##### Table of Contents

---

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 April 30, 2004



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 001-15715



---



TIPPINGPOINT TECHNOLOGIES, INC.



---



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | No.74-2902814                       
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)



7501B North Capital
of Texas Highway

Austin, Texas 78731

(Address of Principal Executive Offices)



Registrants telephone number, including area code: (512) 681-8000



---



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



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



As of May 21, 2004, 7,347,262 shares of the registrants common stock, $0.01 par value, were outstanding.



---



---

##### Table of Contents

TIPPINGPOINT TECHNOLOGIES, INC.

QUARTER ENDED APRIL 30, 2004



TABLE OF CONTENTS



|                               |  |                                                                                                    |  |           
|------------------------------ |  | -------------------------------------------------------------------------------------------------- |  | ----------
|                               |  |                                                                                                    |  | PageNumber
|PART I. FINANCIAL INFORMATION: |  | 1                                                                                                 
|                               |  |                                                                                                   
|Item 1.                        |  | Financial Statements (unaudited)                                                                   |  | 1         
|                               |  |                                                                                                   
|                               |  | Condensed Consolidated Balance Sheets as of April 30, 2004 and January 31, 2004                    |  | 1         
|                               |  |                                                                                                   
|                               |  | Condensed Consolidated Statements of Operations for the three months ended April 30, 2004 and 2003 |  | 2         
|                               |  |                                                                                                   
|                               |  | Condensed Consolidated Statements of Cash Flows for the three months ended April 30, 2004 and 2003 |  | 3         
|                               |  |                                                                                                   
|                               |  | Notes to Condensed Consolidated Financial Statements                                               |  | 4         
|                               |  |                                                                                                   
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations              |  | 7         
|                               |  |                                                                                                   
|Item 3.                        |  | Quantitative and Qualitative Disclosures about Market Risk                                         |  | 24        
|                               |  |                                                                                                   
|Item 4.                        |  | Controls and Procedures                                                                            |  | 25        
|                               | 
|PART II. OTHER INFORMATION:    |  | 25                                                                                                
|                               |  |                                                                                                   
|Item 1.                        |  | Legal Proceedings                                                                                  |  | 25        
|                               |  |                                                                                                   
|Item 6.                        |  | Exhibits and Reports on Form 8-K                                                                   |  | 26        
|                               | 
|Signatures                     |  | 28                                                                                                



---

##### Table of Contents

PART I. FINANCIAL INFORMATION.



ITEM 1. FINANCIAL STATEMENTS.



TIPPINGPOINT TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)



|                                                                                                                                  |  |                |              |   |                  |   |              |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ------------ | - | ---------------- | - | ------------ | -
|                                                                                                                                  |  | April 30, 2004 |              |   | January 31, 2004 |  
|ASSETS                                                                                                                            |  |                |              |   |                  |   |              |  
|Current assets:                                                                                                                   |  |                |              |   |                  |   |              |  
|Cash and cash equivalents                                                                                                         |  | $              | 30,186,352   |   |                  | $ | 33,153,764   |  
|Accounts receivable                                                                                                               |  |                | 2,465,461    |   |                  |   | 1,822,213    |  
|Inventory                                                                                                                         |  |                | 3,843,913    |   |                  |   | 2,485,117    |  
|Prepaid expenses and other current assets                                                                                         |  |                | 1,444,019    |   |                  |   | 2,243,409    |  
|                                                                                                                                  |  |                |              |   |                  |   |              |  
|Total current assets                                                                                                              |  |                | 37,939,745   |   |                  |   | 39,704,503   |  
|                                                                                                                                  |  |               
|Property and equipment, net                                                                                                       |  |                | 2,180,621    |   |                  |   | 2,221,837    |  
|Other                                                                                                                             |  |                | 1,445,886    |   |                  |   | 1,446,936    |  
|                                                                                                                                  |  |                |              |   |                  |   |              |  
|                                                                                                                                  |  | $              | 41,566,252   |   |                  | $ | 43,373,276   |  
|                                                                                                                                  |  |                |              |   |                  |   |              |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                              |  |                |              |   |                  |   |              |  
|Current liabilities:                                                                                                              |  |                |              |   |                  |   |              |  
|Current portion of long-term debt                                                                                                 |  | $              | 608,250      |   |                  | $ | 582,283      |  
|Trade accounts payable                                                                                                            |  |                | 2,414,131    |   |                  |   | 2,031,785    |  
|Deferred revenue                                                                                                                  |  |                | 1,585,489    |   |                  |   | 811,969      |  
|Accrued liabilities                                                                                                               |  |                | 3,960,017    |   |                  |   | 2,878,450    |  
|                                                                                                                                  |  |                |              |   |                  |   |              |  
|Total current liabilities                                                                                                         |  |                | 8,567,887    |   |                  |   | 6,304,487    |  
|                                                                                                                                  |  |               
|Long-term debt                                                                                                                    |  |                | 194,030      |   |                  |   | 420,583      |  
|Deferred revenue, long term                                                                                                       |  |                | 103,133      |   |                  |   |             |  
|Other liabilities                                                                                                                 |  |                | 178,480      |   |                  |   | 216,730      |  
|                                                                                                                                  |  |                |              |   |                  |   |              |  
|Total liabilities                                                                                                                 |  |                | 9,043,530    |   |                  |   | 6,941,800    |  
|                                                                                                                                  |  |                |              |   |                  |   |              |  
|Commitments and Contingencies                                                                                                     |  |                |              |   |                  |   |              |  
|Stockholders equity:                                                                                                             |  |                |              |   |                  |   |              |  
|Common stock, $0.01 par value; 250,000,000 shares authorized; 7,351,933 and 7,335,933 shares issued and outstanding,
respectively |  |                | 73,519       |   |                  |   | 73,359       |  
|Additional paid-in capital                                                                                                        |  |                | 348,959,300  |   |                  |   | 347,950,650  |  
|Deferred stock-based compensation                                                                                                 |  |                | (10,221,076  | ) |                  |   | (10,133,031  | )
|Stockholder notes receivable                                                                                                      |  |                | (652,800     | ) |                  |   | (652,800     | )
|Accumulated deficit                                                                                                               |  |                | (305,636,221 | ) |                  |   | (300,806,702 | )
|                                                                                                                                  |  |                |              |   |                  |   |              |  
|Total stockholders equity                                                                                                        |  |                | 32,522,722   |   |                  |   | 36,431,476   |  
|                                                                                                                                  |  |                |              |   |                  |   |              |  
|                                                                                                                                  |  | $              | 41,566,252   |   |                  | $ | 43,373,276   |  
|                                                                                                                                  |  |                |              |   |                  |   |              |  



See accompanying notes
to condensed consolidated financial statements.



1



---

##### Table of Contents

TIPPINGPOINT TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)



|                                                             |  |                              |            |   |      |   |            |  
|------------------------------------------------------------ |  | ---------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                             |  | Three Months Ended April 30, |           
|                                                             |  | 2004                         |            |   | 2003 |  
|Revenues                                                     |  | $                            | 3,904,683  |   |      | $ | 630,420    |  
|Cost of revenues                                             |  |                              | 1,214,930  |   |      |   | 401,869    |  
|                                                             |  |                              |            |   |      |   |            |  
|Gross margin                                                 |  |                              | 2,689,753  |   |      |   | 228,551    |  
|                                                             |  |                             
|Operating expenses:                                          |  |                              |            |   |      |   |            |  
|Research and development (1)                                 |  |                              | 2,601,180  |   |      |   | 2,385,932  |  
|Sales and marketing (1)                                      |  |                              | 3,394,776  |   |      |   | 1,667,312  |  
|General and administrative (1)                               |  |                              | 771,644    |   |      |   | 744,455    |  
|Amortization of employee deferred stock-based compensation   |  |                              | 834,605    |   |      |   | 124,341    |  
|                                                             |  |                              |            |   |      |   |            |  
|Total operating expenses                                     |  |                              | 7,602,205  |   |      |   | 4,922,040  |  
|                                                             |  |                              |            |   |      |   |            |  
|Operating loss                                               |  |                              | (4,912,452 | ) |      |   | (4,693,489 | )
|                                                             |  |                             
|Interest income, net                                         |  |                              | 82,933     |   |      |   | 99,173     |  
|                                                             |  |                              |            |   |      |   |            |  
|Net loss                                                     |  | $                            | (4,829,519 | ) |      | $ | (4,594,316 | )
|                                                             |  |                              |            |   |      |   |            |  
|Per share data:                                              |  |                              |            |   |      |   |            |  
|Net basic and diluted loss per common share                  |  | $                            | (0.66      | ) |      | $ | (0.87      | )
|Weighted basic and diluted average common shares outstanding |  |                              | 7,345,644  |   |      |   | 5,255,105  |  
|                                                             |  |                              |            |   |      |   |            |  

---

|(1) | Amounts exclude amortization of deferred stock-based compensation as follows:
|--- | -----------------------------------------------------------------------------



|                           |  |                             |         |      |   |        
|-------------------------- |  | --------------------------- | ------- | ---- | - | -------
|                           |  | Three Months EndedApril 30,
|                           |  | 2004                        |         | 2003
|Research and development   |  | $                           | 299,225 |      | $ | 61,341 
|Sales and marketing        |  |                             | 311,704 |      |   | 46,129 
|General and administrative |  |                             | 223,676 |      |   | 16,871 
|                           |  |                             |         |      |   |        
|TOTAL                      |  | $                           | 834,605 |      | $ | 124,341
|                           |  |                             |         |      |   |        



See accompanying notes
to condensed consolidated financial statements.



