<PAGE>

--------------------------------------------------------------------------------

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                              ---------------------

                                    FORM 10-Q

                              ---------------------

(Mark One)

|X|   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934

                  For the quarterly period ended June 30, 2001

                                       OR

|_|   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: 0-30863

                              ---------------------

                              NETWORK ENGINES, INC.
             (Exact name of registrant as specified in its charter)

               Delaware                                 04-3064173
    (State or other jurisdiction of                  (I.R.S. Employer
            incorporation)                          Identification No.)

        25 Dan Road, Canton, MA                            02021
    (Address of principal executive                      (Zip Code)
               offices)

                                 (781) 332-1000
              (Registrant's telephone number, including area code)

                              ---------------------

      Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period than the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No

      As of July 31, 2001, there were 35,132,226 shares of the registrant's
Common Stock, par value $.01 per share, outstanding.

--------------------------------------------------------------------------------
<PAGE>

                              NETWORK ENGINES, INC.

                                      INDEX

                                                                           PAGE
                                                                          NUMBER
                                                                          ------

                     PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

        CONDENSED CONSOLIDATED BALANCE SHEETS ...........................    2
        CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS .................    3
        CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS .................    4
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS ............    5

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
        AND FINANCIAL CONDITION .........................................   10

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
        RISK ............................................................   27

                       PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS ...............................................   28

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS .......................   28

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS .............   28

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ................................   28

SIGNATURES ..............................................................   29

EXHIBIT INDEX ...........................................................   30
<PAGE>

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

                              NETWORK ENGINES, INC.
                      CONDENSED CONSOLIDATED BALANCE SHEETS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                           June 30,    September 30,
                                                                             2001           2000
                                                                         -----------   -------------
<S>                                                                       <C>            <C>
                                 ASSETS                                  (unaudited)

Current assets:
     Cash and cash equivalents ........................................   $  81,672      $ 112,382
     Restricted cash ..................................................       1,098             47
     Accounts receivable, net of allowances ...........................       1,918         11,805
     Inventories ......................................................         733          6,600
     Prepaid expenses and  other current assets .......................         464          1,031
     Due from contract manufacturer ...................................         311          7,113
                                                                          ---------      ---------

        Total current assets ..........................................      86,196        138,978

Property and equipment, net ...........................................       6,221          7,098
Goodwill and intangible assets ........................................       2,097             --
Other assets ..........................................................         106            136
                                                                          ---------      ---------

            Total assets ..............................................   $  94,620      $ 146,212
                                                                          =========      =========

                 LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
     Accounts payable .................................................   $   3,306      $   6,906
     Due to contract manufacturer .....................................       4,726             --
     Accrued compensation and other related benefits ..................         905          1,773
     Other accrued expenses ...........................................         806          1,077
     Deferred revenue .................................................         144            827
     Current portion of capital lease obligations and notes payable ...          59             63
                                                                          ---------      ---------

        Total current liabilities .....................................       9,946         10,646

Capital lease obligations and notes payable, net of current portion ...          30             90

Stockholders' equity:
     Preferred stock ..................................................          --             --
     Common stock .....................................................         351            342
     Additional paid-in capital .......................................     178,630        171,314
     Accumulated deficit ..............................................     (82,219)       (23,915)
     Notes receivable from stockholders ...............................        (919)           (94)
     Deferred stock compensation ......................................     (11,199)       (12,171)
                                                                          ---------      ---------

        Total stockholders' equity ....................................      84,644        135,476
                                                                          ---------      ---------

            Total liabilities and stockholders' equity ................   $  94,620      $ 146,212
                                                                          =========      =========
</TABLE>

          The accompanying notes are an integral part of the condensed
                       consolidated financial statements.


                                       2
<PAGE>

                              NETWORK ENGINES, INC.
                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                      (in thousands, except per share data)
                                   (unaudited)

<TABLE>
<CAPTION>
                                                                          Three months ended June 30,   Nine months ended June 30,
                                                                          ---------------------------   --------------------------
                                                                               2001        2000              2001        2000
                                                                             --------    --------          --------    --------
<S>                                                                          <C>         <C>               <C>         <C>
Net product revenues .....................................................   $  2,130    $ 11,853          $ 11,129    $ 21,872
Net license revenues .....................................................        250       2,666               661       3,113
                                                                             --------    --------          --------    --------
    Total net revenues ...................................................      2,380      14,519            11,790      24,985

Cost of revenues:
    Cost of product revenues (excluding stock compensation) ..............      2,158       8,916            10,804      15,714
    Cost of license revenues (excluding stock compensation) ..............          2          17                 4          24
    Cost of revenues from stock compensation .............................         80          84               251         159
    Inventory write-down (recovery) ......................................     (2,837)         --            20,820          --
                                                                             --------    --------          --------    --------

    Total cost of revenues ...............................................       (597)      9,017            31,879      15,897
                                                                             --------    --------          --------    --------

      Gross profit (loss) ................................................      2,977       5,502           (20,089)      9,088

Operating expenses:
    Research and development .............................................      3,067       2,063            10,909       5,147
    Selling and marketing ................................................      4,156       5,485            16,548      10,112
    General and administrative ...........................................      1,238       1,120             5,691       2,311
    Stock compensation ...................................................      2,217         954             4,844       1,755
    Amortization of goodwill and intangible assets .......................        225          --               600          --
    Restructuring and other charges ......................................      2,812          --             2,812          --
    Loss on retirement of property and equipment .........................         --          --             1,203          --
                                                                             --------    --------          --------    --------

      Total operating expenses ...........................................     13,715       9,622            42,607      19,325
                                                                             --------    --------          --------    --------

Loss from operations .....................................................    (10,738)     (4,120)          (62,696)    (10,237)
Interest income, net .....................................................      1,098         204             4,392         514
                                                                             --------    --------          --------    --------

Net loss .................................................................     (9,640)     (3,916)          (58,304)     (9,723)

Accretion of redeemable convertible preferred stock ......................         --      (3,396)               --      (7,655)
                                                                             --------    --------          --------    --------

Net loss attributable to common stockholders .............................   $ (9,640)   $ (7,312)         $(58,304)   $(17,378)
                                                                             ========    ========          ========    ========

Net loss per common share - basic and diluted ............................   $  (0.28)   $  (1.66)         $  (1.71)   $  (4.59)
                                                                             ========    ========          ========    ========

Shares used in computing net loss per common share - basic and diluted ...     34,436       4,413            34,159       3,784
</TABLE>

          The accompanying notes are an integral part of the condensed
                       consolidated financial statements.


                                       3
<PAGE>

                              NETWORK ENGINES, INC.
                 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)
                                   (unaudited)

<TABLE>
<CAPTION>
                                                                                                      Nine months ended June 30,
                                                                                                      --------------------------
                                                                                                          2001           2000
                                                                                                       ---------       --------
<S>                                                                                                    <C>             <C>
Cash flows from operating activities:
     Net loss ...................................................................................      $ (58,304)      $ (9,723)
     Adjustments to reconcile net loss to net cash used in
      operating activities:
         Depreciation and amortization ..........................................................          2,957            669
         Provision for inventory reserve, net ...................................................         20,820            559
         Provision for doubtful accounts ........................................................            665             90
         Stock compensation .....................................................................          5,279          1,914
         Interest on note receivable from stockholder ...........................................            (13)            (3)
         Loss on retirement of property and equipment ...........................................          1,203             --
         Changes in operating assets and liabilities, net of effects of acquisition:
             Accounts receivable ................................................................          9,222         (5,944)
             Inventories ........................................................................        (14,953)        (8,026)
             Prepaid expenses and other current assets ..........................................            595         (1,013)
             Due from contract manufacturer .....................................................          6,802             --
             Accounts payable ...................................................................         (3,804)         8,536
             Due to contract manufacturer .......................................................          4,726             --
             Accrued expenses ...................................................................         (1,145)         1,452
             Deferred revenue ...................................................................           (683)         1,216
                                                                                                       ---------       --------

                Net cash used in operating activities ...........................................        (26,633)       (10,273)

Cash flows from investing activities:
     Purchases of property and equipment ........................................................         (2,626)        (5,239)
     Deposit of restricted cash .................................................................         (1,051)          (279)
     Decrease (increase) in other assets ........................................................             30            (50)
     Cash of business acquired, net of acquisition expenses .....................................            (30)            --
                                                                                                       ---------       --------

                Net cash used in investing activities ...........................................         (3,677)        (5,568)

Cash flows from financing activities:
     Proceeds from notes payable ................................................................             --          2,205
     Payments on capital lease obligations and notes payable ....................................            (64)        (2,271)
     Issuance of stockholders' notes receivable .................................................           (812)            --
     Proceeds from issuance of common stock .....................................................            476            379
     Proceeds from issuance of redeemable convertible preferred stock, net of issuance costs ....             --         25,168
                                                                                                       ---------       --------

                Net cash provided by (used in) financing activities .............................           (400)        25,481
                                                                                                       ---------       --------

Net increase (decrease) in cash and cash equivalents ............................................        (30,710)         9,640
Cash and cash equivalents, beginning of period ..................................................        112,382          1,435
                                                                                                       ---------       --------

Cash and cash equivalents, end of period ........................................................      $  81,672       $ 11,075
                                                                                                       =========       ========
</TABLE>

          The accompanying notes are an integral part of the condensed
                       consolidated financial statements.


                                       4
<PAGE>

                              NETWORK ENGINES, INC.

              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

      The accompanying condensed consolidated financial statements have been
prepared by Network Engines, Inc. ("Network Engines" or the "Company") in
accordance with generally accepted accounting principles and pursuant to the
rules and regulations of the Securities and Exchange Commission. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to such rules and regulations. These financial
statements should be read in conjunction with the audited financial statements
and the accompanying notes included in the Company's 2000 Annual Report on Form
10-K/A filed by the Company with the Securities and Exchange Commission.

