MITEM
Corporation and Zix Corporation. Filed as Exhibit 10.2 to Zix
Corporations Quarterly Report on Form 10-Q for the period ended
September 30, 2006, and incorporated herein by reference.16.1
    
    
    
    Letter From Deloitte & Touche LLP to the SEC. Filed as Exhibit
16.1 to Zix Corporations Current Report on Form 8-K, dated
September 26, 2006, and incorporated herein by reference.21.1*
    
    
    
    Subsidiaries of Zix Corporation.23.1*
    
    
    
    Consent of Independent Registered Public Accounting Firm (Whitley
Penn LLP).23.2*
    
    
    
    Consent of Independent Registered Public Accounting Firm
(Deloitte & Touche, LLP).31.1*
    
    
    
    Certification of Richard D. Spurr, President and Chief
Executive Officer of the Company, pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.31.2*
    
    
    
    Certification of Barry W. Wilson, Chief Financial Officer
and Treasurer of the Company, pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.32.1*
    
    
    
    Certification of Richard D. Spurr, President and Chief Executive
Officer of the Company and Barry W. Wilson, Chief
Financial Officer and Treasurer of the Company, pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 *
    
    Filed herewith.
    
    Management contract or compensatory plan or arrangement. 57




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##### Table of Contents



SIGNATURES
  ZIX CORPORATIONBy:
    
    /s/ BARRY W. WILSON

      Barry W. WilsonChief Financial Officer and Treasurer
  Signature
    
    
    
    Title/s/ RICHARD D. SPURR

(Richard D. Spurr)
    
    
    
    Chairman, Chief Executive Officer,
President and Director
(Principal Executive Officer)/s/ BARRY W. WILSON

(Barry W. Wilson)
    
    
    
    Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer)/s/ ROBERT C. HAUSMANN
    
    
    
    Director(Robert C. Hausmann)/s/ CHARLES N. KAHN III
    
    
    
    Director(Charles N. Kahn III)/s/ JAMES S. MARSTON
    
    
    
    Director(James S. Marston)Director(Antonio R. Sanchez III)/s/ PAUL E. SCHLOSBERG
    
    
    
    Director(Paul E. Schlosberg)/s/ DR. BEN G. STREETMAN
    
    
    
    Director(Dr. Ben G. Streetman)
 58




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##### Table of Contents



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 Reports of Independent Registered Public Accounting Firms
    
    
    F-2Consolidated Balance Sheets at December 31, 2006 and 2005
    
    
    F-4Consolidated Statements of Operations for the years ended
December 31, 2006, 2005 and 2004
    
    
    F-5Consolidated Statements of
Stockholders Equity for the years ended December 31,
2006, 2005 and 2004
    
    
    F-6Consolidated Statements of Cash Flows for the years ended
December 31, 2006, 2005 and 2004
    
    
    F-8Notes to Consolidated Financial Statements
    
    
    F-10




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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
      
 F-2




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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
     
 F-3




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##### Table of Contents



CONSOLIDATED BALANCE SHEETS
 December 31,2006
    
    
    2005ASSETSCurrent assets:Cash and cash equivalents
    
    $
    12,783,000
    
    
    $
    20,240,000Restricted cash
    
    
    
    
    
    
    5,100,000Receivables, net
    
    
    746,000
    
    
    
    149,000Prepaid and other current assets
    
    
    2,178,000
    
    
    
    1,845,000Total current assets
    
    
    15,707,000
    
    
    
    27,334,000Restricted cash
    
    
    35,000
    
    
    
    35,000Property and equipment, net
    
    
    2,404,000
    
    
    
    3,652,000Intangible assets, net
    
    
    23,000
    
    
    
    559,000Goodwill
    
    
    2,161,000
    
    
    
    2,161,000Deferred financing costs and other assets
    
    
    36,000
    
    
    
    374,000Total assets
    
    $
    20,366,000
    
    
    $
    34,115,000LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    221,000
    
    
    $
    1,313,000Accrued expenses
    
    
    3,079,000
    
    
    
    3,749,000Deferred revenue
    
    
    8,388,000
    
    
    
    7,087,000Customer deposit
    
    
    2,000,000
    
    
    
    1,000,000Capital lease obligations
    
    
    
    
    
    
    165,000Short-term note payable
    
    
    255,000
    
    
    
    268,000Convertible promissory notes payable
    
    
    
    
    
    
    4,404,000Promissory notes payable
    
    
    2,661,000
    
    
    
    Total current liabilities
    
    
    16,604,000
    
    
    
    17,986,000Long-term liabilities:Deferred revenue
    
    
    2,496,000
    
    
    
    1,261,000Customer deposit
    
    
    
    
    
    
    2,000,000Promissory note payable
    
    
    
    
    
    
    2,226,000Deferred rent
    
    
    339,000
    
    
    
    245,000Total long-term liabilities
    
    
    2,835,000
    
    
    
    5,732,000Total liabilities
    
    
    19,439,000
    
    
    
    23,718,000Commitments and contingencies (Note 19)Stockholders equity:Preferred stock, $1 par value, 10,000,000 shares
authorized; none issued and outstanding
    
    
    
    
    
    
    Common stock, $0.01 par value, 175,000,000 shares
authorized; 61,966,020 issued and 59,638,839
outstanding in 2006 and 51,932,561 issued and
49,605,380 outstanding in 2005
    
    
    620,000
    
    
    
    519,000Additional paid-in capital
    
    
    322,330,000
    
    
    
    308,461,000Treasury stock, at cost; 2,327,181 common shares in 2006
and 2005
    
    
    (11,507,000
    )
    
    
    (11,507,000
    )Accumulated deficit
    
    
    (310,516,000
    )
    
    
    (287,076,000
    )Total stockholders equity
    
    
    927,000
    
    
    
    10,397,000$
    20,366,000
    
    
    $
    34,115,000
  F - 4




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##### Table of Contents



ZIX CORPORATION
 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 Year Ended December 31,2006
    
    
    2005
    
    
    2004Revenues:Services
    
    $
    18,358,000
    
    
    $
    13,412,000
    
    
    $
    11,282,000Hardware
    
    
    
    
    
    
    443,000
    
    
    
    1,519,000Software
    
    
    
    
    
    
    109,000
    
    
    
    1,326,000Total revenues
    
    
    18,358,000
    
    
    
    13,964,000
    
    
    
    14,127,000Costs and expenses:Cost of revenues
    
    
    12,552,000
    
    
    
    14,194,000
    
    
    
    15,878,000Research and development expenses
    
    
    6,085,000
    
    
    
    6,520,000
    
    
    
    9,331,000Selling, general and administrative expenses
    
    
    23,188,000
    
    
    
    26,358,000
    
    
    
    29,399,000Customer deposit forfeiture
    
    
    (1,000,000
    )
    
    
    (960,000
    )
    
    
    Net (gain) loss on sale of product lines
    
    
    (53,000
    )
    
    
    3,716,000
    
    
    
    Asset impairment charge
    
    
    125,000
    
    
    
    288,000
    
    
    
    675,000Total costs and expenses
    
    
    40,897,000
    
    
    
    50,116,000
    
    
    
    55,283,000Operating loss
    
    
    (22,539,000
    )
    
    
    (36,152,000
    )
    
    
    (41,156,000
    )Other income (expense):Investment and other income
    
    
    925,000
    
    
    
    776,000
    
    
    
    332,000Interest expense
    
    
    (1,126,000
    )
    
    
    (6,848,000
    )
    
    
    (801,000
    )Gain on derivatives (see Note 15)
    
    
    4,043,000
    
    
    
    
    
    
    
    Loss on extinguishment of convertible debt
    
    
    (871,000
    )
    
    
    (1,283,000
    )
    
    
    Recovery of previously impaired investment
    
    
    
    
    
    
    
    
    
    
    70,000Total other income (expense)
    
    
    2,971,000
    
    
    
    (7,355,000
    )
    
    
    (399,000
    )Loss before income taxes
    
    
    (19,568,000
    )
    