2



---

##### Table of Contents

TIPPINGPOINT TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)



|                                                                                                              |  |                              |            |   |      |   |            |  
|------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                                                              |  | Three Months Ended April 30, |           
|                                                                                                              |  | 2004                         |            |   | 2003 |  
|Cash flows from continuing operating activities:                                                              |  |                              |            |   |      |   |            |  
|Loss from continuing operations                                                                               |  | $                            | (4,829,519 | ) |      | $ | (4,594,316 | )
|Adjustments to reconcile loss from continuing operations to net cash used in continuing operating activities: |  |                              |            |   |      |   |            |  
|Depreciation and amortization                                                                                 |  |                              | 506,529    |   |      |   | 827,154    |  
|Accretion of investment securities                                                                            |  |                              |           |   |      |   | (3,750     | )
|Stock-based compensation expense                                                                              |  |                              | 834,605    |   |      |   | 183,493    |  
|Changes in operating assets and liabilities:                                                                  |  |                              |            |   |      |   |            |  
|Accounts receivable                                                                                           |  |                              | (643,248   | ) |      |   |           |  
|Inventory                                                                                                     |  |                              | (1,358,796 | ) |      |   | (146,696   | )
|Prepaid expenses and other current assets                                                                     |  |                              | 799,390    |   |      |   | (116,675   | )
|Other non-current assets                                                                                      |  |                              | 1,050      |   |      |   | (6,050     | )
|Deferred revenue                                                                                              |  |                              | 876,653    |   |      |   |           |  
|Trade accounts payable, accrued liabilities and other non- current liabilities                                |  |                              | 1,427,017  |   |      |   | 262,876    |  
|                                                                                                              |  |                              |            |   |      |   |            |  
|Net cash used in continuing operating activities                                                              |  |                              | (2,386,319 | ) |      |   | (3,593,964 | )
|                                                                                                              |  |                              |            |   |      |   |            |  
|Cash flows from investing activities:                                                                         |  |                              |            |   |      |   |            |  
|Purchases of property and equipment                                                                           |  |                              | (465,313   | ) |      |   | (327,138   | )
|Investment securities matured                                                                                 |  |                              |           |   |      |   | 6,064,626  |  
|                                                                                                              |  |                              |            |   |      |   |            |  
|Net cash provided by (used in) investing activities                                                           |  |                              | (465,313   | ) |      |   | 5,737,488  |  
|                                                                                                              |  |                              |            |   |      |   |            |  
|Cash flows from financing activities:                                                                         |  |                              |            |   |      |   |            |  
|Proceeds from borrowings under long-term debt                                                                 |  |                              |           |   |      |   | 72,077     |  
|Increase in restricted cash related to leases                                                                 |  |                              |           |   |      |   | 472,327    |  
|Principal payments on debt                                                                                    |  |                              | (200,586   | ) |      |   | (109,035   | )
|Proceeds from exercise of stock options                                                                       |  |                              | 86,160     |   |      |   | 44,848     |  
|                                                                                                              |  |                              |            |   |      |   |            |  
|Net cash provided by (used in) financing activities                                                           |  |                              | (114,426   | ) |      |   | 480,217    |  
|                                                                                                              |  |                              |            |   |      |   |            |  
|Cash used in discontinued operations                                                                          |  |                              | (1,354     | ) |      |   | (491,028   | )
|                                                                                                              |  |                              |            |   |      |   |            |  
|Net increase (decrease) in cash and cash equivalents                                                          |  |                              | (2,967,412 | ) |      |   | 2,132,713  |  
|                                                                                                              |  |                              |            |   |      |   |            |  
|Cash and cash equivalents at beginning of period                                                              |  |                              | 33,153,764 |   |      |   | 21,085,869 |  
|                                                                                                              |  |                              |            |   |      |   |            |  
|Cash and cash equivalents at end of period                                                                    |  | $                            | 30,186,352 |   |      | $ | 23,218,582 |  
|                                                                                                              |  |                              |            |   |      |   |            |  



See accompanying notes
to condensed consolidated financial statements.



3



---

##### Table of Contents

TIPPINGPOINT TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



|(1) | Incorporation, Nature of Business and Significant Accounting Policies
|--- | ---------------------------------------------------------------------



TippingPoint Technologies, Inc. was incorporated in the State of Texas in January 1999 and was reincorporated in the State of Delaware in March 2000. We
design, manufacture and market network security systems and appliances that deliver in-depth protection and attack eradication for corporate enterprises, government agencies, service providers and academic institutions.



As a result of the stage of our network security business, we expect to
report operating losses through at least the end of our fiscal year ending January 31, 2005. We cannot assure you that we will ever achieve positive cash flow from our operations, and we face numerous risks associated with this business.



We have funded our activities primarily through private equity offerings,
which included sales of our common stock and preferred stock, the initial public offering of our common stock on March 17, 2000 and most recently, a private placement offering of our common stock to certain investors that had a dual closing in
October and November 2003. In fiscal 2003, we also established and made borrowings under our term loan facility with a commercial bank, with which we also established a revolving loan facility that was unused through April 30, 2004. We may need to
raise additional funds at any time, and we cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. Due to the volatility of the U.S. equity markets, particularly for smaller technology companies, we may
not have access to new capital investment in the event we need to raise additional funds.



In the opinion of our management, the accompanying condensed consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments and accruals, necessary for a fair presentation
of such information. We derived the balance sheet as of January 31, 2004 from our audited financial statements as of that date. While we believe that the disclosures are adequate to make the information not misleading, we suggest that these
financial statements be read in conjunction with the audited financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended January 31, 2004. Interim results are not necessarily indicative of results we
expect in future periods.



| | (a) | Principles of Consolidation
| | --- | ---------------------------



In February 2004, we incorporated TippingPoint Technologies Europe B.V. to act as our European sales office in Amsterdam, The Netherlands. The
consolidated financial statements include the accounts of TippingPoint Technologies, Inc. and our wholly-owned Netherlands subsidiary. All significant intercompany transactions have been eliminated in consolidation.



| | (b) | Revenue Recognition
| | --- | -------------------



We record revenue from multiple-element arrangements, which include sales of our hardware-based security systems and appliances and maintenance plans. The
fair value of each element is based upon the price for which each is sold separately. We sell primarily to resellers, including value-added resellers (VARs). We recognize revenue when persuasive evidence of an arrangement exists, delivery has
occurred, the fee is fixed or determinable and collection is probable. We do not expect resellers to hold significant inventories of our products, if at all. As a result, we expect returns to be minimal. We record discounts provided to resellers for
achieving purchasing targets as a reduction of revenue. Revenue from maintenance plans is recognized ratably over the service terms that are generally one year in length.



| | (c) | Inventories
| | --- | -----------



Our inventory is stated at the lower of actual cost (first-in, first-out method) or market value (estimated net realizable value). The valuation of inventory at the lower of actual cost or market value requires us to
use estimates



4



---

##### Table of Contents

regarding the amount of current inventory that will be sold and the prices at which it will be sold. These estimates are
dependent on our assessment of expected orders from our customers. Additionally, these estimates reflect changes in our products or changes in demand because of various factors including the market for our products, obsolescence, technology changes
and competition.



As of April 30, 2004 and January 31, 2004,
our inventory consisted of component parts of approximately $1.0 million and finished goods of approximately $2.9 million and $1.5 million, respectively. A portion of our finished goods inventory is held for evaluation purposes at potential customer
locations.



| | (d) | Stock-Based Compensation
| | --- | ------------------------



We apply the intrinsic value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for
Stock Issued to Employees, and related interpretations, in accounting for our fixed plan stock options. As such, we record compensation expense on the date of grant only if the current fair value of the underlying stock exceeds the exercise
price. We have adopted the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No. 148, Accounting for Stock-Based CompensationTransition and Disclosures (SFAS 148) as well as
those outlined in SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123). SFAS 123, as amended by SFAS 148, requires that companies that do not choose to account for stock-based compensation as prescribed by this
Statement must disclose the pro forma effects on earnings and earnings per share as if SFAS 123 had been adopted.



Had compensation cost for all stock option grants been determined based on their fair market value at the grant dates consistent with the method
prescribed by SFAS 148 and SFAS 123, our net loss and loss per share would have been increased to the pro forma amounts indicated below:



|                                                                                                            |  |                                  |            |   |                                  |   |            |  
|----------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ---------- | - | -------------------------------- | - | ---------- | -
|                                                                                                            |  | Three monthsended April 30, 2004 |            |   | Three monthsended April 30, 2003 |  
|Net loss as reported                                                                                        |  | $                                | (4,829,519 | ) |                                  | $ | (4,594,316 | )
|Add: Employee stock-based compensation included in the reported net loss                                    |  |                                  | 834,605    |   |                                  |   | 124,341    |  
|Deduct: Total employee stock-based compensation determined under the fair value based method for all awards |  |                                  | 1,055,684  |   |                                  |   | 271,076    |  
|                                                                                                            |  |                                  |            |   |                                  |   |            |  
|Pro forma net loss                                                                                          |  | $                                | (5,050,598 | ) |                                  | $ | (4,741,051 | )
|                                                                                                            |  |                                  |            |   |                                  |   |            |  
|Basis and diluted loss per share:                                                                           |  |                                  |            |   |                                  |   |            |  
|As reported                                                                                                 |  | $                                | (0.66      | ) |                                  | $ | (0.87      | )
|Pro forma                                                                                                   |  | $                                | (0.69      | ) |                                  | $ | (0.90      | )



The per share
weighted-average fair value of stock options and shares of restricted common stock granted during the three months ended April 30, 2004 and 2003 was $11.59 and $3.76, respectively, on the date of grant using the Black-Scholes option pricing model.
The fair value of options was estimated using a risk-free interest rate of 3.1% and 2.9%, respectively, a dividend yield of zero for all periods presented, volatility of 50% and a weighted average expected life of four years.



|(2) | Long-Term Debt
|--- | --------------



On July 30, 2002, we entered into a loan and security agreement with a commercial bank, which consists of a term loan facility and a revolving loan
facility, and is collateralized by a first priority lien on substantially all of our tangible and intangible assets. Under the term loan facility, we can borrow up to $2.5 million for purchases of equipment and software approved by the bank. Under
the revolving credit facility, we can borrow up to $5 million



5



---

##### Table of Contents

for working capital purposes, subject to availability under a borrowing base. As of April 30, and January 31, 2004, we
had net borrowings outstanding of approximately $0.8 million and $1 million, respectively, under the term loan facility, and had not borrowed any amount under the revolving loan facility.



All amounts borrowed under the term loan facility amortize over periods ending no later than January 30, 2006. The revolving
loan facility terminates and all amounts borrowed thereunder and not previously repaid are due and payable in full (including any accrued interest) on July 30, 2004. As of April 30, 2004, there were no outstanding amounts on the revolving loan
facility. Advances under both facilities accrue interest at a rate equal to the banks prime rate plus 0.75% per annum, which at April 30, 2004 was 4.75%.



The loan agreement contains customary covenants and restrictions on additional indebtedness, liens, disposition of assets, investments and dividends.



|(3) | Net Loss Per Share
|--- | ------------------



Basic and diluted net loss per share are presented in conformity with SFAS No. 128, Earnings Per Share. In accordance with SFAS No. 128, we
compute basic loss per share using the weighted average number of common shares outstanding during the period. Diluted loss per share is equivalent to basic loss per share because outstanding stock options and warrants are anti-dilutive. Our common
stock equivalents consist of common shares issuable upon the exercise of stock options and warrants, and the lapsing of restrictions on shares of restricted stock.



|(4) | Commitments and Contingencies
|--- | -----------------------------



We had purchase obligations of approximately $4.1 million outstanding as of April 30, 2004 related to inventory and other non-manufacturing items.



Under our initial business plan, we developed and operated a
consumer Internet appliance and service business. In January 2001, we decided to exit the consumer Internet appliance and service business due to, among other things, our continued losses and inability to raise additional capital to fund that
business. The accompanying financial statements present our consumer Internet appliance and service business as a discontinued operation for all historical periods.



On July 11, 2001, a purported class action lawsuit was filed against us in Texas state court in Travis County, Texas on
behalf of all persons who purchased an Internet appliance from us and subscribed to the related Internet service. The complaint alleges that, among other things, we disseminated false and misleading advertisements, engaged in unauthorized billing
practices and failed to provide adequate technical and customer support and service with respect to our Internet appliance and service business. The complaint seeks an unspecified amount of damages. Although there has been no substantive activity in
this case for more than a year, this could change at any time. We believe that the action is without merit, that the action is not proper for class action treatment and that we have meritorious defenses available. We intend to defend this action
vigorously.



