##### Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)



|x | Quarterly Report Pursuant to Section 13 or 15(d) Of The Securities Exchange Act of 1934
|- | ---------------------------------------------------------------------------------------



For Quarter Ended October 31, 2003



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.



Organized in
the State of Delaware

Tax Identification No. 74-2902814



7501B North Capital of Texas Highway, Austin, Texas 78731

Telephone No. (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



The number of shares outstanding of each of the issuers classes of
common stock as of November 30, 2003.



|Class                         |  | Number of Shares
|----------------------------- |  | ----------------
|Common Stock, $0.01 par value |  | 7,303,776       



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TIPPINGPOINT TECHNOLOGIES, INC.



INDEX



|         |  |                                                                                                              |  | PageNumber
|-------- |  | ------------------------------------------------------------------------------------------------------------ |  | ----------
|         |  |                                                                                                             
|PART I.  |  | FINANCIAL INFORMATION:                                                                                       |  | 1         
|         |  |                                                                                                             
|Item 1.  |  | Financial Statements (unaudited)                                                                             |  | 1         
|         |  |                                                                                                             
|         |  | Condensed Balance Sheets as of October 31, 2003 and January 31, 2003                                         |  | 1         
|         |  |                                                                                                             
|         |  | Condensed Statements of Operations for the three and nine months ended October 31, 2003 and October 31, 2002 |  | 2         
|         |  |                                                                                                             
|         |  | Condensed Statements of Cash Flows for the nine months ended October 31, 2003 and October 31, 2002           |  | 3         
|         |  |                                                                                                             
|         |  | Notes to Unaudited Condensed Financial Statements                                                            |  | 4         
|         |  |                                                                                                             
|Item 2.  |  | Managements Discussion and Analysis of Results of Operations and Financial Condition                        |  | 9         
|         |  |                                                                                                             
|Item 3.  |  | Quantitative and Qualitative Disclosure About Market Risk                                                    |  | 25        
|         |  |                                                                                                             
|Item 4.  |  | Controls and Procedures                                                                                      |  | 25        
|         |  |                                                                                                             
|PART II. |  | OTHER INFORMATION:                                                                                           |  | 25        
|         |  |                                                                                                             
|Item 1.  |  | Legal Proceedings                                                                                            |  | 25        
|         |  |                                                                                                             
|Item 2.  |  | Changes in Securities and Use of Proceeds                                                                    |  | 26        
|         |  |                                                                                                             
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                          |  | 27        
|         |  |                                                                                                             
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                                             |  | 27        
|         |  |                                                                                                             
|         |  | Signatures                                                                                                   |  | 29        





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##### Table of Contents

|PART  I. |  | FINANCIAL INFORMATION.
|-------- |  | ----------------------



|ITEM  1. |  | FINANCIAL STATEMENTS.
|-------- |  | ---------------------



TIPPINGPOINT TECHNOLOGIES, INC.

CONDENSED BALANCE SHEETS

(UNAUDITED)



|ASSETS                                                                                                                                                                                          |  | October 31,2003 |              |   | January 31, 2003 |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------- | ------------ | - | ---------------- | -
|Current assets:                                                                                                                                                                                 |  |                 |              |   |                  |  
|Cash, cash equivalents and short-term investments                                                                                                                                               |  | $               | 24,834,494   |   |                  | $
|Accounts receivable                                                                                                                                                                             |  |                 | 1,687,691    |   |                  |  
|Inventory                                                                                                                                                                                       |  |                 | 1,818,799    |   |                  |  
|Prepaid expenses and other current assets                                                                                                                                                       |  |                 | 740,440      |   |                  |  
|                                                                                                                                                                                                |  |                 |              |   |                  |  
|Total current assets                                                                                                                                                                            |  |                 | 29,081,424   |   |                  |  
|Property and equipment, net                                                                                                                                                                     |  |                 | 2,816,400    |   |                  |  
|Other                                                                                                                                                                                           |  |                 | 3,310,090    |   |                  |  
|                                                                                                                                                                                                |  |                 |              |   |                  |  
|                                                                                                                                                                                                |  | $               | 35,207,914   |   |                  | $
|                                                                                                                                                                                                |  |                 |              |   |                  |  
|                                                                                                                                                                                                |  |                
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                            |  |                 |              |   |                  |  
|                                                                                                                                                                                                |  |                
|Current liabilities:                                                                                                                                                                            |  |                 |              |   |                  |  
|Trade accounts payable                                                                                                                                                                          |  | $               | 841,663      |   |                  | $
|Current portion of long-term debt                                                                                                                                                               |  |                 | 582,283      |   |                  |  
|Accrued liabilities                                                                                                                                                                             |  |                 | 5,053,409    |   |                  |  
|                                                                                                                                                                                                |  |                 |              |   |                  |  
|Total current liabilities                                                                                                                                                                       |  |                 | 6,477,355    |   |                  |  
|Long-term debt, excluding current portion                                                                                                                                                       |  |                 | 464,902      |   |                  |  
|Other liabilities                                                                                                                                                                               |  |                 | 254,980      |   |                  |  
|                                                                                                                                                                                                |  |                 |              |   |                  |  
|Total liabilities                                                                                                                                                                               |  |                 | 7,197,237    |   |                  |  
|                                                                                                                                                                                                |  |                 |              |   |                  |  
|                                                                                                                                                                                                |  |                
|Commitments and contingencies                                                                                                                                                                   |  |                 |              |   |                  |  
|                                                                                                                                                                                                |  |                
|Stockholders equity:                                                                                                                                                                           |  |                 |              |   |                  |  
|Common stock, $0.01 par value; 250,000,000 shares authorized; 6,353,359 shares issued and outstanding as of October 31, 2003 and
5,250,000 shares issued and outstanding as of January 31, 2003 |  |                 | 63,534       |   |                  |  
|Additional paid-in capital                                                                                                                                                                      |  |                 | 329,002,784  |   |                  |  
|Deferred stock-based compensation                                                                                                                                                               |  |                 | (2,858,100   | ) |                  |  
|Stockholder notes receivable                                                                                                                                                                    |  |                 | (652,800     | ) |                  |  
|Accumulated other comprehensive income                                                                                                                                                          |  |                 |             |   |                  |  
|Accumulated deficit                                                                                                                                                                             |  |                 | (297,544,741 | ) |                  |  
|                                                                                                                                                                                                |  |                 |              |   |                  |  
|Total stockholders equity                                                                                                                                                                      |  |                 | 28,010,677   |   |                  |  
|                                                                                                                                                                                                |  |                 |              |   |                  |  
|                                                                                                                                                                                                |  | $               | 35,207,914   |   |                  | $
|                                                                                                                                                                                                |  |                 |              |   |                  |  



