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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



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



For
the Quarterly Period Ended July 31, 2004



Commission File
Number 001-15715



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TippingPoint Technologies, Inc.



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|                         |  |                         
|------------------------ |  | ------------------------
|Delaware                 |  | No.74-2902814           
|(State of Incorporation) |  | (I.R.S. Employer ID No.)



7501B North Capital
of Texas Highway

Austin, Texas 78731

(Address of Principal Executive Offices)



(512) 681-8000

(Telephone Number)



---



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



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



As of August 27, 2004, 7,378,889 shares of the registrants common
stock, $0.01 par value, were outstanding.



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##### Table of Contents

TIPPINGPOINT TECHNOLOGIES, INC.

FORM 10-Q

QUARTER ENDED JULY 31, 2004



TABLE OF CONTENTS



|                  |  |                        |  |                                                                                                                    |  |            
|----------------- |  | ---------------------- |  | ------------------------------------------------------------------------------------------------------------------ |  | -----------
|                  |  |                        |  |                                                                                                                    |  | Page Number
|                  |  |                       
|PART I.           |  | FINANCIAL INFORMATION: |  | 1                                                                                                                 
|                  |  |                        | 
|                  |  | Item 1.                |  | Financial Statements (unaudited)                                                                                   |  | 1          
|                  |  |                        | 
|                  |  |                        |  | Condensed Consolidated Balance Sheets as of July 31, 2004 and January 31, 2004                                     |  | 1          
|                  |  |                        | 
|                  |  |                        |  | Condensed Consolidated Statements of Operations for the three and six months ended July 31, 2004 and July 31, 2003 |  | 2          
|                  |  |                        | 
|                  |  |                        |  | Condensed Consolidated Statements of Cash Flows for the six months ended July 31, 2004 and July 31, 2003           |  | 3          
|                  |  |                        | 
|                  |  |                        |  | Notes to Condensed Consolidated Financial Statements                                                               |  | 4          
|                  |  |                        | 
|                  |  | Item 2.                |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                              |  | 9          
|                  |  |                        | 
|                  |  | Item 3.                |  | Quantitative and Qualitative Disclosures about Market Risk                                                         |  | 28         
|                  |  |                        | 
|                  |  | Item 4.                |  | Controls and Procedures                                                                                            |  | 28         
|                  |  |                       
|PART II.          |  | OTHER INFORMATION:     |  | 29                                                                                                                
|                  |  |                        | 
|                  |  | Item 1.                |  | Legal Proceedings                                                                                                  |  | 29         
|                  |  |                        | 
|                  |  | Item 2.                |  | Changes in Securities and Use of Proceeds                                                                          |  | 29         
|                  |  |                        | 
|                  |  | Item 4.                |  | Submission of Matters to a Vote of Security Holders                                                                |  | 30         
|                  |  |                        | 
|                  |  | Item 6.                |  | Exhibits and Reports on Form 8-K                                                                                   |  | 30         
|                  |  |                       
|SIGNATURE         |  |                        |  |                                                                                                                   
|                  | 
|INDEX TO EXHIBITS |  |                       





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##### Table of Contents

PART I  FINANCIAL INFORMATION



ITEM 1.Financial Statements



TIPPINGPOINT TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)



|                                                                                                                                                               |  |               |              |   |                  |   |              |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------------ | - | ---------------- | - | ------------ | -
|                                                                                                                                                               |  | July 31, 2004 |              |   | January 31, 2004 |  
|ASSETS                                                                                                                                                         |  |               |              |   |                  |   |              |  
|Current assets:                                                                                                                                                |  |               |              |   |                  |   |              |  
|Cash and cash equivalents                                                                                                                                      |  | $             | 26,571,444   |   |                  | $ | 33,153,764   |  
|Certificate of deposit                                                                                                                                         |  |               | 1,337,332    |   |                  |   |             |  
|Accounts receivable                                                                                                                                            |  |               | 4,470,050    |   |                  |   | 1,822,213    |  
|Inventory                                                                                                                                                      |  |               | 4,257,349    |   |                  |   | 2,485,117    |  
|Prepaid expenses and other current assets                                                                                                                      |  |               | 1,756,146    |   |                  |   | 2,243,409    |  
|                                                                                                                                                               |  |               |              |   |                  |   |              |  
|Total current assets                                                                                                                                           |  |               | 38,392,321   |   |                  |   | 39,704,503   |  
|                                                                                                                                                               |  |              
|Property and equipment, net                                                                                                                                    |  |               | 2,254,573    |   |                  |   | 2,221,837    |  
|Other                                                                                                                                                          |  |               | 746,488      |   |                  |   | 1,446,936    |  
|                                                                                                                                                               |  |               |              |   |                  |   |              |  
|Total assets                                                                                                                                                   |  | $             | 41,393,382   |   |                  | $ | 43,373,276   |  
|                                                                                                                                                               |  |               |              |   |                  |   |              |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                           |  |               |              |   |                  |   |              |  
|Current liabilities:                                                                                                                                           |  |               |              |   |                  |   |              |  
|Current portion of long-term debt                                                                                                                              |  | $             | 781,038      |   |                  | $ | 582,283      |  
|Trade accounts payable                                                                                                                                         |  |               | 1,787,361    |   |                  |   | 2,031,785    |  
|Deferred revenue                                                                                                                                               |  |               | 2,763,369    |   |                  |   | 811,969      |  
|Accrued liabilities                                                                                                                                            |  |               | 4,523,155    |   |                  |   | 2,878,450    |  
|                                                                                                                                                               |  |               |              |   |                  |   |              |  
|Total current liabilities                                                                                                                                      |  |               | 9,854,923    |   |                  |   | 6,304,487    |  
|                                                                                                                                                               |  |              
|Long-term debt                                                                                                                                                 |  |               | 565,939      |   |                  |   | 420,583      |  
|Deferred revenue, long term                                                                                                                                    |  |               | 302,704      |   |                  |   |             |  
|Other liabilities                                                                                                                                              |  |               | 149,336      |   |                  |   | 216,730      |  
|                                                                                                                                                               |  |               |              |   |                  |   |              |  
|Total liabilities                                                                                                                                              |  |               | 10,872,902   |   |                  |   | 6,941,800    |  
|                                                                                                                                                               |  |               |              |   |                  |   |              |  
|Commitments and contingencies                                                                                                                                  |  |               |              |   |                  |   |              |  
|Stockholders equity:                                                                                                                                          |  |               |              |   |                  |   |              |  
|Common stock, $0.01 par value; 35,000,000 and 250,000,000 shares authorized, respectively; 7,377,414 and 7,335,933 shares issued and
outstanding, respectively |  |               | 73,774       |   |                  |   | 73,359       |  
|Additional paid-in capital                                                                                                                                     |  |               | 349,921,659  |   |                  |   | 347,950,650  |  
|Deferred stock-based compensation                                                                                                                              |  |               | (10,090,610  | ) |                  |   | (10,133,031  | )
|Stockholder notes receivable                                                                                                                                   |  |               | (510,000     | ) |                  |   | (652,800     | )
|Accumulated deficit                                                                                                                                            |  |               | (308,874,343 | ) |                  |   | (300,806,702 | )
|                                                                                                                                                               |  |               |              |   |                  |   |              |  
|Total stockholders equity                                                                                                                                     |  |               | 30,520,480   |   |                  |   | 36,431,476   |  
|                                                                                                                                                               |  |               |              |   |                  |   |              |  
|Total liabilities and stockholders equity                                                                                                                     |  | $             | 41,393,382   |   |                  | $ | 43,373,276   |  
|                                                                                                                                                               |  |               |              |   |                  |   |              |  



See accompanying notes
to condensed consolidated financial statements.