On December 5, 2001, we and two of our current and
former officers and directors, as well as the managing underwriters in our initial public offering were named as defendants in a purported class action lawsuit filed in the United States District Court for the Southern District of New York. The
lawsuit, which is part of a consolidated action that includes over 300 similar actions, is captioned In re Initial Public Offering Securities Litigation, Brian Levey vs. TippingPoint Technologies, Inc., et al., No. 01 CV 10976. The principal
allegation in the lawsuit is that the defendants participated in a scheme to manipulate the initial public offering and subsequent market price of our stock by knowingly assisting the underwriters requirement that certain of their customers
had to purchase stock in a specific initial public offering as a condition to being allocated shares in the initial public offerings of other companies. The purported plaintiff class for the lawsuit is comprised of all persons who purchased our
stock from March 17, 2000 through December 6, 2000. The suit seeks rescission of the purchase prices paid by purchasers of shares of our common stock. On September 10, 2002, our counsel and counsel for plaintiffs entered into an agreement pursuant
to which the plaintiffs dismissed, without prejudice, our former and current officers and directors from the lawsuit. In May 2003, a memorandum of understanding was executed by counsel for plaintiffs, issuer-defendants and their insurers setting
forth terms of a settlement that would result in the termination of all



6



---

##### Table of Contents

claims brought by plaintiffs against the issuer-defendants and individual defendants named in the lawsuit. In August
2003, our Board of Directors approved the settlement terms described in the memorandum of understanding. In May 2004, we signed a settlement agreement on behalf of TippingPoint Technologies, Inc. and our current and former directors and officers
with the plaintiffs. This settlement agreement formalizes the previously approved terms of the memorandum of understanding and, subject to certain conditions, provides for the complete dismissal, with prejudice, of all claims against us and our
current and former directors and officers. Any direct financial impact of the settlement is expected to be borne by our insurers. The settlement is subject to numerous conditions, including final approval by the court. There can be no assurance that
such conditions will be met or that the court will approve the terms of the settlement agreement. If the court rejects the settlement agreement, in whole or in part, or the settlement does not occur for any other reason and the litigation against us
continues, we intend to defend this action vigorously, and to the extent necessary, to seek indemnification and/or contribution from the underwriters in our initial public offering pursuant to our underwriting agreement with them. However, there can
be no assurance that indemnification or contribution will be available to us or enforceable against the underwriters.



At this time, we are not involved in any other legal proceedings that our management currently believes would be material to our business, financial
condition or results of operations. We could be forced to incur material expenses with respect to these legal proceedings, and in the event there is an outcome in any proceeding that is adverse to us, our financial position and prospects could be
harmed.



|(5) | Business Segment and Revenue Information
|--- | ----------------------------------------



We operate in one business segment, the sale of network security systems. For the three months ended April 30, 2004, the percentage of revenues
attributable to sales to customers in the United States and the rest of the world was approximately 89% and 11%, respectively. There were no international sales during the three months ended April 30, 2003.



|(6) | Discontinued Operations
|--- | -----------------------



As of April 30, 2004 and January 31, 2004, we had accrued costs of approximately $1.4 million associated with the discontinued operations that we
estimated we would incur in future periods, which costs primarily consist of estimated legal fees and other costs. Any differences between these estimates and the actual amounts incurred in future periods will change the estimated net loss from
discontinued operations accordingly.



|(7) | Reclassifications
|--- | -----------------



We have reclassified certain amounts in prior years to conform to current year presentation.



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



The following discussion and analysis of financial condition and results of operations should be read in conjunction our consolidated financial statements
and related notes included elsewhere in this report. References to fiscal 2003, fiscal 2004 and fiscal 2005 refer to the periods February 1, 2002 through January 31, 2003, February 1, 2003 through January 31, 2004, and February 1, 2004 through
January 31, 2005, respectively.



FORWARD-LOOKING
STATEMENTS



This Quarterly Report on Form 10-Q,
including this Managements Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, both as amended. All statements other than statements of historical fact are forward-looking statements for purposes of federal and state securities laws, including: any projections of earnings, revenues
or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning proposed new products, services or developments; any statements regarding future economic conditions or
performance; any statements of belief; and any statements of assumptions underlying any of the foregoing. Forward-looking statements may include the words



7



---

##### Table of Contents

may, will, estimate, intend, continue, believe,
expect, plan or anticipate and other similar words. Although we believe that the expectations reflected in our forward-looking statements are reasonable, actual results could differ materially from those projected
or assumed. Our future financial condition and results of operation, as well as any forward-looking statements, are subject to change and to inherent risks and uncertainties, such as those disclosed in this report. We do not intend, and undertake no
obligation, to update any forward-looking statement. Readers are referred to risks and uncertainties identified below under Risk Factors, elsewhere in this report and in other documents we file with the SEC. All forward-looking
statements attributable to us are qualified in their entirety by this cautionary statement.



OVERVIEW



Since
January 2001, our strategy has been to develop our network-based hardware security system offerings. Prior to fiscal 2004, we were in a development phase creating our UnityOne line of products. We announced the availability of our first product in
late fiscal 2003, followed by the availability of four additional UnityOne products in early fiscal 2004. Fiscal 2004 was the first year we recognized and derived revenue from sales of our high-speed network-based intrusion prevention systems. As a
result of the stage of our network security business, we have recurring losses, and we expect to report operating losses through at least the end of our fiscal year ending January 31, 2005. We cannot assure you that we will ever achieve positive
cash flow from our operations or positive income, and we face numerous risks and uncertainties associated with this business.



From inception in January 1999 through April 30, 2004, we financed our operations and met our capital expenditure requirements primarily from the net
proceeds of the private and public sale of equity securities totaling approximately $263 million, including $22.6 million of net proceeds from a recent private placement completed in November 2003.



In 2002, we entered into a loan and security agreement with a commercial bank
consisting of a term loan facility and a revolving loan facility, both collateralized by a first priority lien on substantially all of our tangible and intangible assets. Under the term loan facility, we can borrow up to $2.5 million for purchases
of equipment and software approved by the bank. Under the revolving loan facility, we can borrow up to $5 million for working capital purposes, subject to availability under a borrowing base. As of April 30, 2004, we had borrowed approximately $0.8
million under the term loan facility and had not borrowed any amount under the revolving loan facility. We may need to raise additional funds in the future and we cannot assure you that we will be able to obtain additional financing on favorable
terms, if at all. Due to the volatility of the U.S. equity markets, particularly for smaller technology companies, we may not have access to new capital investment in the event that additional funds need to be raised.



We derive revenues from sales of our hardware based security systems and
maintenance plans. Our revenue for the three months ended April 30, 2004 and 2003 was approximately $3.9 million and $0.6 million, respectively. Revenue from maintenance plans is recognized ratably over the service term, generally one year.
Maintenance revenue was approximately $0.3 million for the three months ended April 30, 2004, approximately 8% of total revenue.



In the three months ended April 30, 2004, revenue from customers within the United States totaled approximately $3.5 million, and revenue from customers
outside of the United States totaled approximately $0.4 million or 10% of total revenue. In fiscal 2005, we believe that revenues generated outside the United States will continue to increase in absolute dollars. Based on fluctuating economic
conditions and limited sales history, there can be no assurance that our revenues will continue to grow at this same rate or that we will achieve similar results in future periods.



Cost of revenue consists of the costs associated with manufacturing, assembling and testing our products, related overhead
costs, compensation and other costs related to manufacturing support. We use contract manufacturers to manufacture our hardware products, and a significant portion of our cost of revenues is attributable to component costs and payments to these
contract manufacturers. Cost of maintenance principally consists of certain customer support costs, including costs associated with delivery of the Digital Vaccine attack filter service, and training expenses.



8



---

##### Table of Contents

Our gross margin of approximately 69% in the three months ended April 30, 2004 has been, and will
continue to be, affected by a variety of factors, including competition, the product mix and average selling prices of products, maintenance, new product introductions and enhancements, the cost of components and manufacturing labor, fluctuations in
manufacturing volumes, component shortages and the mix of distribution channels through which our products are sold.



Research and development expenses consist of salaries and related expenses for development and engineering personnel, fees paid to consultants, prototype
costs related to the design, development, testing and enhancement of our systems and hardware, and personnel and development costs associated with the Digital Vaccine attack filter service. We expense our research and development costs as they are incurred. There may be components of
our research and development efforts that require significant expenditures, the timing of which can cause quarterly variability in our expenses. We are devoting resources to the continued development of new products. To meet the changing
requirements of our customers, we will need to fund investments in several development projects. As a result, we expect our research and development expenses to increase in absolute dollars in the future.



Sales and marketing expenses consist of salaries, commissions, travel costs
and related expenses for marketing, sales and sales support personnel and costs associated with promotional and other marketing activities, including all costs associated with customer trials and evaluations. We intend to expand our sales operations
substantially, both domestically and internationally, in order to increase awareness and sales of our products. We also believe part of our future success will be dependent upon establishing successful relationships with a variety of resellers. We
expect that sales and marketing expenses will increase in absolute dollars as we expand our sales efforts domestically and internationally, hire additional sales and marketing personnel and initiate additional marketing programs.



General and administrative expenses consist of salaries and related expenses
for finance, accounting, legal and human resources personnel, professional fees and corporate expenses. We expect general and administrative expenses to increase in absolute dollars as we employ additional personnel and incur additional costs
related to the growth of our business and our operations.



Stock option grants and restricted stock awards are an important element of our compensation programs. We account for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to Employees. As of April 30, 2004, deferred stock compensation was approximately $10.2 million, all of which will be amortized into expense over the next four years.



Prior to 2001, we primarily offered consumers Internet access through devices
commonly known as Internet appliances. We discontinued this business in the first half of 2001 and transitioned to a network-based hardware security business. The financial statements included elsewhere in this report present our former Internet
appliance and service business as discontinued operations for all historical periods.



CRITICAL ACCOUNTING POLICIES AND ESTIMATES



Managements discussion and analysis of financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted
in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an on-going basis, we evaluate our estimates, including those related to our revenue recognition, inventory, deferred taxes, impairment of long-lived assets and litigation related to our discontinued operations. We base our
estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these estimates.



9



---

##### Table of Contents

Our critical accounting policies are as follows:



Revenue Recognition. Revenue is recorded from sales of our
hardware-based security systems and maintenance plans. We sell primarily to resellers, including value-added resellers (VARs). We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or
determinable and collection is probable. We do not expect resellers to hold significant inventories of our products, if at all. As a result, we expect returns to be minimal. If our estimate of returns is too low, additional charges will be incurred
in future periods and these additional charges could have a material adverse effect on our financial position and results of operations. We record discounts provided to resellers for achieving purchasing targets as a reduction of revenue on the date
of sale. Revenue from maintenance plans is recognized ratably over the service terms, which are generally one year in length.



