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



For the Quarterly Period Ended March 31, 2004



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



For the Transition Period From  to



Commission File Number 0-21484



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TARANTELLA, INC.

(Exact name of registrant as specified in this charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|CALIFORNIA                                                     |  | 94-2549086                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



|                                           |  |           
|------------------------------------------ |  | ----------
|425 Encinal Street, Santa Cruz, California |  | 95060     
|(Address of principal executive office)    |  | (Zip Code)



Registrants
telephone number, including area code (831) 427-7222



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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 if disclosure of delinquent filers pursuant to Item 405 of Regulation
S-K is not contained herein, and will not be contained, to contained to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form
10-K. ̈



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



The number of shares outstanding of the registrants common stock as April 30, 2004 was 27,390,646.



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##### Table of Contents

TARANTELLA, INC.



FORM 10-Q



For the Quarterly Period Ended March 31, 2004



Table of Contents



|                              |  |                               |  |                                                                                                                         |  |   
|----------------------------- |  | ----------------------------- |  | ----------------------------------------------------------------------------------------------------------------------- |  | --
|                              |  |                               |  | Page                                                                                                                   
|Part I. Financial Information |  |                              
|                              |  |                               | 
|                              |  | Item 1.                       |  | Financial Statements                                                                                                    |  |   
|                              |  |                               | 
|                              |  |                               |  | a) Condensed Consolidated Statements of Operationsfor the three and six months ended March 31, 2004 and 2003 (restated) |  | 3 
|                              |  |                               | 
|                              |  |                               |  | b) Condensed Consolidated Balance Sheets,as of March 31, 2004 and September 30, 2003                                    |  | 4 
|                              |  |                               | 
|                              |  |                               |  | c) Condensed Consolidated Statements of Cash Flowsfor the six months ended March 31, 2004 and 2003 (restated)           |  | 5 
|                              |  |                               | 
|                              |  |                               |  | d) Notes to Condensed Consolidated Financial Statements                                                                 |  | 7 
|                              |  |                               | 
|                              |  | Item 2.                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                   |  | 23
|                              |  |                               | 
|                              |  | Item 3.                       |  | Quantitative and Qualitative Disclosures about Market Risk                                                              |  | 34
|                              |  |                               | 
|                              |  | Item 4.                       |  | Controls and Procedures                                                                                                 |  | 34
|                              | 
|Part II. Other Information    |  |                              
|                              |  |                               | 
|                              |  | Item 1.                       |  | Legal Proceedings                                                                                                       |  | 35
|                              |  |                               | 
|                              |  | Item 2.                       |  | Changes in Securities and Use of Proceeds                                                                               |  | 35
|                              |  |                               | 
|                              |  | Item 3.                       |  | Defaults Upon Senior Securities                                                                                         |  | 35
|                              |  |                               | 
|                              |  | Item 4.                       |  | Submission of Matters to a Vote of Security Holders                                                                     |  | 35
|                              |  |                               | 
|                              |  | Item 5.                       |  | Other Information                                                                                                       |  | 35
|                              |  |                               | 
|                              |  | Item 6.                       |  | Exhibits and Reports on Form 8-K                                                                                        |  | 36
|                              |  |                              
|                              |  | Signatures and certifications |  | 37                                                                                                                     



2



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Part I. Financial Information

Item I. Financial Statements



TARANTELLA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)



|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|------------------------------------------------------- |  | ---------------------------- | ------ | - | ---------------------------- | - | ------ | ---- |  | - | ---------------------------- | - |  | - | ------ | -
|                                                        |  | Three Months Ended March 31, |        |   | Six Months Ended March 31,   |  
|                                                        |  | 2004                         |        |   | 2003(As restated,see Note 2) |   |        | 2004 |  |   | 2003(As restated,see Note 2) |  
|                                                        |  | (Unaudited)                  |        |   | (Unaudited)                  |  
|Net revenues:                                           |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Licenses                                                |  | $                            | 2,159  |   |                              | $ | 3,433  |      |  | $ | 4,525                        |   |  | $ | 5,795  |  
|Services                                                |  |                              | 978    |   |                              |   | 797    |      |  |   | 2,080                        |   |  |   | 1,380  |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Total net revenues                                      |  |                              | 3,137  |   |                              |   | 4,230  |      |  |   | 6,605                        |   |  |   | 7,175  |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Cost of revenues:                                       |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Licenses                                                |  |                              | 202    |   |                              |   | 82     |      |  |   | 370                          |   |  |   | 138    |  
|Services                                                |  |                              | 394    |   |                              |   | 291    |      |  |   | 724                          |   |  |   | 549    |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Total cost of revenues                                  |  |                              | 596    |   |                              |   | 373    |      |  |   | 1,094                        |   |  |   | 687    |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Gross margin                                            |  |                              | 2,541  |   |                              |   | 3,857  |      |  |   | 5,511                        |   |  |   | 6,488  |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Operating expenses:                                     |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Research and development                                |  |                              | 1,205  |   |                              |   | 906    |      |  |   | 2,166                        |   |  |   | 1,893  |  
|Selling, general and administrative                     |  |                              | 4,867  |   |                              |   | 3,740  |      |  |   | 9,452                        |   |  |   | 7,401  |  
|Restructuring                                           |  |                              | (8     | ) |                              |   |       |      |  |   | 11                           |   |  |   | 1,147  |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Total operating expenses                                |  |                              | 6,064  |   |                              |   | 4,646  |      |  |   | 11,629                       |   |  |   | 10,441 |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Operating loss                                          |  |                              | (3,523 | ) |                              |   | (789   | )    |  |   | (6,118                       | ) |  |   | (3,953 | )
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Other income (expense):                                 |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Interest income (expense), net                          |  |                              | 2      |   |                              |   | 14     |      |  |   | (5                           | ) |  |   | 46     |  
|Other income (expense), net                             |  |                              | (61    | ) |                              |   | 63     |      |  |   | (111                         | ) |  |   | 49     |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Total other income (expense)                            |  |                              | (59    | ) |                              |   | 77     |      |  |   | (116                         | ) |  |   | 95     |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Loss before income taxes                                |  |                              | (3,582 | ) |                              |   | (712   | )    |  |   | (6,234                       | ) |  |   | (3,858 | )
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Income tax expense                                      |  |                              | 97     |   |                              |   | 98     |      |  |   | 195                          |   |  |   | 158    |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Net loss                                                |  |                              | (3,679 | ) |                              |   | (810   | )    |  |   | (6,429                       | ) |  |   | (4,016 | )
|                                                        |  |                              |        |  
|Other comprehensive income (loss):                      |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Unrealized gain (loss) on available for sale securities |  |                              | 689    |   |                              |   | (177   | )    |  |   | 764                          |   |  |   | 106    |  
|Foreign currency translation adjustment                 |  |                              | 52     |   |                              |   | (18    | )    |  |   | 121                          |   |  |   | (22    | )
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Total other comprehensive income (loss)                 |  |                              | 741    |   |                              |   | (195   | )    |  |   | 885                          |   |  |   | 84     |  
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Comprehensive loss                                      |  | $                            | (2,938 | ) |                              | $ | (1,005 | )    |  | $ | (5,544                       | ) |  | $ | (3,932 | )
|                                                        |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Net loss per share:                                     |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Basic and diluted                                       |  | $                            | (0.18  | ) |                              | $ | (0.10  | )    |  | $ | (0.39                        | ) |  | $ | (0.49  | )
|Shares used in net loss per share calculation:          |  |                              |        |   |                              |   |        |      |  |   |                              |   |  |   |        |  
|Basic and diluted                                       |  |                              | 20,232 |   |                              |   | 8,240  |      |  |   | 16,440                       |   |  |   | 8,223  |  



See
accompanying notes to condensed consolidated financial statements.



3



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TARANTELLA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS



|                                                                                                                                               |  |                |          |   |                    |   |          |  
|---------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | -------- | - | ------------------ | - | -------- | -
|(In thousands)                                                                                                                                 |  | March 31, 2004 |          |   | September 30, 2003 |  
|                                                                                                                                               |  | (Unaudited)    |         
|Assets                                                                                                                                         |  |                |          |   |                    |   |          |  
|Current assets:                                                                                                                                |  |                |          |   |                    |   |          |  
|Cash and cash equivalents                                                                                                                      |  | $              | 16,575   |   |                    | $ | 3,151    |  
|Available-for-sale equity securities                                                                                                           |  |                | 1,396    |   |                    |   | 632      |  
|Trade receivables, net of allowances of $0.3 million at March 31, 2004 and $0.5 million at September 30, 2003                                  |  |                | 3,190    |   |                    |   | 2,980    |  
|Other receivables                                                                                                                              |  |                | 181      |   |                    |   | 175      |  
|Prepaids and other current assets                                                                                                              |  |                | 591      |   |                    |   | 720      |  
|                                                                                                                                               |  |                |          |   |                    |   |          |  
|Total current assets                                                                                                                           |  |                | 21,933   |   |                    |   | 7,658    |  
|                                                                                                                                               |  |                |          |   |                    |   |          |  
|Property and equipment, net                                                                                                                    |  |                | 666      |   |                    |   | 734      |  
|Acquired intangible assets, net                                                                                                                |  |                | 1,330    |   |                    |   | 1,262    |  
|Goodwill                                                                                                                                       |  |                | 2,395    |   |                    |   | 2,391    |  
|Other assets                                                                                                                                   |  |                | 403      |   |                    |   | 343      |  
|                                                                                                                                               |  |                |          |   |                    |   |          |  
|Total assets                                                                                                                                   |  | $              | 26,727   |   |                    | $ | 12,388   |  
|                                                                                                                                               |  |                |          |   |                    |   |          |  
|Liabilities and shareholders equity                                                                                                           |  |                |          |   |                    |   |          |  
|Current liabilities:                                                                                                                           |  |                |          |   |                    |   |          |  
|Trade payables                                                                                                                                 |  | $              | 540      |   |                    | $ | 1,043    |  
|Line of credit                                                                                                                                 |  |                |         |   |                    |   | 319      |  
|Royalties payable                                                                                                                              |  |                | 1        |   |                    |   | 22       |  
|Royalties payable - former New Moon shareholders                                                                                               |  |                | 1,713    |   |                    |   | 1,725    |  
|Income taxes payable                                                                                                                           |  |                | 534      |   |                    |   | 549      |  
|Accrued restructuring charges                                                                                                                  |  |                | 416      |   |                    |   | 854      |  
|Accrued expenses and other current liabilities                                                                                                 |  |                | 4,453    |   |                    |   | 3,615    |  
|Deferred revenues                                                                                                                              |  |                | 2,514    |   |                    |   | 1,757    |  
|                                                                                                                                               |  |                |          |   |                    |   |          |  
|Total current liabilities                                                                                                                      |  |                | 10,171   |   |                    |   | 9,884    |  
|                                                                                                                                               |  |                |          |   |                    |   |          |  
|Long-term deferred revenues                                                                                                                    |  |                | 1,205    |   |                    |   | 36       |  
|                                                                                                                                               |  |                |          |   |                    |   |          |  
|Total long-term liabilities                                                                                                                    |  |                | 1,205    |   |                    |   | 36       |  
|                                                                                                                                               |  |                |          |   |                    |   |          |  
|Shareholders equity:                                                                                                                          |  |                |          |   |                    |   |          |  
|Preferred stock, authorized 20,000 shares; no shares issued and outstanding                                                                    |  |                |         |   |                    |   |         |  
|Common stock, no par value, authorized 100,000 shares; issued and outstanding 27,288 at March 31, 2004 and 11,959 shares at September 30,
2003 |  |                | 145,716  |   |                    |   | 126,749  |  
|Deferred stock compensation                                                                                                                    |  |                | (540     | ) |                    |   |         |  
|Accumulated other comprehensive income                                                                                                         |  |                | 1,438    |   |                    |   | 553      |  
|Accumulated deficit                                                                                                                            |  |                | (131,263 | ) |                    |   | (124,834 | )
|                                                                                                                                               |  |                |          |   |                    |   |          |  
|Total shareholders equity                                                                                                                     |  |                | 15,351   |   |                    |   | 2,468    |  
|                                                                                                                                               |  |                |          |   |                    |   |          |  
|Total liabilities and shareholders equity                                                                                                     |  | $              | 26,727   |   |                    | $ | 12,388   |  
|                                                                                                                                               |  |                |          |   |                    |   |          |  



See
accompanying notes to condensed consolidated financial statements.