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TIPPINGPOINT TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)



|                                                             |  |                             |            |   |                           |   |            |      |  |   |            |   |  |   |             |  
|------------------------------------------------------------ |  | --------------------------- | ---------- | - | ------------------------- | - | ---------- | ---- |  | - | ---------- | - |  | - | ----------- | -
|                                                             |  | Three Months Ended July 31, |            |   | Six Months Ended July 31, |  
|                                                             |  | 2004                        |            |   | 2003                      |   |            | 2004 |  |   | 2003       |  
|Revenues                                                     |  | $                           | 6,707,649  |   |                           | $ | 337,017    |      |  | $ | 10,612,332 |   |  | $ | 967,437     |  
|Cost of revenues                                             |  |                             | 2,049,102  |   |                           |   | 752,462    |      |  |   | 3,264,032  |   |  |   | 1,154,331   |  
|                                                             |  |                             |            |   |                           |   |            |      |  |   |            |   |  |   |             |  
|Gross margin                                                 |  |                             | 4,658,547  |   |                           |   | (415,445   | )    |  |   | 7,348,300  |   |  |   | (186,894    | )
|                                                             |  |                             |            |  
|Operating expenses:                                          |  |                             |            |   |                           |   |            |      |  |   |            |   |  |   |             |  
|Research and development (1)                                 |  |                             | 2,342,486  |   |                           |   | 2,342,133  |      |  |   | 4,943,666  |   |  |   | 4,728,065   |  
|Sales and marketing (1)                                      |  |                             | 3,892,551  |   |                           |   | 1,845,313  |      |  |   | 7,287,327  |   |  |   | 3,512,625   |  
|General and administrative (1)                               |  |                             | 1,024,910  |   |                           |   | 671,549    |      |  |   | 1,796,554  |   |  |   | 1,416,004   |  
|Amortization of employee deferred stock-based compensation   |  |                             | 727,073    |   |                           |   | 88,445     |      |  |   | 1,561,678  |   |  |   | 212,786     |  
|                                                             |  |                             |            |   |                           |   |            |      |  |   |            |   |  |   |             |  
|Total operating expenses                                     |  |                             | 7,987,020  |   |                           |   | 4,947,440  |      |  |   | 15,589,225 |   |  |   | 9,869,480   |  
|                                                             |  |                             |            |   |                           |   |            |      |  |   |            |   |  |   |             |  
|Operating loss                                               |  |                             | (3,328,473 | ) |                           |   | (5,362,885 | )    |  |   | (8,240,925 | ) |  |   | (10,056,374 | )
|                                                             |  |                             |            |  
|Interest income, net                                         |  |                             | 90,351     |   |                           |   | 74,313     |      |  |   | 173,284    |   |  |   | 173,486     |  
|                                                             |  |                             |            |   |                           |   |            |      |  |   |            |   |  |   |             |  
|Net loss                                                     |  | $                           | (3,238,122 | ) |                           | $ | (5,288,572 | )    |  | $ | (8,067,641 | ) |  | $ | (9,882,888  | )
|                                                             |  |                             |            |   |                           |   |            |      |  |   |            |   |  |   |             |  
|Per share data:                                              |  |                             |            |   |                           |   |            |      |  |   |            |   |  |   |             |  
|Net basic and diluted loss per common share                  |  | $                           | (0.44      | ) |                           | $ | (1.00      | )    |  | $ | (1.10      | ) |  | $ | (1.87       | )
|Weighted basic and diluted average common shares outstanding |  |                             | 7,357,382  |   |                           |   | 5,290,818  |      |  |   | 7,351,602  |   |  |   | 5,272,974   |  
|                                                             |  |                             |            |   |                           |   |            |      |  |   |            |   |  |   |             |  

---

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



|                           |  |                             |         |                           |   |        |  |      |           |  |   |        
|-------------------------- |  | --------------------------- | ------- | ------------------------- | - | ------ |  | ---- | --------- |  | - | -------
|                           |  | Three Months Ended July 31, |         | Six Months Ended July 31,
|                           |  | 2004                        |         | 2003                      |   | 2004   |  | 2003
|Research and development   |  | $                           | 317,676 |                           | $ | 21,739 |  | $    | 616,901   |  | $ | 83,080 
|Sales and marketing        |  |                             | 232,482 |                           |   | 6,938  |  |      | 544,186   |  |   | 53,067 
|General and administrative |  |                             | 176,915 |                           |   | 59,768 |  |      | 400,591   |  |   | 76,639 
|                           |  |                             |         |                           |   |        |  |      |           |  |   |        
|TOTAL                      |  | $                           | 727,073 |                           | $ | 88,445 |  | $    | 1,561,678 |  | $ | 212,786
|                           |  |                             |         |                           |   |        |  |      |           |  |   |        



See accompanying notes
to condensed consolidated financial statements.



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TIPPINGPOINT TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)



|                                                                                                              |  |                           |            |   |      |   |            |  
|------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                                                              |  | Six Months Ended July 31, |           
|                                                                                                              |  | 2004                      |            |   | 2003 |  
|Cash flows from continuing operating activities:                                                              |  |                           |            |   |      |   |            |  
|Loss from continuing operations                                                                               |  | $                         | (8,067,641 | ) |      | $ | (9,882,888 | )
|Adjustments to reconcile loss from continuing operations to net cash used in continuing operating activities: |  |                           |            |   |      |   |            |  
|Depreciation and amortization                                                                                 |  |                           | 894,450    |   |      |   | 1,569,375  |  
|Accretion of investment securities                                                                            |  |                           |           |   |      |   | (3,750     | )
|Stock-based compensation expense                                                                              |  |                           | 1,561,678  |   |      |   | 271,938    |  
|Inventory writedown                                                                                           |  |                           |           |   |      |   | 362,605    |  
|Changes in operating assets and liabilities:                                                                  |  |                           |            |   |      |   |            |  
|Accounts receivable                                                                                           |  |                           | (2,647,837 | ) |      |   |           |  
|Inventory                                                                                                     |  |                           | (1,772,232 | ) |      |   | (722,098   | )
|Prepaid expenses and other current assets                                                                     |  |                           | 487,263    |   |      |   | (321,284   | )
|Other non-current assets                                                                                      |  |                           | 20,560     |   |      |   | (9,898     | )
|Deferred revenue                                                                                              |  |                           | 2,254,104  |   |      |   |           |  
|Trade accounts payable, accrued liabilities and other non- current liabilities                                |  |                           | 1,334,241  |   |      |   | 329,337    |  
|                                                                                                              |  |                           |            |   |      |   |            |  
|Net cash used in continuing operating activities                                                              |  |                           | (5,935,414 | ) |      |   | (8,406,663 | )
|                                                                                                              |  |                           |            |   |      |   |            |  
|Cash flows from investing activities:                                                                         |  |                           |            |   |      |   |            |  
|Purchases of property and equipment                                                                           |  |                           | (927,186   | ) |      |   | (389,440   | )
|Investment securities matured                                                                                 |  |                           |           |   |      |   | 6,064,626  |  
|                                                                                                              |  |                           |            |   |      |   |            |  
|Net cash provided by (used in) investing activities                                                           |  |                           | (927,186   | ) |      |   | 5,675,186  |  
|                                                                                                              |  |                           |            |   |      |   |            |  
|Cash flows from financing activities:                                                                         |  |                           |            |   |      |   |            |  
|Proceeds from borrowings under long-term debt                                                                 |  |                           | 696,747    |   |      |   | 365,351    |  
|(Increase) decrease in restricted cash related to leases                                                      |  |                           | (657,444   | ) |      |   | 472,326    |  
|Principal payments on debt                                                                                    |  |                           | (352,636   | ) |      |   | (218,071   | )
|Proceeds from stockholder note receivable                                                                     |  |                           | 142,800    |   |      |   |           |  
|Proceeds from issuance of common stock                                                                        |  |                           | 452,167    |   |      |   | 156,575    |  
|                                                                                                              |  |                           |            |   |      |   |            |  
|Net cash provided by financing activities                                                                     |  |                           | 281,634    |   |      |   | 776,181    |  
|                                                                                                              |  |                           |            |   |      |   |            |  
|Cash used in discontinued operations                                                                          |  |                           | (1,354     | ) |      |   | (510,293   | )
|                                                                                                              |  |                           |            |   |      |   |            |  
|Net decrease in cash and cash equivalents                                                                     |  |                           | (6,582,320 | ) |      |   | (2,465,589 | )
|                                                                                                              |  |                           |            |   |      |   |            |  
|Cash and cash equivalents at beginning of period                                                              |  |                           | 33,153,764 |   |      |   | 21,085,869 |  
|                                                                                                              |  |                           |            |   |      |   |            |  
|Cash and cash equivalents at end of period                                                                    |  | $                         | 26,571,444 |   |      | $ | 18,620,280 |  
|                                                                                                              |  |                           |            |   |      |   |            |  



See accompanying notes
to condensed consolidated financial statements.



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TIPPINGPOINT TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



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



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



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



We have funded our activities primarily through private equity offerings,
which included sales of our common stock and preferred stock, the initial public offering of our common stock on March 17, 2000, and borrowings under our term loan facility with a commercial bank, with which we also established a revolving loan
facility. In July 2004, we amended the loan and security agreement with our lender relating to these facilities to, among other things, establish an additional equipment term loan facility, extend the maturity date of our revolving loan facility to
July 31, 2006, increase the amount we may borrow under our revolving loan facility and improve the terms under which the company may borrow. 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.



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



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



In February 2004, we incorporated TippingPoint Technologies Europe B.V. as a subsidiary of TippingPoint Technologies, Inc. to act as our European sales
office in Amsterdam, The Netherlands. In June 2004, we incorporated TippingPoint Holdings, Inc. as a subsidiary of TippingPoint Technologies, Inc. to serve as the U.S.-based holding company for all of our international subsidiaries. In July 2004 we
also incorporated TippingPoint Technologies United Kingdom, Ltd. as a subsidiary of TippingPoint Holdings, Inc. to act as our sales office in the United Kingdom.The consolidated financial statements include the accounts of TippingPoint
Technologies, Inc., TippingPoint Holdings, Inc. and our wholly owned Netherlands and United Kingdom subsidiaries. All significant intercompany transactions have been eliminated in consolidation.