Inventory. We adjust our inventory values so that the carrying value does not exceed net realizable value. The valuation of inventory at the lower
of actual cost or market value requires us to use estimates regarding the amount of current inventory that will be sold and the prices at which it will be sold and our assessment of expected orders from our customers. Additionally, the estimates
reflect changes in our products or changes in demand because of various factors including the market for our products, obsolescence, technology changes and competition. The estimates are subject to revisions and actual results may differ. This
difference may have a material effect on our financial condition and results of operations.



Deferred Taxes. As part of the process of preparing our financial statements, we are required to estimate our income taxes. This process involves estimating our actual current tax exposure together with
assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our balance sheet. We must then assess the
likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase
this allowance in a period, we must include an expense within the tax provision in our statement of operations.



Significant judgment involving multiple variables is required in determining our deferred tax assets and liabilities and any valuation allowance recorded
against our net deferred tax assets. In assessing the potential realization of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of
deferred tax assets is dependent upon achieving future taxable income during the period in which our deferred tax assets are recoverable. Due to the uncertainty surrounding our ability to generate taxable income in the future, we have determined
that it is more likely than not that we will not be able to utilize any of the benefits of our deferred tax assets, including net operating loss carry forwards, before they expire. Therefore, we have provided a 100% valuation allowance on our
deferred tax assets in each year of our existence, and our net deferred tax asset as of April 30, 2004 is zero.



Impairment of Long-Lived Assets. We evaluate the recoverability of our long-lived assets and review these assets for recoverability when events or
changes in circumstances indicate a potential impairment. Factors we consider important that could trigger an impairment review include the following:



| |  | significant underperformance relative to historical or projected operating results;
| | - | -----------------------------------------------------------------------------------



| |  | significant changes in the manner or use of the assets or the strategy for our overall business; and
| | - | ----------------------------------------------------------------------------------------------------



| |  | significant negative industry or economic trends.
| | - | -------------------------------------------------



When we determine that the carrying value of these assets may not be recoverable based on the existence of one or more of the above indicators of
impairment, we measure any impairment by estimating the undiscounted cash flows to be generated from the use and ultimate disposition of these assets. We record assets to be disposed of at the lower of the carrying amount or fair market value less
anticipated costs of sales.



10



---

##### Table of Contents

Discontinued Operations. As of April 30, 2004, we had reflected in accrued liabilities in the
accompanying balance sheet approximately $1.4 million for costs of the discontinued operations that we estimated we would incur in future periods. The accrued costs consist primarily of estimated legal fees for litigation and other costs related to
discontinued operations. We evaluate contingent liabilities, including threatened or pending litigation in accordance with SFAS No. 5, Accounting for Contingencies and record accruals when the outcome of these matters is deemed probable
and the liability is reasonably estimable. We make these assessments based upon the facts and circumstances, and in some instances based in part upon the advice of outside legal counsel. We include in these accruals an estimate to cover legal fees
and expenses to defend ourselves. Because of the uncertainties related to certain pending litigation and claims, we are not able to make a reasonable estimate of the liability that could result from an unfavorable outcome, if any. As additional
information becomes available, we reassess the potential liability related to our pending litigation and revise our estimates. Such revisions in our estimates of the potential liability could materially impact our results of operations and financial
condition. Any differences between these estimated accrued costs and the actual amounts incurred in future periods will change the estimated net loss from discontinued operations accordingly.



Recent Accounting Pronouncements.In January 2003, the FASB issued FIN
46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not
have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new
variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period ending after March
15, 2004. The adoption of FIN 46 has not and is not expected to have a material impact on our financial condition or results of operations.



RESULTS OF CONTINUING OPERATIONS FOR THE

THREE MONTHS ENDED APRIL 30, 2004 AND 2003



Revenues



Our revenues for the three
months ended April 30, 2004 and 2003 were approximately $3.9 million and $0.6 million, respectively, an increase of approximately $3.3 million. Revenue from maintenance plans is recognized ratably over the service term, generally one year, and was
approximately $0.3 million for the three months ended April 30, 2004. The percentage of revenue attributable to sales to customers in the United States and the rest of the world was approximately 89% and 11%, respectively, during the three months
ended April 30, 2004. There were no international sales during the three months ended April 30, 2003. In the three months ended April 2004 and 2003, revenues and sales through distributors and value-added resellers represented approximately 90% and
84% of our total revenues, respectively.



In fiscal 2005,
management believes that revenues will increase in absolute dollars and, as a result, we will continue to make investments in sales and marketing and research and development. However, as a result of the stage of our network security business and
limited selling history, we have not developed any revenue trends. Additionally, we do not have any assurance that our revenues will continue to grow at this same rate or that we will achieve similar results in future periods.



Cost of Revenues; Gross Margin



For the three months ended April 30, 2004 and 2003, cost of revenues was
approximately $1.2 million and $0.4 million, respectively, an increase of approximately $0.8 million. Gross margin was approximately $2.7 million and $0.2 million for the three months ended April 30, 2004 and 2003, respectively, an increase of
approximately $2.5 million. Cost of revenues for each of the three months ended April 30, 2004 and 2003 included approximately $0.3 million of fixed manufacturing overhead and maintenance plan support costs.



11



---

##### Table of Contents

Operating Expenses



Research and development expenses. Research and development expenses approximated $2.6 million and $2.4 million for
the three months ended April 30, 2004 and 2003, respectively, an increase of approximately $0.2 million. The increase in research and development expenses was attributable primarily to the on-going development of our UnityOne line of products. We
expect our research and development expenditures to continue to increase in absolute dollars throughout the remainder of fiscal 2005. The increase in expenditures may include additional research and development personnel to support the expansion of
our product line and product feature set and to support the anticipated growth in our customer base.



Sales and marketing expenses. Sales and marketing expenses approximated $3.4 million and $1.7 million for the three months ended April 30, 2004 and
2003, respectively, an increase of approximately $1.7 million. The increase in sales and marketing expenses was the result of the expansion of our sales efforts and consisted primarily of increased employment, commission and travel-related costs. We
incurred additional marketing expenses associated with the participation and sponsorship of industry trade shows. We expect this type of marketing activity to continue to increase throughout the remainder fiscal 2005. We also expect sales and
marketing expenses to continue to rise throughout the remainder of fiscal year 2005 as we further develop and expand our sales efforts. These expansion efforts may include the hiring of additional sales personnel to support our channel partners and
to increase the size of our direct sales force. The additional investment in sales and marketing efforts is predicated on an anticipated demand for our products.



General and administrative expenses. General and administrative expenses were approximately $0.8 million and $0.7
million for the three months ended April 30, 2004 and 2003, respectively, an increase of approximately $0.1 million. The increase in general and administrative expenses was primarily the result of an increase in employment costs associated with
deferred stock compensation.



Amortization of stock-based
compensation. For the three months ended April 30, 2004 and 2003, we recorded employee stock-based compensation of approximately $0.8 million and $0.1 million, respectively, an increase of $0.7 million. The increase in expense is principally due
to additional amortization related to grants in fiscal 2004. On January 5, 2004, we appointed a new Chief Executive Officer who was granted an option to purchase 300,000 shares of our common stock at an exercise price of $12 per share. Because the
exercise price was lower than the fair market value of our common stock on the date of grant, we recorded approximately $5.3 million in related deferred stock-based compensation. On January 12, 2004, we appointed a new Chief Financial Officer who
was granted 82,500 restricted shares of our common stock. The shares do not have an exercise price, and we recorded approximately $2.4 million in related deferred stock-based compensation. In September 2003, we granted 225,000 restricted shares of
our common stock to two new employees, which included our President and Chief Operating Officer. The shares do not have an exercise price and we recorded approximately $2.7 million of deferred compensation related to these grants. In February 2004,
selected employees were granted options to purchase 80,000 shares of our common stock for $12 per share. Because the exercise price was lower than the fair market value of our common stock on the date of grant, we recorded approximately $0.9 million
in related deferred stock-based compensation. At April 30, 2004, deferred stock compensation approximated $10.2 million, all of which will be amortized into expense over the next four years.



Other



Interest income. Interest income, net of interest expense, approximated $83,000 and $99,000 for the three months
ended April 30, 2004 and 2003, respectively. The decrease in interest income in the three months ended April 30, 2004 is due to a general decrease in the average interest rate for the interest-bearing accounts we held at banking and financial
institutions throughout the year. Interest income, net of interest expense, may change in the future due to the average cash balances, amount of interest expense and/or changes to the interest rates on the interest-bearing accounts.



Discontinued operations. As of April 30, 2004, we maintained an
accrual of $1.4 million for costs estimated to be incurred in future periods associated with our discontinued operations, which costs consisted primarily of estimated legal fees and other expenses. Any differences between these estimates and the
actual amounts incurred in future periods will change the estimated net loss from discontinued operations accordingly.



12



---

##### Table of Contents

CONTRACTUAL CASH OBLIGATIONS AND COMMITMENTS



The following summarizes our contractual cash obligations as of April 30,
2004:



|                                                           |  |                        |           |                  |   |           |  |           |         |                   |   |  |  
|---------------------------------------------------------- |  | ---------------------- | --------- | ---------------- | - | --------- |  | --------- | ------- | ----------------- | - |  | -
|Contractual Obligations                                    |  | Payments Due By Period
|                                                           |  | Total                  |           | Less Than 1 Year |   | 1-3 Years |  | 3-5 Years |         | More Than 5 Years
|Long-Term Debt Obligations                                 |  | $                      | 802,280   |                  | $ | 608,250   |  | $         | 194,030 |                   |  |  | 
|Capital Lease Obligations                                  |  |                        |          |                  |   |          |  |           |        |                   |  |  | 
|Operating Lease Obligations                                |  | $                      | 1,386,263 |                  | $ | 1,288,955 |  | $         | 97,308  |                   |  |  | 
|Purchase Obligations                                       |  | $                      | 4,137,312 |                  | $ | 4,137,312 |  |           |        |                   |  |  | 
|Other Long-Term Liabilities Reflected On The Balance Sheet |  |                        |          |                  |   |          |  |           |        |                   |  |  | 



LIQUIDITY AND
CAPITAL RESOURCES



From inception in January 1999
through April 30, 2004, we financed our operations and met our capital expenditure requirements primarily from the net proceeds of the private and public sale of equity securities totaling approximately $263 million, including approximately $22.6
million of net proceeds from the recent private placement in fiscal 2004. As of April 30, 2004, we had approximately $30.2 million in cash and cash equivalents.



Our business plan will require significant capital to fund anticipated operating losses, including research and development expenses and sales and
marketing expenses, capital expenditures and working capital needs, until we achieve positive cash flows from operations. We cannot give any assurance that any additional financing will be available, that we can ever achieve positive operating cash
flows or that we will have sufficient cash from any source to meet our needs. It is possible that we will exhaust all available funds before we reach the positive cash flow phase of our business model. We believe that we have sufficient capital to
finance our capital expenditures and provide us with adequate liquidity through at least the next twelve months.