      The information furnished reflects all adjustments, which, in the opinion
of management, are of a normal recurring nature and are considered necessary for
a fair presentation of results for the interim periods. It should also be noted
that results for the interim periods are not necessarily indicative of the
results expected for the full year or any future period.

      The preparation of these condensed consolidated financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. The most significant estimates included in the
financial statements are inventory valuation, accounts receivable and sales
allowances and the recoverability of intangible assets. Actual results could
differ from those estimates.

2. SIGNIFICANT ACCOUNTING POLICIES

Recent Accounting Pronouncements

      In December 1999, the Securities and Exchange Commission released Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB
101"). This bulletin summarizes certain views of the staff of the Securities and
Exchange Commission (the "Staff") on applying generally accepted accounting
principles to revenue recognition in financial statements. The Staff believes
that revenue is realized or realizable and earned when all of the following
criteria are met: persuasive evidence of an arrangement exists; delivery has
occurred or services have been rendered; the seller's price to the buyer is
fixed or determinable; and collectibility is reasonably assured. In June 2000,
the Staff issued Staff Accounting Bulletin No. 101B, "Second Amendment: Revenue
Recognition in Financial Statements," ("SAB 101B"). SAB 101B delays the
implementation of SAB 101 until the fourth quarter of the Company's fiscal year
2001. The Company does not expect the application of SAB 101 to have a material
impact on the Company's financial position or results of operations.

      In June 2001, the Financial Accounting Standards Board issued SFAS No. 141
("SFAS 141"), "Business Combinations" and SFAS No. 142 ("SFAS 142"), "Goodwill
and Other Intangible Assets." SFAS 141 requires that all business combinations
be accounted for under the purchase method only and that certain acquired
intangible assets in a business combination be recognized as assets apart from
goodwill. SFAS 142 requires, among other things, the cessation of the
amortization of goodwill. In addition, the standard includes provisions for the
reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the identification of reporting units for purposes of assessing potential future
impairments of goodwill. SFAS 142 also requires the completion of a transitional
goodwill impairment test six months from the date of adoption. SFAS 141 is
effective for all business combinations initiated after June 30, 2001. SFAS 142
is effective for the Company's fiscal quarters beginning on October 1, 2002;
early adoption is not permitted. The Company is currently assessing the impact
of adopting SFAS 142 on its financial position and results of operations.


                                       5
<PAGE>

                              NETWORK ENGINES, INC.

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

Comprehensive Loss

      During each period presented, comprehensive loss was equal to net loss.

Segment Reporting

      During each period presented, the Company operated in a single business
segment, primarily in the United States.

3. NET LOSS PER SHARE

      Basic net loss per share is computed by dividing the net loss attributable
to common stockholders for the period by the weighted average number of shares
of common stock outstanding during the period, excluding shares of common stock
subject to repurchase by the Company ("restricted shares"). Diluted net loss per
share is computed by dividing the net loss attributable to common stockholders
for the period by the weighted average number of shares of common stock and
potential common stock outstanding during the period, if dilutive. Potential
common stock includes restricted shares and incremental shares of common stock
issuable upon the exercise of stock options and warrants and upon conversion of
redeemable convertible preferred stock. Because the inclusion of potential
common stock would be anti-dilutive for all periods presented, diluted net loss
per share is the same as basic net loss per share.

      The following table sets forth the potential common stock excluded from
the calculation of net loss per common share because their inclusion would be
anti-dilutive (in thousands):

                                                                   As of
                                                                  June 30,
                                                            --------------------
                                                             2001          2000
                                                            ------        ------

Options to purchase common stock ....................        6,034         3,729
Warrants to purchase common stock ...................        1,625         1,869
Unvested restricted common stock ....................          458           594
Redeemable convertible preferred stock ..............           --        21,448
                                                            ------        ------

                                                             8,117        27,640
                                                            ======        ======

4. INVENTORIES

      Inventories consisted of the following (in thousands):

                                                    June 30,       September 30,
                                                      2001             2000
                                                    --------       -------------
Raw materials ............................           $  248           $3,524
Work in process ..........................               86              847
Finished goods ...........................              399            2,229
                                                     ------           ------

                                                     $  733           $6,600
                                                     ======           ======

5. CONTINGENCIES


                                       6
<PAGE>

                              NETWORK ENGINES, INC.

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

      On December 29, 1999, a former employee, George Flate, commenced a lawsuit
against the Company, former officers and a current director in Suffolk Superior
Court, a Massachusetts state court. Mr. Flate alleges that he was unlawfully
terminated as Vice President of OEM Sales in an effort to deprive him of
commission payments. Mr. Flate is seeking undisclosed damages based on two
contractual claims relating to his employment, although the Company anticipates
that Mr. Flate will claim damages in the multi-million dollar range.
Specifically, Mr. Flate is alleging a breach of the implied covenant of good
faith and fair dealing against the Company and a claim of intentional
interference with contractual relations against the former officers of the
company named in the lawsuit. Both of these claims are based on Mr. Flate's
allegations that he is entitled to commissions from several transactions that
were negotiated after Mr. Flate was no longer with the Company. Mr. Flate was
employed by the Company for approximately one year. Currently, the matter is in
the early stages of discovery. Although the Company believes that these claims
are without merit and the Company intends to vigorously defend against each
claim asserted in the complaint, an adverse resolution of either of these claims
could require the payment of substantial monetary damages. Moreover, the
Company's defense against these claims might result in the expenditure of
significant financial and managerial resources.

6. ACQUISITION OF IP PERFORMANCE

      On November 8, 2000, the Company completed its acquisition of IP
Performance, Inc. ("IP Performance"), a developer of network acceleration
technology, through the exchange of 128,693 shares of Network Engines common
stock for all outstanding shares of IP Performance capital stock. The
acquisition was accounted for using the purchase method of accounting.
Accordingly, the fair market value of the acquired assets and assumed
liabilities have been included in the Company's financial statements as of the
acquisition date and the results of IP Performance operations have been included
in the Company's financial statements thereafter. The purchase price of
approximately $2,540,000, assumed net liabilities of approximately $94,000 and
acquisition expenses of approximately $63,000, resulted in goodwill and
intangible assets of approximately $2,697,000. The Company is amortizing the
goodwill and intangible assets over a three-year period. Through June 30, 2001,
the Company amortized approximately $600,000 of goodwill and intangible assets.
The Company's pro forma statements of operations prior to the acquisition would
not differ materially from reported results.

      The Company also issued 321,756 shares of restricted common stock to key
employee shareholders of IP Performance. These shares are restricted as to sale
and such restrictions lapse in three equal annual installments beginning on
November 8, 2001, contingent upon continued employment of the holder. In
connection with the issuance of these restricted shares, the Company recorded
approximately $6,351,000 of deferred compensation, which is being recognized as
stock compensation expense ratably over the vesting period. Through June 30,
2001, the Company recognized approximately $2,474,000 of stock compensation
expense. The amount of stock compensation expense to be recorded in future
periods could change if holders of unvested restricted stock cease to be
employees of the Company prior to the lapse of the vesting period.

7. INVENTORY WRITE-DOWN (RECOVERY)

      During the nine months ended June 30, 2001, the Company recorded a net
inventory write-down of approximately $20,820,000 for excess and obsolete
inventory related to the Company's WebEngine Blazer, WebEngine Sierra and
StorageEngine Voyager products. This excess and obsolete inventory was due to an
unanticipated shortfall in sales of these products and the resulting reduction
in expected future sales of these products. The net write-down included
inventory held at the Company's contract manufacturer, inventory on-hand and
firm purchase commitments as of June 30, 2001. During the three months ended
June 30, 2001, the Company reversed approximately $2,837,000 of inventory
reserves recorded during the six months ended March 31, 2001. The reversal was
the result of the Company's better-than-expected sales of products and
components during the quarter ended June 30, 2001, as well as more favorable
negotiations with vendors on inventory commitments, which had been included in
the previously recorded inventory write-down.


                                       7
<PAGE>

                              NETWORK ENGINES, INC.

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

8. RESTRUCTURING AND OTHER CHARGES

      In April 2001, as a result of the effect that the recent economic
down-turn has had on the Company and its customers' information technology
spending, the Company announced and implemented a restructuring plan to align
the Company's operating expenses and cash requirements with current market
conditions. This plan included a reduction in the Company's workforce from 243
employees to 170 employees, the curtailment of a planned expansion into
currently leased facilities, the consolidation of international operations, a
reduction of marketing programs and other items. The Company recorded a charge
in the amount of approximately $951,000 for employee related costs including
severance payments to terminated employees and stock option compensation expense
related to modifications of certain stock options held by terminated employees.
In addition, the Company recorded a charge of approximately $1,331,000 to write
off certain assets related to facilities that the Company will not be occupying.
The Company also recorded an additional charge of approximately $530,000
primarily related to non-refundable deposits on tradeshows the Company will not
be attending as well as certain other sales and marketing commitments. The
following table sets forth restructuring reserve activity during the three
months ended June 30, 2001:

<TABLE>
<CAPTION>
                                                                       Employee   Facility
                                                 Related    Related     Other      Total
                                                 -------    -------    --------   -------
<S>                                              <C>        <C>        <C>        <C>
Restructuring charge                             $   951    $ 1,331    $   530    $ 2,812

Cash payments                                       (678)       (99)      (119)      (896)

Non-cash utilization                                (184)    (1,194)      (277)    (1,655)
                                                 -------    -------    -------    -------
Restructuring reserve balance at June 30, 2001   $    89    $    38    $   134    $   261
                                                 =======    =======    =======    =======
</TABLE>

      The Company expects the remaining restructuring accrual balance to be
fully utilized by December 31, 2001, which will include cash payments of
approximately $261,000.

9. RETIREMENT OF PROPERTY AND EQUIPMENT

      During the nine months ended June 30, 2001, the Company retired fixed
assets related to its WebEngine Blazer product line. These fixed assets had a
total net book value of approximately $1,203,000 and consisted primarily of
computer equipment previously utilized in the production and sales of the
WebEngine Blazer, the Company's previous generation web content appliance server
product.