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TARANTELLA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS



|                                                                             |  |                            |        |   |                              |   |        |  
|---------------------------------------------------------------------------- |  | -------------------------- | ------ | - | ---------------------------- | - | ------ | -
|                                                                             |  | Six Months Ended March 31, |       
|(In thousands)                                                               |  | 2004                       |        |   | 2003(As restated,see note 2) |  
|                                                                             |  | (Unaudited)                |       
|Cash flows from operating activities:                                        |  |                            |        |   |                              |   |        |  
|Net loss                                                                     |  | $                          | (6,429 | ) |                              | $ | (4,016 | )
|Adjustments to reconcile net loss to net cash used for operating activities: |  |                            |        |   |                              |   |        |  
|Depreciation and amortization                                                |  |                            | 525    |   |                              |   | 381    |  
|Foreign currency exchange loss (gain)                                        |  |                            | 78     |   |                              |   | (32    | )
|Loss on disposal of property and equipment                                   |  |                            | 2      |   |                              |   | 82     |  
|Amortization of deferred stock compensation                                  |  |                            | 166    |   |                              |   |       |  
|Stock compensation expense                                                   |  |                            | 74     |   |                              |   |       |  
|Compensation expense to former Caststream shareholders                       |  |                            | 124    |   |                              |   |       |  
|Changes in operating assets and liabilities, net of New Moon acquisition:    |  |                            |        |   |                              |   |        |  
|Trade receivables                                                            |  |                            | (204   | ) |                              |   | (1,155 | )
|Other receivables                                                            |  |                            | (6     | ) |                              |   | (118   | )
|Prepaids and other current assets                                            |  |                            | 129    |   |                              |   | 304    |  
|Other assets                                                                 |  |                            | (60    | ) |                              |   | 22     |  
|Trade payables                                                               |  |                            | (524   | ) |                              |   | 26     |  
|Royalties payable                                                            |  |                            | (21    | ) |                              |   | (56    | )
|Income taxes payable                                                         |  |                            | (15    | ) |                              |   | 36     |  
|Accrued restructuring expenses                                               |  |                            | (438   | ) |                              |   | (83    | )
|Accrued expenses and other current liabilities                               |  |                            | 835    |   |                              |   | (887   | )
|Deferred revenues                                                            |  |                            | 1,926  |   |                              |   | 209    |  
|                                                                             |  |                            |        |   |                              |   |        |  
|Net cash used in operating activities                                        |  |                            | (3,838 | ) |                              |   | (5,287 | )
|                                                                             |  |                            |        |   |                              |   |        |  
|Cash flows from investing activities:                                        |  |                            |        |   |                              |   |        |  
|Purchases of property and equipment                                          |  |                            | (176   | ) |                              |   | (134   | )
|Additional New Moon purchase acquisition costs                               |  |                            | (4     | ) |                              |   |       |  
|Change in royalties payable - former New Moon shareholders                   |  |                            | (12    | ) |                              |   |       |  
|                                                                             |  |                            |        |   |                              |   |        |  
|Net cash used in investing activities                                        |  |                            | (192   | ) |                              |   | (134   | )
|                                                                             |  |                            |        |   |                              |   |        |  
|Cash flows from financing activities:                                        |  |                            |        |   |                              |   |        |  
|Payments on capital lease obligations                                        |  |                            | (31    | ) |                              |   | (2     | )
|Line of credit payments                                                      |  |                            | (319   | ) |                              |   |       |  
|Net proceeds from issuance of common stock and warrants                      |  |                            | 17,810 |   |                              |   | 34     |  
|                                                                             |  |                            |        |   |                              |   |        |  
|Net cash provided by financing activities                                    |  |                            | 17,460 |   |                              |   | 32     |  
|                                                                             |  |                            |        |   |                              |   |        |  
|Effects of exchange rate changes on cash and cash equivalents                |  |                            | (6     | ) |                              |   | (1     | )
|                                                                             |  |                            |        |   |                              |   |        |  
|Increase (decrease) in cash and cash equivalents                             |  |                            | 13,424 |   |                              |   | (5,390 | )
|Cash and cash equivalents at beginning of period                             |  |                            | 3,151  |   |                              |   | 7,055  |  
|                                                                             |  |                            |        |   |                              |   |        |  
|Cash and cash equivalents at end of period                                   |  | $                          | 16,575 |   |                              | $ | 1,665  |  
|                                                                             |  |                            |        |   |                              |   |        |  



See accompanying notes to condensed
consolidated financial statements.



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TARANTELLA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS



|                                                            |  |                            |     |      |   |    
|----------------------------------------------------------- |  | -------------------------- | --- | ---- | - | ---
|                                                            |  | Six Months Ended March 31,
|(In thousands)                                              |  | 2004                       |     | 2003
|                                                            |  | (Unaudited)               
|Supplemental Disclosures of Cash Flow Information:          |  |                            |     |      |   |    
|                                                            |  |                           
|Cash paid during the period for:                            |  |                            |     |      |   |    
|Income taxes                                                |  | $                          | 244 |      | $ | 99 
|Interest                                                    |  |                            | 7   |      |   |   
|Unrealized gain on available-for-sale equity securities     |  |                            | 764 |      |   | 106
|Issuance of restricted stock in lieu of compensation        |  |                            | 706 |      |   |   
|Issuance of stock and warrants to acquire Caststream assets |  |                            | 377 |      |   |   



See
accompanying notes to condensed consolidated financial statements.



6



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



Note 1 - Basis of Presentation



Tarantella, Inc. (the
Company) is a leading provider of Internet infrastructure software that enables web-based access to enterprise applications from virtually any client device. Headquartered in Santa Cruz, California, Tarantella operates development
centers in the United States, the United Kingdom and India with sales representatives in the U.S., U.K., Germany, Canada, France, the Netherlands, Spain and Italy. Tarantella products are sold through an integrated worldwide channel of Tarantella
account executives, distributors, value-added resellers, systems integrators and computer and software manufacturers. Tarantella maintains exclusive distribution relationships in Japan as well as distribution and agent relationships in China,
Northern and Southeast Asia. In total, Tarantella products are available through resellers in more than 30 countries.



The Company was incorporated in 1979 as a California Corporation under the name The Santa Cruz Operation Inc. (SCO). On May 4, 2001, SCO completed the sale of
its Server Software and Professional Services Divisions to Caldera Systems, Inc., retaining the Tarantella Division. A new company, Caldera International, was formed which combined the assets acquired from SCO with the assets of Caldera Systems.
Upon the completion of the sale, SCO changed its corporate name to Tarantella, Inc.



The Companys flagship product, Tarantella Enterprise 3, a UNIX/Linux-based application access suite, is installed in corporations and governmental agencies around the world. Tarantella Enterprise 3 was introduced to the marketplace in
2001. Earlier client integration products, which are part of the Vision2K Suite, were introduced in the late 1990s and are currently still available. In June 2003, Tarantella acquired New Moon Systems Inc, and added New Moon Canaveral iQ from Tarantella ® (Canaveral iQ) to its product offering. Canaveral iQ is a
Windows-based application access suite, intended for small to mid-sized business customers and departmental deployments with Windows-only infrastructure. In aggregate, Tarantella boasts over 12,000 customer sites including several of the most
respected brands in the Fortune Magazine Global 2000.



In the opinion of
management, the accompanying unaudited condensed consolidated statements of operations, balance sheets and statements of cash flows include all material adjustments (consisting of normal recurring adjustments) which the Company considers necessary
for a fair presentation of its financial condition and results of operations as of and for the interim periods presented. The financial statements include the accounts of the Company and its wholly owned subsidiaries after all material intercompany
balances and transactions have been eliminated. These condensed consolidated financial statements should be read in conjunction with the Companys audited consolidated financial statements and notes thereto included in the Companys 2003
Annual Report on Form 10-K. The consolidated interim results presented are not necessarily indicative of results to be expected for a full year. The September 30, 2003 balance sheet was derived from audited financial statements, and is included for
comparative purposes.



The accompanying condensed consolidated financial
statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X.



Revenue Recognition



The Companys revenue is derived primarily from two sources, across many industries: (i) product license revenue, derived primarily
from product sales to resellers and end users, including large scale enterprises and royalty revenue, derived primarily from initial license fees, ongoing royalties from product sales by source code OEMs, and software updates; and (ii) services and
support revenue, derived primarily from support and education and consulting services to end users.



The Company accounts for revenue under the provisions of AICPA Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended. Product revenue is recognized upon shipment if evidence of
an arrangement exists, the fee is fixed and determinable and collection of resulting receivables is probable. Sales to distributors are recognized upon sale by the distributor to resellers or end users. In certain instances when distributors waive
their right to return product, revenue is recognized upon shipment if evidence of an arrangement exists, the fee is fixed and determinable and collection of resulting receivables is probable. Estimated product returns are recorded upon recognition
of revenue from customers having rights of return, including exchange rights for unsold products and product upgrades.



Software revenue is recognized using the residual method. Under the residual method, revenue is recognized if vendor-specific objective evidence of fair value exists for
all the undelivered elements in an arrangement. Vendor-specific objective evidence of fair value is based on the price when the element is sold separately or, if not sold separately, is established by management. Vendor specific objective evidence
of the fair value of maintenance for license agreements is based on stated renewal rates, and for contracts that do not include stated renewal rates, are determined by reference to the price paid by the Companys customers when maintenance is
sold separately. Past history has shown that the rate the Company charges for maintenance on license agreements with a stated renewal rate is similar to the rate the Company charges for maintenance on license agreements without a stated renewal
rate.



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##### Table of Contents

The Company recognizes revenue from maintenance fees for ongoing customer support and product updates ratably over the
period of the maintenance contract. Payments for maintenance fees are generally made in advance and are non-refundable. For revenue allocated to education and consulting services or derived from the separate sale of such services, the Company
recognizes revenue as the related services are performed.



The Company
recognizes product revenue from royalty payments upon receipt of quarterly royalty reports from OEMs (original equipment manufacturer) related to their product sales.



Note 2  Restatement



Subsequent to the issuance of the Companys condensed consolidated financial statements for the three and six months ended March 31, 2003, the Companys
management determined that the accounting treatment initially afforded to certain transactions was not correct. As a result, the accompanying condensed consolidated financial statements have been restated as described below.



The Company announced that it had become aware of business practices in the Companys
Northern European territory that required immediate changes in sales personnel within the region and certain internal controls. After conducting an internal review of certain transactions in the Northern European territory as well as other domestic
and international transactions, the Company determined that is was necessary to restate revenues recorded in previous interim periods of fiscal 2003 and the fourth quarter of fiscal 2002.



In fiscal 2003 there were four revenue transactions in Europe that did not sell out of the Companys distributor, as the Company had
believed. There were two transactions totaling $0.2 million in the first quarter of fiscal 2003 and two transactions totaling $0.2 million in the second quarter of fiscal 2003. Since sales to distributors are recognized upon sell out by the
distributor to resellers or end users, revenue for these transactions was reversed. Two of these transactions sold out of inventory in subsequent quarters and revenue was recognized, and the products for the other two transactions have been returned
to the Company.



There were also two additional transactions in the first
quarter of fiscal 2003 in the United States totaling $0.2 million where the terms of the original transaction were amended. The amendment requires that the Company recognize such revenue no earlier than receipt of payment, which occurred in the
third quarter of fiscal 2003 for both transactions.



In addition, as part of
the internal revenue investigation, the Company determined that there were two revenue transactions, for one customer, one in the first quarter and one in the second quarter of fiscal 2003, totaling $0.2 million, that should have been recorded when
cash was received, as the customers ability to pay was not certain. As of March 31, 2004, $5,000 has been paid and recognized as revenue. For the remaining unpaid portion of these transactions revenue will be recognized upon receipt of cash.



As a result of the reversal of these revenues, there was also a reversal of
the cost of goods sold, commission expense and cooperative (COOP) advertising expense associated with these revenues.



A summary of the significant effects of the restatements on previously reported condensed consolidated financial statements is as follows:



|                                      |  |                                               |       |   |          |   |       |  
|------------------------------------- |  | --------------------------------------------- | ----- | - | -------- | - | ----- | -
|                                      |  | Three Months Ended March 31, 2003 (Unaudited) |      
|(In thousands, except per share data) |  | As Previously Reported *                      |       |   | Restated |  
|License revenues                      |  | $                                             | 3,607 |   |          | $ | 3,433 |  
|Cost of license revenues              |  |                                               | 85    |   |          |   | 82    |  
|Selling, general and administrative   |  |                                               | 3,811 |   |          |   | 3,740 |  
|Net loss                              |  |                                               | (710  | ) |          |   | (810  | )
|                                      |  |                                              
|Loss per share:                       |  |                                               |       |   |          |   |       |  
|Basic and diluted                     |  | $                                             | (0.09 | ) |          | $ | (0.10 | )

---

|* | Amounts as previously reported reflect reclassifications made to conform to current year presentation.
|- | ------------------------------------------------------------------------------------------------------



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##### Table of Contents

|                                      |  |                                             |        |   |          |   |        |  
|------------------------------------- |  | ------------------------------------------- | ------ | - | -------- | - | ------ | -
|                                      |  | Six Months Ended March 31, 2003 (Unaudited) |       
|(In thousands, except per share data) |  | As PreviouslyReported *                     |        |   | Restated |  
|License revenues                      |  | $                                           | 6,609  |   |          | $ | 5,795  |  
|Cost of license revenues              |  |                                             | 154    |   |          |   | 138    |  
|Research and development              |  |                                             | 1,885  |   |          |   | 1,893  |  
|Selling, general and administrative   |  |                                             | 7,534  |   |          |   | 7,401  |  
|Net loss                              |  |                                             | (3,343 | ) |          |   | (4,016 | )
|                                      |  |                                            
|Loss per share:                       |  |                                             |        |   |          |   |        |  
|Basic and diluted                     |  | $                                           | (0.41  | ) |          | $ | (0.49  | )

---

|* | Amounts as previously reported reflect reclassifications made to conform to current year presentation.
|- | ------------------------------------------------------------------------------------------------------



The Company is in contact with the Securities & Exchange Commission in connection with an informal inquiry related to the events leading
up to the Companys restatement.



Note 3 - Recent Accounting
Pronouncements



In January 2003 the FASB issued FIN No. 46,
Consolidation of Variable Interest Entities and a revised interpretation of FIN No. 46 (FIN No. 46-R) in December 2003. FIN No. 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 No. 46-R was effective for the Company during the quarter ended March 31, 2004. The Company has no interest in variable interest entities, so the adoption of FIN No. 46-R had no effect on the Companys financial position or
results of operations.



Stock Based Compensation



The Company accounts for stock-based compensation arrangements under the provisions of
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees for its fixed stock option plan and employee stock purchase plan and accordingly, has not recognized compensation cost in the
accompanying condensed consolidated statement of operations for options issued at fair value. SFAS No. 123 permits the use of either a fair value based method or the intrinsic value method to measure the expense associated with stock-based
compensation arrangements. The Company has recognized stock compensation costs for stock options granted at less than fair value on the date of grant.