In fiscal 2003, we entered into a loan and security agreement with a commercial bank consisting of a term loan facility and a revolving loan facility,
both collateralized by a first priority lien on substantially all of our tangible and intangible assets. Under the term loan facility, we can borrow up to $2.5 million for purchases of equipment and software approved by the bank. Under the revolving
loan facility, we can borrow up to $5 million for working capital purposes, subject to availability under a borrowing base. As of April 30, 2004, we had borrowed approximately $0.8 million under the term loan facility and had not borrowed any amount
under the revolving loan facility. All amounts borrowed under the term loan facility amortize over periods ending no later than January 30, 2006. The revolving loan facility terminates, and all amounts borrowed under this facility and not previously
repaid are due and payable in full (including any accrued interest) on July 30, 2004. Advances under both facilities accrue interest at a rate equal to the banks prime rate plus 0.75% per annum. The loan agreement contains customary covenants
and restrictions on additional indebtedness, liens, and disposition of assets, investments and dividends.



At April 30, 2004, future cash commitments include future minimum lease payments under non-cancelable operating leases of approximately $1.4 million,
primarily related to our headquarters in Austin, Texas.



13



---

##### Table of Contents

Our total debt obligation is $0.8 million, including the current portion of $0.6 million at April 30,
2004.



We have no material commitments for capital expenditures
as of April 30, 2004, but we expect to spend between $0.7 million and $1.2 million on capital expenditures in fiscal year 2005.



We purchase from contract manufacturers and other inventory suppliers on a purchase order basis and do not have a long-term supply contract with any of
them. At April 30, 2004, we had placed non-cancelable purchase orders totaling approximately $4.1 million.



Net cash used by continuing operating activities was approximately $2.4 million for the three months ended April 30, 2004, as compared to approximately
$3.6 million for the three months ended April 30, 2003. Net cash used by continuing operating activities for the three months ended April 30, 2004 resulted from increases in accounts receivable of approximately $0.6 million and inventory of
approximately $1.4 million, which increases resulted from growth in our sales activity. The net cash used was offset by a decrease in prepaid expenses and other current assets by approximately $0.8 million, an increase in trade accounts payable,
accrued liabilities and other non-current liabilities of approximately $1.4 million and an increase in deferred revenue of approximately $0.9 million from January 31, 2004 to April 30, 2004.



Net cash used by investing activities was approximately $0.5 million for the
three months ended April 30, 2004 as compared to approximately $5.7 million of cash provided by investing activities during the three months ended April 30, 2003. Net cash used by investing activities for the three months ended April 30, 2004
resulted from capital expenditures, principally related to network and applications upgrades along with computer equipment and equipment upgrades for new and existing employees, which were partially offset by proceeds received from the exercise of
stock options. The net cash provided by investment securities during the three months ended April 30, 2003 resulted from the maturity of investments, partially offset by capital expenditures.



Net cash used by financing activities for the three months ended April 30,
2004 was approximately $0.1 million, compared to net cash provided by financing activities of approximately $0.5 million for the three months ended April 30, 2003. The principal source of cash used by financing activities in the three months ended
April 30, 2004 was the result of proceeds from the exercise of stock options of approximately $0.1 million, reduced by principal debt payments of approximately $0.2 million. The principal source of cash used by financing activities for the three
months ended April 30, 2003 was the result of a decrease of restricted cash for lease obligations of approximately $0.5 million.



RISK FACTORS



There are numerous risks affecting our business, some of which are beyond our control. An investment in our common stock involves a high degree of risk
and may not be appropriate for investors who cannot afford to lose their entire investment. In addition to the risks outlined below, risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our
business operations. Our future operating results and financial condition are heavily dependent on our ability to successfully develop, manufacture and market technologically innovative solutions in order to meet customer demands for network
security. Inherent in this process are a number of factors that we must successfully manage if we are to achieve positive operating results in the future. Set forth below, elsewhere in this report and in other documents we file with the SEC are
risks and uncertainties that could affect our financial condition and operating results or cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this report.



We cannot predict our future results because we have a limited operating
history within the network security industry.



We have a
limited operating history and little history operating our network security business. Therefore, we have little meaningful historical financial data upon which to base projections of operating expenses or revenues. We began to focus on our network
security offering in the second half of 2001. Our network security offering is still in the early stage, and it was not until fiscal 2003 that we began achieving sales from these product offerings. There are significant risks and costs inherent in
our efforts to undertake this business model. These include the risk that we



14



---

##### Table of Contents

may not be able to achieve market acceptance for our network security line of products or earn significant revenues from
the sale of such products, that our business model may not be profitable and other significant risks related to our business. Our prospects must be considered in light of the uncertainties and difficulties frequently encountered by companies in
their early stages of development. These risks are heightened in rapidly evolving industries, such as network security. It is possible that we will exhaust all available funds before we reach positive cash flow.



It is possible that we may never become profitable.



Successful implementation of our network-based security products business
model continues to involve numerous risks. These risks include:



| |  | reliance upon unproven products and technology;
| | - | -----------------------------------------------



| |  | our unproven and evolving business model;
| | - | -----------------------------------------



| |  | market acceptance of our new products and any additional products that we may be able to develop;
| | - | -------------------------------------------------------------------------------------------------



| |  | our ability to anticipate and adapt to a developing market and to rapidly changing technologies;
| | - | ------------------------------------------------------------------------------------------------



| |  | the effect of competitive pressures in the marketplace;
| | - | -------------------------------------------------------



| |  | our need to structure our internal resources to support the development, marketing and future growth of our product offerings;
| | - | ------------------------------------------------------------------------------------------------------------------------------



| |  | uncertainties concerning our strategic direction and financial condition; and
| | - | -----------------------------------------------------------------------------



| |  | our need to enhance our business development, research and development, product development and support organizations, and to expand our distribution channels, to develop our
business.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In addition, although we believe that
the actions that we are taking under our business plan will help us become profitable, we cannot assure you that such actions will succeed in the long or short term.



Internal and external changes resulting from our financial condition may concern our prospective customers, strategic
relationships, resellers and employees, and produce a prolonged period of uncertainty, which could have a material adverse affect on our business. Our strategy requires pursuing new strategic relationships, adding employees who possess the skills we
believe we will need going forward, investing in new technologies, establishing leadership positions in new high-growth markets, establishing distribution channels for our new products and enhancing our sales and marketing departments. Many factors
may impact our ability to successfully implement our strategy, including our ability to finalize agreements with other companies, sustain the productivity of our workforce, introduce innovative new products in a timely manner, manage operating
expenses and quickly respond to, and recover from, unforeseen events associated with our strategy.



The fluctuating economic conditions, combined with the financial condition of some of our customers, make it difficult to predict revenues for a
particular period, and a shortfall in revenues may harm our operating results.



The recent economic downturn, combined with our own relatively limited operating history, makes it difficult to accurately forecast revenue.



We have experienced and expect, in the foreseeable future, to continue to experience limited visibility into our
customers spending plans and capital budgets. This limited visibility complicates the revenue forecasting process. In addition, our operating expenses are largely based on anticipated revenue trends and a high percentage of our expenses are,
and will continue to be, fixed in the short-term. If we do not achieve our expected revenues, the operating results will be below our expectations and those of investors and market analysts, which could cause the price of our common stock to
decline.



15



---

##### Table of Contents

Fluctuations in our quarterly operating results could affect our stock price.



If our quarterly operating results or our predictions of future operating
results fail to meet the expectations of analysts and investors, the trading price of shares of our common stock could be negatively affected. Our quarterly operating results have varied substantially in the past and may vary substantially in the
future depending upon a number of factors, including:



| |  | the timing of announcements and releases of new or enhanced versions of our products and product upgrades;
| | - | ----------------------------------------------------------------------------------------------------------



| |  | the introduction of competitive products;
| | - | -----------------------------------------



| |  | uncertainty about and customer confidence in the current economic conditions and outlook; and
| | - | ---------------------------------------------------------------------------------------------



| |  | reduced demand for any given product.
| | - | -------------------------------------



Any such volatility may make it more difficult for us to raise capital in the future or pursue acquisitions that involve issuances of our common stock or
securities convertible or exercisable into our common stock.



In addition to the foregoing factors, the risk of quarterly fluctuations is increased by the fact that a disproportionate amount of our net revenues has historically been generated during the second half of each fiscal quarter. Our reliance
on a large portion of revenue occurring at the end of the quarter and the increase in the dollar value of transactions that occur at the end of a quarter can result in increased uncertainty relating to quarterly revenues. Due to this end-of-period
buying pattern, forecasts may not be achieved, either because expected sales do not occur or because they occur at lower prices or on terms that are less favorable to us. In addition, these factors increase the chances that our results could diverge
from the expectations of investors and analysts.



Impact of government entities and academic institutions.



In the first quarter of fiscal 2005 and in fiscal 2004, approximately 36% and 50% of our revenue, respectively, was derived from sales to government entities and academic institutions. Sales to government entities and
academic institutions present risks in addition to those involved in sales to commercial customers, including potential disruption due to appropriation and spending patterns and the governments reservation of the right to cancel contracts and
purchase orders for its convenience.



The market for our
products may not develop as we contemplate, which could result in our failure to achieve sales and profits from our business model.



Our business model involves competing in a dynamic market. Our financial performance and any future growth will depend, in part, upon our ability to
obtain market share from existing competitors. We intend to invest a significant portion of our resources in the network security market, which we anticipate will grow at a significantly higher rate than the broader networking and infrastructure
industry on average. The markets for network security solutions are highly competitive, and we are not certain that our target customers will widely adopt and deploy our technology. Even if our products are effective, our target customers may not
choose to use them for technical, cost, support or other reasons. We are offering a different solution to network security than many of our competitors, and it may not be accepted by the market as an alternative to existing products.



Competition in the network security market may reduce the demand for, or
price of, our products.



The market for network security
products is highly competitive, and we expect competition to intensify in the future. Our competitors may introduce new competitive products for the same markets targeted by our line of products. These products may have better performance, lower
prices and broader acceptance than our products. Competition may reduce the overall market for our products.



Many of our current and potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater
financial, technical, sales, marketing and other resources than we do. Many of our competitors may also have existing relationships with the resellers who we use to sell our products and/or with our potential customers. In addition, some of our
competitors currently combine their products with other companies networking and security products to compete with our products. These competitors also often combine their sales and marketing efforts to compete with our products. This
competition may result in reduced prices and longer sales cycles for our products. If any of our larger competitors were to commit greater technical, sales, marketing and other resources to our markets, our ability to compete would be adversely
affected.



16



---

##### Table of Contents

Our business will suffer if our target customers do not accept our products.