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



We account for revenues in accordance with the AICPAs Statement of Position 97-2 Software Revenue Recognition and its related
interpretations. Revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. In instances where final acceptance of our hardware-based
security systems is specified by the customer, revenues are deferred until all acceptance criteria have been met. Service revenues, which principally consist of our Digital Vaccine attack filter service and related support, are generally deferred
and are recognized ratably over the period in which the services are to be performed, which is typically one to three years.



Contracts and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and customer acceptance, when
applicable, are used to verify delivery. We assess whether the



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fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is
subject to refund or adjustment. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customers payment history.



Our sales involve multiple elements, including the sale of our products and
related services. We use the residual method of accounting to recognize revenues when an arrangement includes one or more elements to be delivered at a future date and vendor specific objective evidence (VSOE) of the fair value of all undelivered
elements exists.



We sell primarily to resellers, including
value-added resellers, or VARs. We do not expect these resellers to hold significant inventories of our products, if at all. As a result, we expect returns to be minimal. If our estimate of returns is too low, additional charges will be incurred in
future periods and these additional charges could have a material adverse effect on our financial position and results of operations. We record discounts, if any, provided to resellers for achieving purchasing targets as a reduction of revenues on
the date of sale.



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



Our inventory is stated at the lower of actual cost (first-in, first-out method) or market value (estimated net realizable value). The valuation of inventory at the lower of actual cost or market value requires us to
use estimates 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 July 31, 2004 and January 31, 2004, our inventory consisted of component parts of approximately $0.5 million and $1.0 million, respectively, and
finished goods of approximately $3.8 million and $1.5 million, respectively. A significant portion of our finished goods inventory is held for evaluation purposes at potential customer locations.



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



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



|                                                                                                            |  |                                 |            |   |                                 |   |            |                               |  |   |                               |   |  |   |             |  
|----------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ------------------------------- | - | ---------- | ----------------------------- |  | - | ----------------------------- | - |  | - | ----------- | -
|                                                                                                            |  | Three monthsended July 31, 2004 |            |   | Three monthsended July 31, 2003 |   |            | Six monthsended July 31, 2004 |  |   | Six monthsended July 31, 2003 |  
|Net loss as reported                                                                                        |  | $                               | (3,238,122 | ) |                                 | $ | (5,288,572 | )                             |  | $ | (8,067,641                    | ) |  | $ | (9,882,888  | )
|Add: Employee stock-based compensation included in the reported net loss                                    |  |                                 | 727,073    |   |                                 |   | 88,445     |                               |  |   | 1,561,678                     |   |  |   | 212,786     |  
|Deduct: Total employee stock-based compensation determined under the fair value based method for all awards |  |                                 | 1,128,520  |   |                                 |   | 108,281    |                               |  |   | 2,184,204                     |   |  |   | 379,453     |  
|                                                                                                            |  |                                 |            |   |                                 |   |            |                               |  |   |                               |   |  |   |             |  
|Pro forma net loss                                                                                          |  | $                               | (3,639,569 | ) |                                 | $ | (5,308,408 | )                             |  | $ | (8,690,167                    | ) |  | $ | (10,049,555 | )
|                                                                                                            |  |                                 |            |   |                                 |   |            |                               |  |   |                               |   |  |   |             |  
|Basis and diluted loss per share:                                                                           |  |                                 |            |   |                                 |   |            |                               |  |   |                               |   |  |   |             |  
|As reported                                                                                                 |  | $                               | (0.44      | ) |                                 | $ | (1.00      | )                             |  | $ | (1.10                         | ) |  | $ | (1.87       | )
|Pro forma                                                                                                   |  | $                               | (0.49      | ) |                                 | $ | (1.00      | )                             |  | $ | (1.18                         | ) |  | $ | (1.91       | )



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The per share weighted-average fair value of stock options and shares of restricted common stock granted
during the six months ended July 31, 2004 and 2003 was $12.50 and $3.49, respectively, on the date of grant using the Black-Scholes option pricing model. The fair value of options was estimated using a risk-free interest rate of 3.5% and 2.75% for
2004 and 2003, respectively, a dividend yield of zero for all periods presented, volatility of 50% and a weighted average expected life of four years.



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



In 2002, we entered into a loan and security agreement with a commercial bank consisting of an equipment term loan facility and a revolving loan facility,
both collateralized by a first priority lien on substantially all of our tangible and intangible assets. In July 2004, we amended this loan and security agreement in order to, among other things, establish an additional equipment term loan facility,
extend the maturity date of the revolving loan facility, increase the amount we may borrow under the revolving loan facility and improve the terms under which we may borrow funds. Under the new equipment term loan facility, we can borrow an
additional $4 million for purchases of equipment and software. Under the amended revolving loan facility, we can borrow up to $10 million for working capital purposes, subject to availability under a borrowing base. As of July 31, 2004, we had
borrowed approximately $0.6 million under our original equipment term loan facility and $0.7 million under our new equipment term loan facility, and had not borrowed any amount under the amended revolving loan facility. We may need to raise
additional funds in the future and we cannot assure you that we will be able to obtain additional financing on favorable terms, if at all.



All amounts borrowed under the original equipment term loan facility amortize over periods ending no later than January 30, 2006, and all amounts borrower
under the new equipment term loan facility amortize over periods ending no later than July 29, 2008. The amended 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 31, 2006. The amended revolving loan facility also provides for the issuance of letters of credit on our behalf in an aggregate face amount not to exceed $1 million. Advances under the original equipment term loan
facility accrue interest at a rate equal to the banks prime rate plus 0.75% per annum, advances under the new equipment term loan facility accrue interest at a rate equal to the banks prime rate plus 0.50% per annum and advances under
the amended revolving loan facility accrue interest at a rate equal to the banks prime rate plus 0.25% per annum. As of July 31, 2004, the banks prime rate was equal to 4.25%.



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



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



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



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



We had purchase obligations of approximately $1.8 million outstanding as of July 31, 2004 related to inventory and other non-manufacturing items.



In June 2004, we amended the office lease for our corporate
headquarters to, among other things, reduce our annual rent payments and extend the rental period through April 30, 2010. The lease amendment was effective retroactively to May 1, 2004. Our minimum lease commitment under this lease at July 31, 2004
was approximately $5.1 million. Terms of the amended office lease require a security deposit in the amount of approximately $0.7 million, which we initially satisfied with a letter of credit supported by a pledge of a portion of one of our cash
accounts with the issuing bank as collateral. The amount of this restricted cash is recorded as an Other asset on our consolidated balance sheet. As of January 31, 2004, we held a certificate of deposit approximating $1.3 million
as collateral under the terms of our original lease. Such amount was recorded as an Other asset at January 31, 2004. Upon amending the lease in June 2004, the restrictions were removed and we reclassified the amount as a certificate of
deposit on our consolidated balance sheet.



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



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



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



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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 materially harmed.



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



We operate in one business segment, the sale of network security systems. For each of the three and six months ended July 31, 2004, the percentage of
revenues attributable to sales to customers in the United States and the rest of the world was approximately 90% and 10%, respectively. There were no international sales during the three and six months ended July 31, 2003.



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



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



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



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



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ITEM 2.Managements Discussion and Analysis of Financial Condition and Results of Operations



The following Managements Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our
condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q, as well as the Managements Discussion and Analysis of Financial Condition and Results of Operations and the consolidated
financial statements and related notes thereto included in our Annual Report on Form 10-K for the year ended January 31, 2004, as filed with the Securities and Exchange Commission. References to fiscal 2003, fiscal 2004 and fiscal 2005 refer to the
periods February 1, 2002 through January 31, 2003, February 1, 2003 through January 31, 2004, and February 1, 2004 through January 31, 2005, respectively.



This Quarterly Report on Form 10-Q, including this Managements Discussion and Analysis of Financial Condition and Results of Operations,
contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, both as amended. All statements other than statements of historical fact are
forward-looking statements for purposes of federal and state securities laws, including: any projections of earnings, revenues or other financial items; any statements of the plans, strategies and objectives of management for future
operations; any statements concerning proposed new products, services or developments; any statements regarding future economic conditions or performance; any statements of belief; and any statements of assumptions underlying any of the foregoing.
Forward-looking statements may include the words may, will, estimate, intend, continue, believe, expect, plan or anticipate and other similar
words. Although we believe that the expectations reflected in our forward-looking statements are reasonable, actual results could differ materially from those projected or assumed. Our future financial condition and results of 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. Readers are referred to
risks and uncertainties identified below under Risk Factors, elsewhere in this report and in other documents we file with the Securities and Exchange Commission. All forward-looking statements attributable to us are qualified in their
entirety by this cautionary statement.