10. RELATED PARTY TRANSACTIONS

      In January 2001, the Company entered into a series of related agreements
with Lawrence A. Genovesi, the Company's current Chairman and former Chief
Technology Officer and Chief Executive Officer. These agreements were entered
into in order to avoid significant sales of the Company's stock by Mr. Genovesi
as a result of a margin call on a personal loan that was collateralized by Mr.
Genovesi's holdings of the Company's common stock. The Company agreed to
guarantee a personal loan obtained by Mr. Genovesi from a financial institution
(the "Bank") through a deposit of $1,051,850 of the Company's cash with the Bank
(the "Guarantee"). The Guarantee period ends on January 9, 2002 and the balance
of the amount deposited with the Bank will be returned to the Company. Mr.
Genovesi and the Company also entered into an agreement whereby Mr. Genovesi has
agreed to reimburse the Company for any obligations incurred by the Company
under the Guarantee (the "Reimbursement Agreement"). Any unpaid balances under
the


                                       8
<PAGE>

                              NETWORK ENGINES, INC.

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

Reimbursement Agreement bear interest at a rate of 10% per annum. In the event
of a default of the Reimbursement Agreement by Mr. Genovesi, the Company has the
right to apply any and all compensation due to Mr. Genovesi against all of Mr.
Genovesi's obligations outstanding under the Reimbursement Agreement. In
addition, the Company and Mr. Genovesi entered into a revolving promissory note
of up to $210,000 (the "Note"). The Note bears interest at a rate of 5.9% per
annum and is due and payable in full upon the earlier of January 9, 2002 or 30
days following the date Mr. Genovesi ceases to be an employee of the Company.

      In conjunction with the Guarantee, the Reimbursement Agreement and the
Note, the Company and Mr. Genovesi entered into a pledge agreement whereby Mr.
Genovesi pledged to the Company all shares of the Company's common stock owned
by Mr. Genovesi as of the date of the agreement or subsequently acquired, and
all options and other rights to acquire shares of the Company's common stock
owned by Mr. Genovesi as of the date of the agreement or subsequently acquired
(collectively the "Pledged Securities"). Additionally, Mr. Genovesi pledged to
the Company all additional securities or other consideration from time to time
acquired by Mr. Genovesi in substitution for, or in respect of, the Pledged
Securities. If Mr. Genovesi elects to sell any of the Pledged Securities during
the term of the agreement, all proceeds of such sale will be applied first to
any outstanding obligations related to the Note and then to any amounts payable
under the Reimbursement Agreement. In addition to the Pledged Securities, the
Note is collateralized by a second mortgage on certain real property owned by
Mr. Genovesi. As of June 30, 2001, approximately $75,000 was outstanding under
the Note (included in the balance sheet as notes receivable from stockholders)
and no amounts were required to be reimbursed to the Company under the
Reimbursement Agreement.

      In April 2001, the Company entered into full recourse loan agreements with
certain current and former employees and certain current and former executive
officers of the Company (the "Loan Agreements"). These loan agreements were
entered into to avoid substantial sales of the Company's common stock by these
employees and executive officers as a result of alternative minimum tax
obligations incurred by these employees and executive officers. The total amount
loaned to these employees and executive officers under the Loan Agreements was
approximately $737,000. Outstanding amounts under the Loan Agreements accrue
interest at a rate of 4.63% per annum and are due and payable in full upon the
earlier of one year from the date of each individual agreement or thirty days
after termination of employment with the Company, unless termination is
involuntary and without cause. In conjunction with the Loan Agreements, each
employee and executive officer pledged all shares of capital stock of the
Company now owned, or acquired in the future, (the "Pledged Stock"), and any
distributions on the Pledged Stock or proceeds from their sale. Amounts due
under these Loan Agreements have been included in the balance sheet as notes
receivable from stockholders.

11. SUBSEQUENT EVENTS

      In July 2001, the Company announced a restructuring plan to realign its
organization and change its business strategy and approach to the appliance
server market. As a result of this plan, the Company is de-emphasizing much of
its customized hardware and software and transitioning from primarily direct
sales channels to indirect sales channels and expects to reduce its workforce
from approximately 160 employees to 95 employees. The Company expects to record
a restructuring charge to operations of approximately $7,000,000 in the three
months ended September 30, 2001. The Company expects this restructuring charge
to be comprised of approximately $2.5 million of cash payments, primarily
severance and employee related, and approximately $4.5 million of write-offs of
impaired assets.

      On August 14, 2001, the Company announced that its board of directors had
approved a $5 million stock repurchase program. The stock repurchase program
will be carried out over time in open market transactions at prevailing market
prices, or in non-solicited privately negotiated transactions, beginning on or
about August 17, 2001.


                                       9
<PAGE>

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION

Special Note Regarding Forward-looking Statements

      This form 10-Q contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended, that involve
risks and uncertainties. All statements other than statements of historical
information provided herein are forward-looking statements and may contain
information about financial results, economic conditions, trends and known
uncertainties. Our actual results could differ materially from those discussed
in the forward-looking statements as a result of a number of factors, which
include those discussed in this section and elsewhere in this report and the
risks discussed in our other filings with the Securities and Exchange
Commission. Readers are cautioned not to place undue reliance on these
forward-looking statements, which reflect management's analysis, judgment,
belief or expectation only as of the date hereof. We undertake no obligation to
publicly reissue these forward-looking statements to reflect events or
circumstances that arise after the date hereof.

      The following discussion and analysis should be read in conjunction with
the condensed consolidated financial statements and the notes thereto included
in Item 1 in this Quarterly Report on Form 10-Q and our 2000 Annual Report on
Form 10-K/A filed by the Company with the Securities and Exchange Commission.

Overview

      When we first entered the market for dense scalable web appliance servers,
we focused our business primarily on providing our scalable web content servers
to Internet-based organizations, content infrastructure providers and larger
enterprises. It was necessary for us to design many of the hardware components,
which went into the server and, as a result, we invested significant resources
in the development of our products. In June 1999, we introduced our first
generation of web servers, the WebEngine Blazer. Since the introduction of our
WebEngine Blazer product, we experienced significant growth as we invested in
the development of our technology and products, the recruitment and training of
personnel for our engineering, sales and marketing and technical support
departments, and the establishment of an administrative organization. As a
result, our employee base grew from 39 as of June 30, 1999 to 244 as of March
31, 2001, and our operating expenses grew significantly.

      Over time, much of the hardware components of appliance servers have
become commoditized and a significant number of companies have entered the
appliance server marketplace. In response to competitive pressures and the
effects of the recent downturn in the economy, we commenced a restructuring plan
in the quarter ended June 30, 2001, to better align our operating expenses with
our reduced revenues. This restructuring plan resulted in a $2.8 million charge
to operations in the April 2001, and included a reduction in our work force to
170 employees, as well as the curtailment of planned facility expansion and
other cost cutting measures. As part of this restructuring plan, we undertook an
extensive review of our business strategy and in July 2001, we announced a
second restructuring of our business to better position us to compete within the
appliance server marketplace. As a result of our July 2001 restructuring, we
will de-emphasize much of our customized software and hardware development and
focus our resources on what we believe to be our core competencies of hardware
packaging and software integration. In addition, this restructuring of our
business includes a transition from primarily direct sales channels to
partnerships with independent software vendors (ISVs) and OEMs in order to offer
"turn-key" appliance server solutions to enterprise customers. The July 2001
restructuring plan includes a reduction in our work force from approximately 160
employees to approximately 95 employees. We expect to incur a charge to
operations of approximately $7 million in the quarter ended September 30, 2001
as we execute our July 2001 restructuring plan. We expect this restructuring
charge to be comprised of approximately $2.5 million of cash payments, primarily
severance and employee related, and approximately $4.5 million of write-offs of
impaired assets. At June 30, 2001, we had an accumulated deficit of
approximately $82.2 million.

      Our revenues are derived from sales of our appliance servers. We recognize
revenues when title to the goods has passed, provided evidence of an arrangement
has been received, no obligations remain


                                       10
<PAGE>

outstanding and collectibility is reasonably assured. The majority of our sales
to date have been to customers in the United States.

      In the past, we generated a portion of our net revenues from license
arrangements, which allowed certain customers to sell our WebEngine Blazer
product under their name in exchange for per unit fees. We recognized license
revenues upon the licensee's sale to its customers. During the nine months ended
June 30, 2001, we recorded approximately $661,000 in license revenues; however,
we do not anticipate future revenues from existing license revenue arrangements.

      Gross profit (loss) represents net revenues recognized less the cost of
revenues. Cost of revenues includes cost of materials, manufacturing costs,
manufacturing personnel expenses, obsolescence charges, packaging, license fees
and shipping and warranty costs. Our gross profit (loss) will be affected
primarily by the mix of product revenues, product pricing, the timing, size and
configuration of customer orders, and new product introductions by us and our
competitors.

      Research and development expenses consist primarily of salaries and
related expenses for personnel engaged in research and development, fees paid to
consultants and outside service providers, material costs for prototype and test
units and other expenses related to the design, development, testing and
enhancements of our products. We expense all of our research and development
costs as they are incurred. We believe that a significant level of investment in
product research and development is required to remain competitive. We expect to
continue to devote substantial resources to product research and development.
However, as a result of our July 2001 restructuring plan, we expect research and
development expenses to decrease in absolute dollars over the remainder of
fiscal 2001 but continue to fluctuate as a percentage of net revenues. After our
July 2001 restructuring, there were 36 employees in research and development
compared to 81 employees at June 30, 2001.

      Selling and marketing expenses consist primarily of salaries, commissions
and related expenses for personnel engaged in sales, marketing and customer
support functions, as well as costs associated with advertising, trade shows,
public relations and marketing materials. As a result of our July 2001
restructuring plan, we expect selling and marketing expenses to decrease in
absolute dollars over the remainder of fiscal 2001 but continue to fluctuate as
a percentage of net revenues. After our July 2001 restructuring, there were 25
employees in sales, marketing and customer support compared to 49 employees at
June 30, 2001.