Our revenues will depend upon the widespread acceptance and use of network
security technology by our target market. Substantially all of our revenues may come from sales of one or two product lines, making us dependent on widespread market acceptance of these products. We may be more dependent on the market acceptance of
individual product lines than our competitors with broader offerings. Factors that may affect the market acceptance of our anticipated line of products include:



| |  | adoption of advanced network security products and technologies;
| | - | ----------------------------------------------------------------



| |  | the need, or perceived need, to maintain or increase network connection speed when adding network security devices;
| | - | -------------------------------------------------------------------------------------------------------------------



| |  | the performance, price and total cost of ownership of our line of products;
| | - | ---------------------------------------------------------------------------



| |  | the availability and price of competing products and technologies; and
| | - | ----------------------------------------------------------------------



| |  | the success and development of our business development and marketing organizations.
| | - | ------------------------------------------------------------------------------------



If our products do not interoperate with our customers networks, installations will be delayed or cancelled and
could harm our business.



Our products are designed to
interface with our customers existing networks, each of which have different specifications and utilize multiple protocol standards from other vendors. Many of our customers networks contain multiple generations of products that have
been added over time as these networks have grown and evolved. Our products must interoperate with the products within these networks as well as future products in order to meet our customers requirements. If we find errors in the existing
software used in our customers networks, we must modify our software to fix or overcome these errors so that our products will interoperate and scale with the existing software and hardware. If our products do not interoperate with those of
our customers networks, installations could be delayed, orders for our products could be cancelled or our products could be returned. This would also damage our reputation, which could seriously harm our business and prospects.



Product returns may negatively affect our net revenues.



Product returns can occur when we introduce upgrades and new versions of
products or when end-users return our products, subject to various contractual limitations. End-users may return our products for a full refund within a reasonably short period from the date of purchase. We have a limited history with which to
estimate future returns. Future returns could exceed the reserves we have established for product returns, which could have a material adverse effect on our operating results.



If we are unable to acquire key components or are unable to acquire them on favorable terms, our business will suffer.



Some key processors and other components of our line of
products upon which we rely are currently available only from single or limited sources. In addition, some of the suppliers of these components will also be supplying certain of our competitors. We cannot be certain that our suppliers will be able
to meet our demand for components in a timely and cost-effective manner. We expect to carry little inventory of some of our products and product components, and we will rely on our suppliers to deliver necessary components to our contract
manufacturers in a timely manner based upon forecasts we provide. Some of the semiconductors and processors we require are complex, and we may not be able to develop an alternate source of supply in a timely manner, which could hurt our ability to
deliver our products to our customers. If we are unable to buy these components on a timely and a cost-efficient basis, we may not be able to deliver products to our customers, which would negatively impact future revenues and, in turn, seriously
harm our business.



At various times, some of the key
components for our products have been in short supply. Delays in receiving components would harm our ability to deliver our products on a timely basis. In addition, because we expect to rely on purchase orders rather than long-term contracts with
our suppliers, we cannot predict with certainty our ability to procure components in the longer term. If we receive a smaller allocation of components than is necessary to manufacture products in quantities sufficient to meet our customers
demand, those customers could choose to purchase competing products.



17



---

##### Table of Contents

Our reliance on third parties to manufacture and assemble our products could cause a delay in our
ability to fill orders, which might cause us to lose sales.



As of April 30, 2004, we used a single third party to manufacture sub-assemblies of our products, and we purchased our components on a purchase order basis. We expect to continue this method of procurement indefinitely. If we cannot
continue our arrangement with our contract manufacturer, and if we cannot establish an arrangement with at least one contract manufacturer who agrees to manufacture our sub-assemblies on terms acceptable to us, we may not be able to produce and ship
our products, and our business will suffer. If we fail to manage our relationships with our contract manufacturers effectively, or if they experience delays, disruptions or quality control problems in their manufacturing operations, our ability to
ship products to our customers could be delayed.



The absence
of dedicated capacity with our contract manufacturers means that, with little or no notice, they could refuse to continue manufacturing some or all of our products. Qualifying new contract manufacturers and commencing volume production would be
expensive and time-consuming. If we are required or choose to change contract manufacturers, we could lose revenues and damage our customer relationships.



Our reliance on third-party manufacturers also exposes us to the following risks that are outside our control:



| |  | unexpected increases in manufacturing and repair costs;
| | - | -------------------------------------------------------



| |  | interruptions in shipments if one of our manufacturers is unable to complete production;
| | - | ----------------------------------------------------------------------------------------



| |  | inability to control delivery schedules;
| | - | ----------------------------------------



| |  | unpredictability of manufacturing yields; and
| | - | ---------------------------------------------



| |  | the inability of a manufacturer to maintain the financial strength to meet our procurement and manufacturing needs.
| | - | -------------------------------------------------------------------------------------------------------------------



If we fail to develop or maintain relationships with significant
resellers, or if these resellers are not successful in their sales efforts, sales of our products and our operating results would suffer.



We expect to derive the bulk of our total revenues from sales by resellers. Sometimes purchasers of network security solutions choose their products based
on which network security solution is carried by the reseller from whom they buy other products, rather than solely on performance characteristics. We do not expect to have any long-term contracts or minimum purchase commitments with any of our
resellers. In addition, our resellers may sell products that are competitive with ours, may devote more resources to those competitive products and may cease selling our products altogether. The resellers through whom we sell our products may not be
successful in selling our products for reasons beyond our control. If any of the foregoing occurs, our operating results will suffer.



Marketing to most of our target customers involves long sales and implementation cycles, which may cause revenues and operating results to vary
significantly.



We market our line of products primarily
to large enterprises, government entities and academic institutions through resellers. A prospective customers decision to purchase our products will often involve a significant commitment of its resources and a lengthy evaluation and product
qualification process. Throughout the sales cycle, we anticipate often spending considerable time educating and providing information to prospective customers regarding the use and benefits of our products. Budget constraints, budget cycles and the
need for multiple approvals within these organizations may also delay the purchase decision. Failure to obtain the required approval for a particular project or purchase decision on a timely basis may delay the purchase of our products. As a result,
we expect that the sales cycle for our network security solutions typically will be 90 to 180 days. These long cycles may cause delays in any potential sale, and we may spend a large amount of time and resources on prospective customers who decide
not to purchase our line of products and services, which could materially and adversely affect our business.



18



---

##### Table of Contents

Even after making the decision to purchase our products, our customers may not deploy our products
broadly within their networks. We expect the timing of implementation to vary widely, depending on the complexity of the customers network environment, the size of the network deployment, budget constraints, the skill set of the customer and
the degree of hardware and software configuration necessary to deploy our products. Enterprises and government entities with large networks usually expand their networks in large increments on a periodic basis. In addition, large enterprises,
government entities and academic institutions, and resellers selling to such entities, typically pay their suppliers over a longer period of time, which could negatively affect our liquidity.



Our products are designed for the network infrastructure market, which
requires us to incur significant expenses to maintain a sophisticated sales force and provide high-level engineering support to complete sales. If we do not successfully market our products to these targeted customers, we will not have the revenue
to offset these expenses, and our operating results will be below our expectations and the expectations of investors and market analysts, which would likely cause the market price of our common stock to decline.



We will not be able to develop or continue our business if we fail to
attract and retain key personnel.



Our future success
depends on our ability to attract, hire, train and retain a number of highly skilled employees and on the service and performance of our senior management and other key personnel. The loss of the services of our executive officers or other key
employees could adversely affect our business. Competition for qualified personnel possessing the skills necessary for success in the competitive market of the network security industry is intense, and we may fail to attract or retain the employees
necessary to execute our business model successfully. Because we have experienced operating losses, we may have a more difficult time in attracting and retaining the employees we need.



We will also offer support and other services through maintenance and other agreements. Although we plan to provide support
services sufficient to meet our expected business level, our growth will be limited in the event we are unable to hire or retain support services personnel or subcontract these services to qualified third parties.



Our success depends to a significant degree upon the continued contributions
of our key management, engineering, research and development, business development and marketing and other personnel, many of whom would be difficult to replace.



We have recently experienced significant additions to our senior management.



Several members of our senior management were only added in the last year,
and we may add new members to senior management. Changes in management may be disruptive to our business and may result in the departure of existing employees and/or customers. It may take significant time to locate, retain and integrate qualified
management personnel.



Our failure to develop or introduce
new products or product enhancements might cause our business to suffer.



The market for network security products is characterized by rapid technological change, frequent new product introductions, changes in customer requirements, intense competition and evolving industry standards.
Therefore, our success will depend upon our ability to identify product opportunities, to develop and introduce products in a timely manner and to gain market acceptance of any products developed. In developing our products, we have made, and will
continue to make, assumptions with respect to the features, security standards and performance criteria that will be required by our customers. We also expect to develop products with strategic partners and incorporate advanced third-party security
capabilities into our products. We may not be able to develop new products or product enhancements in a timely manner, or at all. If we fail to develop or introduce these new products and product enhancements, such failure might cause our products
to be less competitive. In addition, our



19



---

##### Table of Contents

assumptions about customer requirements may be wrong. If we implement features, security standards and performance
criteria that are different from those required by our customers, market acceptance of our products may be significantly reduced or delayed. Even if we are able to develop and introduce new products and enhancements, these products or enhancements
may not achieve widespread market acceptance. Any failure of our products or product enhancements to achieve market acceptance could cause our business to suffer.



Our products incorporate and rely upon licensed third-party technology, and if licenses of third-party technology do not
continue to be available to us or become very expensive, our revenues and ability to develop and introduce new products could be adversely affected.



We integrate licensed third-party technology in certain of our products. From time to time we may be required to license additional technology from third
parties to develop new products or product enhancements. Third-party licenses may not be available or continue to be available to us on commercially reasonable terms. Our inability to maintain or re-license any third party licenses required in our
current products or our inability to obtain third-party licenses necessary to develop new products and product enhancements, could require us to obtain substitute technology of lower quality or performance standards or at a greater cost, any of
which could harm our business, financial condition and results of operations.



Open source software.



Products or technologies acquired or developed by us may include so-called open source software. Open source software is typically licensed for use at no initial charge, but imposes on the user of the open source software
certain requirements to license to others both the open source software as well as the software that relates to, or interacts with, the open source software. Our ability to commercialize products or technologies incorporating open source software or
otherwise fully realize the anticipated benefits of any such acquisition may be restricted because, among other reasons:



| |  | open source license terms may be ambiguous and may result in unanticipated obligations regarding our products;
| | - | --------------------------------------------------------------------------------------------------------------



| |  | competitors will have improved access to information that may help them develop competitive products;
| | - | -----------------------------------------------------------------------------------------------------



| |  | open source software cannot be protected under trade secret law;
| | - | ----------------------------------------------------------------



| |  | it may be difficult for us to accurately determine the developers of the open source code and whether the acquired software infringes third party intellectual property rights; and
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | open source software potentially increases customer support costs because licensees can modify the software and potentially introduce errors.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------



We may not be able to compete effectively if we are not able to protect
our intellectual property.