    
    (43,507,000
    )
    
    
    (41,555,000
    )Income tax benefit (expense)
    
    
    60,000
    
    
    
    (89,000
    )
    
    
    (485,000
    )Net loss
    
    $
    (19,508,000
    )
    
    $
    (43,596,000
    )
    
    $
    (42,040,000
    )Basic and diluted loss per common share:
    
    $
    (0.34
    )
    
    $
    (1.20
    )
    
    $
    (1.33
    )Basic and diluted weighted average common shares
outstanding
    
    
    57,067,678
    
    
    
    36,452,000
    
    
    
    31,533,000
  F - 5




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##### Table of Contents



ZIX CORPORATION
 
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
 Stockholders EquityCommon Stock
    
    
    Additional
    
    
    
    
    
    
    
    
    
    
    TotalPaid-In
    
    
    Treasury
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Deficit
    
    
    EquityBalance, January 1, 2004
    
    
    31,155,646
    
    
    $
    312,000
    
    
    $
    230,554,000
    
    
    $
    (11,507,000
    )
    
    $
    (201,440,000
    )
    
    $
    17,919,000Issuance of common stock upon exercise of stock options
    
    
    1,005,812
    
    
    
    10,000
    
    
    
    5,489,000
    
    
    
    
    
    
    
    
    
    
    
    5,499,000Issuance of common stock upon exercise of warrants
    
    
    1,379,746
    
    
    
    14,000
    
    
    
    15,329,000
    
    
    
    
    
    
    
    
    
    
    
    15,343,000Common stock issued for purchase of MyDocOnline
    
    
    583,411
    
    
    
    6,000
    
    
    
    9,031,000
    
    
    
    
    
    
    
    
    
    
    
    9,037,000Valuation of warrants assigned to promissory note
payable
    
    
    
    
    
    
    
    
    
    
    1,475,000
    
    
    
    
    
    
    
    
    
    
    
    1,475,000Valuation of warrants assigned to convertible promissory
notes payable
    
    
    
    
    
    
    
    
    
    
    3,511,000
    
    
    
    
    
    
    
    
    
    
    
    3,511,000Employee stock compensation expense
    
    
    459,791
    
    
    
    4,000
    
    
    
    3,890,000
    
    
    
    
    
    
    
    
    
    
    
    3,894,000Non-employee stock-based compensation
    
    
    
    
    
    
    
    
    
    
    179,000
    
    
    
    
    
    
    
    
    
    
    
    179,000Other
    
    
    
    
    
    
    
    
    
    
    (52,000
    )
    
    
    
    
    
    
    
    
    
    
    (52,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (42,040,000
    )
    
    
    (42,040,000
    )Balance, December 31, 2004
    
    
    34,584,406
    
    
    
    346,000
    
    
    
    269,406,000
    
    
    
    (11,507,000
    )
    
    
    (243,480,000
    )
    
    
    14,765,000Issuance of common stock and related warrants upon private
investment
    
    
    10,503,862
    
    
    
    105,000
    
    
    
    24,096,000
    
    
    
    
    
    
    
    
    
    
    
    24,201,000Issuance of common stock upon exercise of warrants
    
    
    1,209,712
    
    
    
    12,000
    
    
    
    2,076,000
    
    
    
    
    
    
    
    
    
    
    
    2,088,000Issuance of common stock upon exercise of stock options
    
    
    10,833
    
    
    
    
    
    
    
    28,000
    
    
    
    
    
    
    
    
    
    
    
    28,000Employee stock compensation expense
    
    
    349,615
    
    
    
    4,000
    
    
    
    1,008,000
    
    
    
    
    
    
    
    
    
    
    
    1,012,000Common stock issued in lieu of cash redemption of
convertible promissory notes
    
    
    4,856,129
    
    
    
    48,000
    
    
    
    8,403,000
    
    
    
    
    
    
    
    
    
    
    
    8,451,000Common stock issued in lieu of cash payments for interest
on convertible promissory notes
    
    
    418,004
    
    
    
    4,000
    
    
    
    918,000
    
    
    
    
    
    
    
    
    
    
    
    922,000Valuation of additional anti-dilutive warrants issued upon
private placement
    
    
    
    
    
    
    
    
    
    
    153,000
    
    
    
    
    
    
    
    
    
    
    
    153,000Valuation of additional warrants issued upon retirement of
convertible promissory notes payable
    
    
    
    
    
    
    
    
    
    
    146,000
    
    
    
    
    
    
    
    
    
    
    
    146,000Revaluation of outstanding warrants resulting from
restructure of convertible promissory note payable
    
    
    
    
    
    
    
    
    
    
    (375,000
    )
    
    
    
    
    
    
    
    
    
    
    (375,000
    )Valuation of beneficial conversion feature resulting from
the restructure of promissory note payable
    
    
    
    
    
    
    
    
    
    
    2,518,000
    
    
    
    
    
    
    
    
    
    
    
    2,518,000Non-employee stock-based compensation
    
    
    
    
    
    
    
    
    
    
    110,000
    
    
    
    
    
    
    
    
    
    
    
    110,000Other
    
    
    
    
    
    
    
    
    
    
    (26,000
    )
    
    
    
    
    
    
    
    
    
    
    (26,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (43,596,000
    )
    
    
    (43,596,000
    )Balance, December 31, 2005
    
    
    51,932,561
    
    
    
    519,000
    
    
    
    308,461,000
    
    
    
    (11,507,000
    )
    
    
    (287,076,000
    )
    
    
    10,397,000Issuance of common stock and related warrants upon private
investment (net of issuance costs)
    
    
    9,930,000
    
    
    
    100,000
    
    
    
    4,648,000
    
    
    
    
    
    
    
    
    
    
    
    4,748,000Common stock issued to employees for compensation in lieu
of cash
    
    
    82,196
    
    
    
    1,000
    
    
    
    156,000
    
    
    
    
    
    
    
    
    
    
    
    157,000Common stock issued in lieu of cash for third-party services
    
    
    21,263
    
    
    
    
    
    
    
    30,000
    
    
    
    
    
    
    
    
    
    
    
    30,000Employee share-based compensation costs through September
30, 2006
    
    
    
    
    
    
    
    
    
    
    2,008,000
    
    
    
    
    
    
    
    
    
    
    
    2,008,000Valuation of additional warrants issued relating to the
convertible promissory notes payable
    
    
    
    
    
    
    
    
    
    
    50,000
    
    
    
    
    
    
    
    
    
    
    
    50,000Valuation of beneficial conversion feature in convertible
promissory note resulting from the private placement of
common stock
    
    
    
    
    
    
    
    
    
    
    459,000
    
    
    
    
    
    
    
    
    
    
    
    459,000Valuation of additional anti-dilutive warrants issued upon
private placement of common stock
    
    
    
    
    
    
    
    
    
    
    74,000
    
    
    
    
    
    
    
    
    
    
    
    74,000Valuation of additional warrants issued upon retirement of
convertible promissory note
    
    
    
    
    
    
    
    
    
    
    6,000
    
    
    
    
    
    
    
    
    
    
    
    6,000
 F - 6




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##### Table of Contents



Stockholders EquityCommon Stock
    
    
    Additional
    
    
    
    
    
    
    
    
    
    
    TotalPaid-In
    
    
    Treasury
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Deficit
    
    
    EquityReversal of unamortized valuation of beneficial conversion
feature upon retirement of convertible promissory note
    
    
    
    
    
    
    
    
    
    
    (365,000
    )
    
    
    
    
    
    
    
    
    
    
    (365,000
    )Non-employee stock-based compensation through September 30,
2006
    
    
    
    
    
    
    
    
    
    
    1,000
    
    
    
    
    
    
    
    
    
    
    
    1,000Net loss through September 30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,111,000
    )
    
    
    (16,111,000
    )Balance, September 30, 2006
    
    
    61,966,020
    
    
    $
    620,000
    
    
    $
    315,528,000
    
    
    $
    (11,507,000
    )
    