See accompanying notes
to unaudited condensed financial statements.





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TIPPINGPOINT TECHNOLOGIES, INC.

CONDENSED STATEMENTS OF OPERATIONS

(UNAUDITED)



|                                                                         |  | Three Months Ended October 31, |            |   | Nine Months Ended October 31, |  
|------------------------------------------------------------------------ |  | ------------------------------ | ---------- | - | ----------------------------- | -
|                                                                         |  | 2003                           |            |   | 2002                          |  
|Revenues                                                                 |  | $                              | 2,052,510  |   |                               | $
|Cost of revenues                                                         |  |                                | 627,991    |   |                               |  
|                                                                         |  |                                |            |   |                               |  
|Gross margin                                                             |  |                                | 1,424,519  |   |                               |  
|                                                                         |  |                                |            |   |                               |  
|Operating expenses:                                                      |  |                                |            |   |                               |  
|Research and development1                                                |  |                                | 1,980,872  |   |                               |  
|Sales and marketing1                                                     |  |                                | 1,730,200  |   |                               |  
|General and administrative1                                              |  |                                | 652,399    |   |                               |  
|Amortization of deferred stock-based compensation                        |  |                                | 221,052    |   |                               |  
|                                                                         |  |                                |            |   |                               |  
|Total operating expenses                                                 |  |                                | 4,584,523  |   |                               |  
|                                                                         |  |                                |            |   |                               |  
|Operating loss                                                           |  |                                | (3,160,004 | ) |                               |  
|Interest income, net                                                     |  |                                | 57,476     |   |                               |  
|                                                                         |  |                                |            |   |                               |  
|Loss from continuing operations                                          |  |                                | (3,102,528 | ) |                               |  
|Discontinued operations:                                                 |  |                                |            |   |                               |  
|Loss on disposal of a discontinued business                              |  |                                |           |   |                               |  
|                                                                         |  |                                |            |   |                               |  
|Net loss                                                                 |  | $                              | (3,102,528 | ) |                               | $
|                                                                         |  |                                |            |   |                               |  
|Per share data:                                                          |  |                                |            |   |                               |  
|Net basic and diluted loss from continuing operations per common share   |  | $                              | (0.57      | ) |                               | $
|Net basic and diluted loss from discontinued operations per common share |  |                                |           |   |                               |  
|                                                                         |  |                                |            |   |                               |  
|Net basic and diluted loss per common share                              |  | $                              | (0.57      | ) |                               | $
|                                                                         |  |                                |            |   |                               |  
|Weighted average common shares outstanding                               |  |                                | 5,429,651  |   |                               |  
|                                                                         |  |                                |            |   |                               |  



See accompanying notes
to unaudited condensed financial statements.



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



|                           |  | Three Months Ended |         | Nine Months Ended
|-------------------------- |  | ------------------ | ------- | -----------------
|                           |  | October 31,        |         | October 31,      
|                           |  | 2003               |         | 2002             
|Research and development   |  | $                  | 96,973  |                  
|Sales and marketing        |  |                    | 114,497 |                  
|General and administrative |  |                    | 9,582   |                  
|                           |  |                    |         |                  
|TOTAL                      |  | $                  | 221,052 |                  
|                           |  |                    |         |                  



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TIPPINGPOINT TECHNOLOGIES, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(UNAUDITED)