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In accordance with the interim disclosure provisions of SFAS No. 148, the pro forma effect on the Companys net loss
had compensation expense been recorded for the three and six months ended March 31, 2004 and 2003, respectively, as determined under the fair value method, is shown below:



|                                                                                                              |  |                                       |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------- |  | ------------------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                              |  | Three Months Ended March 31,          |        |   | Six Months Ended March 31, |  
|                                                                                                              |  | 2004                                  |        |   | 2003                       |   |        | 2004 |  |   | 2003   |  
|                                                                                                              |  | (In thousands, except per share data) |       
|Net loss, as reported                                                                                         |  | $                                     | (3,679 | ) |                            | $ | (810   | )    |  | $ | (6,429 | ) |  | $ | (4,016 | )
|                                                                                                              |  |                                       |        |  
|Add: Stock-based employee compensation expense included in reported net loss                                  |  |                                       | 218    |   |                            |   |       |      |  |   | 240    |   |  |   | 0      |  
|                                                                                                              |  |                                       |        |  
|Less: Total stock-based employee compensation expense determined under fair value based method for all awards |  |                                       | (640   | ) |                            |   | (1,363 | )    |  |   | (1,765 | ) |  |   | (2,756 | )
|                                                                                                              |  |                                       |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Pro forma net loss                                                                                            |  | $                                     | (4,101 | ) |                            | $ | (2,173 | )    |  | $ | (7,954 | ) |  | $ | (6,772 | )
|                                                                                                              |  |                                       |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Net loss per share as reported                                                                                |  |                                       |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Basic and diluted                                                                                             |  | $                                     | (0.18  | ) |                            | $ | (0.10  | )    |  | $ | (0.39  | ) |  | $ | (0.49  | )
|                                                                                                              |  |                                       |        |  
|Pro forma net loss per share                                                                                  |  |                                       |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Basic and diluted                                                                                             |  | $                                     | (0.20  | ) |                            | $ | (0.26  | )    |  | $ | (0.48  | ) |  | $ | (0.82  | )



The fair value of each option grant
was estimated on the date of grant using the Black-Scholes option-pricing model. The principal determinants of option pricing are fair market value of the Companys common stock at the date of grant, expected volatility, risk-free interest
rate, expected option lives and dividend yields. Weighted average assumptions employed by the Company were: expected volatility of 105% for the three and six months ended March 31, 2004, 94% for the three and six months ended March 31, 2003, a
risk-free interest rate of 2.88% and 2.97% for the three and six months ended March 31, 2004 and 2003, respectively and no dividend yield for both periods. In addition, the Company assumed an expected option life of four years for non-executive
employees and five years for executive employees.



The fair value for the
Employee Stock Purchase Plan rights was estimated on the date of grant using the Black-Scholes option-pricing model. The principal determinants of option pricing are fair market value of the Companys common stock at the date of grant, expected
volatility, risk-free interest rate, expected option lives and dividend yields. Weighted average assumptions employed by the Company were: expected volatility of 107% for the three and six months ended March 31, 2004, 94% for the three and six
months ended March 31, 2003, a risk-free interest rate of 1.22% and 1.69% for the three and six months ended March 31, 2004 and 2003, respectively and no dividend yield for both periods. In addition, for the three and six months ended March 31, 2004
and 2003, the Company assumed an expected option life of one year and six months, respectively.



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##### Table of Contents

Note 4 - Earnings Per Share Disclosures



Basic and diluted loss per share (EPS) were calculated as follows for the three and six months ended March 31, 2004 and 2003 (in
thousands, except per share data):



|                                                                                                                                                              |  |                             |        |   |                           |   |       |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ----- | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                                                                              |  | Three Months EndedMarch 31, |        |   | Six Months EndedMarch 31, |  
|                                                                                                                                                              |  | 2004                        |        |   | 2003                      |   |       | 2004 |  |   | 2003   |  
|Basic:                                                                                                                                                        |  |                             |        |   |                           |   |       |      |  |   |        |   |  |   |        |  
|Net loss                                                                                                                                                      |  | $                           | (3,679 | ) |                           | $ | (810  | )    |  | $ | (6,429 | ) |  | $ | (4,016 | )
|                                                                                                                                                              |  |                             |        |   |                           |   |       |      |  |   |        |   |  |   |        |  
|Weighted average shares                                                                                                                                       |  |                             | 20,232 |   |                           |   | 8,240 |      |  |   | 16,440 |   |  |   | 8,223  |  
|                                                                                                                                                              |  |                             |        |  
|Loss per share                                                                                                                                                |  | $                           | (0.18  | ) |                           | $ | (0.10 | )    |  | $ | (0.39  | ) |  | $ | (0.49  | )
|                                                                                                                                                              |  |                             |        |   |                           |   |       |      |  |   |        |   |  |   |        |  
|Diluted:                                                                                                                                                      |  |                             |        |   |                           |   |       |      |  |   |        |   |  |   |        |  
|Net loss                                                                                                                                                      |  | $                           | (3,679 | ) |                           | $ | (810  | )    |  | $ | (6,429 | ) |  | $ | (4,016 | )
|                                                                                                                                                              |  |                             |        |   |                           |   |       |      |  |   |        |   |  |   |        |  
|Weighted average shares                                                                                                                                       |  |                             | 20,232 |   |                           |   | 8,240 |      |  |   | 16,440 |   |  |   | 8,223  |  
|Common equivalent shares from stock options and warrants                                                                                                      |  |                             |       |   |                           |   |      |      |  |   |       |   |  |   |       |  
|                                                                                                                                                              |  |                             |        |   |                           |   |       |      |  |   |        |   |  |   |        |  
|Shares used in per share calculation                                                                                                                          |  |                             | 20,232 |   |                           |   | 8,240 |      |  |   | 16,440 |   |  |   | 8,223  |  
|                                                                                                                                                              |  |                             |        |   |                           |   |       |      |  |   |        |   |  |   |        |  
|Loss per share                                                                                                                                                |  | $                           | (0.18  | ) |                           | $ | (0.10 | )    |  | $ | (0.39  | ) |  | $ | (0.49  | )
|                                                                                                                                                              |  |                             |        |   |                           |   |       |      |  |   |        |   |  |   |        |  
|Options and warrants outstanding, not included in computation of diluted EPS because the exercise price was greater than the average market
price.            |  |                             | 1,198  |   |                           |   | 2,947 |      |  |   | 2,891  |   |  |   | 2,839  |  
|                                                                                                                                                              |  |                             |        |  
|Options outstanding, not included in computation of diluted EPS because their inclusion would have an anti-dilutive effect due to net loss
during the period. |  |                             | 3,000  |   |                           |   | 368   |      |  |   | 2,417  |   |  |   | 504    |  



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Note 5  Accrued Restructuring Charges



Fiscal 2004



During the first quarter of fiscal 2004, the Company reduced the number of European countries in which it had a legal presence resulting in the implementation of a
restructuring which reduced the existing workforce by one employee. This reduction eliminated the Companys presence in one European country. The Company recorded a charge of $19,000 for this restructuring for severance payments.



Fiscal 2004 First Quarter Restructuring Accrual



|                                    |  |                    |     |   |       |   |     |  
|----------------------------------- |  | ------------------ | --- | - | ----- | - | --- | -
|(In Thousands)                      |  | Reduction in Force |     |   | Total |  
|Restructuring charge accrued        |  | $                  | 19  |   |       | $ | 19  |  
|Payments/utilization of the accrual |  |                    | (15 | ) |       |   | (15 | )
|                                    |  |                    |     |   |       |   |     |  
|Accrual at December 31, 2003        |  |                    | 4   |   |       |   | 4   |  
|                                    |  |                   
|Payments/utilization of the accrual |  |                    | (4  | ) |       |   | (4  | )
|                                    |  |                    |     |   |       |   |     |  
|Accrual at March 31, 2004           |  | $                  |    |   |       | $ |    |  
|                                    |  |                    |     |   |       |   |     |  



Fiscal 2003



On July 24, 2003, the Company announced a restructuring plan, which resulted in a charge of
$0.4 million. The Company reduced its spending levels to align its operating expenses with the Companys lower than expected revenues. The restructuring included a reduction in staffing of 23 employees, and the disposal of fixed assets.



The expense included a severance charge of $0.4 million for the elimination of
12 positions in the United States and 11 positions in the United Kingdom. The reductions in force affected the product development, support, sales, marketing and general and administrative functions of the Company. There was also a charge of $6,508
for the disposal of fixed assets. As of March 31, 2004, all 23 positions had been eliminated.



Fiscal 2003 Fourth Quarter Restructuring Accrual



|                                    |  |                    |      |   |                          |   |    |       |  |   |      |  
|----------------------------------- |  | ------------------ | ---- | - | ------------------------ | - | -- | ----- |  | - | ---- | -
|(In Thousands)                      |  | Reduction in Force |      |   | Disposal of Fixed Assets |   |    | Total | 
|Restructuring charge accrued        |  | $                  | 442  |   |                          | $ | 6  |       |  | $ | 448  |  
|Payments/utilization of the accrual |  |                    | (393 | ) |                          |   | (6 | )     |  |   | (399 | )
|                                    |  |                    |      |   |                          |   |    |       |  |   |      |  
|Accrual at September 30, 2003       |  |                    | 49   |   |                          |   |   |       |  |   | 49   |  
|                                    |  |                    |     
|Payments/utilization of the accrual |  |                    | (24  | ) |                          |   |   |       |  |   | (24  | )
|                                    |  |                    |      |   |                          |   |    |       |  |   |      |  
|Accrual at December 31, 2003        |  |                    | 25   |   |                          |   |   |       |  |   | 25   |  
|                                    |  |                    |     
|Payments/utilization of the accrual |  |                    | (17  | ) |                          |   |   |       |  |   | (17  | )
|Provision Adjustment                |  |                    | (8   | ) |                          |   |   |       |  |   | (8   | )
|                                    |  |                    |      |   |                          |   |    |       |  |   |      |  
|Accrual at March 31, 2004           |  | $                  |     |   |                          | $ |   |       |  | $ |     |  
|                                    |  |                    |      |   |                          |   |    |       |  |   |      |  



On June 5, 2003, the Company announced
a restructuring plan, which resulted in a charge of $0.2 million. Also, on June 5, 2003 the Company acquired New Moon Systems, Inc. (New Moon). In order to keep spending levels flat with pre-acquisition levels, the Company assessed the
overall resource requirements for the combined business and reduced infrastructure accordingly.



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##### Table of Contents

The entire restructuring charge of $0.2 million was for severance, related to the elimination of 12 positions. The
positions eliminated were 9 in the US, 2 in the UK and 1 in Germany. The reductions in work force affected the product development, sales, marketing and general and administrative functions of the Company. As of September 30, 2003, all 12 positions
had been eliminated.



Fiscal 2003 Third Quarter Restructuring
Accrual



|                                                 |  |                    |     |   |       |   |     |  
|------------------------------------------------ |  | ------------------ | --- | - | ----- | - | --- | -
|(In Thousands)                                   |  | Reduction in Force |     |   | Total |  
|Restructuring charge accrued                     |  | $                  | 153 |   |       | $ | 153 |  
|Payments/utilization of the accrual              |  |                    | (57 | ) |       |   | (57 | )
|                                                 |  |                    |     |   |       |   |     |  
|Accrual at June 30, 2003                         |  |                    | 96  |   |       |   | 96  |  
|                                                 |  |                   
|Payments/utilization of the accrual              |  |                    | (95 | ) |       |   | (95 | )
|Provision Adjustment                             |  |                    | (1  | ) |       |   | (1  | )
|                                                 |  |                    |     |   |       |   |     |  
|Accrual at September 30, 2003 and March 31, 2004 |  | $                  |    |   |       | $ |    |  
|                                                 |  |                    |     |   |       |   |     |  



During the first quarter of fiscal
2003, the Company announced a restructuring plan, which resulted in a charge of $1.1 million. The Company reduced its spending levels to align its operating expenses with the Companys continued lower than expected revenues.



A severance charge of $0.8 million included the elimination of 10 positions in the United
States, 13 positions in the United Kingdom, and 2 positions in Italy. The reductions in work force affected the product development, sales, marketing and general and administrative functions of the Company. As of June 30, 2003, all 25 positions had
been eliminated.



A facilities charge of $0.3 million was related to space the
Company vacated at two locations in the U.K. This included a non-cash charge of $89,000 related to the write-off of leasehold improvements at the two vacated facilities.



The Company completed all of the cost reduction actions initiated in the first quarter of fiscal year 2003 during the fiscal year.
Liabilities remain for lease obligations on one facility in the U.K. The lease for this facility expires at the end of the second quarter of fiscal 2004.



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##### Table of Contents

Fiscal 2003 First Quarter Restructuring Accrual



|                                    |  |                    |      |   |            |   |     |                         |  |   |       |   |  |   |       |  
|----------------------------------- |  | ------------------ | ---- | - | ---------- | - | --- | ----------------------- |  | - | ----- | - |  | - | ----- | -
|(In Thousands)                      |  | Reduction in Force |      |   | Facilities |   |     | Disposal ofFixed Assets |  |   | Total |  
|Restructuring charge accrued        |  | $                  | 820  |   |            | $ | 238 |                         |  | $ | 89    |   |  | $ | 1,147 |  
|Payments/utilization of the accrual |  |                    | (408 | ) |            |   | (24 | )                       |  |   | (89   | ) |  |   | (521  | )
|                                    |  |                    |      |   |            |   |     |                         |  |   |       |   |  |   |       |  
|Accrual at December 31, 2002        |  |                    | 412  |   |            |   | 214 |                         |  |   |      |   |  |   | 626   |  
|                                    |  |                    |      |  
|Payments/utilization of the accrual |  |                    | (240 | ) |            |   | (74 | )                       |  |   |      |   |  |   | (314  | )
|                                    |  |                    |      |   |            |   |     |                         |  |   |       |   |  |   |       |  
|Accrual at March 31, 2003           |  |                    | 172  |   |            |   | 140 |                         |  |   |      |   |  |   | 312   |  
|                                    |  |                    |      |  
|Payments/utilization of the accrual |  |                    | (113 | ) |            |   | (33 | )                       |  |   |      |   |  |   | (146  | )
|Provision Adjustment                |  |                    | (59  | ) |            |   |    |                         |  |   |      |   |  |   | (59   | )
|                                    |  |                    |      |   |            |   |     |                         |  |   |       |   |  |   |       |  
|Accrual at June 30, 2003            |  |                    |     |   |            |   | 107 |                         |  |   |      |   |  |   | 107   |  
|                                    |  |                    |      |  
|Payments/utilization of the accrual |  |                    |     |   |            |   | (34 | )                       |  |   |      |   |  |   | (34   | )
|                                    |  |                    |      |   |            |   |     |                         |  |   |       |   |  |   |       |  
|Accrual at September 30, 2003       |  |                    |     |   |            |   | 73  |                         |  |   |      |   |  |   | 73    |  
|                                    |  |                    |      |  
|Payments/utilization of the accrual |  |                    |     |   |            |   | (23 | )                       |  |   |      |   |  |   | (23   | )
|                                    |  |                    |      |   |            |   |     |                         |  |   |       |   |  |   |       |  
|Accrual at December 31, 2003        |  |                    |     |   |            |   | 50  |                         |  |   |      |   |  |   | 50    |  
|                                    |  |                    |      |  
|Payments/utilization of the accrual |  |                    |     |   |            |   | (25 | )                       |  |   |      |   |  |   | (25   | )
|                                    |  |                    |      |   |            |   |     |                         |  |   |       |   |  |   |       |  
|Accrual at March 31, 2004           |  | $                  |     |   |            | $ | 25  |                         |  | $ |      |   |  | $ | 25    |  
|                                    |  |                    |      |   |            |   |     |                         |  |   |       |   |  |   |       |  



Fiscal 2002



During the first quarter of fiscal 2002, the Company announced a restructuring plan, which
resulted in a charge of $1.6 million. The Company reduced its spending levels to align its operating expenses with the Companys lower than expected revenues. The restructuring included a reduction in staffing of 52 employees, a reserve for
unused facilities at the Companys corporate headquarters, and costs associated with closing several foreign offices.