    $
    (303,187,000
    )
    
    $
    1,454,000Cumulative effect of change in accounting principle (see
Note 15)
    
    
    
    
    
    
    
    
    
    
    5,979,000
    
    
    
    
    
    
    
    (3,932,000
    )
    
    
    2,047,000Employee share-based compensations costs, October 1 -
December 31, 2006
    
    
    
    
    
    
    
    
    
    
    800,000
    
    
    
    
    
    
    
    
    
    
    
    800,000Non-employee stock-based compensation, October 1  December
31, 2006
    
    
    
    
    
    
    
    
    
    
    23,000
    
    
    
    
    
    
    
    
    
    
    
    23,000Net loss, October 1 through December 31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,397,000
    )
    
    
    (3,397,000
    )Balance, December 31, 2006
    
    
    61,966,020
    
    
    $
    620,000
    
    
    $
    322,330,000
    
    
    $
    (11,507,000
    )
    
    $
    (310,516,000
    )
    
    $
    927,000
  F - 7




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##### Table of Contents



ZIX CORPORATION
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 Year Ended December 31,2006
    
    
    2005
    
    
    2004Operating activities:Net loss
    
    $
    (19,508,000
    )
    
    $
    (43,596,000
    )
    
    $
    (42,040,000
    )Non-cash items in net loss:Depreciation and amortization
    
    
    2,754,000
    
    
    
    4,104,000
    
    
    
    4,820,000Amortization of debt discount/premium, financing costs,
and other
    
    
    910,000
    
    
    
    5,543,000
    
    
    
    622,000Valuation of additional warrants issued upon cash
payment of convertible debt
    
    
    10,000
    
    
    
    47,000
    
    
    
    Common stock issued to employees and non-employees in
lieu of cash
    
    
    187,000
    
    
    
    
    
    
    
    Loss on extinguishment of convertible debt
    
    
    871,000
    
    
    
    1,283,000
    
    
    
    Gain on derivative liabilities (see Note 15)
    
    
    (4,043,000
    )
    
    
    
    
    
    
    Acquired in-process research and development
    
    
    
    
    
    
    
    
    
    
    306,000Asset impairment charge
    
    
    125,000
    
    
    
    288,000
    
    
    
    675,000Employee stock compensation expense
    
    
    2,808,000
    
    
    
    1,012,000
    
    
    
    3,894,000Common stock issued in lieu of cash interest payments
    
    
    
    
    
    
    922,000
    
    
    
    Non-employee stock-based compensation
    
    
    24,000
    
    
    
    110,000
    
    
    
    179,000Customer deposit forfeiture
    
    
    (1,000,000
    )
    
    
    (960,000
    )
    
    
    Changes in deferred taxes
    
    
    1,000
    
    
    
    
    
    
    
    Net (gain)/loss on sale of product lines
    
    
    (53,000
    )
    
    
    3,716,000
    
    
    
    Recovery of investment in Maptuit Corporation and
Other
    
    
    
    
    
    
    
    
    
    
    (70,000
    )Changes in operating assets and liabilities, excluding
effects of acquisitions:Accounts receivable
    
    
    (597,000
    )
    
    
    365,000
    
    
    
    (1,000
    )Other assets
    
    
    (9,000
    )
    
    
    362,000
    
    
    
    (492,000
    )Accounts payable
    
    
    (993,000
    )
    
    
    51,000
    
    
    
    718,000Deferred revenue
    
    
    2,536,000
    
    
    
    2,628,000
    
    
    
    3,201,000Customer deposits
    
    
    
    
    
    
    (8,000
    )
    
    
    3,968,000Accrued and other liabilities
    
    
    (701,000
    )
    
    
    (768,000
    )
    
    
    1,453,000Net cash used by operating activities
    
    
    (16,678,000
    )
    
    
    (24,901,000
    )
    
    
    (22,767,000
    )Investing activities:Purchases of property and equipment
    
    
    (1,239,000
    )
    
    
    (1,734,000
    )
    
    
    (3,393,000
    )Purchases of marketable securities
    
    
    
    
    
    
    
    
    
    
    (35,582,000
    )Sales and maturities of marketable securities
    
    
    
    
    
    
    16,000,000
    
    
    
    26,564,000Purchase of restricted cash investment
    
    
    
    
    
    
    (35,000
    )
    
    
    (10,103,000
    )Proceeds from restricted cash investments
    
    
    5,100,000
    
    
    
    5,274,000
    
    
    
    Proceeds from sale of product lines
    
    
    53,000
    
    
    
    3,262,000
    
    
    
    Cash received from Maptuit Corporation
    
    
    
    
    
    
    
    
    
    
    70,000Purchase of MyDocOnline
    
    
    
    
    
    
    
    
    
    
    (282,000
    )Net cash provided by (used in) investing activities
    
    
    3,914,000
    
    
    
    22,767,000
    
    
    
    (22,726,000
    )Financing activities:Proceeds from private placement of common stock
    
    
    11,817,000
    
    
    
    26,288,000
    
    
    
    Payment of expenses relating to private placement of
common stock
    
    
    (853,000
    )
    
    
    (2,057,000
    )
    
    
    Proceeds from exercise of stock options
    
    
    
    
    
    
    28,000
    
    
    
    5,499,000Proceeds from exercise of warrants
    
    
    
    
    
    
    2,088,000
    
    
    
    15,343,000Payment of short term note payable, capital lease, and
other
    
    
    (457,000
    )
    
    
    (530,000
    )
    
    
    Payment of premium on convertible debt
    
    
    (200,000
    )
    
    
    (348,000
    )
    
    
    Payment of convertible debt
    
    
    (5,000,000
    )
    
    
    (6,951,000
    )
    
    
    
 F - 8




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##### Table of Contents



Year Ended December 31,2006
    
    
    2005
    
    
    2004Proceeds from promissory note payable
    
    
    
    
    
    
    
    
    
    
    3,000,000Proceeds from convertible promissory notes, net of
issuance costs
    
    
    
    
    
    
    
    
    
    
    18,908,000Net cash provided by financing activities
    
    
    5,307,000
    
    
    
    18,518,000
    
    
    
    42,750,000(Decrease) increase in cash and cash equivalents
    
    
    (7,457,000
    )
    
    
    16,384,000
    
    
    
    (2,743,000
    )Cash and cash equivalents, beginning of year
    
    
    20,240,000
    
    
    
    3,856,000
    
    
    
    6,599,000Cash and cash equivalents, end of year
    
    $
    12,783,000
    
    
    $
    20,240,000
    
    
    $
    3,856,000
  F - 9




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##### Table of Contents



ZIX CORPORATION
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 1. Company Overview and Liquidity
        F - 10




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##### Table of Contents



F - 11




---



##### Table of Contents




    
    As of December 31, 2006, unrestricted cash on hand was $12,783,000.
    
    Cash receipts for the next twelve months are projected to be approximately
$26,500,000 based on current contracted billings and estimated contract renewals and
new business.
    