Overview



Since January 2001, our strategy has been to develop our network-based
hardware security system offerings. We announced the availability of our first product in January 2002, followed by the availability of four additional UnityOne products in February 2003. We introduced a sixth UnityOne product, the UnityOne-50
intrusion prevention system, during the three months ended July 31, 2004. Prior to fiscal 2004, we were in a development phase creating our UnityOne line of products. Fiscal 2004 was the first year we recognized and derived revenue from sales of our
high-speed network-based intrusion prevention systems. As a result of the stage of our network security business, we have recurring losses, and we expect to report operating losses through at least the end of our fiscal year ending January 31, 2005.
We cannot assure you that we will ever achieve positive cash flow from our operations or positive income, and we face numerous risks and uncertainties associated with this business.



From inception in January 1999 through July 31, 2004, we financed our operations and met our capital expenditure
requirements primarily from the net proceeds of the private and public sale of equity securities totaling approximately $263 million.



We derive revenues from sales of our hardware based security systems and maintenance plans. Our revenues for the three months ended July 31, 2004 and 2003
were approximately $6.7 million and $0.3 million, respectively, and our revenues for the six months ended July 31, 2004 and 2003 were approximately $10.6 million and $1.0 million, respectively. Revenue from maintenance plans is recognized ratably
over the service term, generally one or three years. Maintenance revenue was approximately $0.5 million and $0.8 million for the three and six months ended July 31, 2004, respectively, representing approximately 7% of total revenue for each of these
periods.



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In the three and six months ended July 31, 2004, revenues from customers within the United States totaled
approximately $6.1 million and $9.5 million, respectively, and revenues from customers outside of the United States totaled approximately $0.6 million and $1.1 million, respectively, representing approximately 10% of our total revenues for each of
these periods. We believe that revenues generated outside the United States will continue to increase during the remainder of fiscal 2005 in absolute dollars. Based on fluctuating economic conditions and limited sales history, there can be no
assurance that our revenues will continue to grow at this same rate or that we will achieve similar results in future periods.



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



Our gross margins were approximately 69% in each of the three and six months
ended July 31, 2004. Gross margins have been, and will continue to be, affected by a variety of factors, including competition, the product mix and average selling prices of products, maintenance, new product introductions and enhancements, the cost
of components and manufacturing labor, fluctuations in manufacturing volumes, component shortages and the mix of distribution channels through which our products are sold.



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



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



General and administrative
expenses consist of salaries and related expenses for finance, accounting, legal and human resources personnel, professional fees and corporate expenses. We expect general and administrative expenses to increase in absolute dollars as we employ
additional personnel and incur additional costs related to the growth of our business and our operations. In addition, we expect to see additional increases in general and administrative expense throughout the remainder of fiscal 2005 and during
fiscal 2006 relating to the incremental cost of financial control documentation and testing required by Section 404 of the Sarbanes-Oxley Act of 2002.



Stock option grants and restricted stock awards are an important element of our compensation programs. We account for stock-based awards to employees
using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. As of July 31, 2004, deferred stock compensation was approximately $10.1 million, all of which will
be amortized into expense over the next four years.



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



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Critical Accounting Policies and Estimates



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



Our critical accounting policies are as follows:



Revenue Recognition.We account for revenues in accordance with the AICPAs Statement of Position 97-2
Software Revenue Recognition and its related interpretations. Revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured.
In instances where final acceptance of our hardware-based security systems is specified by the customer, revenues are deferred until all acceptance criteria have been met. Service revenues, which principally consist of our Digital Vaccine attack
filter service and related support, are generally deferred and are recognized ratably over the period in which the services are to be performed, which is typically one to three years.



Contracts and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents
and customer acceptance, when applicable, are used to verify delivery. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We
assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customers payment history.



Our sales involve multiple elements, including the sale of our products and related services. We use the residual method of
accounting to recognize revenues when an arrangement includes one or more elements to be delivered at a future date and vendor specific objective evidence (VSOE) of the fair value of all undelivered elements exists.



We sell primarily to resellers, including value-added resellers, or VARs. We
do not expect these resellers to hold significant inventories of our products, if at all. As a result, we expect returns to be minimal. If our estimate of returns is too low, additional charges will be incurred in future periods and these additional
charges could have a material adverse effect on our financial position and results of operations. We record discounts, if any, provided to resellers for achieving purchasing targets as a reduction of revenues 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



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believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation
allowance or increase this allowance in a period, we must include an expense within the tax provision in our statement of operations.



Significant judgment involving multiple variables is required in determining our deferred tax assets and liabilities and any valuation allowance recorded
against our net deferred tax assets. In assessing the potential realization of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of
deferred tax assets is dependent upon achieving future taxable income during the period in which our deferred tax assets are recoverable. Due to the uncertainty surrounding our ability to generate taxable income in the future, we have determined
that it is more likely than not that we will not be able to utilize any of the benefits of our deferred tax assets, including net operating loss carry forwards, before they expire. Therefore, we have provided a 100% valuation allowance on our
deferred tax assets in each year of our existence, and our net deferred tax asset as of July 31, 2004 is zero.



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



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



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



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



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



Discontinued Operations. As
of July 31, 2004, we had reflected in accrued liabilities in the accompanying balance sheet approximately $1.4 million for costs of the discontinued operations that we estimated we would incur in future periods. The accrued costs consist primarily
of estimated legal fees for litigation and other costs related to discontinued operations. We evaluate contingent liabilities, including threatened or pending litigation in accordance with SFAS No. 5, Accounting for Contingencies and
record accruals when the outcome of these matters is deemed probable and the liability is reasonably estimable. We make these assessments based upon the facts and circumstances, and in some instances based in part upon the advice of outside legal
counsel. We include in these accruals an estimate to cover legal fees and expenses to defend ourselves. Because of the uncertainties related to certain pending litigation and claims, we are not able to make a reasonable estimate of the liability
that could result from an unfavorable outcome, if any. As additional information becomes available, we reassess the potential liability related to our pending litigation and revise our estimates. Such revisions in our estimates of the potential
liability could materially impact our results of operations and financial condition. Any differences between these estimated accrued costs and the actual amounts incurred in future periods will change the estimated net loss from discontinued
operations accordingly.



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



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Results of Operations



Revenues



The following table presents our revenues for the three and six months ended July 31, 2004 and 2003:



|         |  |                             |           |                           |   |         |  |      |            |  |   |        
|-------- |  | --------------------------- | --------- | ------------------------- | - | ------- |  | ---- | ---------- |  | - | -------
|         |  | Three Months Ended July 31, |           | Six Months Ended July 31,
|         |  | 2004                        |           | 2003                      |   | 2004    |  | 2003
|Revenues |  | $                           | 6,707,649 |                           | $ | 337,017 |  | $    | 10,612,332 |  | $ | 967,437



Our revenues increased
$6.4 million and $9.6 million in the three and six months ended July 31, 2004, respectively, as compared to the three and six months July 31, 2003. The increases were primarily due to an increase in the demand for our products resulting from greater
market acceptance of intrusion prevention systems as a network security solution. Revenues from maintenance plans are recognized ratably over the service term, generally one to three years in length. Revenues from maintenance plans were
approximately $0.5 million and $0.8 million for the three months and six months ended July 31, 2004, respectively, and approximately $0.1 million for the six months ended July 31, 2003, respectively. Revenues from maintenance were minimal in the
three months ended July 31, 2003.



The percentage of revenues
attributable to sales to customers in the United States and the rest of the world was approximately 90% and 10%, respectively, during each of the three and six months ended July 31, 2004. There were no international sales during the three or six
months ended July 31, 2003. During the three months ended July 31, 2004 and 2003, revenues and sales through distributors and value-added resellers represented approximately 88% and 80% of our total revenues, respectively, and during the six months
ended July 31, 2004 and 2003, revenues and sales through distributors and value-added resellers represented approximately 89% and 83% of our total revenues, respectively.



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



Cost of
Revenues



The following table presents our cost of
revenues for the three and six months ended July 31, 2004 and 2003:



|                 |  |                             |           |                           |   |         |  |      |           |  |   |          
|---------------- |  | --------------------------- | --------- | ------------------------- | - | ------- |  | ---- | --------- |  | - | ---------
|                 |  | Three Months Ended July 31, |           | Six Months Ended July 31,
|                 |  | 2004                        |           | 2003                      |   | 2004    |  | 2003
|Cost of Revenues |  | $                           | 2,049,102 |                           | $ | 752,462 |  | $    | 3,264,032 |  | $ | 1,154,331



Cost of revenues
increased approximately $1.3 million and $2.1 million in the three and six months ended July 31, 2004, respectively, as compared to the three and six months ended July 31, 2003. These increases were primarily due to an increase in sales of our
products. Cost of revenues for each of the three months ended July 31, 2004 and 2003 included approximately $0.5 million of fixed manufacturing overhead and maintenance plan support costs.