This included a severance charge of $0.9 million for the elimination of 19 positions in the United States, 23 positions in the United Kingdom, and 10 positions in Japan.
The reductions in force affected the product development, support, sales, marketing and general and administrative functions of the Company. As of March 31, 2002, all 52 positions had been eliminated.



Also included was a facilities charge of $0.7 million related to space the Company vacated.
The Company had anticipated that it would sub-lease the space by December 31, 2002. As of September 30, 2003, the Company had not secured a sub-lease tenant, so provision adjustments of $0.5 million and $0.6 million were made at the end of fiscal
2003 and fiscal 2002, respectively. The space is now reserved through September 2004. The Company believes it will be able to sub-lease the space by that date. The lease for this building expires on June 30, 2005. In addition, a charge was taken for
expenses associated with office closures in Japan and Brazil. There was a non-cash charge of $39,000 related to fixed asset disposals at the Japan subsidiary.



The Company completed the cost reduction actions initiated in fiscal 2002, with the exception of sub-leasing excess space at the Companys corporate headquarters
in Santa Cruz, California.



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##### Table of Contents

Fiscal 2002 First Quarter Restructuring Accrual



|                                    |  |            |      |   |       |   |      |  
|----------------------------------- |  | ---------- | ---- | - | ----- | - | ---- | -
|(In Thousands)                      |  | Facilities |      |   | Total |  
|Accrual at September 30, 2002       |  | $          | 750  |   |       | $ | 750  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (157 | ) |       |   | (157 | )
|                                    |  |            |      |   |       |   |      |  
|Accrual at December 31, 2002        |  |            | 593  |   |       |   | 593  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (140 | ) |       |   | (140 | )
|                                    |  |            |      |   |       |   |      |  
|Accrual at March 31, 2003           |  |            | 453  |   |       |   | 453  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (158 | ) |       |   | (158 | )
|                                    |  |            |      |   |       |   |      |  
|Accrual at June 30, 2003            |  |            | 295  |   |       |   | 295  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (135 | ) |       |   | (135 | )
|Provision Adjustment                |  |            | 485  |   |       |   | 485  |  
|                                    |  |            |      |   |       |   |      |  
|Accrual at September 30, 2003       |  |            | 645  |   |       |   | 645  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (158 | ) |       |   | (158 | )
|                                    |  |            |      |   |       |   |      |  
|Accrual at December 31, 2003        |  |            | 487  |   |       |   | 487  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (142 | ) |       |   | (142 | )
|                                    |  |            |      |   |       |   |      |  
|Accrual at March 31, 2004           |  | $          | 345  |   |       | $ | 345  |  
|                                    |  |            |      |   |       |   |      |  



Fiscal 2001



During the fourth quarter of fiscal 2001, the Company announced a restructuring plan, which
resulted in a charge of $0.5 million. The restructuring charge included a reduction in personnel of 10 employees and a planned elimination of offices in Singapore and Australia. Total cash expenditures were $0.4 million.



The severance charge of $0.4 million included the elimination of 4 positions in the United
States and 6 positions in the United Kingdom. The reductions in work force affected the sales, marketing and general and administrative functions of the Company. At September 30, 2001, all 10 positions had been eliminated. A provision adjustment of
$64,000 was made to release excess restructuring reserve, which resulted from the fact that the Company had not anticipated that the Australian office would be sub-leased. The provision adjustment of $8,453 in the fourth quarter of fiscal 2003 was
for the final costs associated with closing the Australian office.



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Fiscal 2001 Fourth Quarter Restructuring Accrual



|                                                 |  |            |     |   |       |   |     |  
|------------------------------------------------ |  | ---------- | --- | - | ----- | - | --- | -
|(In Thousands)                                   |  | Facilities |     |   | Total |  
|Accrual at September 30, 2002                    |  | $          | 15  |   |       | $ | 15  |  
|                                                 |  |           
|Payments/utilization of the accrual              |  |            | (1  | ) |       |   | (1  | )
|                                                 |  |            |     |   |       |   |     |  
|Accrual at December 31, 2002                     |  |            | 14  |   |       |   | 14  |  
|                                                 |  |           
|Payments/utilization of the accrual              |  |            | (9  | ) |       |   | (9  | )
|                                                 |  |            |     |   |       |   |     |  
|Accrual at March 31, 2003                        |  |            | 5   |   |       |   | 5   |  
|                                                 |  |           
|Payments/utilization of the accrual              |  |            | (3  | ) |       |   | (3  | )
|                                                 |  |            |     |   |       |   |     |  
|Accrual at June 30, 2003                         |  |            | 2   |   |       |   | 2   |  
|                                                 |  |           
|Payments/utilization of the accrual              |  |            | (10 | ) |       |   | (10 | )
|Provision Adjustment                             |  |            | 8   |   |       |   | 8   |  
|                                                 |  |            |     |   |       |   |     |  
|Accrual at September 30, 2003 and March 31, 2004 |  | $          |    |   |       | $ |    |  
|                                                 |  |            |     |   |       |   |     |  



During the second quarter of fiscal
2001, the Company announced a restructuring plan which resulted in a charge of $1.6 million, which when taken with a provision adjustment to a previously established restructuring reserve for severance related to the sale of divisions to Caldera,
resulted in a net charge for the period of $1.1 million. The restructuring charge included a reduction in personnel of 28 employees and a reserve for unused facilities. Total cash expenditures were $1.6 million.



The $1.6 million restructuring charge included a severance charge of $1.5 million for the
elimination of 16 positions in the United States, 4 positions in the United Kingdom, and 8 positions in various other geographies. The reduction in work force affected the sales, marketing and general and administrative functions of the Company. As
of September 30, 2001, all 28 positions had been eliminated. The Company vacated additional space within its Santa Cruz, California office in the first quarter of fiscal 2002, and an additional charge of $81,000 was recorded for estimated payments
on the lease for an additional 12 months. In the fourth quarter of fiscal 2002, an additional charge of $85,000 was recorded and in the fourth quarter of fiscal 2003, an additional charge of $64,000 was recorded because the facility was not yet
sub-leased. The facility was not sub-leased as of September 30, 2003 and the restructuring reserve at the end of the fourth quarter of fiscal 2003 covers rents through September 30, 2004. The Company believes it will be able to sub-lease the space
by that date. The lease for this building expires on June 30, 2005.



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##### Table of Contents

Fiscal 2001 Second Quarter Restructuring Accrual



|                                    |  |            |     |   |       |   |     |  
|----------------------------------- |  | ---------- | --- | - | ----- | - | --- | -
|(In Thousands)                      |  | Facilities |     |   | Total |  
|Accrual at September 30, 2002       |  | $          | 106 |   |       | $ | 106 |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (22 | ) |       |   | (22 | )
|                                    |  |            |     |   |       |   |     |  
|Accrual at December 31, 2002        |  |            | 84  |   |       |   | 84  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (20 | ) |       |   | (20 | )
|                                    |  |            |     |   |       |   |     |  
|Accrual at March 31, 2003           |  |            | 64  |   |       |   | 64  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (22 | ) |       |   | (22 | )
|                                    |  |            |     |   |       |   |     |  
|Accrual at June 30, 2003            |  |            | 42  |   |       |   | 42  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (19 | ) |       |   | (19 | )
|Provision Adjustment                |  |            | 64  |   |       |   | 64  |  
|                                    |  |            |     |   |       |   |     |  
|Accrual at September 30, 2003       |  |            | 87  |   |       |   | 87  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (22 | ) |       |   | (22 | )
|                                    |  |            |     |   |       |   |     |  
|Accrual at December 31, 2003        |  |            | 65  |   |       |   | 65  |  
|                                    |  |           
|Payments/utilization of the accrual |  |            | (19 | ) |       |   | (19 | )
|                                    |  |            |     |   |       |   |     |  
|Accrual at March 31, 2004           |  | $          | 46  |   |       | $ | 46  |  
|                                    |  |            |     |   |       |   |     |  



Note 6 - Industry and Geographic
Segment Information



The following table presents information on revenue
and long-lived assets by geography. Revenue is allocated based on the location from which the sale is satisfied and long-lived asset information is based on the physical location of the asset.



|                                      |  |                              |       |      |                            |       |      |  |      |       |  |   |      
|------------------------------------- |  | ---------------------------- | ----- | ---- | -------------------------- | ----- | ---- |  | ---- | ----- |  | - | -----
|                                      |  | Three Months Ended March 31, |       |      | Six Months Ended March 31,
|                                      |  | 2004                         |       | 2003 |                            |       | 2004 |  | 2003
|                                      |  | (In thousands)               |       |      | (In thousands)            
|Net revenues:                         |  |                              |       |      |                            |       |      |  |      |       |  |   |      
|United States                         |  | $                            | 1,357 |      | $                          | 2,292 |      |  | $    | 2,635 |  | $ | 3,255
|Canada and Latin America              |  |                              | 365   |      |                            | 220   |      |  |      | 685   |  |   | 397  
|Europe, Middle East, India and Africa |  |                              | 1,072 |      |                            | 1,387 |      |  |      | 2,606 |  |   | 2,573
|Asia Pacific                          |  |                              | 343   |      |                            | 333   |      |  |      | 679   |  |   | 935  
|Corporate adjustments                 |  |                              |      |      |                            | (2    | )    |  |      |      |  |   | 15   
|                                      |  |                              |       |      |                            |       |      |  |      |       |  |   |      
|Total net revenues                    |  | $                            | 3,137 |      | $                          | 4,230 |      |  | $    | 6,605 |  | $ | 7,175
|                                      |  |                              |       |      |                            |       |      |  |      |       |  |   |      



|                                      |  |                |       |                    |   |      
|------------------------------------- |  | -------------- | ----- | ------------------ | - | -----
|                                      |  | March 31, 2004 |       | September 30, 2003
|                                      |  | (In thousands)
|Long-lived assets:                    |  |                |       |                    |   |      
|United States                         |  | $              | 4,467 |                    | $ | 4,381
|Europe, Middle East, India and Africa |  |                | 327   |                    |   | 349  
|                                      |  |                |       |                    |   |      
|Total long-lived assets               |  | $              | 4,794 |                    | $ | 4,730
|                                      |  |                |       |                    |   |      





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Note 7 - Investments



Available-for-sale equity securities



At March 31, 2004, the Company held 505,767 shares of Rainmaker stock. The Company accounts for this investment as available-for-sale, and accordingly, records it at fair
market value based on quoted market prices. Any unrealized gains or losses are included as part of accumulated other comprehensive income. The fair market value of the investment at March 31, 2004 was $1.4 million and the cost was $0.2 million,
resulting in an unrealized gain of $1.2 million. Rainmakers common stock is traded on the Nasdaq under the symbol RMKR.



Note 8  Reverse Stock Split



On November 14, 2002, the Board of Directors unanimously adopted resolutions approving and recommending to the shareholders for their approval a series of amendments to
the Companys Amended and Restated Articles of Incorporation to effect a reverse stock split of the Companys Common Stock at a ratio to be determined by the Companys Board of Directors. On February 27, 2003, the stockholders
approved amendments to the Companys Amended and Restated Articles of Incorporation to effect a reverse stock split. On May 19, 2003, the Board of Directors unanimously approved the implementation of a reverse split with a ratio of one for
five. On June 6, 2003, the Company implemented a one-for-five reverse split and the Companys outstanding common shares were reduced from 49.7 million shares to approximately 9.9 million shares. The reverse stock split has been retroactively
reflected in the accompanying condensed consolidated financial statements and notes thereto for all periods presented.



Note 9  Business Combinations



Acquisition of New Moon Systems, Inc.



On June 5, 2003, Tarantella completed the acquisition of New Moon Systems, Inc., a privately held California corporation (New Moon) pursuant to an Agreement
and Plan of Reorganization (the Agreement), dated May 29, 2003. New Moon, headquartered in San Jose, CA, develops software to simply and cost-effectively manage and deploy Windows-based applications to end-user desktops in small and
medium-sized businesses, as well as enterprise departmental customers. New Moon Canaveral  iQ from Tarantella ® (Canaveral iQ) extends the capabilities of Microsofts Windows Terminal Services and answers the demand for a simple and intelligent means of centrally managing remote applications.



Pursuant to the Agreement, Tarantella issued a total of 1,592,000 shares of
Tarantella common stock valued at $3.6 million in exchange for all of the outstanding shares of New Moon and to satisfy its obligations to the former employees of New Moon. The fair value of the Companys common stock was determined based on
the average closing price per share of the Companys common stock over the five day period including the two days before and after the terms of the acquisition were agreed to and announced. The New Moon shareholders shall also receive a minimum
cash earnout of approximately $1.7 million over a period from January 1, 2004 to December 31, 2006 based on a royalty of 30% of New Moon product revenues, net of direct costs. After the shareholders have been paid the minimum earnout, they would be
entitled to an additional royalty of 15% of New Moon product revenues, net of direct costs, during this period. In the event the minimum earnout is not achieved by the conclusion of the quarter ending December 31, 2006, Tarantella shall pay along
with the final earnout payment an amount equal to the minimum earnout less all aggregate earnouts paid to date, less any off-sets and any escrow claim deficiencies. The Company also incurred approximately $0.3 million of direct merger costs, for a
total purchase price of approximately $5.7 million.



The residual purchase
price of $2.4 million was recorded as goodwill. Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired. In accordance with SFAS No. 142, Goodwill and Other Intangible
Assets, goodwill relating to the New Moon acquisition is not being amortized and will be carried at cost and tested for impairment annually and whenever events indicate that an impairment may have occurred. As of March 31, 2004, the Company
has incurred acquisition costs of $331,000.



Acquisition of Caststream,
Inc.