    Operating spending plus capital asset purchases for the next twelve months is
projected to be approximately $32,250,000 based upon the Companys organization, cost
reduction actions previously mentioned and order and deployment rates as of December 31,
2006,
   2. Summary of Significant Accounting Policies
 Consolidation
 Use of Estimates
 Cash Equivalents and Restricted Cash
 Inventory
 F - 12




---



##### Table of Contents



Property and Equipment, Long-Lived and Other Intangible Assets, Depreciation and Amortization
   Goodwill
 Goodwill and Other Intangible Assets
   Deferred Tax Assets
 F - 13




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##### Table of Contents



Leases
 Contingent Liabilities Accounting for Contingencies.
 Revenue Recognition Software Revenue
Recognition, Modification of SOP 97-2, Software Revenue Recognition, With respect to
Certain Transactions, Revenue Arrangements with Multiple Deliverables, Revenue Recognition in
Financial Statements,
    F - 14




---



##### Table of Contents



Customer Indemnification Guarantees
 Warranty Costs
 Deferred Cost of Revenue
 Software Development Costs
  Advertising Expense
 Stock Based Compensation Share-Based
Payment
 F - 15




---



##### Table of Contents



Earnings Per Share
 Other Recent Accounting Pronouncements
 Considering the
Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial
Statements
 Fair Value Measurements
 Accounting for
Uncertainty in Income Taxesan interpretation of FASB Statement No. 109
 3. Segment Information
     F - 16




---



##### Table of Contents



Year Ended December 31,(unaudited)
    
    
    (unaudited)2006
    
    
    2005
    
    
    2004Revenue:Email Encryption
    
    $
    14,094,000
    
    
    $
    10,007,000
    
    
    $
    7,071,000e-Prescribing
    
    
    4,264,000
    
    
    
    2,981,000
    
    
    
    2,532,000Corporate
    
    
    
    
    
    
    976,000
    
    
    
    4,524,000Total revenues
    
    
    18,358,000
    
    
    
    13,964,000
    
    
    
    14,127,000Gross margin:Email Encryption
    
    
    8,727,000
    
    
    
    4,744,000
    
    
    
    980,000e-Prescribing
    
    
    (2,921,000
    )
    
    
    (4,344,000
    )
    
    
    (3,017,000
    )Corporate
    
    
    
    
    
    
    (630,000
    )
    
    
    286,000Total gross margin
    
    
    5,806,000
    
    
    
    (230,000
    )
    
    
    (1,751,000
    )Direct costs:Email Encryption
    
    
    10,920,000
    
    
    
    11,826,000
    
    
    
    12,702,000e-Prescribing
    
    
    9,848,000
    
    
    
    10,164,000
    
    
    
    6,053,000Corporate
    
    
    
    
    
    
    1,225,000
    
    
    
    8,921,000Total direct costs
    
    
    20,768,000
    
    
    
    23,215,000
    
    
    
    27,676,000Unallocated (expense) / income:Marketing, general and administrative expense
    
    
    (8,505,000
    )
    
    
    (9,663,000
    )
    
    
    (11,054,000
    )Gain (loss) on sales of product lines
    
    
    53,000
    
    
    
    (3,716,000
    )
    
    
    Asset impairment charge
    
    
    (125,000
    )
    
    
    (288,000
    )
    
    
    (675,000
    )Customer deposit forfeiture
    
    
    1,000,000
    
    
    
    960,000
    
    
    
    Gain on derivatives
    
    
    4,043,000
    
    
    
    
    
    
    
    Loss on extinguishment of debt
    
    
    (871,000
    )
    
    
    (1,283,000
    )
    
    
    Recovery of previously impaired investment
    
    
    
    
    
    
    
    
    
    
    70,000Investment and other income
    
    
    925,000
    
    
    
    776,000
    
    
    
    332,000Interest expense
    
    
    (1,126,000
    )
    
    
    (6,848,000
    )
    
    
    (801,000
    )Total unallocated expenses
    
    
    (4,606,000
    )
    
    
    (20,062,000
    )
    
    
    (12,128,000
    )Loss before income taxes
    
    $
    (19,568,000
    )
    
    $
    (43,507,000
    )
    
    $
    (41,555,000
    )
   December 31,(unaudited)2006
    
    
    2005Total assets:Email Encryption
    
    $
    3,377,000
    
    
    $
    3,969,000e-Prescribing
    
    
    1,813,000
    
    
    
    1,436,000Corporate
    
    
    15,176,000
    
    
    
    28,710,000Total assets
    
    $
    20,366,000
    
    
    $
    34,115,000
 F - 17




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##### Table of Contents



4. Stock Options and Stock-based Employee Compensation
  Authorized
    
    Options
    
    Options
    
    AvailableShares
    
    Outstanding
    
    Vested
    
    for GrantEmployee and Director Stock Option Plans:1992 Stock Option Plan
    
    
    450,000
    
    
    
    64,666
    
    
    
    64,666
    
    
    
    1995 Long-term Incentive Plan
    
    
    1,825,000
    
    
    
    1,161,375
    
    
    
    937,208
    
    
    
    1996 Directors Stock Option Plan
    
    
    225,000
    
    
    
    60,000
    
    
    
    60,000
    
    
    
    1999 Directors Stock Option Plan
    
    
    975,000
    
    
    
    826,153
    
    
    
    770,625
    
    
    
    2001 Stock Option Plan
    
    
    2,525,000
    
    
    
    2,032,181
    
    
    
    917,978
    
    
    
    26,9092001 Employee Stock Option Plan
    
    
    300,000
    
    
    
    179,374
    
    
    
    162,081
    
    
    
    77,0792003 New Employee Stock Option Plan
    
    
    500,000
    
    
    
    204,367
    
    
    
    161,867
    
    
    
    295,6332004 Stock Option Plan
    
    
    3,200,000
    
    
    
    2,838,170
    
    
    
    780,106
    
    
    
    361,8302004 Directors Stock Option Plan
    
    
    300,000
    
    
    
    270,833
    
    
    
    203,125
    
    
    
    2006 Directors Stock Option Plan
    
    
    750,000
    
    
    
    194,190
    
    
    
    48,548
    
    
    
    555,810Total employee and director stock option plans
    
    
    11,050,000
    
    
    
    7,831,309
    
    
    
    4,106,204
    
    
    
    1,317,261Executive Stock Option Agreements:John A. Ryan, former Chairman and CEO
    
    
    1,000,000
    
    
    
    1,000,000
    
    
    
    1,000,000
    
    
    
    Richard D. Spurr, Chairman, President and CEO
    
    
    650,000
    
    
    
    650,000
    
    
    
    605,682
    
    
    
    Other executive stock option agreements
    
    
    450,000
    
    
    
    125,000
    
    
    
    125,000
    
    
    
    Total executive stock option agreements
    
    
    2,100,000
    
    
    
    1,775,000
    
    
    
    1,730,682
    
    
    
    Other stock option agreements
    
    
    70,000
    
    
    
    70,000
    
    
    
    70,000
    
    
    
    Total
    
    
    13,220,000
    
    
    
    9,676,309
    
    
    
    5,906,886
    
    
    
    1,317,261
  Employee and Director Stock Option Plans
  Executive Stock Option Agreements:
 John A. Ryan
 Richard D. Spurr
 Other Executive Stock Option Agreements
 F - 18




---



##### Table of Contents



Other Stock Option Agreements:
  Accounting Treatment
 Share-Based Payment
   Cost of revenues
    
    $
    177,000Research and development expenses
    
    
    127,000Selling, general and administrative expenses
    
    
    2,504,000Stock-based compensation expense
    
    $
    2,808,000
  Transition
Election Related to Accounting for the Tax Effects of Share-Based Payment Awards
  Year Ended December 31,2005
    
    
    2004Net loss, as reported
    
    $
    (43,596,000
    )
    
    $
    (42,040,000
    )Add employee stock compensation expense
recorded under the intrinsic value
method
    
    
    
    
    
    
    1,115,000Deduct pro forma stock compensation
expense computed under the fair value
method
    
    
    (6,166,000
    )
    
    
    (9,214,000
    )Pro forma net loss
    
    $
    (49,762,000
    )
    
    $
    (50,139,000
    )Basic and diluted loss per common share:As reported
    
    $
    (1.20
    )
    
    $
    (1.33
    )Pro forma
    
    $
    (1.37
    )
    
    $
    (1.59
    )
 F - 19




---



##### Table of Contents



Share Based Payment
 Year Ended December 31,2006
    
    
    2005
    
    
    2004Risk-free interest rate
    
    
    4.59
    %
    
    
    3.41
    %
    
    
    1.86
    %Expected option life
    
    5.8 years
    
    3.6 years
    
    2.5 yearsExpected stock price volatility
    
    
    93
    %
    
    
    96
    %
    
    
    108
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    Fair value of options granted
    