|                                                                                                                  |  | Nine Months Ended October 31, |            
|----------------------------------------------------------------------------------------------------------------- |  | ----------------------------- | -----------
|                                                                                                                  |  | 2003                          |            
|Cash flows from continuing operating activities:                                                                  |  |                               |            
|Net loss from continuing operations                                                                               |  | $                             | (12,985,416
|Adjustments to reconcile net loss from continuing operations to net cash used in continuing operating activities: |  |                               |            
|Depreciation and amortization                                                                                     |  |                               | 2,162,252  
|Accretion of investment securities                                                                                |  |                               | (3,750     
|Amortization of deferred stock-based compensation                                                                 |  |                               | 492,990    
|Inventory writedown                                                                                               |  |                               | 362,605    
|Changes in operating assets and liabilities:                                                                      |  |                               |            
|Accounts receivable                                                                                               |  |                               | (1,687,691 
|Inventory                                                                                                         |  |                               | (1,042,835 
|Prepaid expenses and other current assets                                                                         |  |                               | 121,646    
|Other non-current assets                                                                                          |  |                               | (13,775    
|Trade accounts payable, accrued liabilities, and other non-current liabilities                                    |  |                               | 399,790    
|                                                                                                                  |  |                               |            
|Net cash used in continuing operating activities                                                                  |  |                               | (12,194,184
|                                                                                                                  |  |                               |            
|Cash flows from investing activities:                                                                             |  |                               |            
|Purchases of property and equipment                                                                               |  |                               | (479,207   
|Purchases of investment securities                                                                                |  |                               |           
|Investment securities matured                                                                                     |  |                               | 6,064,626  
|                                                                                                                  |  |                               |            
|Net cash provided by investing activities                                                                         |  |                               | 5,585,419  
|                                                                                                                  |  |                               |            
|Cash flows from financing activities:                                                                             |  |                               |            
|Net increase in restricted cash in other non-current assets                                                       |  |                               | (1,399,674 
|Proceeds from borrowings under long-term debt                                                                     |  |                               | 365,351    
|Principal payments on debt                                                                                        |  |                               | (349,061   
|Payment of debt issuance costs                                                                                    |  |                               |           
|Net proceeds from private placement of common stock                                                               |  |                               | 11,642,495 
|Proceeds from exercise of stock options                                                                           |  |                               | 187,311    
|                                                                                                                  |  |                               |            
|Net cash provided by financing activities                                                                         |  |                               | 10,446,422 
|                                                                                                                  |  |                               |            
|Cash used in discontinued operations                                                                              |  |                               | (89,032    
|                                                                                                                  |  |                               |            
|Net increase (decrease) in cash and cash equivalents                                                              |  |                               | 3,748,625  
|                                                                                                                  |  |                               |            
|Cash and cash equivalents at beginning of period                                                                  |  |                               | 21,085,869 
|                                                                                                                  |  |                               |            
|Cash and cash equivalents at end of period                                                                        |  | $                             | 24,834,494 
|                                                                                                                  |  |                               |            
|Short-term investments                                                                                            |  | $                             |           
|                                                                                                                  |  |                               |            
|Cash, cash equivalents and short-term investments                                                                 |  | $                             | 24,834,494 
|                                                                                                                  |  |                               |            



See accompanying notes
to unaudited condensed financial statements.



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NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS



|1) | Incorporation and Nature of Business
|-- | ------------------------------------



TippingPoint Technologies, Inc. was incorporated in the State of Texas in January 1999 and was reincorporated in the State of Delaware on March 15, 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.



We were formerly named Netpliance, Inc. while 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. See Note 9, Discontinued Operations.



As a result of the early 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 whom we also established a revolving loan facility that was unused through October 31, 2003. In
the future, we may seek additional funding through private or public equity offerings, additional credit facilities or other financing arrangements, at least until such time as we achieve positive cash flow from operations. However, we cannot assure
you that such financing will be available or that we will ever achieve positive operating cash flows.



In the opinion of our management, the accompanying unaudited condensed 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, 2003 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, 2003. Interim
results are not necessarily indicative of results we expect in future periods.



|(2) | Inventory
|--- | ---------



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 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 October 31, 2003 and January 31, 2003, our inventory consisted of component parts of approximately $770,000 and $839,000, respectively, and finished
goods of approximately $1,049,000 and



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$300,000, respectively. During the nine months ended October 31, 2003, the Company recorded a $363,000 inventory
writedown in cost of revenues. The charge arose from the Companys determination that certain component parts were obsolete because the components were incompatible with enhancements made to our product designs.



|(3) | 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 loan facility, we can borrow up to $5 million for working capital purposes, subject to availability under a borrowing base. As of October 31, 2003 and January 31, 2003, we had borrowings outstanding of approximately $1.0 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 credit 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. 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, disposition of assets, investments and dividends.



|(4) | Common Stock
|--- | ------------



On October 17, 2003, we entered into an agreement to obtain approximately $24 million, in gross proceeds, from investors acquiring 1,995,833 shares of our
common stock in a private placement. In the first of two closings, on October 20, 2003, we received approximately $11.6 million, net of related offering costs, for the sale of 1,045,833 common shares. The completion of the sale of 950,000 common
shares required shareholder approval that was obtained in a special meeting of our stockholders on November 20, 2003. On November 24, 2003, we completed the second closing and received approximately $10.9 million, net of related offering costs.
Included in the investors are John F. McHale, our Chairman and Chief Executive Officer, The McKinney Family Trust, a current stockholder, 033 Asset Management LLC, and certain other related parties including another executive officer and a director.



|(5) | Net Loss Per Share
|--- | ------------------



Basic and diluted net loss per share are presented in conformity with Statement of Financial Accounting Standards (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.



|(6) | Stock-Based Compensation
|--- | ------------------------



We apply the intrinsic value-based method of accounting prescribed by Accounting Principles Board 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. SFAS No.
123, Accounting for Stock-Based Compensation (SFAS 123), as amended by SFAS 148 Accounting for



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Stock-Based CompensationTransition and Disclosures, requires that companies that do not choose to account for
stock-based compensation as prescribed by SFAS 123 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 value at the grant dates consistent with the method prescribed by
SFAS 148 and SFAS 123, our net loss and net loss per share would have been increased to the pro forma amounts indicated below:



|                                                                                                            |  | ThreeMonthsEndedOctober 31,2003 |            |   | ThreeMonthsEndedOctober 31,2002 |   |            | NineMonthsEndedOctober 31,2003 |  |   | Nine MonthsEndedOctober 31,2002 |  
|----------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ------------------------------- | - | ---------- | ------------------------------ |  | - | ------------------------------- | -
|Net loss as reported                                                                                        |  | $                               | (3,102,528 | ) |                                 | $ | (6,450,419 | )                              |  | $ | (12,985,416                     | )
|Add: Employee stock-based compensation included in the reported net loss                                    |  |                                 | 221,052    |   |                                 |   | 176,529    |                                |  |   | 431,766                         |  
|Deduct: Total employee stock-based compensation determined under the fair value based method for all awards |  |                                 | 321,641    |   |                                 |   | 215,267    |                                |  |   | 700,364                         |  
|                                                                                                            |  |                                 |            |   |                                 |   |            |                                |  |   |                                 |  
|Pro forma net loss                                                                                          |  | $                               | (3,203,117 | ) |                                 | $ | (6,489,157 | )                              |  | $ | (13,254,014                     | )
|                                                                                                            |  |                                 |            |   |                                 |   |            |                                |  |   |                                 |  
|Basis and diluted net loss per share:                                                                       |  |                                 |            |   |                                 |   |            |                                |  |   |                                 |  
|As reported                                                                                                 |  | $                               | (0.57      | ) |                                 | $ | (1.45      | )                              |  | $ | (2.44                           | )
|Pro forma                                                                                                   |  | $                               | (0.59      | ) |                                 | $ | (1.46      | )                              |  | $ | (2.49                           | )



The per share
weighted-average fair value of stock options granted during the nine months ended October 31, 2003 and 2002 was $3.52 and $2.91, 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 2.94% and 3.98% for 2003 and 2002, respectively, a dividend yield of zero and volatility of 50% for all periods presented and a weighted average expected life of four years.



In September 2003, we granted 225,000 shares of restricted common stock to
two new employees, including our President and Chief Operating Officer. We recorded approximately $2.7 million of deferred compensation related to these grants that we will amortize ratably over the vesting period of four years, with unvested shares
being subject to forfeiture under certain circumstances. Upon certain change of control events, to the extent certain shares of restricted stock are not then fully vested, one-half of such shares will immediately vest.



We have recorded stock-based compensation expense of approximately $221,000
and $493,000 for the three months and nine months ended October 31, 2003, respectively, and approximately $183,000 and $684,000 for the three months and nine months ended October 31, 2002, respectively, as a result of granting stock options with
exercise prices below the deemed fair market value of our common stock for financial reporting purposes at the date of grant or the granting of restricted stock.



|(7) | Commitments and Contingencies
|--- | -----------------------------



We lease our office space and certain equipment under non-cancelable operating leases expiring in various years through 2007. Our minimum lease
commitments under non-cancelable leases at October 31, 2003 are approximately $4.5 million, of which $2.3 million is recorded in accrued liabilities in the



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accompanying balance sheet for lease termination costs of the discontinued operations. Terms of our facility lease call
for letters of credit totaling approximately $1.2 million. We have pledged certificates of deposit (included in other noncurrent assets at October 31, 2003) as collateral.



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. 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. Any direct financial impact of the settlement is expected to be borne by our insurers. In August 2003, our Board of Directors approved the settlement terms described in the
Memorandum of Understanding. The settlement is subject to numerous conditions, including approval by the court. There can be no assurance that such conditions will be met or that the court will approve the final terms of the settlement. If the
settlement does not occur, and the litigation against us continues, we intend to defend it 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.



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|(8) | Business Segment and Revenue Information
|--- | ----------------------------------------



We operate in one business segment, the sale of network security systems. For the quarter ended October 31, 2003, all of our revenues were attributable to
sales to customers in the United States. Approximately $311,000 and $621,000 of the revenues for the three months and nine months ended October 31, 2003, respectively, were from a university in which an officer and director of our company is on the
board of trustees and is a benefactor.



|(9) | Discontinued Operations
|--- | -----------------------



In connection with our consumer Internet appliance and service business, we experienced operating losses since our inception primarily as a result of
selling our Internet appliance at a significant loss; trying to build and support our Internet service offering for Internet appliance customers; expanding our subscriber base; and ultimately winding this business down.



In November 2000, we began shifting our business model away from our consumer
Internet offering and restructured our operations. In February 2001, we entered into an agreement with a third party for the transfer of our service obligations relating to most of our existing customers, and we transferred approximately 50,000 of
our customers to the third partys service on March 12, 2001. We ceased providing any Internet access service to our remaining customers in June 2001. In December 2001, any obligation for us to continue providing support services for other
Internet service providers expired. Effective January 1, 2002, the third party began operating the Internet portal for their customers who had been using our portal. We have exited our consumer-focused business entirely, but we continue to have
certain obligations, contingencies and potential liabilities relating to this business. There were no operating results of the discontinued consumer Internet appliance and service business for the nine months ended October 31, 2003.



As of October 31, 2003, we had reflected in accrued liabilities in the
accompanying balance sheet approximately $3.3 million for costs of the discontinued operations that we estimated we would incur in future periods. The accrued costs consist primarily of a restructuring accrual of approximately $2.3 million relating
to lease termination costs and approximately $1.0 million relating to estimated legal fees and other expenses. Of the $2.3 million, approximately $1.9 million was recently ordered by a Texas state court in Travis County, Texas to be placed in its
registry pending the outcome of litigation concerning the lease related to the discontinued operations. We intend to appeal this order. Any differences between these estimates and the actual amounts incurred in future periods will change the
estimated net loss from discontinued operations accordingly.



In connection with the restructuring plan, we accrued lease termination costs related to an unused facility in Austin, Texas that we utilized with our old business. During the nine months ended October 31, 2002, we increased our reserve for
lease termination costs by approximately $813,000, and recorded an additional expense in that amount for discontinued operations, due to the weakness in the commercial real estate market. We have attempted unsuccessfully to sub-lease the unused
facility in an effort to minimize lease termination costs, which are currently in dispute and the subject of a lawsuit with the landlord. The terms of the lease called for letters of credit totaling approximately $470,000. We pledged certificates of
deposit (included in other noncurrent assets at January 31, 2003) as collateral. In March 2003, all of the letters of credit were drawn upon by the landlord. Accordingly, the reserve and noncurrent other assets have been reduced by approximately
$470,000 during the nine month period ended October 31, 2003.