Gross Margin



The following table presents our gross margin for the three and six months ended July 31, 2004 and 2003:



|             |  |                             |           |      |                           |          |      |  |      |           |  |   |          |  
|------------ |  | --------------------------- | --------- | ---- | ------------------------- | -------- | ---- |  | ---- | --------- |  | - | -------- | -
|             |  | Three Months Ended July 31, |           |      | Six Months Ended July 31, |         
|             |  | 2004                        |           | 2003 |                           |          | 2004 |  | 2003 |          
|Gross Margin |  | $                           | 4,658,547 |      | $                         | (415,445 | )    |  | $    | 7,348,300 |  | $ | (186,894 | )



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Our gross margin increased approximately $5.1 million and $7.5 million in the three and six months ended
July 31, 2004, respectively, as compared to the three and six months July 31, 2003. These increases were primarily due to an increase in the volume of sales of our products and a more efficient manufacturing process associated with these higher
volumes.



Operating Expenses



The following table presents certain information regarding our operating
expenses for the three and six months ended July 31, 2004 and 2003:



|                               |  |                             |  |              |                           |  |           |  |              |   |  |           |  |              |   |  |           |  |              |  
|------------------------------ |  | --------------------------- |  | ------------ | ------------------------- |  | --------- |  | ------------ | - |  | --------- |  | ------------ | - |  | --------- |  | ------------ | -
|                               |  | Three Months Ended July 31, |  |              | Six Months Ended July 31, | 
|                               |  | 2004                        |  | % ofRevenues |                           |  | 2003      |  | % ofRevenues |   |  | 2004      |  | % ofRevenues |   |  | 2003      |  | % ofRevenues |  
|Research and development (1)   |  | 2,342,486                   |  | 35           | %                         |  | 2,342,133 |  | 695          | % |  | 4,943,666 |  | 47           | % |  | 4,728,065 |  | 489          | %
|Sales and marketing (1)        |  | 3,892,551                   |  | 58           | %                         |  | 1,845,313 |  | 548          | % |  | 7,287,327 |  | 69           | % |  | 3,512,625 |  | 363          | %
|General and administrative (1) |  | 1,024,910                   |  | 15           | %                         |  | 671,549   |  | 199          | % |  | 1,796,554 |  | 17           | % |  | 1,416,004 |  | 146          | %

---

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



|                           |  |                             |         |                           |   |        |  |      |           |  |   |        
|-------------------------- |  | --------------------------- | ------- | ------------------------- | - | ------ |  | ---- | --------- |  | - | -------
|                           |  | Three Months Ended July 31, |         | Six Months Ended July 31,
|                           |  | 2004                        |         | 2003                      |   | 2004   |  | 2003
|Research and development   |  | $                           | 317,676 |                           | $ | 21,739 |  | $    | 616,901   |  | $ | 83,080 
|Sales and marketing        |  |                             | 232,482 |                           |   | 6,938  |  |      | 544,186   |  |   | 53,067 
|General and administrative |  |                             | 176,915 |                           |   | 59,768 |  |      | 400,591   |  |   | 76,639 
|                           |  |                             |         |                           |   |        |  |      |           |  |   |        
|TOTAL                      |  | $                           | 727,073 |                           | $ | 88,445 |  | $    | 1,561,678 |  | $ | 212,786
|                           |  |                             |         |                           |   |        |  |      |           |  |   |        



Research and
development expenses. Research and development expenses were approximately $2.3 million for each of the three months ended July 31, 2004 and 2003. The approximately $0.2 million increase in research and development expenses from the six months
ended July 31, 2004 as compared to the six months ended July 31, 2003 was attributable primarily to the on-going development of our UnityOne line of products. We expect our research and development expenditures to continue to increase in absolute
dollars throughout the remainder of fiscal 2005. The increase in these expenditures may include additional research and development personnel to support the expansion of our product line and product feature set and to support the anticipated growth
in our customer base.



Sales and marketing expenses.
Sales and marketing expenses increased approximately $2.0 million in the three months ended July 31, 2004 as compared to the three months ended July 31, 2003, and increased approximately $3.8 million in the six months ended July 31, 2004 as compared
to the six months ended July 31, 2003. These increases in sales and marketing expenses were the result of the expansion of our sales efforts and consisted primarily of increased employment, commission and travel-related costs. We incurred additional
marketing expenses associated with the participation and sponsorship of industry trade shows in the more recent periods. We expect this type of marketing activity to continue to increase throughout the remainder of fiscal 2005. We also expect sales
and marketing expenses to continue to rise throughout the remainder of fiscal year 2005 as we further develop and expand our sales efforts. These expansion efforts may include the hiring of additional sales personnel to support our channel partners
and to increase the size of our direct sales force. The additional investment in sales and marketing efforts is predicated on an anticipated demand for our products.



General and administrative expenses. The increases in general and administrative expenses in the three and six months
ended July 31, 2004 as compared to the three and six months ended July 31, 2004, respectively, were primarily the result of an increase in employment costs associated with additional headcount and increase costs associated with the formation and
operation of our international subsidiaries. General and administrative expenses for the three months ended July 31, 2004 included a charge of approximately $330,000 in bad debt expense related to a specific uncollectible account receivable.



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Amortization of stock-based compensation. For the three months ended July 31, 2004 and 2003, we
recorded employee stock-based compensation of approximately $0.7 million and $0.1 million, respectively, an increase of $0.6 million. The increase in expense is principally due to additional amortization related to grants in fiscal 2004. On January
5, 2004, we appointed a new Chief Executive Officer who was granted an option to purchase 300,000 shares of our common stock at an exercise price of $12 per share. Because the exercise price was lower than the fair market value of our common stock
on the date of grant, we recorded approximately $5.3 million in related deferred stock-based compensation. On January 12, 2004, we appointed a new Chief Financial Officer who was granted 82,500 restricted shares of our common stock. The shares do
not have an exercise price, and we recorded approximately $2.4 million in related deferred stock-based compensation. In September 2003, we granted 225,000 restricted shares of our common stock to two new employees, which included our President. The
shares do not have an exercise price and we recorded approximately $2.7 million of deferred compensation related to these grants. In February 2004, selected employees were granted options to purchase 80,000 shares of our common stock for $12 per
share. Because the exercise price was lower than the fair market value of our common stock on the date of grant, we recorded approximately $0.9 million in related deferred stock-based compensation. At July 31, 2004, deferred stock compensation
approximated $10.1 million, all of which will be amortized into expense over the next four years.



Other



Interest
income. Interest income, net of interest expense, was approximately $90,000 and $74,000 for the three months ended July 31, 2004 and 2003, respectively, and approximately $173,000 for each of the six months ended July 31, 2004 and 2003. Interest
income, net of interest expense, may change in the future due to changes in our average cash balances, amount of our outstanding debt and/or changes in interest rates.



Discontinued operations. As of July 31, 2004, we maintained an accrual of $1.4 million for costs estimated to be
incurred in future periods associated with our discontinued operations. These costs consisted primarily of estimated legal fees and other expenses. Any differences between these estimates and the actual amounts incurred in future periods will change
the estimated net loss from discontinued operations accordingly.



Contractual Cash Obligations and Commitments



The following table summarizes our contractual cash obligations as of July 31, 2004:



|                                                           |  |                        |           |                 |   |           |  |           |           |                  |   |           |  |   |        
|---------------------------------------------------------- |  | ---------------------- | --------- | --------------- | - | --------- |  | --------- | --------- | ---------------- | - | --------- |  | - | -------
|                                                           |  | Payments Due By Period
|Contractual Obligations                                    |  | Total                  |           | Less Than 1Year |   | 1-3 Years |  | 3-5 Years |           | More Than 5Years
|Long-Term Debt Obligations                                 |  | $                      | 1,346,977 |                 | $ | 781,038   |  | $         | 565,939   |                  |   |          |  |   |       
|Capital Lease Obligations                                  |  |                        |          |                 |   |          |  |           |          |                  |   |          |  |   |       
|Operating Lease Obligations                                |  | $                      | 5,132,009 |                 | $ | 883,699   |  | $         | 1,747,493 |                  | $ | 1,803,874 |  | $ | 696,943
|Purchase Obligations                                       |  | $                      | 1,817,400 |                 | $ | 1,817,400 |  |           |          |                  |   |          |  |   |       
|Other Long-Term Liabilities Reflected On The Balance Sheet |  |                        |          |                 |   |          |  |           |          |                  |   |          |  |   |       



Liquidity and Capital Resources



From inception in January 1999 through July 31, 2004, we
financed our operations and met our capital expenditure requirements primarily from the net proceeds of the private and public sale of equity securities totaling approximately $263 million. As of July 31, 2004, we had approximately $26.6 million in
cash and cash equivalents and a $1.3 million certificate of deposit, which matures in June 2005.