    $
    1.03
    
    
    $
    2.31
    
    
    $
    4.23
 Stock Option Activity
  WeightedWeighted
    
    
    AverageAverage
    
    
    Remaining
    
    
    AggregateExercise
    
    
    Contractual
    
    
    IntrinsicShares
    
    
    Price
    
    
    Term (Yrs)
    
    
    ValueOutstanding at January 1, 2004
    
    
    5,960,717
    
    
    $
    7.66Granted at market price
    
    
    3,793,716
    
    
    $
    6.99Cancelled or expired
    
    
    (728,592
    )
    
    $
    9.15Exercised
    
    
    (1,005,812
    )
    
    $
    5.47Outstanding at December 31, 2004
    
    
    8,020,029
    
    
    $
    7.64Granted at market price
    
    
    976,200
    
    
    $
    3.64Granted above market price
    
    
    138,780
    
    
    $
    3.05Cancelled or expired
    
    
    (1,528,761
    )
    
    $
    7.72Exercised
    
    
    (10,833
    )
    
    $
    2.61Outstanding at December 31, 2005
    
    
    7,595,415
    
    
    $
    7.03Granted at market price
    
    
    15,000
    
    
    $
    1.93Granted above market price
    
    
    3,968,486
    
    
    $
    2.27Cancelled or expired
    
    
    (1,902,592
    )
    
    $
    5.44Exercised
    
    
    
    
    
    $
    Outstanding at December 31, 2006
    
    
    9,676,309
    
    
    $
    5.38
    
    
    
    6.96
    
    
    $
    Options exercisable at December 31, 2006
    
    
    5,906,886
    
    
    $
    7.08
    
    
    
    5.78
    
    
    $
    
  F - 20




---



##### Table of Contents



Options Outstanding
    
    Options ExercisableWeighted Average
    
    Weighted
    
    
    
    
    
    WeightedRange of
    
    Number
    
    Remaining
    
    Average
    
    Number
    
    AverageExercise Prices
    
    Outstanding
    
    Contractual Life
    
    Exercise Price
    
    Exercisable
    
    Exercise Price$
    1.42
    
    
    -
    
    $
    1.92
    
    
    
    1,753,375
    
    
    
    9.63
    
    
    $
    1.50
    
    
    
    31,250
    
    
    $
    1.50$
    1.93
    
    
    -
    
    $
    3.50
    
    
    
    1,846,230
    
    
    
    8.17
    
    
    $
    2.73
    
    
    
    638,710
    
    
    $
    2.80$
    3.51
    
    
    -
    
    $
    4.99
    
    
    
    1,969,665
    
    
    
    6.56
    
    
    $
    4.18
    
    
    
    1,388,066
    
    
    $
    4.21$
    5.00
    
    
    -
    
    $
    5.99
    
    
    
    1,679,468
    
    
    
    5.34
    
    
    $
    5.17
    
    
    
    1,679,468
    
    
    $
    5.17$
    6.00
    
    
    -
    
    $
    8.99
    
    
    
    915,048
    
    
    
    6.44
    
    
    $
    6.54
    
    
    
    756,715
    
    
    $
    6.62$
    9.00
    
    
    -
    
    $
    19.99
    
    
    
    1,291,495
    
    
    
    5.51
    
    
    $
    10.64
    
    
    
    1,191,649
    
    
    $
    10.67$
    20.00
    
    
    -
    
    $
    57.60
    
    
    
    221,028
    
    
    
    2.37
    
    
    $
    35.05
    
    
    
    221,028
    
    
    $
    35.059,676,309
    
    
    
    
    
    
    $
    5.38
    
    
    
    5,906,886
    
    
    $
    7.08
  Reserved Common Stock
  Employee Stock Purchase Plan
  Common Stock Issued in Lieu of Cash
  F - 21




---



##### Table of Contents



Year Ended December 31,2006
    
    
    2005
    
    
    2004Stock compensation relating to accelerated option vesting
    
    $
    
    
    
    $
    
    
    
    $
    1,115,000Common stock issued to employees for compensation in lieu of cash
    
    
    157,000
    
    
    
    1,012,000
    
    
    
    2,779,000Stock granted to third parties
    
    
    30,000
    
    
    
    110,000
    
    
    
    179,000Total
    
    $
    187,000
    
    
    $
    1,122,000
    
    
    $
    4,073,000
 5. Supplemental Cash Flow Information
  Year Ended December 31,2006
    
    
    2005
    
    
    2004Cash interest paid
    
    $
    265,000
    
    
    $
    389,000
    
    
    $
    1,000Income tax (refund) payment
    
    $
    (12,000
    )
    
    $
    261,000
    
    
    $
    163,000Supplemental schedule of noncash investing and
financing activities:Common stock issued for purchase of MyDocOnline
(see Note 6)
    
    $
    
    
    
    $
    
    
    
    $
    9,037,000Issuance of warrants related to convertible
promissory notes payable (see Note 14)
    
    $
    
    
    
    $
    
    
    
    $
    3,511,000Issuance of warrants related to promissory note
payable (see Note 14)
    
    $
    
    
    
    $
    
    
    
    $
    1,475,000Assets acquired on capital lease
    
    $
    
    
    
    $
    160,000
    
    
    $
    213,000Payables related to purchases of assets
    
    $
    99,000
    
    
    $
    34,000
    
    
    $
    Assets sold to customers as part of their
subscription service
    
    $
    45,000
    
    
    $
    
    
    
    $
    Insurance premiums financed by short-term note
payable (see Note 14)
    
    $
    279,000
    
    
    $
    367,000
    
    
    $
    193,000Stock redemption of convertible promissory notes
payable (see Note 14)
    
    $
    
    
    
    $
    8,451,000
    
    
    $
    Valuation of additional anti-dilutive warrants
issued upon private placement
    
    $
    130,000
    
    
    $
    153,000
    
    
    $
    Revaluation of warrants resulting from
restructuring of convertible promissory notes
(see Note 14)
    
    $
    
    
    
    $
    375,000
    
    
    $
    Valuation of beneficial conversion feature
resulting from restructure of convertible
promissory notes payable (see Note 14)
    
    $
    94,000
    
    
    $
    2,518,000
    
    
    $
    Accrued expenses relating to private placement
common stock (see Note 15)
    
    $
    55,000
    
    
    $
    30,000
    
    
    $
    Accumulated effect of adjustment resulting from
change in accounting principle for previously
recorded derivative
    
    $
    2,047,000
    
    
    $
    
    
    
    $
    
 6. Business Sales and Acquisitions
 MyDocOnline, Inc.
   Fair market value of 583,411 shares of the Companys common
stock
    
    $
    9,037,000Transaction costs
    
    
    282,000Total acquisition cost
    
    $
    9,319,000
 F - 22




---



##### Table of Contents



Working capital items:Receivables and prepaid expenses
    
    $
    354,000Deferred revenue
    
    
    (140,000
    )Net working capital acquired
    
    
    214,000Property and equipment
    
    
    1,293,000Customer relationships
    
    
    658,000Developed technology
    
    
    2,051,000Goodwill
    
    
    4,797,000In-process research and development
    
    
    306,000$
    9,319,000
      F - 23




---



##### Table of Contents



Net assets sold (liabilities transferred):Accounts receivable, net
    
    $
    34,000Equipment, net
    
    
    37,000Intangibles, net
    
    
    575,000Deferred revenue
    
    
    (739,000
    )Net
    
    
    (93,000
    )Goodwill
    
    
    4,797,000Net proceeds:Cash receivable
    
    
    150,000Note receivable, net
    
    
    Service obligation
    
    
    (30,000
    )Transaction fees
    
    
    (167,000
    )Net proceeds
    
    
    (47,000
    )Initial loss on sale of product line
    
    $
    (4,751,000
    )Subsequent payments received on note receivable
    
    
    53,000Loss on sale of product line
    
    $
    (4,698,000
    )
   Elron Software, Inc.
   Fair market value of 1,709,402 shares of the Companys
common stock
    
