# **UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

### **WASHINGTON, D.C. 20549**

###  

# **FORM 10-K**

# ** **

**(Mark One)**

**ý****ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the fiscal year endedOctober 31, 2004**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from             to               .**

 

**Commission file number: 0-29911**

 

**THE SCO GROUP, INC.**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                               |       | **87-0662823**                                             |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------|
| (State of incorporation)                                                   |       | (I.R.S. Employer  Identification No.)                      |
|                                                                       |       |                                                       |
| **355 South 520 West  Lindon, Utah 84042**                                 |       | **(801) 765-4999**                                         |
| (Address of principal executive  offices, including zip code)              | ** ** | (Registrant’s telephone  number, including area code) |
|                                                                       |       |                                                       |
| Securities pursuant to  Section 12(b) of the Act:**  None** |
| Securities registered pursuant  to Section 12(g) of the Act:     |
|                                                                       |
| **Title of Each Class  Common Stock, par value $.001 per share**           |

 

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. YES o  NOý

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof the Registrant’s knowledge, in definitive proxy or information statementsincorporated by reference on Part III of this Form 10-K or anyamendment to this Form 10-K.  o

 

Indicate by check mark whether the Registrant isan accelerated filer (as defined in Rule 12b-2 of the Act).  YES o  NOý

 

The aggregate market value of the common stockheld by non-affiliates of the Registrant already made $33,021,000 based on thereported last sale price of common stock on April 30, 2004, which is thelast business day of the Registrant’s most recently completed second fiscalquarter.

 

The number of shares of the Registrant’s commonstock outstanding as of March 30, 2005, was 17,915,292.

 

 

----

 
| ** **         | ** ** | ** **                                                                                                              | ** ** |
|--------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|
| **PART I.**   | ** ** | ** **                                                                                                              | ** ** |
| Item 1.            |       | Business                                                                                                                |       |
| Item  2.           |       | Properties                                                                                                              |       |
| Item 3.            |       | Legal Proceedings                                                                                                       |       |
| Item  4.           |       | Submission  of Matters to a Vote of Security Holders                                                                    |       |
|               |       |                                                                                                                    |       |
| **PART II.**  |       |                                                                                                                    |       |
| Item  5.           |       | Market  for the Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |       |
| Item 6.            |       | Selected Financial  Data                                                                                                |       |
| Item  7.           |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                             |       |
| Item  7A.          |       | Quantitative  and Qualitative Disclosures About Market Risk                                                             |       |
| Item 8.            |       | Financial  Statements and Supplementary Data                                                                            |       |
| Item  9.           |       | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                                   |       |
| Item 9A.           |       | Controls and  Procedures                                                                                                |       |
| Item 9B.           |       | Other Information                                                                                                       |       |
|               |       |                                                                                                                    |       |
| **PART III.** |       |                                                                                                                    |       |
| Item  10.          |       | Directors  and Executive Officers of the Registrant                                                                     |       |
| Item 11.           |       | Executive  Compensation                                                                                                 |       |
| Item  12.          |       | Security  Ownership of Certain Beneficial Owners and Management                                                         |       |
| Item  13.          |       | Certain  Relationships and Related Transactions                                                                         |       |
| Item  14.          |       | Principal  Accounting Fees and Services                                                                                 |       |
|               |       |                                                                                                                    |       |
| **PART IV.**  |       |                                                                                                                    |       |
| Item  15.          |       | Exhibits,  Financial Statement Schedules                                                                                |       |
| Signatures         |       |                                                                                                                    |       |

 

3

----

 

**PART I**

 

**Item 1. Business**

 

*The Businesssection and other parts of this Annual Report on Form 10-K (“Form 10-K”)contains forward-looking statements relating to our business and strategy.  These forward-looking statements involverisks and uncertainties.  Manyforward-looking statements are located in “Management’s Discussion and Analysisof Financial Condition and Results of Operations” in Part II, Item 7 of thisForm 10-K.  Forward-looking statementscan also be identified by words such as “intends,” “anticipates,” “expects,”“believes,” “plans,” “predicts,” and similar terms.  Forward-looking statements are not guaranteesof future performance and our actual results may differ significantly from theresults discussed in the forward-looking statements.  Factors that might cause such differencesinclude, but are not limited to, those set forth below in the section entitled“Risk Factors” under Part II, Item 7 of this Form 10-K. We assume no obligationto revise or update any forward-looking statements for any reason, except asrequired by law.*

 

*Asused in the Form 10-K, “SCO,” and “OpenServer” are trademarks orregistered trademarks of our Company in the United States and othercountries.  “UNIX” and “UnixWare” areregistered trademarks of The Open Group in the United States and other countries.  All other brand or product names are or maybe trademarks of, and are used to identify the products and services of, theirrespective owners.  As used herein, the “Company”or “us,” “we,” “ours,” or similar terms refer to The SCO Group, Inc. andour operating subsidiaries.*

 

##### ***Overview***

 

Weown the UNIX operating system and are a provider of UNIX-based products andservices.  We generate revenue from salesof our UNIX-based products and services through our UNIX business and fromsales of SCOsource intellectual property (“IP”) licenses and vendor licenses ofour UNIX technology through our SCOsource business.  Our core business is to sell and service ourUNIX software products to small-to-medium sized businesses and franchisees orbranch offices of Fortune 1000 businesses. Our most significant products that drive the majority of our UNIXrevenue are OpenServer and UnixWare. During fiscal year 2004, we released a new version of our UnixWareproduct and we intend to continue to maintain our core UNIX business in fiscalyear 2005 by continuing our research and development efforts.  We plan to release the next major upgrade toour OpenServer product during the first half of calendar year 2005.