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



In fiscal 2003, we entered into a loan and security agreement with a commercial bank consisting of an equipment term loan
facility and a revolving loan facility, both collateralized by a first priority lien on substantially all of our tangible and intangible assets. In July 2004, we amended this loan and security agreement in order to, among other things, establish an
additional equipment term loan facility, extend the maturity date of the revolving loan facility, increase the amount we may borrow under the revolving loan facility and improve the terms under which we may borrow funds. Under the new equipment term
loan facility, we can borrow up to $4 million for additional purchases of equipment and software. Under the amended revolving loan facility, we can borrow up to $10 million for working capital purposes, subject to availability under a borrowing
base. As of July 31, 2004, we had borrowed approximately $0.6 million under our original equipment term loan facility, $0.7 million under our new equipment term loan facility and had not borrowed any amount under the amended revolving loan facility.



All amounts borrowed under the original equipment term loan
facility amortize over periods ending no later than January 30, 2006, and all amounts borrower under the new equipment term loan facility amortize over periods ending no later than July 29, 2008. The amended 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 31, 2006. The amended revolving loan facility also provides for the issuance of letters of credit on our behalf in an
aggregate face amount not to exceed $1 million. Advances under the original equipment term loan facility accrue interest at a rate equal to the banks prime rate plus 0.75% per annum, advances under the new equipment term loan facility accrue
interest at a rate equal to the banks prime rate plus 0.50% per annum and advances under the amended revolving loan facility accrue interest at a rate equal to the banks prime rate plus 0.25% per annum. As of July 31, 2004, the
banks prime rate was equal to 4.25%.



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



At July 31, 2004, future cash commitments included future minimum lease payments under non-cancelable operating leases of
approximately $5.1 million, primarily related to our headquarters in Austin, Texas.



Our total debt obligation is $1.3 million, including the current portion of $0.8 million at July 31, 2004.



We have no material commitments for capital expenditures as of July 31, 2004, but we expect to spend between $1.5 million and $2.5 million on capital
expenditures in fiscal year 2005.



We purchase from
contract manufacturers and other inventory suppliers on a purchase order basis and do not have a long-term supply contract with any of them. At July 31, 2004, we had placed non-cancelable purchase orders totaling approximately $1.8 million.



Net cash used by continuing operating activities was
approximately $5.9 million for the six months ended July 31, 2004, as compared to approximately $8.4 million for the six months ended July 31, 2003. The reduction in cash used in continuing operations is attributable to smaller net losses of $8.1
million and $9.9 million for the six months ended July 31, 2004 and July 31, 2003, respectively.



Net cash flows from investing activities decreased from a positive $5.7 million for the six months ended July 31, 2003 to a negative $0.9 million for the
six months ended July 31, 2004. This decrease in cash from investing activities is attributable to the maturation of an investment security in the six month period ended July 31, 2003. No investment securities matured in the period ended July 31,
2004.



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Net cash flow from financing activities decreased from $0.8 million in the six months ended July 31, 2003
to $0.3 million for the six months ended July 31, 2004. This decrease in cash flows from financing activities is attributable to an increase in restricted cash partially offset by an increase in borrowings and the proceeds from the issuance of
common stock related to employee options.



Risk Factors



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



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



We have a limited operating history and little history operating our network security business. Therefore, we have little meaningful historical
financial data upon which to base projections of operating expenses or revenues. We began to focus on our network security offering in the second half of 2001. Our network security offering is still in the early stage, and it was not until fiscal
2004 that we began achieving sales from these product offerings. There are significant risks and costs inherent in our efforts to undertake this business model. These include the risk that we may not be able to achieve market acceptance for our
network security line of products or earn significant revenues from the sale of such products, that our business model may not be profitable and other significant risks related to our business. Our prospects must be considered in light of the
uncertainties and difficulties frequently encountered by companies in their early stages of development. These risks are heightened in rapidly evolving industries, such as network security. It is possible that we will exhaust all available funds
before we reach positive cash flow.



It is possible that we
may never become profitable.



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



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



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



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



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



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



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



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



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



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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.



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



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



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



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



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



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



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



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



We rely on distribution partners to sell our
products, and disruptions to or our failure to effectively develop these channels could adversely affect our ability to generate revenues from the sale of our products.



We derive the bulk of our total revenues from sales by distributors and resellers of our products. During the three months
ended July 31, 2004 and 2003, revenues and sales through distributors and value-added resellers represented approximately 88% and 80% of our total revenues, respectively, and during the six months ended July 31, 2004 and 2003, revenues and sales
through distributors and value-added resellers represented approximately 89% and 83% of our total revenues, respectively. We expect that our revenues will continue to depend, in part, on the performance of these distributors and value-added
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.



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Impact of government entities and academic institutions.



In the first six months of fiscal 2005 and in fiscal 2004, approximately 37%
and 64% of our revenues, respectively, were derived from sales to government entities and academic institutions. Sales to government entities and academic institutions present risks in addition to those involved in sales to commercial customers,
including potential disruption due to appropriation and spending patterns and the governments reservation of the right to cancel contracts and purchase orders for its convenience.



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



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



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



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



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



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



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



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



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



| |  | 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.
| | - | ------------------------------------------------------------------------------------



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



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



Product returns may negatively affect our net revenues.



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



If we are unable to acquire key components on favorable terms, or at all,
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.



As of July 31, 2004, we used two third parties to manufacture sub-assemblies
of our products, and we purchased our components on a purchase order basis. If we cannot continue our arrangements with these contract manufacturers, 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
| | - | ---------------------------------------------



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



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



We market our line of products primarily to large enterprises, government entities and academic institutions through resellers. A prospective
customers decision to purchase our products will often involve a significant commitment of its resources and a lengthy evaluation and product qualification process. Throughout the sales cycle, we anticipate often spending considerable time
educating and providing information to prospective customers regarding the use and benefits of our products. Budget constraints, budget cycles and the need for multiple approvals within these organizations may also delay the purchase decision.
Failure to obtain the required approval for a particular project or purchase decision on a timely basis may delay the purchase of our products. As a result, our sales cycle for our network security solutions can take up to and beyond 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 and government entities with large networks usually expand their networks in large increments on a
periodic basis. In addition, large enterprises, government entities and academic institutions, and resellers selling to such entities, typically pay their suppliers over a longer period of time, which could negatively affect our liquidity.



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



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



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



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



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



We have recently experienced significant additions to our senior management.



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



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



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



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



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



Open source software.



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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 time and attention. Our business liability insurance coverage may be inadequate or future coverage may be unavailable on acceptable terms or at all.



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



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



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



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



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



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



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



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



Our officers and directors own a majority of our outstanding stock and
could control the outcome of actions.



Our executive
officers and directors, in the aggregate, owned a majority of our outstanding shares of common stock as of July 31, 2004. These stockholders, if acting together, would be able to control 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, the 1,995,833 shares recently issued in
the private placement completed in November 2003 may be resold, which may have a negative impact on the market price of our common stock. Certain holders of shares of our common stock issued in our October 2002 private placement have the right to
require us to register the resale of those shares at any time. Any such registration will result in additional shares being sold in the market, which could also have a negative impact on the market price of our common stock.



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As our business activities expand internationally, we face risks and challenges that could adversely
impact us.



We have recently expanded our sales and
operating activities to locations outside of the United States, including throughout EMEA and the Asia/Pacific region. Among other activities, we conduct sales and customer support operations directly and indirectly through our distributors and
value added resellers in these locations. For example, during each of the three and six months ended July 31, 2004, 10% of our revenues were attributable to sales to customers outside of the United States.



Our international presence and expansion exposes us to risks and challenges
not present in our U.S. operations, including:



| |  | the challenges of managing an organization spread over various countries located throughout the world;
| | - | ------------------------------------------------------------------------------------------------------



| |  | compliance with, and unexpected changes in, a wide range of complex regulatory requirements in countries where we conduct our business;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------



| |  | increased financial accounting and reporting burdens;
| | - | -----------------------------------------------------



| |  | potentially adverse tax consequences;
| | - | -------------------------------------



| |  | fluctuations in currency exchange rates resulting in losses or gains from transactions and expenses denominated in foreign currencies;
| | - | --------------------------------------------------------------------------------------------------------------------------------------



| |  | reduced protection for intellectual property rights in some countries;
| | - | ----------------------------------------------------------------------



| |  | reduced protection for enforcement of creditor and contractual rights in some countries; and
| | - | --------------------------------------------------------------------------------------------



| |  | import and export license requirements and restrictions on the import and export of certain technology, especially encryption technology and trade restrictions.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



Any or all of these risks and challenges could have a material
adverse impact on our business, operating results and financial condition.



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



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



Provisions of
Delaware law and our certificate of incorporation and bylaws could also delay or make a merger, tender offer or proxy contest involving us more difficult. For example, any stockholder wishing to make a stockholder proposal (including director
nominations) at our fiscal 2006 annual meeting must meet the qualifications and follow the procedures specified under both the Exchange Act of 1934 and our certificate of incorporation, which is filed with the Securities and Exchange Commission.