On March 29, 2004, the Company entered into a Stock Exchange
Agreement with Caststream, Inc. (Caststream). Pursuant to the terms of the agreement, the Company acquired all of the capital stock of Caststream in exchange for 100,000 shares of the Companys common stock and warrants for 100,000
shares of common stock. The Company also assumed certain liabilities of Caststream of approximately $40,000. The transaction was considered a related party transaction because two of the Caststream shareholders were hired in December 2003 as the
Companys Vice President of Corporate Development and Vice President of Corporate Marketing. In addition, the Company hired three other Caststream shareholders in December 2003 in various marketing and technical positions. The Companys
Audit Committee and the Board of Directors approved the transaction.



The
acquisition has been accounted for as a purchase of assets by the Company for financial reporting purposes. Beginning March 30, 2004, the results of Caststream are being included in the Companys consolidated financial statements. The purchase
price has



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##### Table of Contents

been allocated based on the fair value of the assets acquired and the liabilities assumed. Pursuant to the Emerging
Issues Task Forces Issue No. 98-3, Determining Whether a Non-monetary Transaction Involves the Receipt of Productive Assets or of a Business, Caststream does not meet the criteria necessary to qualify as a business. Therefore, the
Companys acquisition of Caststream does not qualify as a business combination under Statement of Financial Accounting Standards No. 141, Business Combinations, and no goodwill resulted from recording the transaction. Identified
intangible assets with finite lives will be amortized over their respective estimated useful life. The Company is required to review long-lived assets on at least an annual basis. To the extent the value of the long-lived assets are impaired, the
Company will be required to record the impairment charge. The fair market value of the Companys stock and stock warrants, issued net of liabilities assumed exceeds the fair market value of the acquired assets based upon an independent, third
party appraisal. This excess value has been charged to operations upon the close of the merger as compensation expense.



The total purchase price for Caststream is $432,000 as follows (in thousands):



|                                               |  |   |    
|---------------------------------------------- |  | - | ---
|Fair value of Tarantella common stock          |  | $ | 227
|Fair value of Tarantella common stock warrants |  |   | 150
|Liabilities assumed                            |  |   | 40 
|Acquisition costs                              |  |   | 15 
|                                               |  |   |    
|Total consideration                            |  | $ | 432
|                                               |  |   |    



The allocation of the purchase price
is based upon an independent, third-party appraisal and managements estimates as follows (in thousands):



|                                |  |   |    
|------------------------------- |  | - | ---
|Technology                      |  | $ | 304
|Compensation expense            |  |   | 124
|Computer equipment              |  |   | 4  
|                                |  |   |    
|Total purchase price allocation |  | $ | 432
|                                |  |   |    



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##### Table of Contents

Note 10  Acquired Intangibles Assets, Net



|                                                   |  |                       |       |                        |   |                          |   |                        |  |   |      
|-------------------------------------------------- |  | --------------------- | ----- | ---------------------- | - | ------------------------ | - | ---------------------- |  | - | -----
|                                                   |  | Gross Carrying Amount |       | Estimated Useful Lives |   | Accumulated Amortization |   | Intangible Assets, Net
|                                                   |  | (In thousands)        |       | (In years)             |   | (In thousands)          
|Amortized intangible assets                        |  |                       |       |                        |   |                          |   |                        |  |   |      
|Technology                                         |  | $                     | 804   |                        | 3 |                          | $ | 139                    |  | $ | 665  
|Patents                                            |  |                       | 700   |                        | 3 |                          |   | 194                    |  |   | 506  
|Trademarks                                         |  |                       | 200   |                        | 3 |                          |   | 56                     |  |   | 144  
|Other                                              |  |                       | 20    |                        | 3 |                          |   | 5                      |  |   | 15   
|                                                   |  |                       |       |                        |   |                          |   |                        |  |   |      
|Total                                              |  | $                     | 1,724 |                        |   |                          | $ | 394                    |  | $ | 1,330
|                                                   |  |                       |       |                        |   |                          |   |                        |  |   |      
|Aggregate amortization expense:                    |  |                       |       |                        |   |                          |   |                        |  |   |      
|                                                   |  |                       |       |                       
|For six months ended March 31, 2003                |  | $                     |      |                        |   |                          |   |                        |  |   |      
|                                                   |  |                       |       |                        |   |                          |   |                        |  |   |      
|For six months ended March 31, 2004                |  | $                     | 237   |                        |   |                          |   |                        |  |   |      
|                                                   |  |                       |       |                        |   |                          |   |                        |  |   |      
|Estimated remaining amortization expense:          |  |                       |       |                        |   |                          |   |                        |  |   |      
|                                                   |  |                       |       |                       
|For remaining six months ending September 30, 2004 |  | $                     | 287   |                        |   |                          |   |                        |  |   |      
|                                                   |  |                       |       |                       
|For year ending September 30, 2005                 |  |                       | 575   |                        |   |                          |   |                        |  |   |      
|                                                   |  |                       |       |                       
|For year ending September 30, 2006                 |  |                       | 417   |                        |   |                          |   |                        |  |   |      
|                                                   |  |                       |       |                       
|For year ending September 30, 2007                 |  |                       | 51    |                        |   |                          |   |                        |  |   |      
|                                                   |  |                       |       |                        |   |                          |   |                        |  |   |      
|                                                   |  | $                     | 1,330 |                        |   |                          |   |                        |  |   |      
|                                                   |  |                       |       |                        |   |                          |   |                        |  |   |      



Note 11  Private Placement
Financing



On September 30, 2003, the Company completed a private
placement of common stock and warrants to Special Situations Technology Funds and Vertical Ventures resulting in gross proceeds to the Company of approximately $2,254,200 for which the Company paid fees of $155,345. The Company issued 1,950,000
shares of common stock at a price of $1.156 per share and warrants to purchase 1,950,000 shares of common stock at $1.395 per share. The warrants have a value of $895,592, based on the relative fair value using a Black-Scholes calculation, using a
volatility of 100%, an annual dividend of zero and a discount rate of 2.63%. The Company can require the warrant holders to exercise one-third of the warrants provided the shares issuable thereunder are registered with the SEC and the share price
equals or exceeds $1.674 for a period of twenty consecutive trading days. In addition, the Company can redeem up to two-thirds of the warrants or all of the warrants for $0.01 per share should the closing bid price of the shares reach the target
prices of $2.232 and $2.790, respectively. The warrant holders may exercise the warrants prior to redemption. The warrants expire on September 30, 2008. If the warrants are fully exercised, the Company would receive additional gross proceeds of
approximately $2,700,000. The Company has agreed to register the shares of common stock issued to the investors as well as the shares issuable upon exercise of the warrants. If the shares and warrants are not registered in a timely manner, the
Company will be obligated to pay damages for the delay, in an amount equal to one-percent per month of the aggregate amount invested, until registered.



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On December 26, 2003, the Company completed a private placement of common stock and warrants to Special Situations
Technology Funds, Starlight Technology Partners LLC, an investment group in which the President of the Company acts as Managing Director and the Companys Vice President of OEM sales is an investor, and an additional private investor, resulting
in gross proceeds to the Company of approximately $2,750,000. In connection with the financing, we paid placement fees in the amount of $91,250 and issued 140,000 shares of common stock. The Company issued 2,750,000 shares of common stock at a price
of $1.00 per share and warrants to purchase 550,000 shares of common stock at $1.39 per share. The warrants have a value of $310,624 based on the relative fair value using a Black-Scholes calculation, using a volatility of 100%, an annual dividend
of zero and a discount rate of 3.20%. The warrants expire on December 11, 2008. If the warrants are fully exercised, the Company would receive additional gross proceeds of $764,500. The Company has agreed to register the shares of common stock
issued to the investors as well as the shares issuable upon exercise of the warrants.



On February 23, 2004, the Company completed a private placement of common stock and warrants to various investors. In the private placement, the investors purchased 11,678,580 shares of Tarantella common stock at a price of $1.40 per share.
The investors also acquired warrants to purchase up to an additional 2,335,714 shares at an exercise price of $1.70 per share for gross proceeds of $16,350,000. The warrants are exercisable for five years. If the warrants are fully exercised, the
Company would receive additional gross proceeds of approximately $3,970,714. The Company also has agreed to register the shares of common stock issued to the investors as well as the shares issuable upon exercise of the warrants for resale. In
connection with the financing, the Company incurred fees in the amount of $1,198,000, which included private placement, legal and accounting fees, and issued warrants to purchase 322,500 shares at $1.70 per share. The warrants have lives of five
years. On March 29, 2004, the Company completed an agreement pursuant to which it issued 140,000 shares in lieu of payment of a finders fee for the December 2003 private placement.



Note 12  Indemnification and Warranties



Indemnification



The Company licenses its software and services pursuant to a software license agreement, in which the Company agrees to indemnify, hold harmless and defend the customer
against damages arising out of claims filed by third parties that the Companys products infringe any copyright or other intellectual property right. The term of the indemnification is generally perpetual, limited by applicable statutes of
limitations. The license agreement generally limits the scope of the remedies for such indemnification obligation, including but not limited to certain product usage limitations and the right to replace an infringing product or modify it to make it
non-infringing. If the Company cannot address the infringement by replacing or repairing the product, the Company is allowed to cancel the license and return the fees paid by the customer. The Company has never incurred expense under such
indemnification provisions. The Company believes that the exposure from these indemnification agreements is minimal.



As permitted under California law, the Company has agreements whereby it indemnifies its officers and directors for certain events while the officer or director is, or
was serving at the Companys request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a Directors and
Officers insurance policy that limits the Companys exposure and enables it to recover at least a portion of any future amounts paid. As a result of its insurance policy coverage, the Company believes that the exposure from
indemnification agreements is minimal.



Warranties



The Company generally warrants for a period of 90 days that its software products will
perform substantially in accordance with its published specifications, that the reproduction of the software on the media material provided by the Company is correct and that the documentation is correctly printed. In the event of any
non-conformance, the Company agrees to repair, replace or accept return of the non-conforming product and refund any fees paid by the customer for said non-conforming product. The Company has never incurred significant expense under its product
warranties. The Company believes the estimated fair value of these warranty agreements is immaterial.



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Note 13  Subsequent Events



Operating Lease Surrender



On April 15, 2004 the Company signed an Agreement to Surrender (Agreement) its property lease in Leeds, UK. The Agreement has a completion date of July 12,
2004, upon which date the lease agreement shall terminate, provided the conditions stated in the Agreement to Surrender have been met. The conditions include a payment of $28,000 to the landlord for dilapidations and repairs to be made to the
property, and payment of all lease amounts owed up to and including July 12, 2004. The termination of this lease will reduce the total future operating lease commitment, net of sublease income, by $9.3 million. After the termination of this lease,
which extended to 2020, the Companys various remaining operating lease commitments will extend to 2007.



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##### Table of Contents

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



This Managements Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Companys condensed
consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q, as well as the Managements Discussion and Analysis of Financial Condition and Result of Operations included in the Companys
Annual Report on Form 10-K for the fiscal year ended September 30, 2003. In addition to historical information contained herein, this Discussion and Analysis contains forward-looking statements. These statements involve risks and uncertainties and
can be identified by the use of forward-looking terminology such as estimates, projects, anticipates, plans, future, may, will, should,
predicts, potential, continue, expects, intends, believes, and similar expressions. Examples of forward-looking statements include those relating to financial risk management
activities and the adequacy of financial resources for operations. These and other forward-looking statements are only estimates and predictions. While the Company (also referred to as Tarantella) believes that the expectations reflected
in the forward-looking statements are reasonable, the Companys actual results could differ materially. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect managements expectations only as
of the date hereof.



Overview



Tarantella is a leading provider of Internet infrastructure software that enables web-based
access to enterprise applications.



Tarantella products provide managed and
secure web access to enterprise mainframe, Windows, AS/400, Linux, and UNIX applications. It leverages existing IT assets to provide cost savings, improved productivity, and the flexibility to accommodate the rapid changes in todays
organizations.



Restatement



Subsequent to the issuance of the Companys condensed consolidated financial statements
for the three and six months ended March 31, 2003 the Companys management determined that the accounting treatment initially afforded to certain transactions was not correct. As a result, the accompanying condensed consolidated financial
statements for the quarter and the six months ended March 31, 2003 have been restated.



The effects of the restatement are presented in Note 2 to the condensed consolidated financial statements and have been reflected in managements discussion and analysis of financial condition and results of operations.



Critical Accounting Policies



The preparation of financial statements and related disclosures in conformity with
accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Companys consolidated financial statements and the accompanying notes. Note
3 to the consolidated financial statements in our Annual Report on Form 10-K for the fiscal year ended September 30, 2003 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements for
the three fiscal years in the period ended September 30, 2003. The amounts of assets and liabilities reported on the Companys balance sheets and the amounts of revenues and expenses reported for each of our fiscal periods are affected by
estimates and assumptions which are used for, but not limited to, the accounting for revenue, bad debts, product returns, certain accrued expenses, restructuring and liabilities and a valuation allowance for deferred tax assets. Actual results could
differ from these estimates. The following critical accounting policies are significantly affected by judgments, assumptions and estimates used in the preparation of the condensed consolidated financial statements.



Revenue Recognition



The Companys revenue is derived primarily from two sources, across many industries:
(i) products license revenue, derived primarily from product sales to resellers and end users, including large scale enterprises and royalty revenue, derived primarily from initial license fees, ongoing royalties from product sales by source code
OEMs, and software updates; and (ii) services and support revenue, derived primarily from support and education and consulting services to end users.



The Company accounts for revenue under the provisions of AICPA Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended. Product
revenue is recognized upon shipment if evidence of an arrangement exists, the fee is fixed and determinable and collection of resulting receivables is probable. Sales to distributors are recognized upon sale by the distributor to resellers or end
users. In certain instances when distributors waive their right to return product, revenue is recognized upon shipment if evidence of an arrangement exists, the fee is fixed and determinable and collection of resulting receivables is probable.
Estimated product returns are recorded upon recognition of revenue from customers having rights of return, including exchange rights for unsold products and product upgrades.