We intend to rely on a
combination of patent, trademark, trade secret and copyright law and contractual restrictions to protect the intellectual property we develop. We have filed eleven patent applications related to our network security products in the United States. We
have also applied to register certain trademarks relating to our business in the United States. We anticipate filing additional patent and trademark applications relating to our business. If we are not successful in obtaining the patent protection
we need, our competitors may be able to replicate our technology and compete more effectively against us. We also enter, and plan to continue to enter, into confidentiality or license agreements with our employees, consultants and other parties with
whom we contract, and control access to and distribution of our software, documentation and other proprietary information. The legal protections described above would afford only limited protection. Unauthorized parties may attempt to copy aspects
of our products, or otherwise attempt to obtain and use our intellectual property. Monitoring unauthorized use of our products will be difficult, and the steps we have taken may not prevent unauthorized use of our technology, particularly in foreign
countries where the laws may not protect our proprietary rights as fully as in the United States.



20



---

##### Table of Contents

Downturns in the network security and related markets may cause our revenues and operating results to
suffer.



The market for our products depends on economic
conditions affecting the broader network security and information technology markets. A prolonged downturn in these markets may cause large enterprises to delay or cancel security projects, reduce their overall or security-specific information
technology budgets or reduce or cancel orders for our products. In this environment, customers may experience financial difficulty, cease operations or not budget for the purchase of our products. This, in turn, may lead to longer sales cycles,
price pressures and/or delays in payment and collection, causing us to realize lower revenues and margins. Recent political turmoil in many parts of the world, including terrorist and military actions, may continue to put pressure on global economic
conditions. If the economic and market conditions in the United States and globally deteriorate, we may experience material adverse impacts on our business, operating results and financial condition as a result of the factors stated above or
otherwise.



Undetected product errors or defects could
result in loss of revenues, delayed market acceptance and claims against us.



We offer a warranty on all of our products, allowing the customer to have any defective unit repaired or to receive a replacement product within a certain period after the date of sale. Our products may contain
undetected errors or defects. If one of our products fails, we may have to replace all affected products without being able to record any revenue for the replacement units, or we may have to refund the purchase price for the defective units. Some
errors are discoverable only after a product has been installed and used by customers. Any errors discovered after our products have been widely used by customers could result in loss of revenues and claims against us.



If we are unable to fix errors or other problems that later are identified
after installation, in addition to the consequences described above, we could experience:



| |  | failure to achieve market acceptance;
| | - | -------------------------------------



| |  | loss of customers;
| | - | ------------------



| |  | loss of market share;
| | - | ---------------------



| |  | diversion of development resources;
| | - | -----------------------------------



| |  | increased service and warranty costs; and
| | - | -----------------------------------------



| |  | increased insurance costs.
| | - | --------------------------



If we fail to predict our manufacturing requirements accurately, we could incur additional costs or experience manufacturing delays, which could reduce
our gross margins or cause us to lose sales.



We provide
forecasts of our demand to our contract manufacturer prior to the scheduled delivery of products to our customers. If we overestimate our requirements, our contract manufacturer may have excess component inventory, which would increase our costs. If
we underestimate our requirements, our contract manufacturer may have an inadequate component inventory, which could interrupt the manufacturing of our products and result in delays in shipments and revenues. In addition, lead times for materials
and components that we order vary significantly and depend on factors such as the specific supplier, contract terms and demand for each component at a given time. We may also experience shortages of components from time to time, which also could
delay the manufacturing of our products.



A breach of
network security could harm public perception of our products, which could harm our business.



If an actual or perceived breach occurs in one of our customers network security systems, regardless of whether the breach is attributable to our
products, the market perception of the effectiveness of our products could be harmed. This could cause us to lose existing and potential customers or cause us to lose existing and potential resellers. Because the techniques used by computer hackers
to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques.



21



---

##### Table of Contents

Because we are in the business of providing network security, our own networks may be more likely to
become a target of attacks. If attacks on our internal networks are successful, public perception of our products would be harmed.



We might have to defend lawsuits or pay damages in connection with any alleged or actual failure of our products.



Because our products will provide and monitor network security and may
protect valuable information, we could face claims for product liability, tort or breach of warranty. Anyone who circumvents our network security measures could misappropriate the confidential information or other property of customers using our
products, or interrupt their operations. If that happens, affected customers or others may sue us. In addition, we may face liability for breaches caused by faulty installation of our products by our service and support organizations. Defending a
lawsuit, regardless of its merit, could be costly and divert management attention. Our business liability insurance coverage may be inadequate or future coverage may be unavailable on acceptable terms or at all.



We could become subject to litigation regarding intellectual property
rights that could be costly and result in the loss of significant rights.



In recent years, there has been a significant increase in litigation in the United States involving patents and other intellectual property rights. In the future, we may become a party to litigation to protect our
intellectual property or to defend against an alleged infringement by us of another partys intellectual property. Claims for alleged infringement and any resulting lawsuit, if successful, could subject us to significant liability for damages
and invalidation of our intellectual property rights. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation
could also force us to do one or more of the following:



| |  | stop or delay selling, integrating or using products that use the challenged intellectual property;
| | - | ---------------------------------------------------------------------------------------------------



| |  | obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology, which license might not be available on reasonable terms, or at
all; or
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | redesign the products that use that technology.
| | - | -----------------------------------------------



If we are forced to take any of these actions, our business might be seriously harmed. Our business insurance may not cover potential claims of this type
or may not be adequate to indemnify us for all liability that could be imposed.



We are party to lawsuits, which, if determined adversely to us, could require us to pay damages which could harm our business and financial condition.



We and certain of our former officers and current and former members of our
board of directors are subject to various lawsuits. There can be no assurance that actions that have been or will be brought against us will be resolved in our favor. Regardless of whether they are resolved in our favor, these lawsuits are, and any
future lawsuits to which we may become a party in the future will likely be, expensive and time consuming to defend or resolve. Any losses resulting from these claims could adversely affect our profitability and cash flow.



Our officers and directors own a large percentage of our outstanding stock
and could significantly influence the outcome of actions.



Our executive officers and directors, in the aggregate, owned approximately 54% of our outstanding stock as of April 30, 2004. These stockholders, if acting together, would be able to significantly influence all matters requiring approval
by our stockholders, including the election of directors and the approval of mergers or other business combination transactions.



22



---

##### Table of Contents

Shares of common stock eligible for public sale could cause our stock price to decline.



The market price of our common stock could decline as a
result of sales by our existing stockholders of a large number of shares of our common stock in the market, or the perception that such sales could occur. This circumstance may be more significant because of the relatively low volume of our common
stock that is traded on any given day. All of our outstanding common stock that was issued in private placements prior to December 2002 may currently be resold in reliance on Rule 144 of the Securities Act of 1933. In addition, the 1,995,833 shares
recently issued in the private placement completed in November 2003 may be resold, which may have a negative impact on the market price of our common stock. Certain holders of shares of our common stock issued in our October 2002 private placement
have the right to require us to register the resale of those shares at any time. Any such registration will result in additional shares being sold in the market, which could also have a negative impact on the market price of our common stock. In
addition, employees of our company own a significant number of vested shares of our common stock and hold options to purchase a significant number of vested shares of our common stock at exercise prices below our per share closing price as of April
30, 2004. These employees are generally subject to trading restrictions that only allow them to trade these securities during the period beginning at the opening of the third trading day following the public disclosure of our quarterly financial
results and ending on the last day of the second month of each fiscal quarter. In addition, these employees may also be subject to extended black out periods imposed on them by us from time to time. As a result, there will be periods of
time from quarter to quarter during which a significant number of additional shares held by our employees may be sold or offered for sale, which could cause our stock price to decline.



Our charter documents and Delaware law may impede or discourage a takeover, which could lower our stock price.



Pursuant to our charter, our board of directors has the
authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by our stockholders. The issuance
of preferred stock could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock.



Provisions of Delaware law and our certificate of incorporation and bylaws could also delay or make a merger, tender offer or proxy contest involving us
more difficult. For example, any stockholder wishing to make a stockholder proposal (including director nominations) at our 2005 annual meeting, must meet the qualifications and follow the procedures specified under both the Exchange Act of 1934 and
our certificate of incorporation, which is filed with the Securities and Exchange Commission.



We may be unable to obtain the additional capital required to grow our business, which could harm our business. If we raise additional funds, our current stockholders may suffer substantial dilution.



As of April 30, 2004, we had approximately $30.2 million
in cash and cash equivalents on hand. In July 2002, we entered into a loan agreement consisting of a term loan facility for equipment and software purchases of up to $2.5 million, of which we had outstanding borrowings of $802,000 at April 30, 2004,
and a revolving loan facility for working capital of up to $5.0 million that was unused at April 30, 2004. We may need to raise additional funds at any time, and we cannot be certain that we will be able to obtain additional financing on favorable
terms, if at all. Due to the volatility of the U.S. equity markets, particularly for smaller technology companies, we may not have access to new capital investment in the event we need to raise additional funds.



Our future capital requirements will depend upon several factors, including
whether we are successful in marketing our products and our level of operating expenditures. Our expenditures are likely to rise as we continue our technology and business development efforts. If our capital requirements vary materially from those
we currently project, we may require additional financing. If we cannot raise funds on acceptable terms, we may not be able to develop our products and services, take advantage of future opportunities or respond to competitive pressures or
unanticipated requirements, any of which could have a material adverse effect on our ability to develop and grow our business.



Further, if we issue equity securities, our existing stockholders will experience dilution of their ownership percentages, and the new equity securities
may have rights, preferences or privileges senior to those of our common stock. If we do not obtain additional funds when needed, we could quickly cease to be a viable going concern.



We do not intend to declare dividends, and our common stock could be subject to volatility.



We have never declared or paid any cash dividends on our common stock. We
presently intend to retain all future earnings, if any, to finance the development of our business and do not expect to pay any dividends in the foreseeable future.



23



---

##### Table of Contents

The market price of our common stock may fluctuate significantly in response to a number of factors, some
of which are beyond our control, including:



| |  | variations in the magnitude of our losses from operations from quarter to quarter;
| | - | ----------------------------------------------------------------------------------



| |  | changes in market valuations of companies in the network security industry;
| | - | ---------------------------------------------------------------------------



| |  | announcements by us or our competitors of new technology, products, services, significant contracts, acquisitions, strategic relationships, joint ventures, capital commitments or
other material developments that affect our prospects and our relative competitive position in our prospective markets;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our inability to locate or maintain suppliers of components of our line of network security products at prices that will allow us to attain profitability;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | product or design flaws, or our inability to bring functional products to market, product recalls or similar occurrences, or failure of a substantial market to develop for our
planned products;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | additions or departures of key personnel;
| | - | -----------------------------------------



| |  | sales of capital stock in the future;
| | - | -------------------------------------



| |  | stock liquidity or cash flow constraints; and
| | - | ---------------------------------------------



| |  | fluctuations in stock market prices and volume, which are particularly common for the securities of highly volatile technology companies pursuing untested markets and new
technology.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We have exited our old line of
business, and have attempted to minimize our obligations related to that business, but if we are unsuccessful in minimizing those obligations, our business will suffer.