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



As of July 31, 2004, we had approximately $26.6 million in cash and cash equivalents on hand and a $1.3 million certificate of deposit. In July 2004, we
amended our loan and security agreement in order to, among other things, establish an additional equipment term loan facility, extend the maturity date of the revolving loan facility and increase the amount we may borrow under the revolving loan
facility. Under the new equipment term loan facility, we can borrow up to $4 million for additional purchases of equipment and software approved by the bank. Under the amended revolving loan facility, we can borrow up to $10 million for working
capital purposes, subject to availability under a borrowing base. As of July 31, 2004, we had borrowed approximately $0.6 million under our original equipment term loan facility, $0.7 million under our new equipment term loan facility and had not
borrowed any amount under the amended revolving loan facility. We may need to raise additional funds at any time, and we



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cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. Due to the
volatility of the U.S. equity markets, particularly for smaller technology companies, we may not have access to new capital investment in the event we need to raise additional funds.



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



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



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



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



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



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



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



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



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ITEM 3.Quantitative and Qualitative Disclosures About Market Risk



We are exposed to interest rate risk primarily through our loan facilities, which accrue interest at a floating rate. If our effective interest rate under
our loan facilities were to increase by 100 basis points (1.00%), our annual financing expense would increase by approximately $12,000, based on the average balances utilized under our loan facilities during the period ended July 31, 2004. We did
not experience a material impact from interest rate risk during the three months ended July 31, 2004.



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



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



ITEM 4.Controls and Procedures.



We maintain a set of disclosure controls and procedures that are designed to ensure that the information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 (the Exchange
Act) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commissions rules and forms. As of July 31, 2004, we carried out an evaluation, under the supervision and with the
participation of our management, including our principal executive officer and our principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the
Exchange Act). Based upon that evaluation, our principal executive officer and principal financial officer concluded that, as of July 31, 2004, the design and operation of these disclosure controls and procedures were effective.



There have been no changes in our internal control over financial reporting
(as defined in Rule 13a-15(f) under the Exchange Act) that occurred during our fiscal quarter ended July 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



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PART II  OTHER INFORMATION



ITEM 1.Legal Proceedings



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



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



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 June 25, 2004, TippingPoints stockholders approved the following amendments to TippingPoints Restated Certificate of Incorporation
(Certificate):



| | (a) | An amendment to reduce the number of authorized shares of Common Stock from 250,000,000 to 35,000,000; and
| | --- | ----------------------------------------------------------------------------------------------------------



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| | (b) | An amendment to allow the number of authorized shares of common stock to be increased or decreased by the affirmative vote of the holders of a majority of TippingPoints
outstanding capital stock.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The amendment to our
Certificate reducing the number of authorized shares of common stock has no effect on the number of shares of common stock currently held by, or the rights of, existing holders of our common stock. The amendment to our Certificate reducing the vote
required to increase of decrease the number of authorized shares of common stock reduces the number of shares that must be voted for approval of future increases or decreases in the number of authorized shares of common stock from 80% to a majority
(greater than 50%).



ITEM 4.Submissions of Matters to a Vote of Security Holders



Our Annual Meeting of Stockholders was held on June 25, 2004. There were represented, in person or by proxy, 6,406,988 shares of our common stock entitled
to vote at the meeting, constituting a quorum. The following matters were voted upon and duly and validly approved by our stockholders at the meeting:



|1. | Amendment to our Restated Certificate of Incorporation to (i) reduce the number of authorized shares of Common Stock from 250,000,000 to 35,000,000, and (ii) permit the number of
authorized shares of common stock to be increased or decreased by the affirmative vote of the holders of a majority of our outstanding capital stock.
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                 |  |         |  |         |  |                 
|---------------- |  | ------- |  | ------- |  | ----------------
|Number of Shares
|For              |  | Against |  | Abstain |  | Broker Non-Votes
|6,335,310        |  | 68,659  |  | 3,019   |  | 0               



|2. | Election of directors to serve until the 2005 Annual Meeting of Stockholders
|-- | ----------------------------------------------------------------------------



|                    |  |                  |  |         
|------------------- |  | ---------------- |  | --------
|                    |  | Number of Shares
|Nominee             |  | For              |  | Withheld
|John F. McHale      |  | 6,335,439        |  | 71,549  
|                    |  |                 
|Michael R. Corboy   |  | 6,325,044        |  | 81,944  
|                    |  |                 
|Richard D. Eyestone |  | 6,302,588        |  | 104,400 
|                    |  |                 
|Kip McClanahan      |  | 6,335,478        |  | 71,510  
|                    |  |                 
|Donald K. McKinney  |  | 6,319,605        |  | 87,383  
|                    |  |                 
|Paul S. Zito        |  | 6,295,763        |  | 111,225 



ITEM 6.Exhibits and Reports on Form 8-K



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



|              |  |                                                                                                                                                    |  |      |  |                  |  |              
|------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- |  | ---------------- |  | -------------
|ExhibitNumber |  | Exhibit Description                                                                                                                                |  | Form |  | Date Filed       |  | FiledHerewith
|3.1           |  | Restated Certificate of Incorporation, as filed with the Secretary of State of the State of Delaware on October 29, 2001.                          |  | 10-Q |  | November 9, 2001 |  |              
|              |  |                                                                                                                                                    |  |     
|3.2           |  | Certificate of Amendment to Restated Certificate of Incorporation, as filed with the Secretary of State of the State of Delaware on June 25, 2004. |  |      |  |                  |  | X            



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|              |  |                                                                                                                                                                                                           |  |         |  |                   |  |              
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------- |  | ----------------- |  | -------------
|ExhibitNumber |  | Exhibit Description                                                                                                                                                                                       |  | Form    |  | Date Filed        |  | FiledHerewith
|3.3           |  | Restated Bylaws adopted by the Board of Directors on August 22, 2002.                                                                                                                                     |  | 10-Q    |  | September 6, 2002 |  |              
|              |  |                                                                                                                                                                                                           |  |        
|3.4           |  | Amendment to Restated Bylaws adopted by the Board of Directors on November 19, 2003.                                                                                                                      |  |         |  |                   |  | X            
|              |  |                                                                                                                                                                                                           |  |        
|4.1           |  | Specimen Certificate for Common Stock.                                                                                                                                                                    |  | 10-K    |  | March 27, 2002    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|4.2           |  | Registration Rights Agreement among TippingPoint Technologies, Inc. and the purchasers of its capital stock dated October 2, 2002                                                                         |  | 8-K     |  | October 4, 2002   |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.1          |  | Office Lease by and between TippingPoint Technologies, Inc. and SV Bull Creek Limited Partnership dated February 16, 2000.                                                                                |  | S-1     |  | February 25, 2000 |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.2          |  | First Amendment to Lease by and between TippingPoint Technologies, Inc. and HUB Properties LLC (as successor to SV Bull Creek Limited Partnership) dated June 21, 2004 to be effective as of
May 1, 2004. |  |         |  |                   |  | X            
|              |  |                                                                                                                                                                                                           |  |        
|10.3*         |  | Fourth Amended and Restated 1999 Stock Option and Restricted Stock Plan.                                                                                                                                  |  | DEF 14A |  | May 4, 2004       |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.4          |  | Amended and Restated 2000 Employee Stock Purchase Plan.                                                                                                                                                   |  | 10-Q    |  | September 6, 2002 |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.5          |  | Form of Indemnity Agreement by and between TippingPoint Technologies, Inc. and its Directors and Officers                                                                                                 |  | 10-Q    |  | September 6, 2002 |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.6*         |  | Employment Agreement by and between James E. Cahill and TippingPoint Technologies, Inc. dated as of March 1, 2001.                                                                                        |  | 10-K    |  | March 27, 2002    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.7          |  | Promissory Note of James E. Cahill payable to TippingPoint Technologies, Inc. dated November 8, 1999.                                                                                                     |  | 10-K    |  | March 27, 2002    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.8          |  | Pledge Agreement by and between James E. Cahill and TippingPoint Technologies, Inc. dated November 8, 1999.                                                                                               |  | 10-K    |  | March 27, 2002    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.9          |  | Loan and Security Agreement by and between TippingPoint Technologies, Inc. and Comerica Bank-California dated July 30, 2002.                                                                              |  | 8-K     |  | August 5, 2002    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.10         |  | First Amendment to Loan and Security Agreement by and between TippingPoint Technologies, Inc. and Comerica Bank-California dated March 24, 2003.                                                          |  | 10-K    |  | April 28, 2003    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.11         |  | Second Amendment to Loan and Security Agreement by and between TippingPoint Technologies, Inc. and Comerica Bank-California dated July 30, 2003.                                                          |  |         |  |                   |  | X            
|              |  |                                                                                                                                                                                                           |  |        
|10.12         |  | Third Amendment to Loan and Security Agreement by and between TippingPoint Technologies, Inc. and Comerica Bank-California dated July 29, 2004.                                                           |  |         |  |                   |  | X            
|              |  |                                                                                                                                                                                                           |  |        
|10.13*        |  | Employment Agreement by and between Kip McClanahan and TippingPoint Technologies, Inc. dated April 13, 2004.                                                                                              |  | 10-K    |  | April 20, 2004    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.14*        |  | Employment Agreement by and between Adam Chibib and TippingPoint Technologies, Inc. dated April 12, 2004.                                                                                                 |  | 10-K    |  | April 20, 2004    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.15*        |  | Employment Agreement by and between James A. Hamilton and TippingPoint Technologies, Inc. dated as of September 10, 2003.                                                                                 |  | 10-Q    |  | December 12, 2003 |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.16*        |  | First Amendment to Employment Agreement by and between James A. Hamilton and TippingPoint Technologies, Inc. dated as of July 19, 2004                                                                    |  |         |  |                   |  | X            
|              |  |                                                                                                                                                                                                           |  |        
|10.17*        |  | Restricted Stock Agreement by and between James A. Hamilton and TippingPoint Technologies, Inc. dated as of September 15, 2003.                                                                           |  | 10-Q    |  | December 12, 2003 |  |              