    $
    6,333,000Fair market value of the 5.75% $1,000,000 convertible
promissory note payable
    
    
    1,000,000Transaction costs
    
    
    136,000Total acquisition cost
    
    $
    7,469,000
 F - 24




---



##### Table of Contents



Working capital items:Cash
    
    $
    1,000,000Receivables and prepaid expenses
    
    
    587,000Accounts payable and accrued liabilities
    
    
    (487,000
    )Deferred revenue
    
    
    (776,000
    )Net working capital acquired
    
    
    324,000Property and equipment
    
    
    113,000Developed technology
    
    
    943,000Customer contracts and relationships
    
    
    1,336,000Trademarks and trade names
    
    
    432,000Goodwill
    
    
    4,321,000$
    7,469,000
     Net assets sold (liabilities transferred):Equipment, net
    
    $
    15,000Prepaid expenses
    
    
    165,000Intangibles, net
    
    
    1,499,000Initial deferred revenue
    
    
    (1,546,000
    )Subsequent additional transfer of deferred revenue, net
    
    
    (85,000
    )Net
    
    
    48,000Goodwill
    
    
    2,161,000Net proceeds:Cash
    
    
    2,126,000Note receivable, net
    
    
    1,435,000Transaction fees
    
    
    (317,000
    )Net proceeds
    
    
    3,244,000Gain on sale of product lines
    
    $
    1,035,000
 F - 25




---



##### Table of Contents



7. Restricted Cash
   8. Accounts Receivable
 December 312006
    
    
    2005Gross accounts receivable
    
    $
    4,523,000
    
    
    $
    3,153,000Allowance for returns and doubtful accounts
    
    
    (71,000
    )
    
    
    (35,000
    )Unpaid portion of deferred revenue
    
    
    (3,706,000
    )
    
    
    (2,969,000
    )Receivables, net
    
    $
    746,000
    
    
    $
    149,000
   9. Prepaid and other current assets
 December 312006
    
    
    2005Inventory
    
    $
    767,000
    
    
    $
    248,000Deferred cost of sales charges
    
    
    334,000
    
    
    
    265,000Prepaid insurance, maintenance and other
    
    
    1,025,000
    
    
    
    1,279,000Tax-related
    
    
    52,000
    
    
    
    53,000Prepaid and other current assets
    
    $
    2,178,000
    
    
    $
    1,845,000
 Inventory
 F - 26




---



##### Table of Contents



Deferred Cost of Revenue
 Prepaid insurance, maintenance
 10. Property and Equipment
 December 312006
    
    
    2005Computer and office equipment and software
    
    $
    30,711,000
    
    
    $
    31,627,000Leasehold improvements
    
    
    4,815,000
    
    
    
    4,691,000Furniture and fixtures
    
    
    1,224,000
    
    
    
    1,191,00036,750,000
    
    
    
    37,509,000Less accumulated depreciation and amortization
    
    
    (34,346,000
    )
    
    
    (33,857,000
    )$
    2,404,000
    
    
    $
    3,652,000
    11. Intangible Assets and Goodwill
  December 31,2006
    
    
    2005Intangible asset cost
    
    $
    2,034,000
    
    
    $
    2,034,000Accumulated amortization
    
    
    (2,011,000
    )
    
    
    (1,475,000
    )Net intangible assets
    
    $
    23,000
    
    
    $
    559,000
  F-27




---



##### Table of Contents



AccumulatedCost
    
    
    AmortizationBalance at January 1, 2005
    
    $
    5,967,000
    
    
    $
    2,135,000Amortization of intangibles
    
    
    
    
    
    
    1,199,000Sale of intangibles to CyberGuard
    
    
    (2,711,000
    )
    
    
    (1,212,000
    )Sale of intangibles to MITEM
    
    
    (1,222,000
    )
    
    
    (647,000
    )Balance at December 31, 2005
    
    
    2,034,000
    
    
    
    1,475,000Amortization of intangibles
    
    
    
    
    
    
    536,000Ending balance at December 31, 2006
    
    $
    2,034,000
    
    
    $
    2,011,000
   12. Accrued Expenses
 2006
    
    
    2005Employee compensation and benefits
    
    $
    1,199,000
    
    
    $
    1,766,000Professional fees
    
    
    628,000
    
    
    
    615,000Taxes
    
    
    875,000
    
    
    
    800,000Other
    
    
    377,000
    
    
    
    568,000Total accrued expenses
    
    $
    3,079,000
    
    
    $
    3,749,000
 13. Customer Deposit
   F-28




---



##### Table of Contents



14. Notes Payable
  AdditionalDiscount from
    
    
    Additional DebtDebt
    
    
    Incurred/Stated
    
    
    Effective
    
    
    
    
    
    
    December 31,
    
    
    Amendments/
    
    
    Discount/
    
    
    
    
    
    
    December 31,Interest
    
    
    Interest
    
    
    
    
    
    
    2005 Net
    
    
    Additional
    
    
    Premium
    
    
    Payments
    
    
    2006 NetRate
    
    
    Rate
    
    
    Term
    
    
    Book Value
    
    
    Warrants
    
    
    Amortization
    
    
    Made
    
    
    Book ValueConvertible promissory
notes payable
    
    
    8.22
    %
    
    
    37.41
    %
    
    
    
    
    
    $
    4,404,000
    
    
    $
    (573,000
    )
    
    $
    1,169,000
    
    
    $
    (5,000,000
    )
    
    $
    Promissory note
payable
    
    
    4.50
    %
    
    
    11.00
    %
    
    
    2007
    
    
    
    2,226,000
    
    
    
    
    
    
    
    435,000
    
    
    
    
    
    
    
    2,661,000Short-term promissory
note (2005  2006)
    
    
    6.99
    %
    
    
    6.99
    %
    
    
    
    
    
    
    268,000
    
    
    
    
    
    
    
    
    
    
    
    (268,000
    )
    
    
    Short-term promissory
note (2006  2007)
    
    
    7.75
    %
    
    
    7.75
    %
    
    
    2007
    
    
    
    
    
    
    
    
    
    
    
    279,000
    
    
    
    (24,000
    )
    
    
    255,000Total notes
payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    6,898,000
    
    
    $
    (573,000
    )
    
    $
    1,883,000
    
    
    $
    (5,292,000
    )
    
    $
    2,916,000
 Convertible Promissory Notes Payable
    Accounting treatment of the amended convertible promissory notes payable
 Accounting for Derivative Financial instruments Indexed to, and Potentially Settled in a
Companys Own Stock Accounting for Convertible Debt and Debt Issued with Stock
Purchase Warrants.
 F-29




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##### Table of Contents



Accounting for Convertible Securities with Beneficial Conversion Features of Contingently
Adjustable Conversion Features Application of Issue No. 98-5 to Certain
Convertible Instruments
  2005 payment activity on the convertible promissory notes payable
      
    
    Per anti-dilution terms included in the amended convertible promissory notes
payable, the Company issued additional warrants to purchase 264,718 shares of common
stock. These warrants expire on the following schedule: 57,529 in November 2006 and
2007, 25,651 in November 2008 and 124,009 in November 2009. The additional warrants
were
valued at $74,000 using the BSOPM and recorded as discount against the outstanding note
and amortized to interest expense using the effective interest method.
 F-30




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##### Table of Contents




    
    The conversion price of the outstanding convertible promissory notes payable
was reduced from $5.24 per share to $4.47 per share. The reduced conversion price
caused the Company to record the intrinsic value of a beneficial conversion feature as
the adjusted conversion price was reset to a price below the market price of the
Companys stock on the date the notes were originally issued (November 2, 2004). The
intrinsic value of the adjusted conversion price is $459,000 and was recorded as
additional discount on the remaining convertible promissory note payable and was
amortized to interest expense using the effective interest method.
  
    
    The Company retired the full $5,000,000 using restricted cash and paid a
$200,000 early payment premium plus accrued interest for a total payoff amount of
$5,259,000.
    