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The following table provides a summary of charges and changes in the lease termination restructuring
accrual for the nine months ended October 31, 2003:



|                                            |  | Nine Months Ended October 31, 2003 |          
|------------------------------------------- |  | ---------------------------------- | ---------
|Accrual at January 31, 2003                 |  | $                                  | 2,758,760
|Cash payments in period                     |  |                                    | (472,327 
|Expensed in period                          |  |                                    |         
|                                            |  |                                    |          
|Accrual at April 30, 2003                   |  |                                    | 2,286,433
|Cash payments in period                     |  |                                    |         
|Expensed in period                          |  |                                    |         
|                                            |  |                                    |          
|Accrual at July 31, 2003 & October 31, 2003 |  | $                                  | 2,286,433
|                                            |  |                                    |          



|(10) | Subsequent Events
|---- | -----------------



In a special meeting on November 20, 2003, our stockholders approved the sale of 950,000 shares of our common stock in a private placement as discussed in
note 4. In that meeting, our stockholders also approved an amendment to our Third Amended and Restated 1999 Stock Option and Restricted Stock Plan to increase the number of shares available for issuance from 1,033,333 to 2,033,333.



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



This report, including the discussion in this Managements Discussion and Analysis of Results of Operations and
Financial Condition, contains trend analysis and other forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All of our 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 our plans, strategies
and objectives for future operations; any statements concerning our 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 may, will, estimate, intend, continue, believe, expect or anticipate
and other similar words.



Although we believe that the
expectations reflected in any of our forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any of our forward-looking statements. Our future financial condition and results of
operations, 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.



Actual results could differ materially from those set forth in
such forward-looking statements as a result of the Factors Affecting Operating Results and other risks detailed in this report and our other reports filed with the Securities and Exchange Commission. We urge you to review carefully the
section Factors Affecting Operating Results in this report for a more complete discussion of the risks associated with an investment in our securities.



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



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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, litigation and 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.



Our critical accounting policies are as follows:



Revenue Recognition.Revenue is recorded from sales of our hardware-based security systems and appliances, and to a lesser extent, from services.
We sell primarily to resellers, including value-added resellers (VARs). Generally, we will 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 will record discounts provided to resellers for achieving purchasing targets as a reduction of revenue on the date of
sale.



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 not more likely than not that we will 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 October 31, 2003 is zero.



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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.



Litigation. 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. At October 31, 2003,
we had approximately $1 million accrued for legal fees and other expenses, which was included in the estimated loss from discontinued operations in prior fiscal years.



Discontinued Operations. As of October 31, 2003, we had reflected in accrued liabilities in the accompanying balance
sheet approximately $3.3 million for costs of the discontinued operations that we estimated we would incur in future periods. The accrued costs consist primarily of a restructuring accrual of approximately $2.3 million relating to lease termination
costs and approximately $1.0 million relating to estimated legal fees and other expenses. Of the $2.3 million, approximately $1.9 million was recently ordered by a Texas state court in Travis County, Texas to be placed in its registry pending the
outcome of litigation concerning the lease related to the discontinued operations. We intend to appeal this order. The lease termination costs related to an unused facility in Austin, Texas that we utilized with our old business. We have attempted
unsuccessfully to sub-lease the unused facility in an effort to minimize lease termination costs, which are currently in dispute and the subject of a lawsuit with the landlord. The terms of the lease called for letters of credit totaling
approximately $470,000. We pledged certificates of deposit (included in other noncurrent assets at January 31, 2003) as collateral. In March 2003, the letters of credit were drawn upon by the landlord. Accordingly, the reserve and noncurrent other
assets have been reduced by approximately $470,000 during the nine month period ended October 31, 2003. 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.



Overview



We are a provider of network-based Intrusion Prevention Systems
(IPS) that provide enterprise network protection from external and internal threats, including malicious viruses, cyber-terrorist and hacker attacks. In February 2002, we announced our entry into the network security industry with our
UnityOne line of products, the result of the development effort we initiated in 2001. This product line delivers high-speed network-based intrusion prevention systems to corporate enterprises, governmental agencies, service providers and academic
institutions. In September 2002, we announced the availability of our UnityOne product line and in the current fiscal year have announced four additional offerings in



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the UnityOne product line. Going forward, we anticipate that we will primarily focus our efforts on developing and
marketing products and services in the network security industry.



Our UnityOne line of appliances and systems, which have high-speed, security-optimized, processors that can operate at gigabit speeds, are hardware-based products designed to protect enterprise information systems from external and internal
hostile, malicious or cyber-terrorist attacks. Our products are designed to continually analyze Internet and Intranet traffic and block attacks, commonly referred to as viruses, worms, Trojans and denial-of-service attacks, before damage occurs and
without compromising network operating performance. Our peer-to-peer piracy prevention functionality allows enterprises to control the use of peer-to-peer file sharing applications by blocking, limiting and prioritizing peer-to-peer traffic based on
specific client, server, IP address or application type.



We
believe that our competitive advantage is the ability of our products to stop attacks in a network at gigabit per second speeds, without slowing network operating performance. Our hardware-based platform is designed for network-based attack
prevention and is capable of supporting thousands of filters that can perform deep packet inspections across a network segment without compromising network operating performance. We believe that our approach offers customers an effective
network-based security solution with attractive economics, high performance, scalability and reliability.