      General and administrative expenses consist primarily of salaries and
other related costs for executive, finance, accounting, information technology,
facilities and human resources personnel, as well as accounting, legal, other
professional fees and allowance for doubtful accounts. As a result of our July
2001 restructuring plan, we expect these expenses to increase in absolute
dollars over the remainder of fiscal 2001 as we complete the transition of our
organization to our new business strategy, but continue to fluctuate as a
percentage of net revenues. After our July 2001 restructuring, there were 14
general and administrative employees compared to 19 employees at June 30, 2001.

      We have recorded deferred stock compensation on our balance sheet of $15.5
million in connection with stock option and restricted stock grants to our
employees and directors that were granted between February 1, 1999 and June 30,
2000. This amount represents the difference between the exercise price and the
deemed fair value of our common stock for financial reporting purposes at the
date of grant. We are amortizing this stock compensation over the vesting period
of the related options. All options granted subsequent to June 30, 2000 have
been issued with exercise prices equal to the deemed fair market value of the
common stock and, accordingly, no additional deferred compensation has been
recorded. Through June 30, 2001, we amortized $5.6 million to stock compensation
expense and $2.5 million of deferred stock compensation has been reversed due to
the cancellation of options for terminated employees.

      We recorded $6.4 million of deferred compensation on our balance sheet as
a result of restricted stock issued to the employees of IP Performance, Inc.
("IP Performance") retained as our employees in connection with our acquisition
of IP Performance in November 2000. The restricted stock vests annually through
November 2003 and is contingent upon continued employment. Through June 30,
2001, we amortized $2.5 million to stock compensation expense.


                                       11
<PAGE>

During the next twelve months, after reversing deferred compensation to
employees terminated in the July 2001 restructuring plan, we expect to amortize
stock compensation of:

                                                              Expected
                                                            Amortization
                                                              of Stock
Fiscal Quarter Ending                                       Compensation
---------------------                                       ------------
                                                           (in thousands)
September 30, 2001 .......................................     $1,040
December 31, 2001 ........................................      1,027
March 31, 2002 ...........................................      1,021
June 30, 2002 ............................................      1,021

      We expect aggregate per quarter stock compensation amortization of
approximately $1.0 million during the remainder of fiscal 2002 and fiscal 2003
and an aggregate of approximately $1.0 million thereafter. The amount of stock
compensation expense to be recorded in future periods could change if restricted
common stock, or options, for accrued but unvested compensation are forfeited.

Results of Operations

      The following table sets forth financial data for the periods indicated as
a percentage of net revenues:

<TABLE>
<CAPTION>
                                                                              Three months ended  Nine months ended
                                                                                   June 30,            June 30,
                                                                              ------------------  -----------------
                                                                                2001     2000       2001     2000
                                                                                ----     ----       ----     ----
<S>                                                                             <C>       <C>       <C>       <C>
Net revenues ................................................................    100%     100%       100%     100%

Cost of revenues:
     Cost of product revenues (excluding stock compensation) ................     91       61         92       63
     Cost of license revenues (excluding stock compensation) ................     --       --         --       --
     Cost of revenues stock compensation ....................................      3        1          2        1
     Inventory write-down (recovery)  .......................................   (119)      --        176       --
                                                                                ----     ----       ----     ----

     Total cost of revenues .................................................    (25)      62        270       64
                                                                                ----     ----       ----     ----

        Gross profit (loss) .................................................    125       38       (170)      36

Operating expenses:
     Research and development ...............................................    129       14         93       21
     Selling and marketing ..................................................    175       38        140       40
     General and administrative .............................................     52        8         48        9
     Stock compensation .....................................................     93        6         41        7
     Amortization of goodwill and intangible assets .........................      9       --          5       --
     Restructuring and other charges ........................................    118       --         24       --
     Loss on retirement of property and equipment ...........................     --       --         10       --
                                                                                ----     ----       ----     ----

        Total operating expenses ............................................    576       66        361       77
                                                                                ----     ----       ----     ----

Loss from operations ........................................................   (451)     (28)      (531)     (41)
Interest income, net ........................................................     46        1         37        2
                                                                                ----     ----       ----     ----

Net loss ....................................................................   (405%)    (27%)     (494%)    (39%)
                                                                                ====     ====       ====     ====
</TABLE>

Three Months Ended June 30, 2001 and June 30, 2000


                                       12
<PAGE>

Net Revenues

      Net revenues decreased to $2.4 million in the three months ended June 30,
2001 from $14.5 million in the three months ended June 30, 2000. The decrease is
due primarily to a decrease in product sales volumes as a result of the general
economic slowdown, which significantly impacted the information technology
spending of our traditional "new economy" customer base. To a lesser extent, the
decline in net revenues is the result of a decrease in license revenues and to a
lower average selling price of our products due to increased competitive pricing
pressure. We do not expect significant future license revenues.

Gross Profit (Loss)

      Gross profit (loss) decreased to a profit of $3.0 million for the three
months ended June 30, 2001 from a profit of $5.5 million in the three months
ended June 30, 2000. This decrease is primarily due to the decrease in license
revenues and, to a lesser extent, lower average selling prices and lower sales
volumes. The decline in gross profit (loss) was offset by a reversal of $2.8
million of inventory reserves recognized during the three months ended June 30,
2001. This inventory reversal was due primarily to better-than-expected sales of
products and components as well as favorable negotiations with vendors regarding
inventory commitments previously reserved for. Excluding this inventory reserve
reversal, gross profit (loss), in the three months ended June 30, 2001, was a
profit of $140,000, which is attributable to license revenues of $250,000.

Operating Expenses

      Research and Development. Research and development expenses increased to
$3.1 million in the three months ended June 30, 2001 from $2.1 million in the
three months ended June 30, 2000. This increase was due primarily to increased
compensation costs as research and development personnel increased from 49
employees at June 30, 2000 to 81 employees at June 30, 2001. The increase in
research and development expenses was offset by a decrease in prototype and test
unit costs as well as decreases in consulting and recruiting.

      Selling and Marketing. Selling and marketing expenses decreased to $4.2
million in the three months ended June 30, 2001 from $5.5 million in the three
months ended June 30, 2000. This decrease was due primarily to decreased
compensation costs as sales, marketing and customer support personnel decreased
from 60 employees at June 30, 2000 to 49 employees at June 30, 2001. To a lesser
extent, the decrease in selling and marketing expenses is also attributable to
decreased advertising costs and a decrease in recruiting costs.

      General and Administrative. General and administrative expenses increased
to $1.2 million in the three months ended June 30, 2001 from $1.1 million in the
three months ended June 30, 2000. This increase was due primarily to increased
insurance costs as a result of the Company's July 2000 initial public offering.
To a lesser extent, the increase in general and administrative expenses was due
to increased facilities costs as a result of the Company's move into its Canton,
MA headquarters in May 2000, which were somewhat offset by decreases in
recruiting costs.

      Stock Compensation. We recognized stock compensation expense of $705,000
and $1.0 million in the three months ended June 30, 2001 and 2000, respectively,
related to the grant of options and restricted stock to employees and directors
during fiscal 1999 and prior to our initial public offering in fiscal 2000. In
connection with restricted stock issued to employees as a result of our
acquisition of IP Performance, Inc., we recorded deferred stock compensation of
$6.4 million, of which we recognized $1.6 million as stock compensation expense
during the three months ended June 30, 2001.


                                       13
<PAGE>

      Amortization of Goodwill and Intangible Assets. In connection with our
acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and
intangible assets of $2.7 million, of which we amortized $225,000 in the three
months ended June, 2001.

      Restructuring and Other Charges. As a result of our April 2001
restructuring, we recorded a charge to operations of $2.8 million. This charge
was due to a reduction in our workforce from 243 employees to 170 employees, the
curtailment of a planned expansion into leased facilities and other items. This
restructuring was to better align our operating expenses with reduced revenues.
This charge included approximately $951,000 for employee related costs including
severance payments to terminated employees and stock option compensation expense
related to modifications of certain stock options held by terminated employees,
approximately $1,331,000 to write off certain assets related to facilities that
we will not be occupying and approximately $530,000 primarily related to
non-refundable deposits on tradeshows the Company will not be attending as well
as certain other sales and marketing commitments. In July 2001, we announced a
second restructuring and expect to record a charge to operations of
approximately $7.0 million. Our July 2001 restructuring is the result of an
intensive review of our business and includes a re-focus of our resources on
hardware packaging and software integration and away from the custom hardware
and software development that we had done in the past.

Interest income, net

      Interest income, net increased to $1.1 million in the three months ended
June 30, 2001 from $204,000 in the three months ended June 30, 2000. This
increase was due to the investment of the net proceeds from our initial public
offering in July 2000.

Nine Months Ended June 30, 2001 and June 30, 2000

Net Revenues

      Net revenues decreased to $11.8 million in the nine months ended June 30,
2001 from $25.0 million in the nine months ended June 30, 2000. The decrease is
due primarily to a decrease in product sales volumes as a result of the general
economic slowdown and its impact on the information technology spending of our
traditional "new economy" customer base. To a lesser extent, the decline in net
revenues during the nine months ended June 30, 2001 is the result of a decrease
in license revenues recognized as well as a lower average selling price of our
products due to increased competitive pricing pressure.