    In accordance with the terms of the note, the Company issued warrants to the
note holder to purchase an additional 782,998 shares of common stock at $4.47 per
share. 50% of these warrants expire in November 2006 and 50% expire in November 2007.
These warrants were valued at $6,000 using the BSOPM.
  Early payment premium
    
    $
    200,000Write-off of unamortized discount
    
    
    449,000Write-off of unamortized financing costs
    
    
    216,000Value of warrants issued upon extinguishment
    
    
    6,000Loss on extinguishment of debt
    
    $
    871,000
  Effective yield and interest expense
 Promissory Note Payable
  F-31




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##### Table of Contents



Short-term Notes Payable
  15. April 2006 Private Placement of Common Stock
     F-32




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##### Table of Contents



Gross proceeds
    
    $
    11,817,000Less:Fair value of warrants issued to investors in the private placement
    
    
    (5,979,000
    )Fair value of liquidated damages
    
    
    (123,000
    )Potential future payments to transaction underwriters
    
    
    (59,000
    )Warrants issued to underwriters
    
    
    (199,000
    )Cash issuance costs
    
    
    (908,000
    )Proceeds allocated to common stock
    
    $
    4,549,000
 Warrants issued to investors in the private placement
 Liquidated damages
 Potential future payments to transaction underwriters
 Warrants issued to underwriters
 Common stock
  Accounting for Registration
Payment Arrangements
 
    
    Warrants issued to investors in the private placement The warrants issued to
investors are no longer considered a derivative liability and the initial value of the
warrants ($5,979,000) was reclassified to additional paid-in capital by reducing the
derivative liability by $1,950,000 (the September 30, 2006, value after revaluation) and
a cumulative adjustment to accumulated deficit of $4,029,000 (the cumulative gain
recognized on the warrants in the second and third quarters of 2006).
 F-33




---



##### Table of Contents




    
    Liquidated damages The liquidated damages are no longer considered a derivative
liability and the September 30, 2006, value of the liquidated damages ($97,000) was
written-off through a cumulative adjustment to the September 30, 2006 accumulated
deficit.
    
    Potential future payments to transaction underwriters The potential future payments
to the transaction underwriters are considered a contingent liability in accordance with
FASB Statement No. 5, Accounting for Contingencies,and recorded as an accrued expense.
This contingent liability is revalued each quarter with the change in valuation being
recorded as a gain or loss in the statement of operations. The total liability recorded
is $70,000 at December 31, 2006, and is included in accrued expense.
 16. Equity Financing Arrangements and Related Warrants
 Warrants Summary
  December 31,
    
    
    
    
    
    
    
    
    
    December 31,2005
    
    
    
    
    
    
    
    
    
    2006Warrants
    
    Warrants
    
    Warrants
    
    Warrants
    
    Exercise
    
    WarrantWarrant Grants:
    
    Outstanding
    
    Issued
    
    Expired
    
    Outstanding
    
    Price
    
    Expiration2006 private placement
of common stock
    
    
    
    
    
    
    5,958,000
    
    
    
    
    
    
    
    5,958,000
    
    
    $
    1.54
    
    
    Oct 20112006 private placement agent
warrants
    
    
    
    
    
    
    198,600
    
    
    
    
    
    
    
    198,600
    
    
    
    1.54
    
    
    Oct 20112005 private placement of
common stock
    
    
    3,466,274
    
    
    
    
    
    
    
    
    
    
    
    3,466,274
    
    
    
    3.04
    
    
    Aug 20102005 private placement broker
warrants
    
    
    108,964
    
    
    
    
    
    
    
    
    
    
    
    108,964
    
    
    
    3.04
    
    
    Aug 20102005 private placement agent
warrants
    
    
    178,111
    
    
    
    
    
    
    
    
    
    
    
    178,111
    
    
    
    3.04
    
    
    Aug 20102004 private placement of
convertible notes payable
    
    
    1,115,244
    
    
    
    153,806
    
    
    
    
    
    
    
    1,269,050
    
    
    
    4.47 1.42
    
    
    Nov 20092004 private placement
broker warrants
    
    
    166,667
    
    
    
    
    
    
    
    
    
    
    
    166,667
    
    
    
    6.00
    
    
    Nov 2009Additional warrants issued
with cash payment of
convertible promissory
notes payable
    
    
    795,590
    
    
    
    944,964
    
    
    
    (782,998
    )
    
    
    957,556
    
    
    
    4.47
    
    
    Nov 2006  Nov 20082003 private placement of
common stock
    
    
    181,452
    
    
    
    
    
    
    
    
    
    
    
    181,452
    
    
    
    4.96
    
    
    June 2007Series A Convertible
Preferred Stock
    
    
    243,899
    
    
    
    
    
    
    
    (243,899
    )
    
    
    
    
    
    
    
    
    
    Sept 2006Series B Convertible
Preferred Stock
    
    
    270,509
    
    
    
    
    
    
    
    (270,509
    )
    
    
    
    
    
    
    
    
    
    Sept 20062002 private placement of
equity securities
    
    
    916,667
    
    
    
    
    
    
    
    
    
    
    
    916,667
    
    
    
    57.60
    
    
    May 2010Promissory note payable (see
Note 14)
    
    
    145,853
    
    
    
    
    
    
    
    
    
    
    
    145,853
    
    
    
    13.01
    
    
    Jan 2007Total
    
    
    7,589,230
    
    
    
    7,255,370
    
    
    
    (1,297,406
    )
    
    
    13,547,194
   2006 Private Placement of Common Stock and Warrants




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##### Table of Contents



2005 Private Placement of Common Stock and Warrants
      2004 Private Placement of Convertible Notes Payable and Related Transactions
   F-35




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2006 Private Placement of Common Stock and Warrants
 
    
    Per anti-dilution terms included in the amended convertible promissory notes
payable, the Company issued additional warrants to purchase 264,718 shares of common
stock. These warrants expire on the following schedule: 57,529 expired in November
2006, 57,529 expire in November 2007, 25,651 expire in November 2008, and 124,009
expire in November 2009.
    
    The exercise prices of the warrants relating to the convertible promissory
notes payable were reduced from a range of $1.44 to $5.24 to a range of $1.42 to $4.47.
    2003 Private Placement of Common Stock and Warrants
  F-36




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##### Table of Contents



2002 Private Placement of Convertible Equity Securities and Warrants
  
    
    Warrants related to the issuance of $8,000,000 of convertible notes Concurrent with the
issuance of $8,000,000 of convertible notes in September 2002, the Company issued
immediately exercisable warrants to purchase 386,473 shares of the Companys common stock at
a price per share of $4.14. In April 2003, the Company and the former noteholders completed
a warrant exercise and replacement program whereby the Company received $1,600,000 in cash
as a result of the noteholders exercising their original warrants and issued replacement
warrants to the noteholders to purchase 455,017 shares of the Companys common stock at
$5.00 per share. Subsequently, as a result of the Companys private placement in June 2003,
the Elron Software acquisition in September 2003, redemptions of the convertible notes
throughout 2005 and the Companys private placement of common stock in August 2005, and
certain anti-dilution provisions of the replacement warrants, the price per common share
pursuant to these replacement warrants was reduced from $5.00 to $1.44 and the number of
common shares available for purchase was increased from 648,172 to 1,209,712. The additional
warrants were assigned a value of $249,000 using the BSOPM, which was reallocated from the
original additional paid-in capital that was recorded at the time the initial warrants were
issued. All 1,209,712 warrants were exercised in 2005 for total proceeds of $2,088,365, or
an average of $1.73 per share.
    
    Warrants related to the issuance of $3,250,000 of Series A Convertible Preferred Stock
Concurrent with the issuance of $3,250,000 of Series A Convertible Preferred Stock in
September 2002, the Company issued warrants to purchase 288,244 shares of the Companys
common stock at a price per share of $4.42. At December 31, 2005, 243,899 of these warrants
were outstanding all of which expired in September 2006.
    