We provide a real-time attack filter update service, called Digital Vaccine, that delivers rapid inoculation of our products against emerging threats. Our Threat Management Center monitors and collects
security intelligence from alert services around the world, we perform investigations of new software vulnerabilities and then we create filters that are delivered to subscribers in the form of an update to our appliances and systems. We develop and
deploy these UnityOne attack filters to address specific vulnerabilities before related exploits occur. Our ability to deliver these filters generates savings for our customers by eliminating the costs associated with the significant operational
efforts needed to quickly patch hundreds or thousands of servers and/or client systems during or following an actual attack. Further, as a public service, we partner with SANS (SysAdmin, Audit, Network, Security) Institute, a cooperative research
and education organization, to evaluate, assess and rate (based on greatest threat) new vulnerabilities every week.



Our products are currently complementary to firewalls, but significantly improve protection against malicious attacks. Even with firewalls, organizations
are still plagued by dangerous attacks such as Blaster, Sobig, Code Red, Nimda and Sapphire, which continue to penetrate through firewalls. Accordingly, prevention products are increasingly seen as a critical tier of any multi-tier security
strategy. Firewalls offer security mechanisms for limited layers of network communications. Our UnityOne intrusion prevention products protect information technology infrastructures from attacks that firewalls miss, and prevent intrusions within
network communication that firewalls cannot prevent. Firewalls are also typically positioned at the network perimeter. UnityOne products have the ability to be located either at the core of the network or at the perimeter, enabling protection from
external and internal attacks and abuses.



Results of Continuing Operations



Revenues



We recognized approximately $2.1 million and $3.0 million of revenues during
the three months and nine months ended October 31, 2003, respectively. These are the first periods in which we have recognized revenue from sales of our high-speed network-based intrusion prevention systems and appliances. Included in revenues is
approximately $216,000 from sales transactions that occurred during the fourth quarter of fiscal year 2003. At January 31, 2003, this revenue was deferred under applicable



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accounting rules and our policy and subsequently met the recognition criteria during the first quarter of fiscal 2003.
All of the revenues were attributable to sales to customers in the United States.



Gross Margin



For the three months and nine
months ended October 31, 2003, cost of revenues were approximately $628,000 and $1,782,000, respectively, and gross margins were approximately $1.4 million and $1.2 million, respectively. Included in cost of revenues for the nine months ended
October 31, 2003 is an inventory writedown of $363,000. The charge arose from our determination that certain component parts were obsolete because the components were incompatible with enhancements made to our product designs. Cost of revenues also
included approximately $190,000 and $762,000 of fixed manufacturing overhead and warranty support costs for the three months and nine months ended October 31, 2003, respectively.



Operating Expenses



Research and development expenses. Research and development expenses were approximately $2.0 million and $4.1 million for the three months ended
October 31, 2003 and 2002, respectively. For the nine months ended October 31, 2003 and 2002, research and development expenses were approximately $6.7 million and $11.8 million, respectively. The decrease in research and development expenses during
both periods was due to decreases in employment costs, as a result of decreased headcount, and reduction in expenses incurred in developing our product offerings, including prototype and outside services.



Sales and marketing expenses.Sales and marketing expenses totaled
approximately $1.7 million and $1.2 million for the three months ended October 31, 2003 and 2002, respectively. Sales and marketing expenses totaled approximately $5.2 million and $2.7 million for the nine months ended October 31, 2003 and 2002,
respectively. The increase in sales and marketing expenses during both periods was the result of growth in our sales organizations supporting the expansion of sales efforts, principally employment and travel costs. The increases were partially
offset by a reduction in certain advertising expenses.



General and administrative expenses. General and administrative expenses were approximately $652,000 and $1.1 million for the three months ended October 31, 2003 and 2002, respectively. For the nine months ended October 31, 2003 and
2002, general and administrative expenses were approximately $2.1 million and $3.6 million, respectively. The decrease in general and administrative expenses during both periods was primarily the result of decreases in employment costs, due to
reductions in headcount.



Amortization of deferred
stock-based compensation. We have recorded stock-based compensation expense of approximately $221,000 and $183,000 for the three months ended October 31, 2003 and 2002, respectively. The increase in expense for the three months ended October 31,
2003 as compared to the prior year was due to restricted stock grants issued in September 2003. We have recorded stock-based compensation expense of approximately $493,000 and $684,000 for the nine months ended October 31, 2003 and 2002,
respectively. The decrease in expense for the nine months ended October 31, 2003 as compared to the prior year was due to forfeitures resulting from employees whose employment terminated in the more recent period.



Other



Interest income. Interest income, net of interest expense, totaled approximately $57,000 for the three months ended
October 31, 2003 as compared to approximately $142,000 for the three months ended October 31, 2002, and approximately $231,000 for the nine months ended October 31, 2003 as compared



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to approximately $489,000 for the nine months ended October 31, 2002. The decrease in interest income in fiscal year 2003
was due to a general decrease in the average cash balances in interest-bearing accounts we held at banking and financial institutions throughout the year, as well as a general reduction in the average yield earned on invested funds.



Discontinued operations. There were no operating results of the
discontinued consumer Internet appliance and service business for the three months and nine months ended October 31, 2003. As of October 31, 2003, we had reflected in accrued liabilities in the accompanying balance sheet approximately $3.3 million
for costs of the discontinued operations that we estimated we would incur in future periods. The accrued costs consist primarily of a restructuring accrual of approximately $2.3 million relating to lease termination costs and approximately $1
million relating to estimated legal fees and other expenses. Of the $2.3 million, approximately $1.9 million was recently ordered by a Texas state court in Travis County, Texas to be placed in its registry pending the outcome of litigation
concerning the lease related to the discontinued operations. We intend to appeal this order. The net loss from our discontinued operations totaled approximately $813,000 for the nine months ended October 31, 2002. That loss consisted of an increase
in our reserve for lease termination costs due to continued weakness in the commercial real estate market in Austin, Texas, where the facility is located. 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.