Gross Profit (Loss)

      Gross profit (loss) decreased to a loss of ($20.1) million for the nine
months ended June 30, 2001 from a profit of $9.1 million in the nine months
ended June 30, 2000. This decrease is primarily attributable to a charge of
approximately $20.8 million to write-down excess and obsolete inventory in the
nine months ended June 30, 2001, for which there was no comparable charge in the
nine months ended June 30, 2000. The inventory write-down resulted from an
unanticipated decline in sales during the nine months ended June 30, 2001 as
well as a high level of inventory, and firm inventory commitments, compared to
the Company's reduced expectations for future product sales. Excluding the
inventory write-down, and stock compensation, gross profit (loss) decreased to a
profit of $982,000, or 8% of net revenues, in the nine months ended June 30,
2001 from a profit of $9.2 million, or 37% of net revenues, in the nine months
ended June 30, 2000. This decrease was primarily due to the decrease in product
sales volumes and a decrease in license revenues recognized during the nine
months ended June 30, 2001. To a lesser extent, the decrease in gross profit
(loss) is the result of a lower average selling price of our products due to
competitive pricing pressure in the nine months ended June 30, 2001.

Operating Expenses

      Research and Development. Research and development expenses increased to
$10.9 million in the nine months ended June 30, 2001 from $5.1 million in the
nine months ended June 30, 2000. This increase was due primarily to increased
compensation costs as research and development personnel increased from 49
employees at June 30, 2000 to 81 employees at June 30, 2001. To a lesser extent,
the increase in research


                                       14
<PAGE>

and development expenses was due to increased prototype and test unit costs and
higher consulting costs related to development efforts associated with the
development of new products released during the nine months ended June 30, 2001.

      Selling and Marketing. Selling and marketing expenses increased to $16.5
million in the nine months ended June 30, 2001 from $10.1 million in the nine
months ended June 30, 2000. This increase was due primarily to increased
compensation costs as we increased our sales, marketing and customer support
personnel to a peak of 98 employees during the nine months ended June 30, 2001
from 60 employees at June 30, 2000. As of June 30, 2001, we had approximately 49
employees in our sales, marketing and customer support organization. To a lesser
extent, the increase in selling and marketing expenses is also attributable to
increased travel costs associated with the increase in sales, marketing and
customer support personnel as well as increased advertising costs.

      General and Administrative. General and administrative expenses increased
to $5.7 million in the nine months ended June 30, 2001 from $2.3 million in the
nine months ended June 30, 2000. This increase was due primarily to increased
compensation costs as general and administrative personnel increased from 24
employees at June 30, 2000 to a peak of 34 employees during the nine months
ended June 30, 2001 and ended at 19 employees as of June 30, 2001. In addition,
this increase was due to increased professional service fees and insurance costs
associated with our operation as a public company and increased bad debt
expense. To a lesser extent, the increase was due to increase consulting costs
associated with the expansion of our information technology infrastructure.

      Stock Compensation. We recognized stock compensation expense of $2.6
million and $1.9 million in the nine months ended June 30, 2001 and 2000,
respectively, related to the grant of options and restricted stock to employees
and directors during fiscal 1999 and prior to our initial public offering in
fiscal 2000. In connection with restricted stock issued to employees as a result
of our acquisition of IP Performance, Inc., we recorded deferred stock
compensation of $6.4 million, of which we recognized $2.5 million as stock
compensation expense during the nine months ended June 30, 2001.

      Amortization of Goodwill and Intangible Assets. In connection with our
acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and
intangible assets of $2.7 million, of which we amortized $600,000 in the nine
months ended June 30, 2001.

      Loss on Retirement of Property and Equipment. In the nine months ended
June 30, 2001, we retired fixed assets related to our WebEngine Blazer product
line. These fixed assets had a total net book value of approximately $1,203,000
and consisted primarily of computer equipment previously utilized in the
production and sales of the WebEngine Blazer, our previous generation web
content appliance server product.

Interest income, net

      Interest income, net increased to $4.4 million in the nine months ended
June 30, 2001 from $514,000 in the nine months ended June 30, 2000. This
increase was due to the investment of the net proceeds from our initial public
offering in July 2000.

Liquidity and Capital Resources

      Since fiscal 1997, we have financed our operations primarily through the
sale of equity securities, borrowings and the sale of our products. On July 18,
2000, we completed our initial public offering by selling 7,475,000 shares of
our common stock, including the exercise of the underwriters' overallotment
option of 975,000 shares, at $17 per share and raised approximately $116.9
million, net of offering costs and underwriting fees totaling approximately
$10.2 million. Prior to our initial public offering, we raised approximately
$37.3 million, net of offering costs, from the issuance of preferred stock. As
of June 30, 2001, we had $81.7 million in cash and cash equivalents, excluding
restricted cash of $1.1 million.


                                       15
<PAGE>

      Cash used in operating activities was $26.6 million and $10.3 million in
the nine months ended June 30, 2001 and 2000, respectively. Cash used in
operating activities during the nine months ended June 30, 2001 was primarily
due to a net loss of $58.3 million, an increase in inventories and decreases in
accounts payable and accrued expenses, offset in part by a decrease in accounts
receivable and a net increase in the amount due to our contract manufacturer and
adjusted for non-cash charges for inventory reserves, stock compensation,
depreciation and amortization and a loss on the retirement of property and
equipment. Cash used in operations during the six months ended June 30, 2000 was
primarily due to a net loss of $9.7 million and increases in inventories,
accounts receivable and prepaid expenses, offset in part by increases in
accounts payable, accrued expenses and deferred revenue and adjusted for charges
for depreciation, inventory reserves and stock-based compensation.

      Cash used in investing activities was $3.7 million and $5.6 million in the
nine months ended June 30, 2001 and 2000, respectively. Cash used in investing
activities was primarily for purchases of property and equipment, deposits of
restricted cash for an executive loan guarantee and an increase in other assets
during the nine months ended June 30, 2001. For the nine months ended June 30,
2000, cash used in investing activities was primarily for purchases of property
and equipment and leasehold improvements to our headquarters in Canton,
Massachusetts.

      Cash used in financing activities was $400,000 during the nine months
ended June 30 2001 and cash provided by financing activities was $25.5 million
in the nine months ended June 30, 2001. Cash used in financing activities in the
nine months ended June 30, 2001 was primarily through the issuance of notes to
stockholders, offset in part by cash provided by the issuance of common stock
from the exercise of stock options and through our employee stock purchase plan.
Cash provided by financing activities in the nine months ended June 30, 2000 was
primarily from the sale of our series D preferred stock through which we raised
net proceeds of approximately $25.2 million.

      In connection with our April 2001 restructuring, we are obligated to make
additional cash payments of approximately $261,000 over the next two quarters.
In connection with the July 2001 restructuring, we have committed to actions
which will require cash payments of approximately $2.5 million, the majority of
which will be made over the next two quarters. We anticipate that funds required
to make all restructuring payments will be available from its current working
capital.

      Our future liquidity and capital requirements will depend upon numerous
factors, including:

      o     the successful transition of our sales distribution focus from
            direct sales to strategic partnerships with independent software
            vendors and OEM's;

      o     the costs and timing of product engineering efforts and the success
            of these efforts;

      o     the costs involved in maintaining and enforcing intellectual
            property rights;

      o     market developments; and

      o     other factors.

      We believe that our available cash resources, including cash and cash
equivalents, together with cash we expect to generate from sales of our products
will be sufficient to meet our debt service, operating and capital requirements
through at least the next 12 months. After that, we may need to raise additional
funds. We may seek to raise additional funds through borrowings, public or
private equity financings or from other sources. There can be no assurance that
additional financing will be available at all or, if available, will be on terms
acceptable to us. If additional financing is needed and is not available on
acceptable terms, we would need to reduce our operating expenses.


                                       16
<PAGE>

Recent Accounting Pronouncements

      In December 1999, the Securities and Exchange Commission released Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB
101"). This bulletin summarizes certain views of the staff of the Securities and
Exchange Commission (the "Staff") on applying generally accepted accounting
principles to revenue recognition in financial statements. The Staff believes
that revenue is realized or realizable and earned when all of the following
criteria are met: persuasive evidence of an arrangement exists; delivery has
occurred or services have been rendered; the seller's price to the buyer is
fixed or determinable; and collectibility is reasonably assured. In June 2000,
the Staff issued Staff Accounting Bulletin No. 101B, "Second Amendment: Revenue
Recognition in Financial Statements," ("SAB 101B"). SAB 101B delays the
implementation of SAB 101 until the fourth quarter of the Company's fiscal year
2001. The Company does not expect the application of SAB 101 to have a material
impact on the Company's financial position or results of operations.

      In June 2001, the Financial Accounting Standards Board issued SFAS No. 141
("SFAS 141"), "Business Combinations" and SFAS No. 142 ("SFAS 142"), "Goodwill
and Other Intangible Assets." SFAS 141 requires that all business combinations
be accounted for under the purchase method only and that certain acquired
intangible assets in a business combination be recognized as assets apart from
goodwill. SFAS 142 requires, among other things, the cessation of the
amortization of goodwill. In addition, the standard includes provisions for the
reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the identification of reporting units for purposes of assessing potential future
impairments of goodwill. SFAS 142 also requires the completion of a transitional
goodwill impairment test six months from the date of adoption. SFAS 141 is
effective for all business combinations initiated after June 30, 2001. SFAS 142
is effective for the Company's fiscal quarters beginning on October 1, 2002;
early adoption is not permitted. The Company is currently assessing the impact
of adopting SFAS 142 on its financial position and results of operations.


                                       17
<PAGE>

                FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

      The risks and uncertainties described below are not the only ones we are
faced with. Additional risks and uncertainties not presently known to us, or
that are currently deemed immaterial, may also impair our business operations.
If any of the following risks actually occur, our financial condition and
operating results could be materially adversely affected.

                         Risks Related to Restructuring

We have recently announced plans to restructure our business. There can be no
assurance that these plans will have the intended effect on our business.

      On July 31, 2001, we announced plans to restructure our business. These
plans include a considerable reduction in our workforce and our future operating
expenses and an adjustment to our business plan to concentrate our resources on
our core competencies, which include hardware platform packaging and integration
and the ability to integrate our hardware platforms with various operating
systems, management systems and application software systems. Our restructuring
plans also include a transition from primarily direct sales channels to
partnerships with independent software vendors and OEMs in order to offer
"turn-key" solutions for enterprise customers. There can be no assurance that
these restructuring plans will have a positive effect on our financial results,
our market share, the market price of our common stock or public perception of
us in the appliance server marketplace, or that we will ever achieve substantial
revenues, each of which could cause further decline in the market price of our
common stock.