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Software revenue is recognized using the residual method. Under the residual method revenue is recognized if
vendor-specific objective evidence of fair value exists for all the undelivered elements in an arrangement. Vendor-specific objective evidence of fair value is based on the price when the element is sold separately or, if not sold separately, is
established by management. Vendor specific objective evidence of the fair value of maintenance for license agreements is based on stated renewed rates, and for contracts that do not include stated renewal rates, are determined by reference to the
price paid by the Companys customers when maintenance is sold separately. Past history has shown that the rate the Company charges for maintenance on license agreements with a stated renewal rate is similar to the rate the Company charges for
maintenance on license agreements without a stated renewal rate.



The Company
recognizes revenue from maintenance fees for ongoing customer support and product updates ratably over the period of the maintenance contract. Payments for maintenance fees are generally made in advance and are non-refundable. For revenue allocated
to education and consulting services or derived from the separate sale of such services, the Company recognizes revenue as the related services are performed.



The Company recognizes product revenue from royalty payments upon receipt of quarterly royalty reports from OEMs (original equipment manufacturer) related to their
product sales.



The Company performs ongoing credit evaluations of its
customers financial condition and does not require collateral. The Company maintains allowances for potential credit losses and such losses have been within managements expectations.



Returns and Reserves



The Company records a provision for product returns for related sales in the same period as
the related revenues are recorded. These estimates are based on historical sales returns, analysis of credit memo data and other known factors. If the historical data the Company uses to calculate these estimates do not properly reflect future
returns, revenue could be affected.



Allowance
for Doubtful Accounts



Payments from customers are continuously monitored and
allowances are maintained for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. When evaluating the adequacy of allowances for doubtful accounts, various factors are taken into account,
including accounts receivable aging, customer credit-worthiness, historical bad debts, and geographic and political risk. If the financial condition of customers were to deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required. As of March 31, 2004, the Companys net accounts receivable balance was $3.2 million.



Income Taxes



Tarantella has operations in many countries other than the United States. Transfer prices for services provided between the United States and these countries have been
documented as reasonable, however, tax authorities could challenge these transfer prices and assess additional taxes on prior period transactions. Any such assessment could require the Company to record an additional tax provision in its statement
of operations.



Income tax assets and liabilities are determined by taxable
jurisdiction. The Company evaluates net deferred tax assets in each tax jurisdiction by estimating the likelihood of the Company generating future profits to realize these assets. The Company has assumed that it will not generate sufficient future
taxable income to realize these assets and has created valuation reserves to reduce the net deferred tax asset values to zero.



Restructuring



During fiscal 2004 and fiscal 2003, the Company recorded several reserves in connection with restructuring programs. These reserves include estimates for employee
severance, facility redundancies and disposal of fixed assets. Actual costs have not differed materially from these estimates.



Goodwill and Other Intangible Assets



Intangible assets have been recorded in connection with the acquisition of New Moon and with the acquisition of Caststream. The cost of the New Moon acquisition was
allocated to the assets and liabilities acquired, including identifiable intangible assets, with the remaining amount being classified as goodwill. The cost of the Caststream acquisition was allocated to the assets and liabilities acquired,
including identifiable intangible assets, with excess value charged to operations as compensation expense. Certain identifiable intangible assets such as purchased technology and customer lists are amortized to operating expense over time. Under
current accounting guidelines adopted on July 1, 2002, goodwill will not be amortized to expense but rather periodically assessed for impairment. Accordingly, the allocation of the acquisition cost to identifiable intangible assets and goodwill has
a significant impact



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on our future operating results. The allocation process requires extensive use of estimates and assumptions, including
estimates of future cash flows expected to be generated by the acquired assets. Furthermore, when impairment indicators are identified with respect to previously recorded intangible assets, the values of the assets are determined using valuation
techniques that require significant management judgment. Should conditions be different than managements current assessment, material write-downs of intangible assets may be required. The Company will perform the annual goodwill impairment
test as of July 1, 2004 to determine if there is any goodwill impairment. Under SFAS 142, goodwill and intangible assets of a reporting unit shall be tested for impairment between annual tests if an event occurs or circumstances change that would
more likely than not reduce the fair value of a reporting unit below its carrying amount. The Company believes that there has been no event as of March 31, 2004, that reduced the fair value of our reporting unit below the goodwill and intangible
assets carrying amounts. The Company will perform evaluations more frequently if business conditions indicate an assessment in an interim period is warranted. The Company will periodically review the estimated remaining useful lives of other
intangible assets. A reduction in estimate of remaining useful lives could result in increased amortization expense in future periods.



De-Listing Status



On October 20, 2003, the Company announced that it had received notification from the Nasdaq Listing Qualifications Panel that the Companys stock would discontinue trading on the Nasdaq SmallCap Market effective
with the open of business on Tuesday, October 21, 2003.



This action followed
Tarantellas appeal to Nasdaq for a listing extension after not meeting the stated time requirements to file SEC Form 10-Q for the Companys third fiscal quarter of fiscal 2003. The Nasdaq Panel determination to delist the Companys
stock was based on the Companys filing delinquency, public interest concerns, and the nature of the ongoing internal revenue investigation. On December 8, 2003, the Company filed an appeal to reverse that portion of the Nasdaq Panels
decision relating to its public interest concerns. On February 27, 2004, the Nasdaq advised the Company that its appeal had been denied.



Tarantellas common stock is currently quoted on the OTC Pink Sheets. The Companys trading symbol has changed to TTLA.PK. Now that the Company has regained
compliance with the periodic reporting requirements of the 1934 Exchange Act, it will attempt to meet the listing requirements for the Nasdaq SmallCap Market, however some requirements such as minimum bid price and market capitalization are outside
of the Companys control.



Results of Operations



The Companys net revenues are derived from software licenses and fees for services.



Net revenues for the three months ended March 31, 2004 decreased by 26% to
$3.1 million from $4.2 million in the same period in fiscal 2003. Net revenues for the six months ended March 31, 2004 decreased by 8% to $6.6 million from $7.2 million in the same period of fiscal 2003. The decrease in revenue performance year to
date, broken out geographically, was due primarily to a $0.6 million decrease in United States and $0.3 million decrease in Asia. The decrease in net revenues was mainly due to a reduction in license revenue caused by fewer licenses being sold.



License revenues for the three months ended March 31, 2004 were $2.2 million
compared to $3.4 million in the same quarter of fiscal 2003, a decrease of 37% from the prior year. License revenues for the six months ended March 31, 2004 were $4.5 million compared to $5.8 million for the same period of fiscal 2003, a decrease of
22% from the prior year. The decrease in year to date revenues is attributed to the reduction in the number of licenses sold.



Service revenues increased to $1.0 million for the three months ended March 31, 2004, from $0.8 million in the same period in fiscal 2003, an increase of 23%. Service
revenues were 31% of the total revenue for the second fiscal quarter of 2004, compared to 19% for the same period in the prior year. Service revenues increased to $2.1 million for the six months ended March 31, 2004, from $1.4 million in the same
period in fiscal 2003, an increase of 51%. Service revenues were 31% of the total revenue for the first six months of 2004, compared to 19% for the same period in the prior year. The increase in service revenues is the result of an increased
percentage of customers purchasing service contracts with new product purchases, as well as an increase in the renewal rate.



International revenues were 57% of total revenues for the second quarter of fiscal 2004 and 46% for the same period in the prior year. For the six months ended March 31,
2004, international revenues were 60%, compared to 55% for the same period in the prior year.



Costs and Expenses



Cost of license
revenues for the three months ended March 31, 2004 increased by 146% to $0.2 million from $0.1 million in the same period of fiscal 2003. For the six months ended March 31, 2004, cost of license revenues increased by 168% to $0.4 million from $0.1
million in the same period of fiscal 2003. Cost of license revenues increased because of the cost of amortization for technology acquired from New Moon. The amortization expense for the three and six months ended March 31, 2004 was $.1 million and
$.2 million, respectively. The first six months of fiscal 2003 did not include any amortization for New Moon technology since the acquisition occurred during the third quarter of fiscal 2003.



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Cost of service revenues for the three months ended March 31, 2004 increased by 35% to $0.4 million from $0.3 million in
the same period of fiscal 2003. Cost of service revenues for the six months ended March 31, 2004 increased by 32% to $0.7 million from $0.5 million in the same period of fiscal 2003. Cost of service revenues increased as a percentage of service
revenue, decreasing service gross margin from 63% in the second quarter of fiscal 2003, to 60% in the second quarter of fiscal 2004. Service gross margin increased to 65% for the six months ended March 31, 2004, from 60% for the same period of
fiscal 2003. The improvement in the services gross margin for the six months ended March 31, 2004 is a result of higher revenue partially offset by higher personnel cost in the second quarter of 2004.



Total cost of revenues as a percentage of net revenues increased to 19% in the second quarter
of fiscal 2004 from 9% for the same period in fiscal 2003. For the six months ended March 31, 2004, cost of revenues as a percentage of net revenues increased to 17% from 10% for the same period in fiscal 2003. Cost of revenues as a percentage of
net revenue increased due primarily to the cost of amortization for technology acquired from New Moon. The first six months of fiscal 2003 did not include any amortization for New Moon technology since the acquisition occurred during the third
quarter of fiscal 2003.



Research and development expenses increased 33% to
$1.2 million in the second quarter of fiscal 2004 from $.9 million in the comparable quarter of fiscal 2003, and as a percentage of net revenues were 38% and 21%, respectively. For the six months ended March 31, 2004 research and development
expenses increased 14% to $2.2 from $1.9 million in the comparable period of fiscal 2003, and as a percentage of net revenues were 33% and 26%, respectively. The increase in research and development expenses can be attributed primarily to additional
head count in India, one-time start-up costs for the Companys new India development center, and increased travel costs, partially offset by reduction in headcount in the UK development center.



Selling, general and administrative expenses increased 30% to $4.9 million in the second
quarter of fiscal 2004 from $3.7 million in the comparable quarter of the prior year. For the six months ended March 31, 2004, selling, general and administrative expenses increased 28% to $9.5 from $7.4 million in the comparable period of fiscal
2003. The significant increase in expenses is due mainly to an increase of $0.9 million in audit and legal fees related to the internal revenue investigation. There was also an increase in commission expense due to payments made for a large
professional services transaction which was recorded in the second quarter of fiscal 2004, with revenue to be taken over three years. Selling, general and administrative expenses as a percentage of net revenues were 155% in the second quarter of
fiscal 2004 and 88% in the same period in fiscal 2003. For the six months ended March 31, 2004, selling, general and administrative expenses were 143% of net revenues compared to 103% in the same period of fiscal 2003.



There was a provision adjustment to the restructuring accrual of $8,000 in the second quarter
of fiscal 2004 because the actual restructuring charges were lower than originally estimated. In the second quarter of fiscal 2003 there was no restructuring charge. For the six months ended March 31, 2004 there was a restructuring charge of
$11,000. For the six months ended March 31, 2003, restructuring charges were $1.1 million for a restructuring plan that was initiated in the first quarter of fiscal 2003. The Company cannot assure that its current estimates of costs associated with
these restructuring actions will not change during the implementation period.



Interest income, net was $2,000 for the second quarter of fiscal 2004 and $14,000 for the same period in fiscal 2003. For the six months ended March 31, 2004, interest expense, net was $5,000 as compared to interest income, net of $46,000
for the same period in fiscal 2003. The decrease in interest income, net reflects the lower average cash balances held for the quarter and the six month period ended March 31, 2004. Interest income was also lower due to a lower average interest rate
for the period. In the second quarter of fiscal 2004, the interest rate was approximately 0 .9%. In the second quarter of fiscal 2003, the interest rate was approximately 1.2%.



Other expense, net was $61,000 in the second quarter of fiscal 2004, compared to other income, net of $63,000 for the same period of fiscal
2003. For the six months ended March 31, 2004, other expense, net was $111,000 compared to other income, net of $49,000 for the same period in fiscal 2003.



Income tax provision was $0.1 million for the second quarter of fiscal 2004 and 2003. For the six months ended March 31, 2004 and 2003 the income tax provision was $0.2
million. The tax provision for the three and six months ended March 31, 2004 and 2003, reflects foreign taxes payable.



Net loss for the second quarter of fiscal 2004 was $3.7 million compared to net loss of $.8 million for the same quarter of fiscal 2003. For the six months ended March
31, 2004, net loss was $6.4 million compared to $4.0 million for the same period of fiscal 2003. The increase in net loss is primarily due to lower revenues and higher operating expenses.



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Liquidity and Capital Resources



The Company has financed its operations through private offerings of the Companys common stock and bank borrowings. As of March 31,
2004, the Companys principal source of liquidity included cash and cash equivalents of $16.6 million, representing 62% of total assets. During the second quarter of fiscal 2004, the Company closed its available bank line of credit under which
the Company had no outstanding borrowings. The increase in cash and short-term investments of $13.4 million in the first six months of fiscal 2004 is due to the completion of two private placements of common stock and warrants which resulted in net
proceeds to the Company of approximately $17.8 million. The increase in cash from the proceeds from the private placement was partially offset by cash used for operating activities of $3.8 million and a reduction in borrowings on the line of credit
of $0.3 million.



The Companys operating activities used cash of $3.8
million during the first six months of fiscal 2004, compared to $5.3 million used for operating activities in the first six months of fiscal 2003. The decrease in the cash used for operating activities is due primarily to the net loss offset by an
increase in deferred revenues. Cash used in investing activities was $192,000 in the first six months of fiscal 2004 compared to $134,000 in the first six months of fiscal 2003. Cash provided by financing activities was $17.5 million in the first
six months of fiscal 2004 compared with $32,000 for the same six months of fiscal 2003. Cash provided by financing activities in the first six months of fiscal 2004 includes proceeds from two private placements of $17.8 million, net of expenses,
partially offset by a reduction of borrowing on the line of credit of $0.3 million.



The Companys days sales outstanding (DSO) at March 31, 2004 was 92, a decrease of 6 days from 98 days at March 31, 2003. DSO decreased because the accounts receivable over 60 days decreased from $0.3 million to $0.1 million.



On December 26, 2003, the Company completed a private placement of common
stock and warrants to the following investors: Special Situations Technology Funds, Starlight Technology Partners LLC, an investment group in which Mr. Wilde acts as Managing Director, and an additional private investor, resulting in gross proceeds
to the Company of approximately $2,750,000. In connection with the financing, the Company paid placement fees in the amount of $232,303.