Liquidity and Capital Resources



From inception in January 1999 through October 31, 2003, 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 $250
million, including $11.6 million from the October 2003 recent private placement. As of October 31, 2003, we had approximately $24.8 million in cash, cash equivalents and short-term investments, compared to approximately $27.2 million at January 31,
2003. In November 2003, we received net proceeds of approximately $10.9 million from the completion of the recent private placement. 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.



On July 30, 2002, we entered into a loan and security
agreement with a commercial bank. The loan agreement 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 loan facility, we can borrow up to $5 million for working capital purposes, subject to availability under a borrowing base.
As of October 31, 2003, we had borrowed approximately $1.0 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 thereunder 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, disposition of assets, investments and dividends.



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In the nine months ended October 31, 2003, working capital decreased by approximately $0.7 million, to
approximately $22.6 million from approximately $23.3 million as of January 31, 2003. The decrease in working capital during the nine months ended October 31, 2003 was primarily the result of losses incurred in our continuing operations, a net
increase in restricted cash, as well as capital expenditures during that period, offset by net proceeds received from the recent private placement.



Net cash used in continuing operating activities was approximately $12.2 million for the nine months ended October 31, 2003, compared to net cash used in
continuing operating activities of approximately $15.9 million for the nine months ended October 31, 2002. The decrease in net cash used in continuing operating activities in the nine months ended October 31, 2003 as compared with the nine months
ended October 31, 2002, was principally the result of a reduction in the net loss by approximately $5.3 million offset by the increase in accounts receivable of approximately $1.7 million.



Net cash provided by investing activities was approximately $5.6 million for
the nine months ended October 31, 2003 as compared to approximately $3.6 million for the nine months ended October 31, 2002. A reduction in capital expenditures, in connection with the reduction in research and development costs of approximately
$2.0 million, contributed to the increase in net cash provided by investing activities.



Net cash provided by financing activities was approximately $10.4 million for the nine months ended October 31, 2003, compared to approximately $11.0 million for the nine months ended October 31, 2002. The net cash
provided by financing activities in 2003 was primarily due to receipt of $11.6 million of net proceeds from the recent private placement offset by an increase in restricted cash.



Net cash used in discontinued operations was approximately $89,000 for the nine months ended October 31, 2003, as compared
to approximately $859,000 for the nine months ended October 31, 2002. The net cash used in discontinued operations activities in 2003 was primarily due to the draw down of approximately of $470,000 of the letters of credit by the landlord of the
unused facility that we utilized with our discontinued operations offset by a reimbursement of legal fees of approximately $440,000 from our insurer.



At October 31, 2003, future minimum payments due under our lease obligations were approximately $4.5 million, of which $2.3 million is recorded in accrued
liabilities in the accompanying balance sheet for lease termination costs of the discontinued operations.



During the nine months ended October 31, 2003, there have been no material changes in the contractual obligations that are outside the ordinary course of
the Companys business.



Factors Affecting Operating Results



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.
Potential risks and uncertainties that could affect our operating results and financial condition include, without limitation, the following:



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We cannot predict our future results because we have a limited operating history and have only recently introduced our
line of products within the network security industry.



We
have a limited operating history and little history operating our network security business. Our line of products only recently became generally available for purchase. 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 later half of 2001. Our network security offering is still in the early stage, and it was not until 2003 that we began achieving sales from
our product offerings. There are significant risks and costs inherent in our efforts to undertake this business model. These include the risk that we 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 model. 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 several 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.



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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, 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.



Current and potential competitors in our market include the following:



| |  | intrusion detection system vendors such as Internet Security Systems, Inc., Cisco Systems, Inc., Symantec Corporation, NetScreen Technologies, Inc., Network Associates, Inc.,
Intrusion Inc., Enterasys Networks, Inc. and other emerging startups;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | firewall and virtual private network vendors such as NetScreen Technologies, Inc., Check Point Software Technologies Ltd and Symantec Corporation;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------



| |  | network equipment manufacturers such as Cisco Systems, Inc., Lucent Technologies, Inc., Nokia Corporation and Nortel Networks Corporation;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------



| |  | security appliance suppliers such as NetScreen Technologies, Inc., SonicWALL, Inc., iPolicy Networks, WatchGuard Technologies, Inc., Network Associates, Inc. and Symantec
Corporation; and
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | emerging security companies that may position their systems as alternatives to our products.
| | - | --------------------------------------------------------------------------------------------



Many of these 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.



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



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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 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.



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.



We currently use a single third party to manufacture sub-assemblies of our products, and we purchase 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.



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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
| | - | ---------------------------------------------



| |  | 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 agencies 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.



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, including governmental agencies, with large networks usually expand their networks in large increments on a periodic basis. In addition, large enterprises, governmental agencies 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 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, 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.



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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. In particular, we believe that our future success is highly dependent on John F. McHale, Chairman and Chief Executive Officer, with
whom we do not have an employment agreement.



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 which features, security standards and performance criteria 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 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.



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



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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.



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, 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 do not improve, or if they deteriorate further, 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



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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.



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.



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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 52% of our outstanding stock as of November 30, 2003. 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.



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, upon effectiveness of the shelf registration statement we are required to file, the 1,995,833 shares recently
issued in the private placement will be tradable, 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.



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 October 31, 2003, we had approximately $24.8 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 approximately $1.0 million at October 31, 2003, and a revolving loan facility for working capital of up to $5 million that
was unused at October 31, 2003. In November 2003, we also received approximately $10.9 million of net proceeds in the second and final closing of the recent private placement of our common stock. 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
when we need to raise additional funds.



Our future capital
requirements will depend upon several factors, including whether we are successful in developing 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 plan, 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.



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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.