                Risks Related to Competition Within Our Industry

If we are not able to effectively compete against providers of general-purpose
servers or specific-purpose servers, our revenues will not increase and may
decrease further.

      In the market for appliance servers, we face significant competition from
larger companies who market general-purpose or specific-purpose servers and have
greater financial resources and name recognition than we do. Many of these
companies have larger and more established service organizations to support
these products. These and other large competitors may be able to leverage their
existing resources, including their service organizations, and provide a wider
offering of products and higher levels of support on a more cost-effective basis
than we can. In addition, competing companies may be able to undertake more
extensive promotional activities, adopt more aggressive pricing policies and
offer more attractive terms to their customers than we can. If these large
competitors provide lower cost appliance servers with greater functionality or
support than our products, or if some of their products are comparable to ours
and are offered as part of a range of products that is broader than ours, our
products could become undesirable. Even if the functionality of competing
products is equivalent to ours, we face a substantial risk that a significant
number of customers would elect to pay a premium for similar functionality
rather than purchase products from a less-established vendor. Increased
competition may continue to negatively affect our business and future operating
results by leading to price reductions, higher selling expenses or a reduction
in our market share.

Our revenues could be reduced if general-purpose server, or specific-purpose
server, manufacturers make acquisitions in order to join their extensive
distribution capabilities with our smaller competitors' products.

      Compaq, Dell, Hewlett-Packard, IBM, Sun Microsystems, Network Appliance
and other server manufacturers may not only develop their own appliance server
solutions, but they may also acquire or establish cooperative relationships with
our other current competitors, including smaller private companies. Because
general-purpose server, and certain specific-purpose server, manufacturers have
significant financial and organizational resources available, they may be able
to quickly penetrate the appliance server market by leveraging the technology
and expertise of smaller companies and utilizing their own extensive
distribution channels. For example, Cobalt, an appliance server company was
acquired by Sun


                                       18
<PAGE>

Microsystems in December 2000. We expect that the appliance server industry will
experience further consolidation. It is possible that new competitors or
alliances among competitors may emerge and rapidly acquire significant market
share through consolidation.

We may sell fewer products if other vendors' products are no longer compatible
with ours or other vendors bundle their products with those of our competitors
and sell them at lower prices.

      Our ability to sell our products depends in part on the compatibility of
our products with other vendors' software and hardware products. Developers of
these products may change their products so that they will no longer be
compatible with our products. These other vendors may also decide to bundle
their products with other appliance servers for promotional purposes and
discount the sales price of the bundle. If that were to happen, our business and
future operating results could suffer if we were no longer able to offer
commercially viable products.

If we fail to successfully transition our customer base to strategic
partnerships with independent software vendors and OEM's, our operations could
be materially adversely affected.

      To date, our revenues have been principally derived from smaller companies
in the Internet marketplace, otherwise known as "new economy" customers. As a
component of our July 2001 announced restructuring plans, we will focus our
sales and marketing efforts on strategic partnerships with independent software
vendors and OEM's. This strategy may fail to generate sufficient revenues to
offset the demands that this strategy will place on our business. A failure to
successfully transition our revenues to strategic partnerships could materially
adversely affect our operations.

Appliance server products are subject to rapid technological change due to
changing operating system software and network hardware and software
configurations, and our sales will suffer if our products are rendered obsolete
by new technologies.

      The appliance server market is characterized by rapid technological
change, frequent new product introductions and enhancements, potentially short
product life cycles, changes in customer demands and evolving industry
standards. Our products could be rendered obsolete if products based on new
technologies are introduced or new industry standards emerge.

      New products and product enhancements can require long development and
testing periods, which requires us to hire and retain scarce, technically
competent personnel. Significant delays in new product releases or significant
problems in installing or implementing new products could seriously damage our
business. We have on occasion experienced delays in the scheduled introduction
of new and enhanced products and cannot be certain that we will avoid similar
delays in the future.

      Our future success depends upon our ability to utilize our creative
packaging and hardware and software integration skills to combine industry
standard hardware and software to produce low-cost, high-performance products
that satisfy our strategic partners' requirements and achieve market acceptance.
We cannot be certain that we will successfully identify new product
opportunities and develop and bring new products to market in a timely and
cost-effective manner.

                     Risks Related to Our Financial Results

We are an early-stage company in the evolving market for appliance servers.

      Because of our limited operating history in the appliance server market,
it is difficult to discern trends that may emerge and affect our business. We
may experience negative trends associated with seasonality that, due to our
limited operating history, we have not experienced in the past. In the past, it
was necessary for us to custom design almost all of the hardware in our
appliance servers. To date, these products have not obtained significant market
acceptance and, as the appliance server market has evolved, much of the
hardware, and software, has become standardized. As a result, we have decided to
de-emphasize our focus on customized hardware and software and to develop
appliance servers using more standardized hardware and software. We can not be
sure whether our future product offerings



                                       19
<PAGE>

will obtain market acceptance, whether they will capture adequate market share
or whether we will be able to recognize significant revenue from them. Our
limited historical financial performance may make it difficult for you to
evaluate the success of our business to date and to assess its future viability.

      If our customers do not purchase our future products, our revenues and
operating results will be adversely affected. Factors that may affect the market
acceptance of our products, some of which are beyond our control, include the
following:

      o     the growth and changing requirements of the appliance server market;

      o     the performance, quality, price and total cost of ownership of our
            products;

      o     the availability, price, quality and performance of competing
            products and technologies; and

      o     the successful development of our relationships with existing and
            potential channel partners.

We have a history of losses and expect to experience losses in the future, which
could result in the market price of our common stock declining.

      Since our inception, we have incurred significant net losses, including
net losses of $4.2 million, $5.8 million and $12.5 million in fiscal 1998, 1999
and 2000, respectively, as well as net losses of $9.6 million and $58.3 million
in the three and nine-month periods ended June 30 2001, respectively. We expect
to have net losses in the future. In addition, we had an accumulated deficit of
$82.2 million as of June 30, 2001. We believe that our future growth depends
upon the success of our new product development and selling and marketing
efforts, which will require us to incur significant product development, selling
and marketing and administrative expenses. As a result, we will need to generate
significant revenues to achieve profitability. We cannot be certain that we will
achieve profitability in the future or, if we achieve profitability, that we
will be able to sustain it. If we do not achieve and maintain profitability, the
market price for our common stock may continue to decline.

      We anticipate that our expenses will decrease through at least the
remainder of the current fiscal year as a result of our recently announced
restructuring plans as we curtail discretionary selling, general and
administrative expenses, consolidate our international operations, defer our
expansion into Asia, implement new business strategies to efficiently maximize
our resources and utilize other cost saving methods. If these, or other cost
control measures that we may employ, are unsuccessful, our expenses could
increase and our losses could be greater than expected, which could negatively
impact the market price for our common stock.

Our revenues have fallen sharply recently and we may not be able to return to
our historical revenue growth rates, which could cause our stock price to
decline even further.

      Our revenues grew rapidly in fiscal 1999 and fiscal 2000 and fell sharply
in the nine months ended June 30, 2001. We are unable to predict whether or not
we will be able to return to the rate of revenue growth achieved in fiscal 1999
and fiscal 2000 because of uncertain economic conditions, growing competition,
the incremental manner in which customers implement appliance servers and our
recently announced transition from primarily direct sales channels to indirect
channels. If we are unable to return to the rate of revenue growth we
experienced in fiscal 1999 and fiscal 2000, our stock price could experience
further declines.

If the commodification of products and competition in the appliance server
market increases, then the average unit price of our products may decrease and
our operating results may suffer.

      Products in the appliance server market may be subject to further
commodification as the industry matures and other businesses introduce more
competing products. The average unit price of some of our products


                                       20
<PAGE>

has already decreased, and may continue to decrease, in response to changes in
product mix, competitive pricing pressures, or new product introductions by us
or our competitors. If we are unable to offset decreases in our average selling
prices by increasing our sales volumes, our revenues will decline. Changes in
the mix of sales of our products, including the mix of higher margin sales of
products sold in smaller quantities and somewhat lower margin sales of products
sold in larger quantities, could adversely affect our operating results for
future quarters. To improve our gross margins, we also must reduce the
manufacturing cost of our products. Our efforts to produce higher margin
products, continue to improve our products and produce new products may make it
difficult to reduce our manufacturing cost per product. Further, our current
reliance on our single manufacturer, SCI Systems, may not allow us to reduce our
cost per product.

Our quarterly revenues and operating results may fluctuate due to a lack of
growth of the appliance server market in general or failure of our products to
achieve market acceptance.

      Our quarterly revenues and operating results are difficult to predict and
may fluctuate significantly from quarter to quarter because appliance servers
generally, and our current products in particular, are relatively new and the
future growth of the market for our products is uncertain. In addition, we
expect to rely on additional new products for growth in our net revenues in the
future. If the appliance server market in general fails to grow as expected or
our products fail to achieve market acceptance, our quarterly net revenues and
operating results may fall below the expectations of investors and public market
research analysts. In this event, the price of our common stock could decline.

We expect to continue to derive a substantial portion of our revenues from a
small number of customers, and our financial results may suffer significantly if
major customers do not purchase of our products.

      A relatively small number of customers accounted for a significant portion
of our net revenues. In fiscal 1999, sales to three customers accounted for 46%,
28% and 14% of net revenues. In fiscal 2000, sales to two customers accounted
for 16% and 12% of net revenues. In the three months ended June 30, 2001, sales
to two customers accounted for 11% each of net revenues. None of our customers
is obligated to purchase any quantity of our products in the future. As a result
of our recently announced restructuring, we will focus primarily on partnerships
with independent software vendors and OEMs and we will significantly de-
emphasize our sales to end-user customers. Accordingly, we expect to derive a
substantial portion of our future revenues from a small number of independent
software vendors and OEMs. If we are unsuccessful in partnering with substantial
independent software vendors and OEMs, our financial results may be adversely
affected, our reputation in the industry may suffer and our ability to predict
cash flow accurately may decrease.