On February 23, 2004, the Company announced the completion of a second private placement of common stock and warrants to various investors. In the private placement, the
investors purchased 11,678,580 shares of Tarantella common stock at a price of $1.40 per share for gross proceeds of $16,350,000. The investors also acquired warrants to purchase up to an additional 2,335,714 shares at an exercise price of $1.70 per
share. The warrants are exercisable for five years. If the warrants are fully exercised, the Company would receive additional gross proceeds of approximately $3,970,714. The Company also has agreed to register the shares of common stock issued to
the investors as well as the shares issuable upon exercise of the warrants for resale once the Company has complied with its reporting obligations under the Securities Exchange Act of 1934, as amended. In connection with the financing, the Company
incurred fees in the amount of $1,198,000, which included private placement, legal and accounting fees, and issued warrants to purchase 322,500 shares at $1.70 per share. The warrants have lives of five years.



The Company has capital lease commitments of $32,000 in fiscal 2004. There are no capital
lease commitments beyond fiscal 2004. At March 31, 2004, the Company had operating lease commitments of $1.4 million for fiscal 2004 and the Companys various operating lease commitments extended to 2020. On April 15, 2004 the Company signed an
Agreement to surrender the property in Leeds, UK, which reduced the Companys operating commitments to $1.3 million for fiscal 2004. The Companys various remaining operating lease commitments now extend to 2007.



The Companys management believes that, based on the Companys current plans, its
existing cash and cash equivalents, short-term investments, cash received from private placements and funds generated from operations will be sufficient to meet its operating requirements for the next twelve months.



Factors that may affect future results



Set forth below and elsewhere in this filing and in other documents the Company files with
the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements in this filing.



The Companys operating results may fluctuate in future periods.



The results of operations for any quarter or fiscal year are not necessarily indicative of the results to be expected in future periods. The
Companys operating results have in the past been, and will continue to be, subject to quarterly and annual fluctuations as a result of a number of factors, including but not limited to:



| |  | Overall technology spending
| | - | ---------------------------



| |  | Changes in general economic conditions and specific market conditions in the Internet infrastructure industry
| | - | -------------------------------------------------------------------------------------------------------------



| |  | Rapid technological changes that can adversely affect the demand for the Companys products
| | - | -------------------------------------------------------------------------------------------



| |  | Fluctuations in demand for the Companys products and services
| | - | --------------------------------------------------------------



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| |  | The publics perception of the Company and its products
| | - | -------------------------------------------------------



| |  | The long sales and implementation cycle for the Companys products
| | - | ------------------------------------------------------------------



| |  | General industry trends and the potential effects of price and product competition in the Internet infrastructure industry
| | - | --------------------------------------------------------------------------------------------------------------------------



| |  | The introduction and acceptance of new technologies and products
| | - | ----------------------------------------------------------------



| |  | Reductions in sales to, or loss of, significant customers
| | - | ---------------------------------------------------------



| |  | The timing of orders, timing of shipments, and the ability to satisfy all contractual obligations in customer contracts
| | - | -----------------------------------------------------------------------------------------------------------------------



| |  | The impact of acquired technologies and businesses
| | - | --------------------------------------------------



| |  | The Companys ability to control spending and achieve targeted cost reductions
| | - | ------------------------------------------------------------------------------



| |  | The ability of the Company to generate cash adequate to continue operations
| | - | ---------------------------------------------------------------------------



| |  | The potential loss of key employees
| | - | -----------------------------------



| |  | The Companys ability to attract and retain qualified personnel
| | - | ---------------------------------------------------------------



| |  | Adverse changes in the value of equity investments in third parties held by the Company
| | - | ---------------------------------------------------------------------------------------



| |  | The ability of the Companys customers and suppliers to obtain financing or to fund capital expenditures
| | - | --------------------------------------------------------------------------------------------------------



As a consequence, operating results for a particular future period are difficult to predict.
The Company participates in a highly dynamic industry and future results could be subject to significant volatility, particularly on a quarterly basis. The Companys revenues and operating results may be unpredictable due to the Companys
shipment patterns. The Company operates with little backlog of orders because its products are generally shipped as orders are received. In general, a substantial portion of the Companys revenues have been booked and shipped in the third month
of the quarter, with a concentration of these revenues in the latter half of that third month. In addition, the timing of closing of large license contracts and the release of new products and product upgrades increase the risk of quarter to quarter
fluctuations and the uncertainty of quarterly operating results. The Companys staffing and operating expense levels are based on an operating plan and are relatively fixed throughout the quarter. As a result, if revenues are not realized in
the quarter as expected, the Companys expected operating results and cash balances could be adversely affected, and such effect could be substantial and could result in an operating loss and depletion of the Companys cash balances.



The Company is exposed to general economic and market conditions.



Any significant downturn in the Companys customers markets,
or domestic and global conditions, which result in a decline in demand for their software and services could harm the Companys business. The state of the economy has had a negative impact on the software industry. This could result in
customers continuing to delay or cancel orders for software. Any of these occurrences could have a significant impact on the Companys operating results, revenues and costs and may cause the market price of the Companys common stock to
decline or become more volatile.



The Companys future operating results
may be affected by various uncertain trends and factors that are beyond the Companys control. These include adverse changes in general economic conditions and rapid or unexpected changes in the technologies affecting the Companys
products. The process of developing new high technology products is complex and uncertain and requires accurate anticipation of customer needs and technological trends.



The Company depends on the development and acceptance of new products in a rapidly changing market.



The market for the Companys products is characterized by rapidly changing technology,
evolution of new industry standards, and frequent introductions of new products and product enhancements. The Companys success will depend upon its continued ability to enhance its existing products, to introduce new products on a timely and
cost-effective basis to meet evolving customer requirements, to achieve market acceptance for new product offerings, and to respond to emerging industry standards and other technological changes. There can be no assurance that the Company will be
successful in developing new products or enhancing its existing products or that such new or enhanced products will receive market acceptance. The Companys success also depends upon its ability to license from third parties and to incorporate
into its products new technologies that become industry standards. There can be no assurance that the Company will continue to obtain such licenses on favorable terms or that it will successfully incorporate such third-party technologies into its
own products.



The Company anticipates new releases of products in the fiscal
year ending September 30, 2004. There can be no assurance that such new releases will not be affected by technical problems or bugs, as is common in the software industry. Furthermore, there can be no assurance that these or other future
product introductions will not be delayed. Delays in the availability, or a lack of market acceptance, of new or enhanced products could have an adverse effect on the Companys business. There can be no assurance that product introductions in
the future will not disrupt product revenues and adversely affect operating results.



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The Company competes in the highly competitive Internet infrastructure market.



The industry has become increasingly competitive and, accordingly, the Companys
results may also be adversely affected by the actions of existing or future competitors, including the development of new technologies, the introduction of new products, and the reduction of prices by such competitors to gain or retain market share.
The Companys results of operations could be adversely affected if it were required to lower its prices significantly.



It may be difficult to raise needed capital in the future.



Although the Companys current business plan does not foresee the need for further financing activities to fund the Companys operations for the foreseeable
future, due to risks and uncertainties in the market place, the Company may need to raise additional capital. The Company may raise additional funds through public or private financing, strategic relationships or other arrangements. The Company
cannot be certain that the funding, if needed, will be available on attractive terms, or at all. Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants.
Strategic arrangements, if necessary to raise additional funds, may require the Company to relinquish its rights to certain of its technologies or products. If the Company fails to raise capital when needed, the business will be negatively affected,
which could cause the stock price to decline.



The Companys revenues
may be affected by the seasonality of revenues in the European and government markets.



The Company experiences seasonality of revenues for both the European and the U.S. federal government markets. European revenues during the quarter ending June 30 are historically lower or relatively flat compared to
the prior quarter. This reflects a reduction of customer purchases in anticipation of reduced selling activity during the summer months. Sales to the U.S. federal government generally increase during the quarter ending September 30. This seasonal
increase is primarily attributable to increased purchasing activity by the U.S. federal government prior to the close of its fiscal year. Additionally, net revenues for the first quarter of the fiscal year are typically lower or relatively flat
compared to net revenues of the prior quarter.



Cost of revenues may be
affected by changes in the mix of products and services.



The overall cost of revenues may be affected by changes in the mix of net revenue contribution between licenses and services, geographical regions and channels of distribution, as the costs associated with these revenues may have
substantially different characteristics. The Company may also experience a change in margin as net revenues increase or decrease since technology costs and services costs are fixed within certain volume ranges.



The Companys operational results could be affected by price
variations.



The Companys results of operations could
be adversely affected if it were to lower its prices significantly. In the event the Company reduced its prices, the Companys standard terms for selected distributors would be to provide credit for inventory ordered in the previous 180 days,
such credits to be applied against future purchases. The Company, as a matter of policy, does not allow product returns for a refund, unless the product is covered under the 90 day warranty period, the product is non-conformant and the Company
cannot repair or replace the product. Product returns are generally allowances for stock balancing and are accompanied by compensating and offsetting orders. Revenues are net of a provision for estimated future stock balancing and excess quantities
above levels the Company believes are appropriate in its distribution channels. The Company monitors the quantity and mix of its product sales.



If the Company fails to manage the distribution of its products and services properly, or if the Companys distributors financial condition or operations
weaken, the Companys revenue could suffer.



The Company markets
products directly and through resellers and distributors. Since direct sales may compete with the sales made by resellers and distributors, these resellers and distributors may elect to use other suppliers that do not directly sell their own
products. Any increase in our commitment to direct sales could cause conflict with some of our channel partners. Further, some of the Companys resellers and distributors may have insufficient financial resources and may not be able to
withstand changes in business conditions, including economic weakness and industry consolidation. Revenue from indirect sales could suffer if the Companys distributors and resellers financial condition weakens.



The Company is dependent upon information received from third parties in order to
determine reserves for product returns.



The Company depends on
information received from its distribution partners in evaluating the inventory levels at distribution partners in the determination of reserves for the return of materials not sold, stock rotation and price protection. Significant effort has gone
into developing systems and procedures for determining the appropriate reserve level. In the event information is not received timely or accurately, the Companys ability to monitor the inventory levels will be affected and may negatively
impact the Companys business.



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The Companys business depends upon its proprietary rights and there is a risk that such rights will be
infringed.



The Company attempts to protect its software with a
combination of patent, copyright, trademark, and trade secret protection, employee and third party nondisclosure agreements, license agreements, and other methods of protection. Despite these precautions, it may be possible for unauthorized third
parties to copy certain portions of the Companys products or reverse engineer or obtain and use information the Company regards as proprietary. While the Companys competitive position may be affected by its ability to protect its
intellectual property rights, the Company believes that trademark and copyright protections are less significant to the Companys success than other factors, such as the knowledge, ability, and experience of the Companys personnel, name
recognition, and ongoing product development and support. Further, certain provisions of the Companys licenses, including provisions protecting against unauthorized use, copying, transfer, and disclosure of the licensed product, may be
unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect the Companys intellectual property rights to the same extent as do the laws of the U.S.



Risks of claims from third parties for intellectual property infringement could adversely
affect the business.



As the number of software products in
the industry increases and the functionality of these products further overlaps, the Company believes that software products will increasingly become subject to infringement claims. There can be no assurance that third parties will not assert
infringement claims against the Company and/or against the Companys suppliers of technology. In general, the Companys suppliers have agreed to indemnify the Company in the event any such claim involves supplier-provided software or
technology, but any such claim, whether or not involving a supplier, could require the Company to enter into royalty arrangements or result in costly litigation.



The Companys business may be adversely affected by events outside the Companys control.



While the Company has not been the target of software viruses specifically designed to
impede the performance of the Companys products, such viruses could be created and deployed against the Companys products in the future. Similarly, experienced computer programmers or hackers could attempt to penetrate the Companys
network security or the security of the Companys web sites. A hacker who penetrates the Companys network or web sites could misappropriate proprietary information or cause interruptions of services. The Company might be required to
expend significant capital and resources to protect against, or to alleviate, problems caused by virus creators and/or hackers. In addition, war, power shortage, natural disasters, acts of terror, and regional and global health risks could impact
the Companys ability to conduct business in certain regions. Any of these events could have an adverse effect on the Companys business, results of operations, and financial condition.



The Companys results of operations may be affected by fluctuations in foreign
currency exchange rates.



Although the Companys revenues are
predominantly in U.S. dollars, substantial portions of the Companys revenues are derived from sales to customers outside the United States. Trade sales to international customers represented 53%, 44% and 52% of total revenues for fiscal 2003,
2002 and 2001 respectively. The Companys revenues can be affected by general economic conditions in the United States, Europe and other international markets. Also, portions of the Companys operating expenses are transacted in foreign
currencies. The Companys operating strategy and pricing take into account changes in exchange rates over time. However, the Companys results of operations may be significantly affected in the short term by fluctuations in foreign
currency exchange rates.



The Companys results of operations may be
affected by the assessment of additional taxes.



Tarantella has operations
in many countries other than the United States. Transfer prices for services provided between the United States and these countries have been documented as reasonable, however, tax authorities could challenge these transfer prices and assess
additional taxes on prior period transactions. Any such assessment could require the Company to record an additional tax provision in its statement of operations.



Any inability to hire, retain or integrate key personnel will impact our business



The Company relies heavily on the contributions of its senior management and other key
management and technical personnel. The competition for such employees is extremely intense, particularly in the technology-centric regions where we operate. The Company may not be able to hire, retain and integrate such key personnel. The loss of
any individual member of the Companys management team or other key employees may create disruptions in its business. In fact, most of the Companys senior management team, including:



| |  | Francis E. Wilde, its Chief Executive Officer (CEO), President and a Director;
| | - | ------------------------------------------------------------------------------



| |  | John M. Greeley, its Chief Financial Officer;
| | - | ---------------------------------------------



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| |  | Gregory Quinn, its Vice President North American Operations and Strategic Alliances;
| | - | ------------------------------------------------------------------------------------



| |  | Stephen Bannerman, its Vice President Corporate Marketing;
| | - | ----------------------------------------------------------



| |  | E. Joseph Vitetta, Jr., its Vice President Corporate Development;
| | - | -----------------------------------------------------------------



| |  | Joseph Makoid, its Vice President OEM Sales; and
| | - | ------------------------------------------------



| |  | Thomas P. Rhodes, its Vice President-General Counsel
| | - | ----------------------------------------------------



joined the Company recently between December 2003 and January 2004. The Companys ability to integrate and retain these members of its management team and other
employees it hires is crucial to its success. If the Company fails to do so or if it experiences further changes in its management team, its business may be adversely affected.