 

We developed our SCOsourceinitiatives as part of our ongoing efforts to establish and protect ourintellectual property rights, particularly relating to our ownership of theUNIX source code.  In reviewing ourintellectual property rights in 2003, we became aware that parts of ormodifications made to our proprietary UNIX source code and derivative workshave been included in the Linux operating system without our authorization orappropriate copyright attribution.

 

Inconnection with our SCOsource initiatives, in March 2003, we filed acomplaint against International Business Machines Corporation (“IBM”),alleging, in part, that IBM had breached its license agreement with us by,among other things, inappropriately contributing UNIX source code andderivative works to the open source community and seeking to use its knowledgeand methods related to UNIX source code and derivative works and modificationslicensed to it to decrease the value of the UNIX operating system in favor ofpromoting the Linux operating system, of which it has been a major backer.  Based on these alleged breaches, we deliveredto IBM notice of termination of our license agreement with IBM that permittedIBM’s use of our UNIX source code in developing its AIX operating system.

 

Inaddition to our action against IBM, we have filed other complaints against suchcompanies as Novell, Inc. (“Novell”), AutoZone Inc. (“AutoZone”), andDaimlerChrysler Corporation (“DaimlerChrysler”).  We describe our legal action against theseparties and the procedural status of these cases in more detail below under Part I,Item 3 of this Form 10-K.

 

4

----

 

**Historical Information**

 

Weoriginally incorporated as Caldera Systems, Inc., a Utah corporation (“CalderaSystems”), in August 1998, and reincorporated as a Delaware corporation inMarch 2000, when we completed an initial public offering of our commonstock.  In May 2001, we formed a newholding company in Delaware under the name of Caldera International, Inc.(“Caldera International”) to acquire substantially all of the assets andoperations of the server and professional services groups of The Santa CruzOperation, now known as Tarantella, Inc. In connection with this acquisition, Caldera Systems became awholly-owned subsidiary of Caldera International.  Former holders of shares and options topurchase shares of Caldera Systems received an equal number of shares andoptions to purchase shares in Caldera International.  On May 16, 2003, our stockholdersapproved our corporate name change from Caldera International, Inc. to TheSCO Group, Inc.  

 

***UNIX Business***

 

**Background**

 

Ourcore business focus is to serve the needs of small-to-medium sized businesses,including branch offices and franchisees of Fortune 1000 companies, byproviding reliable, cost-effective UNIX operating systems and software productsto power computers based on the Intel architecture.  We also provide a full range of pre- andpost-sale technical support for all of our products, primarily focusing onOpenServer and UnixWare.  Additionally,we provide UNIX-based technical support services and consulting services.

 

Ourlargest source of revenue for our core UNIX business is derived from ourworldwide, indirect, leveraged channel of partners, which includes distributorsand independent solution providers (collectively, “resellers”).  We have a presence in a number of countriesthat provides support and services to resellers and end-user customers in thosegeographic areas.  The other principalchannel for selling and marketing our products is through large corporations whichhave a large number of branch offices or franchisees.  We access these corporations through theirinformation technology or purchasing departments.  In addition, we also sell our UNIX productsto original equipment manufacturers (“OEMs”).

 

TheUNIX operating system, which we own, was conceived on the premise that anoperating system should be easily adapted to a broad range of hardwareplatforms and should provide a simple way of developing programs.  Over the years, the UNIX operating system hasbeen adapted for almost every OEM’s hardware architecture, and today UNIX hasachieved the goal of seamlessly sharing data across heterogeneousenvironments.  We own a broad and deepset of intellectual property rights relating to the UNIX operating system whichwe intend to continue to enforce and protect through our SCOsource initiatives,described in more detail below in the subsection entitled “SCOsourceInitiatives” under the section entitled “SCOsource Business.”

 

UNIX has had a longhistory of small business implementation, and has a large and loyal base ofboth customers and vendors that provides solutions and applications.  On the Intel platform, our OpenServer andUnixWare products represent a low-cost UNIX operating system available forbusiness.  Our UNIX product offeringspermit businesses, particularly small businesses, to take advantage of thereliability of UNIX at a relatively low cost.

 

##### ***Current Statusand Strategy***

 

Sales of our UNIX-based products and serviceshave been declining over the last several years.  This decline in revenue has been primarilyattributable to significant competition from alternative operating systems,particularly Linux.