     Risks Related to the Growth of the Appliance Server Market and the
Internet.

If appliance servers are not increasingly adopted as a means to deliver
on and conduct commerce over the Internet, the market for our products
may not grow and the market price for our common stock could decline as a result
of lower revenues or reduced investor expectations.

      We expect that substantially all of our revenues will come from sales of
our newest and future appliance server products. As a result, we depend on the
growing use of appliance servers as a means to deliver information and conduct
commerce over the Internet. The market for appliance server products,
particularly those using the Internet to deliver information and process
commercial transactions, has only recently begun to develop and is evolving
rapidly. Because this market is new, we cannot predict its potential size or
future growth rate. Our revenues may not grow and the market price for our
common stock could decline if the appliance server market does not grow rapidly.

      We believe that our expectations for the growth of the appliance server
market may not be fulfilled if customers continue to use general-purpose
servers. The role of our appliance servers could, for example, be limited if
general-purpose servers become better at performing functions currently being
performed by our appliance servers or are offered at a lower cost. This could
force us to further lower the prices of our products or result in fewer sales of
our products.


                                       21
<PAGE>

If the market for appliance server products does not grow because medium to
large Internet service providers and application service providers in our target
market are not receptive to them, our revenues may not grow.

      Large Internet service providers and application service providers that
offer hosting services may not be as receptive to our products as other
organizations because they currently rely on, and their buying programs are more
likely to be based on, established, proprietary operating systems and
general-purpose servers. In addition, we expect that Internet service providers
that specialize in providing Internet access and non-hosting services to
consumers will not be substantial purchasers of our products. Consolidation has
begun to occur in the Internet service provider and application service provider
market, with many large Internet service providers and application service
providers acquiring smaller and regional companies. Continued consolidation in
this market could result in some of our customers being absorbed into larger
organizations. This consolidation may increase the number of larger corporations
that may not be as receptive to our products and, as a result, our revenues
would not grow and may even decrease.

Potential increases or changes in governmental regulation of Internet
communication and commerce could discourage the growth of the Internet, which
could decrease the demand for our products.

      Due to concerns arising from the increasing use of the Internet, a number
of laws and regulations have been, and may be, adopted covering issues including
user privacy, taxation, pricing, acceptable content and quality of products and
services. Legislative changes could dampen the growth in use of the Internet
generally and decrease the acceptance of the Internet as a communications and
commercial medium. Further, due to the global nature of the Internet, it is
possible that multiple federal, state or foreign jurisdictions might attempt to
regulate Internet transmissions or levy sales or other taxes relating to
Internet-based activities. Moreover, the applicability to the Internet of
existing laws, including laws governing property ownership, libel and personal
privacy, is uncertain. We cannot assess the possible negative impact of any
future regulation of the Internet on our business.

                Risks Related to Our Marketing and Sales Efforts

We need to effectively manage our sales and marketing operations to continue to
increase market awareness and sales of our products. If we fail to do so, our
growth, if any, will be limited.

      Through our recent restructuring plans, we significantly reduced our
selling and marketing personnel in an attempt to reduce operating expenses and
to conserve cash. Although we have fewer selling and marketing personnel, we
must continue to increase market awareness and sales of our products. If we fail
in this endeavor, our growth, if any, will be limited.

Our efforts to promote our brand may not result in the desired brand recognition
by customers or in increased sales.

      In the fast growing market for appliance servers, we believe we need a
strong brand to compete successfully. In order to attract and retain customers,
we believe that our brand must be recognized and viewed favorably by our
customers and end users. As part of our recent restructuring plans, we reduced
our marketing programs. If we are unable to design and implement effective
marketing campaigns or otherwise fail to promote and maintain our brand, our
sales may not increase and our business may be adversely affected. Our business
may also suffer if we incur excessive expenses promoting and maintaining our
brand but fail to achieve the expected or desired increase in revenues.

If we are unable to effectively manage our customer service and support
activities, we may not be able to retain our existing customers and attract new
customers.

      We have a small customer service and support organization. We need to
effectively manage our customer support operations to ensure that we maintain
good relationships with our customers. If our customer support organization is
unsuccessful in maintaining good customer relationships, we may lose customers
to


                                       22
<PAGE>

our competitors and our reputation in the market could be damaged. As a result,
we may lose revenue and incur losses greater than expected.

                   Risks Related to Our Product Manufacturing

We rely on a single contract manufacturer to produce our products, which could
have an adverse affect on our operations.

      Our agreement with SCI Systems does not guarantee production levels,
manufacturing line space or manufacturing prices. In addition, our agreement
with SCI renews annually and allows either party to elect not to renew the
agreement. If we are required to, or if we choose to, change outside
manufacturers, we may experience transitional difficulties and we may lose sales
and customer relationships may suffer. In addition, in the event that we require
additional manufacturing capacity, SCI Systems may not have additional
facilities available when we need them. Commencing volume production or
expanding production to another facility owned by SCI Systems may be expensive
and time-consuming. In addition, commencement of the manufacturing of our
products at additional SCI Systems manufacturing sites we may need in the future
may cause transitional problems, including delays and quality control issues,
which could cause us to lose sales and impair our ability to achieve
profitability. We may need to find new outside manufacturers to manufacture our
products in higher volume and at lower costs to meet increased demand and
competition.

      In addition, Sanmina Corporation and SCI Systems have recently announced
their plans to merge. There can be no assurance as to the effect, positive or
negative, that this merger will have on the operation of SCI as it relates to
our agreement with them.

If we do not accurately forecast our component requirements, our business and
operating results could be adversely affected.

      We use rolling forecasts based on anticipated product orders to determine
our component requirements. Lead times for materials and components that we
order vary significantly and depend on factors including specific supplier
requirements, contract terms and current market demand for those components. In
addition, a variety of factors, including the timing of product releases,
potential delays or cancellations of orders and the timing of large orders, make
it difficult to predict product orders. As a result, our component requirement
forecasts may not be accurate. If we overestimate our component requirements, we
may have excess inventory, which would increase our costs. If we underestimate
our component requirements, we may have inadequate inventory, which could
interrupt our manufacturing and delay delivery of our products to our customers.
Any of these occurrences would negatively impact our business and operating
results.

Our dependence on sole source and limited source suppliers for key components
makes us susceptible to supply shortages that could prevent us from shipping
customer orders on time, if at all, and could result in lost sales or customers.

      We depend upon single source and limited source suppliers for our
industry-standard processors and power supplies and our printed circuit boards,
chassis and sheet metal parts. We also depend on limited sources to supply
several other industry-standard components. We have in the past experienced, and
may in the future experience, shortages of, or difficulties in acquiring,
components needed to produce our products. Shortages have been of limited
duration and have not yet caused delays in production of our products. However,
shortages in supply of these key components for an extended time would cause
delays in the production of our products, prevent us from satisfying our
contractual obligations and meeting customer expectations, and result in lost
sales or customers. If we are unable to buy components we need or if we are
unable to buy components at acceptable prices, we will not be able to
manufacture and deliver our products on a timely or cost-effective basis to our
customers.


                                       23
<PAGE>

 Risks Related to Our Products' Dependence on Intellectual Property and Our Use
                                  of Our Brand

Our reliance upon contractual provisions and domestic trademark laws to protect
our proprietary rights may not be sufficient to protect our intellectual
property from others who may sell similar products.

      Our products are differentiated from those of our competitors by our
internally developed software and hardware and the manner in which they are
integrated into our products. If we fail to protect our intellectual property,
other vendors could sell products with features similar to ours, and this could
reduce demand for our products. We believe that the steps we have taken to
safeguard our intellectual property afford only limited protection. Others may
develop technologies that are similar or superior to our technology or design
around the copyrights and trade secrets we own. Despite the precautions we have
taken, laws and contractual restrictions may not be sufficient to prevent
misappropriation of our technology or deter others from developing similar
technologies.

      In addition, the laws of the countries in which we decide to market our
services and solutions may offer little or no effective protection of our
proprietary technology. Reverse engineering, unauthorized copying or other
misappropriation of our proprietary technology could enable third-parties to
benefit from our technology without paying us for it, which would significantly
harm our business.

We have invested substantial resources in developing our products and our brand,
and our operating results would suffer if we were subject to a protracted
infringement claim or one with a significant damages award.

      Substantial litigation regarding intellectual property rights and brand
names exists in our industry. We expect that appliance server products may be
increasingly subject to third-party infringement claims as the number of
competitors in our industry segment grows and the functionality of products in
different industry segments overlaps. We are not aware that our products employ
technology that infringes any proprietary rights of third parties. However,
third parties may claim that we infringe their intellectual property rights. Any
claims, with or without merit, could:

      o     be time-consuming to defend;

      o     result in costly litigation;

      o     divert our management's attention and resources;

      o     cause product shipment delays; or

      o     require us to enter into royalty or licensing agreements.

      Royalty or licensing agreements may not be available on terms acceptable
to us, if at all. A successful claim of product infringement against us or our
failure or inability to license the infringed or similar technology could
adversely affect our business because we would not be able to sell the impacted
product without redeveloping it or incurring significant additional expenses.

                       Other Risks Related to Our Business

If we do not retain our senior management, we may not be able to successfully
execute our business plan.

      As a result of our recent restructurings, we have lost members of our
management team. The loss of key members of our current management team could
harm us. Our success is substantially dependent on the ability, experience and
performance of these members of our senior management team. Because of their
ability and experience, we may not be able to implement successfully our
business strategy, if we lose one or more of these members.


                                       24
<PAGE>

If we fail to retain a significant number of qualified technical personnel, we
may not be able to develop and introduce our products on a timely basis.