Furthermore, the Company has historically used stock options and other forms of equity-related compensation as a key component to its
employee compensation program in order to align employees interests with the interests of shareholders, encourage employee retention, and provide competitive compensation packages. In recent periods, a majority of the Companys employee
stock options have had exercise prices in excess of its stock price, which may affect its ability to retain or attract present and prospective employees. In addition, the Financial Accounting Standards Board and other agencies have proposed, and are
currently considering, changes to United States generally accepted accounting principles that would require the Company and other companies to record a charge to earnings for employee stock option grants and other equity incentives. These and other
developments in the provision of equity compensation to employees could make it more difficult to attract, retain and motivate employees and result in additional expenses to the Company.



The Company may never achieve profitability in the future.



Following the divestiture of its server software and professional services divisions in May 2001, the Company has not achieved
profitability, and may never generate sufficient revenues to achieve profitability. As of March 31, 2004 the Company had an accumulated deficit of approximately $131,263,000. Many of the Companys operating expenses are relatively fixed in
nature, particularly in the short term, and it expects to continue to incur significant operating expenses in connection with the expansion of its sales and marketing efforts. The Company also expects to incur noncash charges relating to
amortization of intangibles related to past acquisitions. The Company must therefore generate revenues sufficient to offset these increased expenses in order for it to become profitable. The Company cannot guarantee that it will successfully
generate sufficient revenues or that it will ever achieve profitability. If it does achieve profitability, it may not be able to sustain it.



The outcome of SEC inquiry is uncertain.



The Company is in contact with the Securities and Exchange Commission in connection with an informal inquiry related to the events leading up to the Companys
restatement. The Company cannot predict the outcome of this inquiry.



If the
Company is unable to effectively integrate and develop the operations of its recent acquisitions, its business may suffer.



The Company acquired New Moon Systems, Inc. in June 2003, and Caststream Inc. in March 2004. The Company is in the process of integrating the operations, certain
employees, products and technology of both New Moon and Caststream into its business, and it faces various risks as a result of this acquisition including, but not limited to:



| |  | The ability to retain and motivate certain New Moon and Caststream employees;
| | - | -----------------------------------------------------------------------------



| |  | The ability to retain and develop New Moon and Caststream customers;
| | - | --------------------------------------------------------------------



| |  | The failure to integrate the technology, operations and certain members of the workforce of New Moon and Caststream with its business;
| | - | --------------------------------------------------------------------------------------------------------------------------------------



| |  | The failure to realize the potential financial or strategic benefits of the acquisitions;
| | - | -----------------------------------------------------------------------------------------



| |  | The incurrence of substantial unanticipated integration costs;
| | - | --------------------------------------------------------------



| |  | The disruption of the Companys ongoing business.
| | - | -------------------------------------------------



If the Company is not able to successfully integrate and develop the businesses of New Moon and Caststream, its business may be negatively affected in future periods,
which may cause its stock price to decline. In addition, if the value of intangible assets and goodwill acquired becomes impaired, the Company will be required to write down the value of the assets, which would negatively affect its financial
results. The Company may incur liabilities from New Moon or Caststream including liabilities for IP infringement or indemnification of New Moons or Caststreams customers for similar claims, which could materially and adversely affect its
business.



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The Company may make future acquisitions that may result in additional risks.



The Company may continue to make investments in complementary companies, products or
technologies. If the Company buys a company or a division of a company, they may experience difficulty integrating that company or divisions personnel and operations, which could negatively affect operating results. In addition:



| |  | Key personnel of the acquired company may decide not to accept employment with the Company;
| | - | -------------------------------------------------------------------------------------------



| |  | The ongoing business may be disrupted or receive insufficient management attention;
| | - | -----------------------------------------------------------------------------------



| |  | The Company may not be able to recognize the anticipated cost savings or other financial benefits;
| | - | --------------------------------------------------------------------------------------------------



In connection with future acquisitions, the Company may be required to assume the liabilities of the acquired companies. By assuming the
liabilities, the Company may incur liabilities, including liabilities for IP infringement or indemnification of customers of acquired businesses for similar claims, which could materially and adversely affect the business. The Company may have to
incur debt or issue equity securities to pay for any future acquisition, the issuance of which may involve restrictive covenants or be dilutive to existing shareholders.



The Companys stock is subject to substantial price and volume fluctuations due to a number of factors, many of which are beyond its
control, and those fluctuations may prevent shareholders from reselling their common stock at a profit.



The stock market in general, and the market for shares of technology companies in particular, has experienced extreme price and volume fluctuations, which have often been unrelated to the operating performance of the
affected companies. Strategic factors such as new product introductions, acquisitions or restructurings by the Company or its competitors may have a significant impact on the market price of the Companys common stock. Furthermore,
quarter-to-quarter fluctuations in operating results may have a significant impact on the market price of the stock. These conditions, as well as factors that generally affect the market for stocks of high technology companies, could cause the price
of the Companys stock to fluctuate substantially over short periods.



The Companys common stock may be difficult to trade.



The Companys stock was de-listed by the Nasdaq on October 21, 2003, and is now quoted on the Over-the-Counter (OTC) Pink Sheets. Trading the Companys stock may be more difficult due to the limited trading activity on
the OTC market. This could cause a further decline in the Companys stock price. Declines in the market price of the Companys stock could greatly impair the Companys ability to raise capital through equity or debt financing.



The Company has issued a significant number of shares of common stock in
the past year, substantially diluting the Companys outstanding common stock. A substantial portion of those shares may soon be eligible for sale on the open market, which may cause the trading price of the Companys common stock to
fluctuate or decline.



In connection with several transactions since June
2003, the Company has issued a substantial number of shares of its common stock and warrants to purchase shares of its common stock to investors and shareholders of acquired companies. While certain of the shares and warrants are subject to trading
restrictions, the majority of them are not. Therefore, the Company has little control over the timing of any sales of shares by any of the selling shareholders. As a result, the market price of the Companys common stock may fall if a large
portion of those shares is sold in the public market. If the Company continues to issue shares of its common stock, further diluting the number of shares outstanding, this may cause the price of its common stock to decline.



The corporate actions of the Company are substantially controlled by principal
shareholders.



The Companys principal shareholders beneficially own
approximately 50% of its outstanding common stock. These shareholders, if they acted together, could exert substantial control over matters requiring approval by the Companys shareholders, including electing directors and approving mergers or
other business combination transactions. This concentration of ownership may also influence the outcome of a change in control of the Company, which could deprive its shareholders of an opportunity to receive a premium for their stock as part of a
sale of the Company and might reduce its stock price. These actions may be taken even if they are opposed by the Companys other shareholders, including those who purchase shares in this offering.



The Company will incur increased costs as a result of being a public company subject to
the Sarbanes-Oxley Act of 2002, as well as new rules implemented by the Securities Exchange Commission.



As a public company, the Company incurs significant legal, accounting and other expenses. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the Securities and Exchange
Commission, have required changes in



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corporate governance practices of public companies. The Company expects these new rules and regulations to increase its
legal and financial compliance costs and to make some activities more time-consuming and costly. For example, as a result of being a public company, the Company has created additional board committees and adopted policies regarding internal controls
and disclosure controls and procedures. The Company is currently evaluating and monitoring developments with respect to these new rules, and cannot predict or estimate the amount of additional costs it may incur or the timing of such costs.



Recent Accounting Pronouncements



In January 2003 the FASB issued FIN No. 46, Consolidation of Variable Interest
Entities and a revised interpretation of FIN No. 46 (FIN No. 46-R) in December 2003. FIN No. 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 No. 46-R was effective
for the Company during the quarter ended March 31, 2004. The Company has no interest in variable interest entities, so the adoption of FIN No. 46-R had no effect on the Companys financial position or results of operations.



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Item 3. Quantitative and Qualitative Disclosures About Market Risk



Reference is made to part II, Item 7A, Quantitative and Qualitative Disclosures about Market Risk, in the Companys Annual Report on Form 10-K for the year ended September 30, 2003.



Item 4. Controls and Procedures



(a) Evaluation
of disclosure controls and procedures.



The events cited in this report
are the subject of the restatement that resulted from material weaknesses in the Companys system of internal controls and operations. The Company has taken and intends to continue to take measures to cure these weaknesses, which include
changes in senior management and tightening internal policies and procedures.



The Company has carried out an evaluation, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. It should be noted that the design of any system of controls is based in part upon certain
assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. Based upon their evaluation, the Chief
Executive Officer and the Chief Financial Officer concluded that disclosure controls and procedures are effective to ensure that material information required to be disclosed in the Company reports that are filed or submitted under the Exchange Act
is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, except as noted below with respect to the restatement.



(b) Changes in internal controls.



There has been no change in the Companys internal control over financial reporting
that occurred during the most recent fiscal quarter that has materially affected or is reasonably likely to materially affect the Companys internal control over financial reporting. The Company will continue to assess disclosure controls and
procedures and will take any further actions that are deemed necessary.



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Part II. Other Information



Item 1. Legal Proceedings



On August 28, 2003, a
former Tarantella sales representative filed an action against Tarantella, Inc. and Tarantella International, Inc., a wholly owned subsidiary of Tarantella Inc., (collectively, Tarantella) in the California Superior Court in Santa Clara
County, California. The complaint purports to state claims for breach of contract, negligent and intentional misrepresentation, fraud, and deceit. The complaint alleges that the plaintiff is owed commissions on certain sales of Tarantella products,
and seeks an unspecified amount of damages, correction of the purported contract, prejudgment interest, punitive damages and costs. On September 25, 2003, Tarantella filed a response denying the claims and asserting affirmative defenses. The case is
presently in the discovery stage.



Tarantella believes the allegations
contained in the complaint are without merit and intends to defend the action vigorously. Should the plaintiffs claims succeed, however, Tarantella could be required to pay monetary damages, which could have a material adverse effect on
Tarantellas business, financial position and results of operations.



No
other material legal proceedings are pending to which the Company is a party.



Item 2. Changes in Securities and Use of Proceeds



On December 26, 2003, the Company completed a private placement of common stock and warrants resulting in gross proceeds to the Company of approximately $2,750,000. In connection with the financing, the Company paid fees in the amount of
$232,303. In the private placement, the investors purchased 2,750,000 shares of Tarantella common stock at a price of $1.00 per share. The investors also acquired warrants to purchase up to an additional 550,000 shares at an exercise price of $1.39
per share. The warrants are exercisable for five years. The Company also has agreed to register the shares of common stock issued to the investors as well as the shares issuable upon exercise of the warrants for resale. In connection with the
investment, the Company also amended its existing shareholder rights plan such that Special Situations shall be permitted to acquire up to 30% beneficial ownership of the outstanding stock of the Company without triggering the Companys
shareholder rights plan, provided that for purposes of determining Special Situations beneficial ownership, neither the warrants nor any future exercises of warrants will be considered.



On February 23, 2004, the Company announced the completion of a second private placement of
common stock and warrants to various investors. In the private placement, the investors purchased 11,678,580 shares of Tarantella common stock at a price of $1.40 per share for gross proceeds of $16,350,000. The investors also acquired warrants to
purchase up to an additional 2,335,714 shares at an exercise price of $1.70 per share. The warrants are exercisable for five years. If the warrants are fully exercised, the Company would receive additional gross proceeds of approximately $3,970,714.
The Company also has agreed to register the shares of common stock issued to the investors as well as the shares issuable upon exercise of the warrants for resale. In connection with the financing, the Company incurred fees in the amount of
$1,198,000 and issued warrants to purchase 322,500 shares at $1.70 per share.



Item 3. Defaults Upon Senior Securities



Not
applicable



Item 4. Submission of Matters to a Vote of Security Holders



Not applicable



Item 5. Other Information



Not applicable



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Item 6. Exhibits and Reports on Form 8-K



(a)
Exhibits



|      |  |                                                                                                                                                                    
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.37 |  | Michels employment agreement                                                                                                                                       
|      | 
|31.1  |  | Certifications of Chief Executive Officer Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
|      | 
|31.2  |  | Certifications of Chief Financial Officer Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
|      | 
|32.1  |  | Certifications of Chief Executive Officer Pursuant To 18 U.S.C. Section 1350, as Adopted Pursuant To Section 906 Of the Sarbanes-Oxley Act of 2002                 
|      | 
|32.2  |  | Certifications of Chief Financial Officer Pursuant To 18 U.S.C. Section 1350, as Adopted Pursuant To Section 906 Of the Sarbanes-Oxley Act of 2002                 



(b) Reports on Form 8-K



The Company filed the following Report on Form 8-K during the quarter
ended March 31, 2004.



On March 8, 2004, Tarantella, Inc. filed a Report on
Form 8-K reporting the results of operations for Tarantellas third fiscal quarter for the period ended June 30, 2003 and for the fiscal year for the period ended September 30, 2003



On March 2, 2004, Tarantella, Inc. filed a Report on Form 8-K/A amending one of the exhibits that were filed on Form 8-K on February 23,
2004.



On February 24, 2004, Tarantella, Inc. filed a Report on Form 8-K/A
amending the closing date of the transaction that was filed on Form 8-K on February 23, 2004.



On February 23, 2004, Tarantella, Inc. filed a Report on Form 8-K announcing that the Company has entered into two Purchase Agreements dated February 19, 2004, by and among Tarantella, Inc. and certain investors named
therein (the Agreements). Pursuant to the Agreements, investors purchased 11,678,580 shares of the Companys common stock at a purchase price of $1.40 per share. The transactions contemplated in the Agreements closed on February 20,
2004. The Agreements also include accompanying warrants to purchase up to an aggregate of 2,335,714 shares (twenty percent warrant coverage) at a price of $1.70 per share. The warrants are exercisable within five years. In addition, the Company
announced additions to its management team.



On January 20, 2004, Tarantella,
Inc. filed a Report on Form 8-K announcing that the Board of Directors of the Company had appointed John M. Greeley as the Chief Financial Officer of the Company, replacing Alok Mohan, Tarantellas Chairman, who was acting CFO.



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Signatures



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



TARANTELLA, INC.By:

/s/ JOHN M. GREELEYJohn M. Greeley Vice President, Chief Financial Officer May 14, 2004By:

/s/ ROBERT MORLEYRobert Morley Vice President, Corporate Controller May 14, 2004




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