    Warrants related to the issuance of $4,750,000 of Series B Convertible Preferred Stock
Concurrent with the issuance of $4,750,000 of Series B Convertible Preferred Stock in
September 2002, the Company issued warrants to purchase 421,284 shares of the Companys
common stock at a price per share of $4.42. At December 31, 2005, 270,509 of these warrants
were outstanding all of which expired in September 2006.
 2002 Private Placement of Equity Securities
  17. Earnings Per Share and Potential Dilution
  2006
    
    
    2005
    
    
    2004Stock options
    
    
    9,676,309
    
    
    
    7,595,415
    
    
    
    8,020,029Warrants issued in relation to debt and equity
arrangements (see Note 14)
    
    
    13,547,194
    
    
    
    7,589,230
    
    
    
    3,573,219Shares issuable for conversion of convertible
promissory notes payable
    
    
    700,000
    
    
    
    929,368
    
    
    
    3,333,333Total antidilutive securities excluded from EPS
Calculation
    
    
    23,923,503
    
    
    
    16,114,013
    
    
    
    14,926,581
  F-37




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##### Table of Contents



18. Significant Customers
  19. Commitments and Contingencies
 Leases and Debt
   2007
    
    
    2008
    
    
    2009
    
    
    2010
    
    
    2011
    
    
    Thereafter
    
    
    TotalDebt
    
    $
    255,000
    
    
    $
    600,000
    
    
    $
    800,000
    
    
    $
    200,000
    
    
    $
    
    
    
    $
    
    
    
    $
    1,855,000Operating leases
    
    
    1,321,000
    
    
    
    1,141,000
    
    
    
    1,077,000
    
    
    
    992,000
    
    
    
    968,000
    
    
    
    2,439,000
    
    
    
    7,938,000Consulting contract
    
    
    50,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    50,000Total cash obligations
    
    
    1,626,000
    
    
    
    1,741,000
    
    
    
    1,877,000
    
    
    
    1,192,000
    
    
    
    968,000
    
    
    
    2,439,000
    
    
    
    9,843,000Interest on obligations
    
    
    53,000
    
    
    
    73,000
    
    
    
    35,000
    
    
    
    2,000
    
    
    
    
    
    
    
    
    
    
    
    163,000Total
    
    $
    1,679,000
    
    
    $
    1,814,000
    
    
    $
    1,912,000
    
    
    $
    1,194,000
    
    
    $
    968,000
    
    
    $
    2,439,000
    
    
    $
    10,006,000
   Lawsuits
  F-38




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F-39




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##### Table of Contents



20. Income Taxes
  2006
    
    
    2005
    
    
    2004Current:U.S
    
    $
    
    
    
    $
    
    
    
    $
    State
    
    
    (24,000
    )
    
    
    30,000
    
    
    
    Foreign
    
    
    (36,000
    )
    
    
    59,000
    
    
    
    501,000Deferred:Foreign
    
    
    
    
    
    
    
    
    
    
    (16,000
    )$
    (60,000
    )
    
    $
    89,000
    
    
    $
    485,000
  2006
    
    
    2005
    
    
    2004Expected tax benefit at U.S. statutory
rate
    
    $
    (6,597,000
    )
    
    $
    (14,760,000
    )
    
    $
    (14,128,000
    )Unbenefited U.S. losses, net
    
    
    7,915,000
    
    
    
    14,772,000
    
    
    
    14,144,000Nondeductible expense and nontaxable income
    
    
    (1,326,000
    )
    
    
    47,000
    
    
    
    469,000State income taxes
    
    
    (24,000
    )
    
    
    30,000
    
    
    
    Foreign income taxes
    
    
    (36,000
    )
    
    
    
    
    
    
    Other
    
    
    8,000
    
    
    
    
    
    
    
    $
    (60,000
    )
    
    $
    89,000
    
    
    $
    485,000
  2006
    
    
    2005Deferred tax assets:Reserves currently nondeductible
    
    $
    1,347,000
    
    
    $
    1,614,000U.S. net operating loss carryforwards
    
    
    88,627,000
    
    
    
    83,153,000State net operating loss carryforwards
    
    
    529,000
    
    
    
    2,167,000Capital loss carryforwards
    
    
    
    
    
    
    987,000Tax credit carryforwards
    
    
    3,239,000
    
    
    
    3,033,000Stock-based compensation
    
    
    2,361,000
    
    
    
    1,540,000Start-up costs
    
    
    87,000
    
    
    
    96,000Intangible assets
    
    
    4,045,000
    
    
    
    4,731,000Depreciable assets
    
    
    1,809,000
    
    
    
    1,981,000Other assets
    
    
    3,771,000
    
    
    
    238,000Total deferred tax assets
    
    
    105,815,000
    
    
    
    99,540,000Less valuation allowance
    
    
    (105,767,000
    )
    
    
    (99,325,000
    )Net deferred tax assets
    
    
    48,000
    
    
    
    215,000Deferred tax liability:Prepaid Interest
    
    
    (13,000
    )
    
    
    (180,000
    )Net deferred income taxes
    
    $
    35,000
    
    
    $
    35,000
    F-40




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##### Table of Contents



21. Employee Benefit Plan
 4 01(k) Plan
 22. Quarterly Results of Operations (Unaudited)
  Quarter EndedMarch 31
    
    
    June 30
    
    
    September 30
    
    
    December 312006Revenues
    
    $
    3,895,000
    
    
    $
    4,209,000
    
    
    $
    4,710,000
    
    
    $
    5,544,000Cost of revenues
    
    
    (3,375,000
    )
    
    
    (3,090,000
    )
    
    
    (3,131,000
    )
    
    
    (2,956,000
    )Net loss
    
    
    (6,874,000
    )
    
    
    (5,086,000
    )
    
    
    (4,151,000
    )
    
    
    (3,397,000
    )Basic and diluted net loss per
common share
    
    
    (0.14
    )
    
    
    (0.09
    )
    
    
    (0.07
    )
    
    
    (0.06
    )2005Revenues
    
    $
    3,583,000
    
    
    $
    3,449,000
    
    
    $
    3,484,000
    
    
    $
    3,448,000Cost of revenues
    
    
    (3,891,000
    )
    
    
    (3,508,000
    )
    
    
    (3,580,000
    )
    
    
    (3,215,000
    )Net loss
    
    
    (9,572,000
    )
    
    
    (8,915,000
    )
    
    
    (14,481,000
    )
    
    
    (10,628,000
    )Basic and diluted net loss per
common share
    
    
    (0.30
    )
    
    
    (0.28
    )
    
    
    (0.40
    )
    
    
    (0.24
    )
  
    
    In the second quarter of 2006 the Company recognized a $2,930,000 gain on revaluation of
derivative liabilities recorded as a result of April 2006 private placement of common stock
(see Note 15).
    
    In the second quarter of 2006 the Company paid the remaining $5,000,000 balance of its
convertible promissory note payable ahead of the maturity date, recording a loss of $871,000
on the extinguishment of the note (see Note 14).
    
    In the third quarter of 2006 the Company recognized a $1,120,000 gain on revaluation of
derivative liabilities recorded as a result of April 2006 private placement of common stock
(see Note 15).
  
    
    In the first quarter of 2005 the Company sold its MI/WI product lines to CyberGuard,
resulting in a gain of $1,035,000 (see Note 6). The MI/WI product line revenues were
$637,000 in the first quarter of 2005.
    
    The interest expense incurred in the second, third, and fourth quarters of 2005 includes
amortization of a beneficial conversion feature totaling $2,518,000 resulting from the April
2005 restructuring of the $20,000,000 convertible promissory note payable (see Note 14).
    
    In third quarter of 2005 the Company sold its MyDocOnline product (Dr. Chart) to MITEM,
resulting in a loss of $4,751,000 (see Note 6). Dr. Chart contributed revenues of $70,000,
$125,000, and $135,000 in the first, second, and third quarter of 2005, respectively.
 F-41




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23. Subsequent Events
       F-42