      We require the services of a substantial number of qualified technical
personnel. The market for qualified personnel is characterized by intense
competition, as well as a high level of employee mobility, which makes it
particularly difficult to attract and retain the qualified technical personnel
we require. We have experienced the negative effects of an economic slowdown.
Our revenues have declined significantly during the past six months and the
market price of our common stock has decreased significantly. As a result, we
have undertaken plans to substantially reduce our operating expenditures,
including a reduction in the number of personnel in our organization. This
reduction in personnel places added pressure on the remaining employees and
management of the Company. These and other factors may make it difficult for us
to retain the qualified employees and management that we need to effectively
manage our business operations, including key research and development
activities. If we are unable to retain a sufficient number of technical
personnel we may not be able to complete development of, or upgrade or enhance,
our products in a timely manner, which could negatively impact our business and
could hinder any future growth.

If the market price of our common stock is not quoted on a national exchange,
our ability to raise future capital may be hindered and the market price of our
common stock may be negatively impacted.

      The market price for our common stock has significantly declined recently
and our common stock failed to achieve a closing bid price of one dollar for a
period of thirty days. As a result, we received notification from the NASDAQ
stock market that, if our common stock failed to maintain a closing bid price of
one dollar or greater for a period of ten trading days prior to and including
October 29, 2001, then there is the potential that our common stock could be
de-listed from the NASDAQ National Market. If our common stock is de-listed from
the NASDAQ National Market, we may experience difficulties in raising future
capital, if needed, to continue our business operations. In addition, in the
event that the market price of our common stock is not quoted on the NASDAQ
National Market, our stock price may be further negatively impacted.

If we cannot manage our international operations profitably, our revenues may
not increase and our business and results of operations would be adversely
affected.

      We have limited experience managing an international sales operation.
There are risks and complexities inherent in conducting international
operations, including, for example, longer payment cycles, local labor laws and
practices and the complexity of complying with additional regulatory
requirements. Any of these factors, and our inexperience, may limit our ability
to profitably manage our international operations and, consequently, our
business and results of operations may suffer.

If our products fail to perform properly and conform to our specifications, our
customers may demand refunds or assert claims for damages and our reputation and
operating results may suffer.

      Because our appliance server products are complex, they could contain
errors or bugs that can be detected at any point in a product's life cycle. In
the past we have discovered errors in some of our products and have experienced
delays in the shipment of our products during the period required to correct
these errors or we have had to replace defective products that were already
shipped. These delays and replacements have principally related to new product
releases. Errors in our products may be found in the future and any of these
errors could be significant. Detection of any significant errors may result in:

      o     the loss of or delay in market acceptance and sales of our products;

      o     diversion of development resources;

      o     injury to our reputation; or

      o     increased maintenance and warranty costs.

      These problems could harm our business and future operating results.
Product errors or delays could be material, including any product errors or
delays associated with the introduction of new products or the versions of our
products that support Windows or UNIX-based operating systems. If our products
fail to conform to warranted specifications, customers could demand a refund for
the purchase price or assert claims for damages.

      Moreover, because our products are used in connection with critical
distributed computing systems services, we may receive significant liability
claims if our products do not work properly. Our agreements with customers
typically contain provisions intended to limit our exposure to liability claims.
However, these limitations may not preclude all potential claims. Liability
claims could exceed our insurance coverage and require us to spend significant
time and money in litigation or to pay significant damages.


                                       25
<PAGE>

Any claims for damages, whether or not successful, could seriously damage our
reputation and our business.

Our stock may be subject to substantial price and volume fluctuations due to a
number of factors, many of which will be beyond our control that may prevent our
stockholders from reselling our common stock at a profit.

      The securities markets have experienced significant price and volume
fluctuations in the past and the market prices of the securities of technology
companies have been especially volatile. This market volatility, as well as
general economic, market or political conditions, could reduce the market price
of our common stock in spite of our operating performance. In addition, our
operating results could be below the expectations of public market analysts and
investors, and in response the market price of our common stock could decrease
significantly. Investors may be unable to resell their shares of our common
stock for a profit. In the past, companies that have experienced volatility in
the market price of their stock have been the object of securities class action
litigation. If we were the object of securities class action litigation, it
could result in substantial costs and a diversion of management's attention and
resources. The recent decline in the market price of our common stock and market
conditions generally could adversely affect our ability to raise additional
capital, to complete future acquisitions of or investments in other businesses
and to attract and retain qualified technical and sales and marketing personnel.

We have anti-takeover defenses that could delay or prevent an acquisition and
could adversely affect the price of our common stock.

      Our board of directors has the authority to issue up to 5,000,000 shares
of preferred stock and, without any further vote or action on the part of the
stockholders, will have the authority to determine the price, rights,
preferences, privileges and restrictions of the preferred stock. This preferred
stock, if issued, might have preference over the rights of the holders of common
stock and could adversely affect the price of our common stock. The issuance of
this preferred stock may make it more difficult for a third party to acquire us
or to acquire a majority of our outstanding voting stock. We currently have no
plans to issue preferred stock.

      In addition, provisions of our second amended and restated certificate of
incorporation, second amended and restated by-laws and equity compensation plans
may deter an unsolicited offer to purchase Network Engines. These provisions,
coupled with the provisions of the Delaware General Corporation Law, may delay
or impede a merger, tender offer or proxy contest involving Network Engines. For
example, our board of directors will be divided into three classes, only one of
which will be elected at each annual meeting. These factors may further delay or
prevent a change of control of our business.

Future sales by existing stockholders could depress the market price of our
common stock.

      Sales of a substantial number of shares of our common stock by existing
stockholders could depress the market price of our common stock and impair our
ability to raise capital through the sale of additional equity securities.


                                       26
<PAGE>

We may need additional capital that may not be available to us and, if raised,
may dilute our existing investors' ownership interest in us.

      We may need to raise additional funds to develop or enhance our services
and solutions, to fund expansion, to respond to competitive pressures or to
acquire complementary products, businesses or technologies. Additional financing
may not be available on terms that are acceptable to us. If we raise additional
funds through the issuance of equity or convertible debt securities, the
percentage ownership of our stockholders would be reduced and these securities
might have rights, preferences and privileges senior to those of our current
stockholders. If adequate funds are not available on acceptable terms, our
ability to fund our expansion, take advantage of unanticipated opportunities,
develop or enhance products or services, or otherwise respond to competitive
pressures would be significantly limited.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

      We do not engage in any foreign currency hedging transactions and
therefore, do not believe we are subject to material exchange rate risk. We are
exposed to market risk related to changes in interest rates. We invest excess
cash balances in cash equivalents. We believe that the effect, if any, of
reasonably possible near-term changes in interest rates on our financial
position, results of operations and cash flows will not be material.


                                       27
<PAGE>

PART II--OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

      On December 29, 1999, a former employee, George Flate, commenced a lawsuit
against us, a current officer and director and a former officer and director in
Suffolk Superior Court, a Massachusetts state court. Mr. Flate alleges that he
was unlawfully terminated as Vice President of OEM Sales in an effort to deprive
him of commission payments. He is seeking undisclosed damages based on two
contractual claims relating to his employment, although we anticipate he will
claim damages in the multi-million dollar range. Specifically, he is alleging a
breach of the implied covenant of good faith and fair dealing against Network
Engines and a claim of intentional interference with contractual relations
against the current and former officers of the company named in the lawsuit.
Both of these claims are based on Mr. Flate's allegations that he is entitled to
commissions from several transactions that were negotiated after Mr. Flate was
no longer with the company. Mr. Flate was employed by Network Engines for
approximately one year. Currently, the matter is in the early stages of
discovery. Although we believe these claims are without merit and we intend to
vigorously defend against each claim asserted in the complaint, an adverse
resolution of either of these claims could require the payment of substantial
monetary damages. Moreover, our defense against these claims might result in the
expenditure of significant financial and managerial resources.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

      (d)   Use of Proceeds from Sales of Registered Securities

      On July 18, 2000, we sold 7,475,000 shares of our common stock in an
initial public offering at a price of $17.00 per share pursuant to a
Registration Statement on Form S-1 (the "Registration Statement") (Registration
No. 333-34286), which was declared effective by the Securities and Exchange
Commission on July 12, 2000. The aggregate proceeds to us from the offering were
approximately $116.9 million reflecting gross proceeds of $127.0 million net of
underwriting fees of approximately $8.9 million and other offering costs of
approximately $1.3 million. None of the proceeds of the offering was paid by us,
directly or indirectly, to any director, officer or general partner of ours or
any of their associates, to any persons owning ten percent or more of our
outstanding stock, or to any of our affiliates. During the period from the
offering to June 30, 2001, we have used the proceeds as follows: approximately
$31.9 million was used to fund the operations of the Company and approximately
$4.1 million was used for capital acquisitions.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

      No matters were submitted to a vote of security holders during the three
months ended June 30, 2001.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

      (a)   Exhibits

      The exhibits which are filed with this report or which are incorporated by
      reference are set forth in the Exhibit Index hereto.

      (b)   Reports on Form 8-K

      We did not file any reports on Form 8-K during the period covered by this
      report.


                                       28
<PAGE>

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.


                                   NETWORK ENGINES, INC.


Date: August 14, 2001


                                   /s/ John H. Curtis
                                   --------------------------------------------
                                   John H. Curtis
                                   President and Chief Executive Officer
                                   (Principal Executive Officer)


                                   /s/ Douglas G. Bryant
                                   --------------------------------------------
                                   Douglas G. Bryant
                                   Vice President of Administration, Chief
                                   Financial Officer, Treasurer and Secretary
                                   (Principal Financial Officer and Principal
                                   Accounting Officer)


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<PAGE>

                                  EXHIBIT INDEX

Exhibit No.       Exhibit
10.31             Sub-lease agreement dated June 21, 2001, with Techmar
                  Communications, Inc. for 45 Dan Road, Canton, Massachusetts.
10.32             Consent to Sub-lease from Dan Road Buildings, LLC regarding
                  sub-lease agreement for 45 Dan Road, Canton, Massachusetts.


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