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|              |  |                                                                                                                                |  |      |  |            |  |              
|------------- |  | ------------------------------------------------------------------------------------------------------------------------------ |  | ---- |  | ---------- |  | -------------
|ExhibitNumber |  | Exhibit Description                                                                                                            |  | Form |  | Date Filed |  | FiledHerewith
|31.1          |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Chief Executive Officer).                             |  |      |  |            |  | X            
|              |  |                                                                                                                                |  |     
|31.2          |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Chief Financial Officer).                             |  |      |  |            |  | X            
|              |  |                                                                                                                                |  |     
|32            |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Chief Executive Officer and Chief Financial Officer). |  |      |  |            |  | X            

---

|* | Identifies an Exhibit that consists of or includes a management contract or compensatory plan or arrangement.
|- | -------------------------------------------------------------------------------------------------------------



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



On June 1, 2004, TippingPoint furnished a Current Report on Form 8-K in which we disclosed, pursuant to Items 7 and 12 of Form 8-K, that we had issued a
press release announcing our results of operations for the quarter ended April 30, 2004.



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



32



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##### Table of Contents

SIGNATURE



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: August 31, 2004 |  | /S/ ADAM CHIBIB                             
|                      |  | Adam Chibib                                 
|                      |  | Chief Financial Officer                     
|                      |  | (Principal Financial and Accounting Officer)



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##### Table of Contents

INDEX TO EXHIBITS



|              |  |                                                                                                                                                                                                           |  |         |  |                   |  |              
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------- |  | ----------------- |  | -------------
|ExhibitNumber |  | Exhibit Description                                                                                                                                                                                       |  | Form    |  | Date Filed        |  | FiledHerewith
|3.1           |  | Restated Certificate of Incorporation, as filed with the Secretary of State of the State of Delaware on October 29, 2001.                                                                                 |  | 10-Q    |  | November 9, 2001  |  |              
|              |  |                                                                                                                                                                                                           |  |        
|3.2           |  | Certificate of Amendment to Restated Certificate of Incorporation, as filed with the Secretary of State of the State of Delaware on June 25, 2004.                                                        |  |         |  |                   |  | X            
|              |  |                                                                                                                                                                                                           |  |        
|3.3           |  | Restated Bylaws adopted by the Board of Directors on August 22, 2002.                                                                                                                                     |  | 10-Q    |  | September 6, 2002 |  |              
|              |  |                                                                                                                                                                                                           |  |        
|3.4           |  | Amendment to Restated Bylaws adopted by the Board of Directors on November 19, 2003.                                                                                                                      |  |         |  |                   |  | X            
|              |  |                                                                                                                                                                                                           |  |        
|4.1           |  | Specimen Certificate for Common Stock.                                                                                                                                                                    |  | 10-K    |  | March 27, 2002    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|4.2           |  | Registration Rights Agreement among TippingPoint Technologies, Inc. and the purchasers of its capital stock dated October 2, 2002                                                                         |  | 8-K     |  | October 4, 2002   |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.1          |  | Office Lease by and between TippingPoint Technologies, Inc. and SV Bull Creek Limited Partnership dated February 16, 2000.                                                                                |  | S-1     |  | February 25, 2000 |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.2          |  | First Amendment to Lease by and between TippingPoint Technologies, Inc. and HUB Properties LLC (as successor to SV Bull Creek Limited Partnership) dated June 21, 2004 to be effective as of
May 1, 2004. |  |         |  |                   |  | X            
|              |  |                                                                                                                                                                                                           |  |        
|10.3*         |  | Fourth Amended and Restated 1999 Stock Option and Restricted Stock Plan.                                                                                                                                  |  | DEF 14A |  | May 4, 2004       |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.4          |  | Amended and Restated 2000 Employee Stock Purchase Plan.                                                                                                                                                   |  | 10-Q    |  | September 6, 2002 |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.5          |  | Form of Indemnity Agreement by and between TippingPoint Technologies, Inc. and its Directors and Officers                                                                                                 |  | 10-Q    |  | September 6, 2002 |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.6*         |  | Employment Agreement by and between James E. Cahill and TippingPoint Technologies, Inc. dated as of March 1, 2001.                                                                                        |  | 10-K    |  | March 27, 2002    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.7          |  | Promissory Note of James E. Cahill payable to TippingPoint Technologies, Inc. dated November 8, 1999.                                                                                                     |  | 10-K    |  | March 27, 2002    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.8          |  | Pledge Agreement by and between James E. Cahill and TippingPoint Technologies, Inc. dated November 8, 1999.                                                                                               |  | 10-K    |  | March 27, 2002    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.9          |  | Loan and Security Agreement by and between TippingPoint Technologies, Inc. and Comerica Bank-California dated July 30, 2002.                                                                              |  | 8-K     |  | August 5, 2002    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.10         |  | First Amendment to Loan and Security Agreement by and between TippingPoint Technologies, Inc. and Comerica Bank-California dated March 24, 2003.                                                          |  | 10-K    |  | April 28, 2003    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.11         |  | Second Amendment to Loan and Security Agreement by and between TippingPoint Technologies, Inc. and Comerica Bank-California dated July 30, 2003.                                                          |  |         |  |                   |  | X            
|              |  |                                                                                                                                                                                                           |  |        
|10.12         |  | Third Amendment to Loan and Security Agreement by and between TippingPoint Technologies, Inc. and Comerica Bank-California dated July 29, 2004.                                                           |  |         |  |                   |  | X            
|              |  |                                                                                                                                                                                                           |  |        
|10.13*        |  | Employment Agreement by and between Kip McClanahan and TippingPoint Technologies, Inc. dated April 13, 2004.                                                                                              |  | 10-K    |  | April 20, 2004    |  |              
|              |  |                                                                                                                                                                                                           |  |        
|10.14*        |  | Employment Agreement by and between Adam Chibib and TippingPoint Technologies, Inc. dated April 12, 2004.                                                                                                 |  | 10-K    |  | April 20, 2004    |  |              



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##### Table of Contents

|              |  |                                                                                                                                        |  |      |  |                   |  |              
|------------- |  | -------------------------------------------------------------------------------------------------------------------------------------- |  | ---- |  | ----------------- |  | -------------
|ExhibitNumber |  | Exhibit Description                                                                                                                    |  | Form |  | Date Filed        |  | FiledHerewith
|10.15*        |  | Employment Agreement by and between James A. Hamilton and TippingPoint Technologies, Inc. dated as of September 10, 2003.              |  | 10-Q |  | December 12, 2003 |  |              
|              |  |                                                                                                                                        |  |     
|10.16*        |  | First Amendment to Employment Agreement by and between James A. Hamilton and TippingPoint Technologies, Inc. dated as of July 19, 2004 |  |      |  |                   |  | X            
|              |  |                                                                                                                                        |  |     
|10.17*        |  | Restricted Stock Agreement by and between James A. Hamilton and TippingPoint Technologies, Inc. dated as of September 15, 2003.        |  | 10-Q |  | December 12, 2003 |  |              
|              |  |                                                                                                                                        |  |     
|31.1          |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Chief Executive Officer).                                     |  |      |  |                   |  | X            
|              |  |                                                                                                                                        |  |     
|31.2          |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Chief Financial Officer).                                     |  |      |  |                   |  | X            
|              |  |                                                                                                                                        |  |     
|32            |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Chief Executive Officer and Chief Financial Officer).         |  |      |  |                   |  | X            

---

|* | Identifies an Exhibit that consists of or includes a management contract or compensatory plan or arrangement.
|- | -------------------------------------------------------------------------------------------------------------