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. While
the action remains pending, the plaintiffs have not taken any action to prosecute this case in more than a year, or otherwise attempted to have this matter set for resolution. If the plaintiffs begin prosecuting this case again, regardless of its
success, it will likely be time-consuming and expensive to resolve and may divert management time and attention. If this action is successful, we could be subject to significant liability for damages.



We have attempted, unsuccessfully, to sublease the unused facility that we
utilized with our discontinued operations in an effort to minimize lease termination costs. These costs, which are currently in dispute and the subject of a lawsuit with the landlord, have been reflected in accrued liabilities at October 31, 2003. A
Texas state court in Travis County, Texas recently ordered us to place $1.9 million in the courts registry pending the outcome of this lawsuit. We intend to appeal this order.



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|ITEM  3. |  | QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
|-------- |  | ----------------------------------------------------------



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.



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
those facilities were to increase by 100 basis points (1.00%), our annual financing expense would increase by approximately $10,000, based on the average balances utilized under our loan facilities during the period ended October 31, 2003. We did
not experience a material impact from interest rate risk during fiscal 2003.



Currently, we do not have any significant investments in financial instruments for trading or other speculative purposes, or to manage our interest rate exposure.



|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 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 the end of the period covered by this quarterly report, 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 our disclosure controls and procedures pursuant to
Rules 13a-15(e) and 15d-15(e) 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 as of the end of the period
covered by this quarterly report.



There have
been no changes in our internal control over financial reporting during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control 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. 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



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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. Any direct financial impact of the settlement is expected to be borne by our insurers. In August 2003,
our Board of Directors approved the settlement terms described in the Memorandum of Understanding. The settlement is subject to numerous conditions, including approval by the court. There can be no assurance that such conditions will be met or that
the court will approve the final terms of the settlement. If the settlement does not occur, and the litigation against us continues, we intend to defend it 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.



|ITEM  2. |  | CHANGES IN SECURITIES AND USE OF PROCEEDS.
|-------- |  | ------------------------------------------



On October 17, 2003, we entered into a Stock Purchase Agreement to obtain approximately $24 million in gross proceeds from certain investors acquiring
1,995,833 shares of our common stock at a purchase price of $12.00 per share in a private placement. The investors in the private placement included institutional investors, certain members of our management and other individual accredited
investors. The Stock Purchase Agreement contemplated two closings, with the second closing contingent upon receiving stockholder approval at a special meeting of stockholders. At the first closing, which occurred in October 2003, we sold 1,045,833
shares of our common stock for proceeds of approximately $11.6 million, net of related offering costs. We received the necessary stockholder approval at a special meeting of stockholders on November 20, 2003 and following compliance with other terms
and conditions of the Stock Purchase Agreement, the second closing of the private placement occurred on November 24, 2003, and we sold an additional 950,000 shares of our common stock for proceeds of approximately $10.9 million, net of related
offering costs. The purchase price of our common stock under the Stock Purchase Agreement was $12.00 per share, which represented a 25% discount on our common stock price as of October 16, 2003, the date that the Stock Purchase Agreement was
approved by a special committee of our Board of Directors, and the date immediately preceding the effective date of the Stock Purchase Agreement.



The 1,995,833 shares were issued and sold in reliance on an exemption from registration under Section 4(2) of the Securities Act of 1933 and Regulation D.
All of the investors that participated in the private placement represented that they were accredited investors as defined in the Securities Act of 1933.



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



At a special meeting of stockholders held on November 20, 2003, our stockholders voted on (1) a proposal to approve the sale of 950,000 shares of our
common stock, par value $0.01 per share, in a private placement with certain investors, a majority of whom are related parties, pursuant to a Stock Purchase Agreement, dated October 17, 2003, and (2) a proposal to approve an amendment to our Third
Amended and Restated 1999 Stock Option and Restricted Stock Plan to increase the number of shares available for issuance from 1,033,333 to 2,033,333.



Voting tabulations for the sale of 950,000 shares of our common stock were as follows:



|FOR       |  | AGAINST |  | ABSTAIN
|--------- |  | ------- |  | -------
|2,837,059 |  | 30,668  |  | 1,123  



Broker non-votes were
not permitted for this vote.



Voting tabulations for the
amendment to our Third Amended and Restated 1999 Stock Option and Restricted Stock Plan were as follows:



|FOR       |  | AGAINST |  | ABSTAIN
|--------- |  | ------- |  | -------
|2,817,090 |  | 50,626  |  | 1,134  



Broker non-votes were
not permitted for this vote.



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



| | (a) | Exhibits.
| | --- | ---------



10.13  Employment Agreement by and between James A. Hamilton and the Registrant dated as of September 10, 2003.



10.14  Restricted Stock Agreement by and between James
A. Hamilton and the Registrant dated as of September 15, 2003.



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).



| | (b) | Current Reports on Form 8-K:
| | --- | ----------------------------



| | (1) | On September 8, 2003, we furnished Current Reports on Form 8-K and Form 8-K/A in which we disclosed, pursuant to Item 9 of Form 8-K, that we had issued a press release announcing
our results of operations for the first quarter ended July 31, 2003.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | (2) | On October 21, 2003, we filed a Current Report on Form 8-K in which we disclosed, pursuant to Item 5 of Form 8-K, that we entered into a Stock Purchase Agreement for the issuance
and sale of 1,995,833 shares of our common stock, par value $0.01 per share, in a private placement for gross proceeds of approximately $24 million.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We neither filed nor furnished any other reports on Form 8-K during the quarter for which this report is filed.



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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:  December 12, 2003 |  |  |  | /s/  MICHAEL J. RAPISAND                        
|                         |  |  |  | Michael J. Rapisand                             
|                         |  |  |  | Chief Financial Officer and Treasurer (Principal
|                         |  |  |  | Financial and Accounting Officer)