We have exited our consumer-focused business, but continue to have certain obligations, contingencies and potential
liabilities relating to this business.



On July 11, 2001, a
purported class action lawsuit was filed against us in Texas state court in Travis County, Texas on behalf of all persons who purchased an Internet appliance from us and subscribed to the related Internet service. The complaint alleges that, among
other things, we disseminated false and misleading advertisements, engaged in unauthorized billing practices and failed to provide adequate technical and customer support and service with respect to our discontinued operations. The complaint seeks
an unspecified amount of damages. We could be forced to incur material expenses with respect to this legal proceeding, and in the event there is an outcome that is adverse to us, our financial position and results of operations could be harmed.



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.



We are exposed to interest rate risk primarily through our loan facilities, which accrue interest at a floating rate. If our effective interest rate under
our loan facilities were to increase by 100 basis points (1.00%), our annual financing expense would increase by approximately $9,000, based on the average balances utilized under our loan facilities during the period ended April 30, 2004. We did
not experience a material impact from interest rate risk during the three months ended April 30, 2004.



We do not use derivative financial instruments to hedge interest rate and foreign currency exposure. We limit our interest rate risks by placing our
marketable securities investments with high quality issuers, principally the United States government, and corporate debt securities with terms of less than one year. We do not expect any material losses from our marketable securities investments
and believe that our interest rate exposure is modest. We do not currently have, or hedge against, foreign currency exposure.



Currently, we do not have any significant investments in financial instruments for trading or other speculative purposes.



24



---

##### Table of Contents

ITEM 4. CONTROLS AND PROCEDURES.



We maintain a set of disclosure controls and procedures that are designed to ensure that the information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the Securities and Exchange Commissions rules and forms. As of April 30, 2004, we carried out an evaluation, under the supervision and with the participation of our management, including our principal
executive officer and our principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-14 of the Exchange Act of 1934. Based on that evaluation, our principal executive
officer and principal financial officer concluded that our disclosure controls and procedures were effective.



There have been no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect,
our internal controls over financial reporting.



PART II. OTHER INFORMATION.



ITEM 1. LEGAL PROCEEDINGS.



On
July 11, 2001, a purported class action lawsuit was filed against us in Texas state court in Travis County, Texas on behalf of all persons who purchased an Internet appliance from us and subscribed to the related Internet service. The complaint
alleges that, among other things, we disseminated false and misleading advertisements, engaged in unauthorized billing practices and failed to provide adequate technical and customer support and service with respect to our Internet appliance and
service business. The complaint seeks an unspecified amount of damages. Although there has been no substantive activity in this case for more than a year, this could change at any time. We believe that the action is without merit, that the action is
not proper for class action treatment and that we have meritorious defenses available. We intend to defend this action vigorously.



On December 5, 2001, we and two of our current and former officers and directors, as well as the managing underwriters in our initial public offering were
named as defendants in a purported class action lawsuit filed in the United States District Court for the Southern District of New York. The lawsuit, which is part of a consolidated action that includes over 300 similar actions, is captioned In re
Initial Public Offering Securities Litigation, Brian Levey vs. TippingPoint Technologies, Inc., et al., No. 01 CV 10976. The principal allegation in the lawsuit is that the defendants participated in a scheme to manipulate the initial public
offering and subsequent market price of our stock by knowingly assisting the underwriters requirement that certain of their customers had to purchase stock in a specific initial public offering as a condition to being allocated shares in the
initial public offerings of other companies. The purported plaintiff class for the lawsuit is comprised of all persons who purchased our stock from March 17, 2000 through December 6, 2000. The suit seeks rescission of the purchase prices paid by
purchasers of shares of our common stock. On September 10, 2002, our counsel and counsel for plaintiffs entered into an agreement pursuant to which the plaintiffs dismissed, without prejudice, our former and current officers and directors from the
lawsuit. In May 2003, a memorandum of understanding was executed by counsel for plaintiffs, issuer-defendants and their insurers setting forth terms of a settlement that would result in the termination of all claims brought by plaintiffs against the
issuer-defendants and individual defendants named in the lawsuit. In August 2003, our Board of Directors approved the settlement terms described in the memorandum of understanding. In May 2004, we signed a settlement agreement on behalf of
TippingPoint Technologies, Inc. and our current and former directors and officers with the plaintiffs. This settlement agreement formalizes the previously approved terms of the memorandum of understanding and, subject to certain conditions, provides
for the complete dismissal, with prejudice, of all claims against us and our current and former directors and officers. Any direct financial impact of the settlement is expected to be borne by our insurers. The settlement is subject to numerous
conditions, including final approval by the court. There can be no assurance that such conditions will be met or that the court will approve the terms of the settlement agreement. If the court rejects the settlement agreement, in whole or in part,
or the settlement does not occur for any other reason and the litigation against us continues, we intend to defend this action vigorously, and to the extent necessary, to seek indemnification and/or contribution from the underwriters in our initial
public offering pursuant to our underwriting agreement with them. However, there can be no assurance that indemnification or contribution will be available to us or enforceable against the underwriters.



25



---

##### Table of Contents

At this time, we are not involved in any other legal proceedings that our management currently believes
would be material to our business, financial condition or results of operations. We could be forced to incur material expenses with respect to these legal proceedings, and in the event there is an outcome in any proceeding that is adverse to us, our
financial position and prospects could be harmed.



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



|      |   |  |                                                                                                                                 
|----- | - |  | --------------------------------------------------------------------------------------------------------------------------------
|      |  
|(a)   |   |  | Exhibits.                                                                                                                       
|      |  
|3.1   |   |  | Restated Certificate of Incorporation of the Company. (1)                                                                       
|      |  
|3.2   |   |  | Restated Bylaws of Registrant. (2)                                                                                              
|      |  
|4.1   |   |  | Specimen Certificate for Common Stock. (3)                                                                                      
|      |  
|4.2   |   |  | Registration Rights Agreement among the Company and the purchasers of its capital stock dated October 2, 2002. (5)              
|      |  
|10.1  |   |  | Office Lease by and between the Company and SV Bull Creek Limited Partnership dated February 16, 2000. (4)                      
|      |  
|10.2  | * |  | The Companys Fourth Amended and Restated 1999 Stock Option and Restricted Stock Plan. (3)                                      
|      |  
|10.3  | * |  | The Companys Amended and Restated 2000 Employee Stock Purchase Plan. (2)                                                       
|      |  
|10.4  | * |  | Form of Indemnity Agreement between the Company and its Directors and Officers. (2)                                             
|      |  
|10.5  | * |  | Employment Agreement by and between James E. Cahill and the Company dated as of March 1, 2001. (3)                              
|      |  
|10.6  | * |  | Promissory Note of James E. Cahill payable to the Company dated November 8, 1999. (3)                                           
|      |  
|10.7  | * |  | Pledge Agreement by and between James E. Cahill and the Company dated November 8, 1999. (3)                                     
|      |  
|10.8  | * |  | Promissory Note of Craig Cantrell payable to the Company dated June 30, 1999. (3)                                               
|      |  
|10.9  | * |  | Pledge Agreement by and between Craig Cantrell and the Company dated June 30, 1999. (3)                                         
|      |  
|10.10 |   |  | Loan and Security Agreement by and between the Company and Comerica Bank-California dated July 30, 2002. (6)                    
|      |  
|10.11 |   |  | First Amendment to Loan and Security Agreement by and between the Company and Comerica Bank-California dated March 24, 2003. (7)
|      |  
|10.12 | * |  | Employment Agreement by and between Kip McClanahan and the Company dated April 13, 2004. (8)                                    
|      |  
|10.13 | * |  | Employment Agreement by and between Adam Chibib and the Company dated April 12, 2004. (8)                                       
|      |  
|10.14 | * |  | Employment Agreement by and between James A. Hamilton and the Registrant dated as of September 10, 2003. (9)                    



26



---

##### Table of Contents

|      |   |  |                                                                                                                               
|----- | - |  | ------------------------------------------------------------------------------------------------------------------------------
|10.15 | * |  | Restricted Stock Agreement by and between James A. Hamilton and the Registrant dated as of September 15, 2003. (9)            
|      |  
|31.1  |   |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Chief Executive Officer).                            
|      |  
|31.2  |   |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Chief Financial Officer).                            
|      |  
|32    |   |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Chief Executive Officer and Chief Financial Officer).

---

|* | Management contract or compensatory plan, contract or arrangement required to be filed as an exhibit pursuant to Item 4(c) of Form 10-K
|- | ---------------------------------------------------------------------------------------------------------------------------------------

|(1) | Incorporated herein by reference to Registrants Quarterly Report on Form 10-Q filed with the Commission on November 9, 2001.
|--- | -----------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated herein by reference to Registrants Quarterly Report on Form 10-Q filed with the Commission on September 6, 2002.
|--- | ------------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated herein by reference to Registrants Annual Report on Form 10-K filed with the Commission on March 27, 2002.
|--- | ------------------------------------------------------------------------------------------------------------------------

|(4) | Incorporated herein by reference to Registrants Amendment No.4 to Registration Statement on Form S-1 filed with the Commission on February 25, 2000.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Incorporated herein by reference to Registrants Current Report on Form 8-K filed with the Commission on October 4, 2002.
|--- | -------------------------------------------------------------------------------------------------------------------------

|(6) | Incorporated herein by reference to Registrants Current Report on Form 8-K filed with the Commission on August 5, 2002.
|--- | ------------------------------------------------------------------------------------------------------------------------

|(7) | Incorporated herein by reference to Registrants Annual Report on Form 10-K filed with the Commission on April 28, 2003.
|--- | ------------------------------------------------------------------------------------------------------------------------

|(8) | Incorporated herein by reference to Registrants Annual Report on Form 10-K filed with the Commission on April 20, 2004.
|--- | ------------------------------------------------------------------------------------------------------------------------

|(9) | Incorporated herein by reference to Registrants Quarterly Report on Form 10-Q filed with the Commission on December 12, 2003.
|--- | ------------------------------------------------------------------------------------------------------------------------------



|   |   |  |                                                                                                                                                                                                                                              
|-- | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   |  
|(b | ) |  | Current Reports on Form 8-K:                                                                                                                                                                                                                 
|   |  
|   |   |  | On April 21, 2004, we furnished a Current Report on Form 8-K in which we disclosed, pursuant to Item 12 of Form 8-K, that we had issued a press release announcing our results of operations
for the quarter and year ended January 31, 2004.
|   |  
|   |   |  | We neither filed nor furnished any other reports on Form 8-K during the quarter for which this report is filed.                                                                                                                              



27



---

##### Table of Contents

SIGNATURES



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



|                   |  |                                             
|------------------ |  | --------------------------------------------
|                   |  | TIPPINGPOINT TECHNOLOGIES, INC.             
|                   | 
|Date: June 1, 2004 |  | /s/ ADAM CHIBIB                             
|                   |  | Adam Chibib                                 
|                   |  | Chief Financial Officer                     
|                   |  | (Principal Financial and Accounting Officer)



28