 

5

----

 

We anticipate that our OpenServer and UnixWareproducts will continue to provide a future revenue stream for our UNIXbusiness.  Unless there is a change inthe current operating system environment, we expect revenue from these productswill continue to decline.  Both of theseUNIX products have a strong and loyal existing customer base and constitute awell-known brand with a reputation for quality and reliability.  We also have a seasoned, mature sales channelof resellers focused on the small-to-medium sized business market.  This channel is a unique asset that shouldallow us to continue to provide reliable UNIX operating systems forsmall-to-medium sized business customers.

 

In fiscal year 2005, we intend to focus ourdevelopment resources on releasing our next OpenServer product and maintainingour recently updated UnixWare product. We anticipate that the benefits of our next OpenServer product will beincreased system reliability and performance, backward compatibility withexisting applications and software, increased application support, increased hardwaresupport and integration with widely used internet applications.  We also plan to focus development resourceson augmenting our current UNIX products and our application products with otherproducts that will solve business problems for our existing installed base ofcustomers.  Our research and developmentefforts are described in more detail below in the subsection entitled “SoftwareEngineering and Development.”

 

**Competition**

 

Weface direct competition in the operating system market from Linux operatingsystem providers, other non-UNIX operating system providers and otherUNIX-based operating system providers. In the operating system market, some of our competitors include IBM, RedHat, Novell, Hewlett-Packard, Microsoft, and Sun.  Operating systems, primarily Linux, areaggressively taking market share away from UNIX and our UNIX revenue hasdeclined over the last several years.

 

We believe that wecompete favorably with many of our competitors in a number of respects,including product performance, functionality and price, networking capabilityand breadth of hardware compatibility. Notwithstanding these factors, our revenue has declined over the lastseveral years.  Many of our competitorsare significantly larger than we are and have much greater access to funding,technical expertise, marketing, and research and development.  In addition, many of our competitors haveestablished brand recognition and market presence that may prevent us fromobtaining or retaining significant market share.  Additionally, the assertion of our legalrights relating to our UNIX ownership and related copyrights and our otherlegal actions has resulted in us becoming the focus of a significant amount ofnegative publicity from various sources that has hampered our ability tocompete favorably to some degree.

 

The success of our UNIXbusiness will, in large measure, depend on the level of commitment andcertification we receive from industry partners and developers.  In recent years, we have seen hardware andsoftware vendors as well as software developers turn their certification andapplication development efforts toward Linux and elect not to continue tosupport or certify to our UNIX operating system products.  This trend continued in fiscal year 2004, andwe believe that it will continue in fiscal year 2005.  If this trend does continue as expected, ourcompetitive position will be adversely impacted and our future revenue from ourUNIX business will decline, possibly at an even faster rate than it hasdeclined over the last several years. The decline in our UNIX business may be accelerated if industry partnerswithdraw their support from us as a result of our SCOsource initiatives.

 

##### ***Products andServices***

 

*OpenServer. *OpenServeris our UNIX-based offering targeted at small-to-medium businesses.  Businesses use OpenServer to simplify andspeed business operations, better understand and respond to their customers’needs and achieve a competitive advantage. OpenServer excels at running multi-user, transaction and businessapplications, communications gateways, and mail and messaging servers in bothhost and client/server environments.  Wecontinue to aggressively support existing users of

 

6

----

 

OpenServer, keeping the operatingsystem current with hardware platforms available in the market.  The latest release, OpenServer 5.0.7, beganshipping in February 2003.  Weanticipate releasing the next version of OpenServer in the first half ofcalendar year 2005.

 

*UnixWare*.  UnixWare is our UNIX-based offering targetedat medium-size businesses and enterprise customers.  UnixWare is an advanced deployment platformfor industry standard Intel processor systems. UnixWare is a foundation for solutions where proven scalability,reliability and affordability are critical. UnixWare includes enhancements and refinements to the UNIX platform,representing significant added value for existing UnixWare customers.  The latest release of UnixWare, UnixWare7.1.4, began shipping in May 2004.

 

*SCO Applications.*  We have released twoapplication products: SCO Office Server and SCO Web Services Substrate (“WSS”).  These products run in conjunction with ourUNIX operating systems.  SCO OfficeServer provides smaller companies the ability to send and receive e-mailmessages, set calendar appointments, and perform other collaboration tasksusing standard client software.  SCO WSSenables business users to modernize their legacy applications, making themfunction with modern systems that more readily share data for improvedefficiency.  These application productsrepresent increased capability and functionality for our UNIX customers.

 

*Technical Support Services.*  We provide a full range of pre-and post-sale technical support for all of our products, primarily focusing onOpenServer and UnixWare.

 

Wealso provide technical support to our partners, including resellers, hardwareand software vendors and solution providers, as well as directly supporting ourend-user customers.  Our partners havethe option to direct their customers to us for technical support or to providefirst-level customer support themselves and utilize our technical expertise forsecond-tier support.

 

Technical supportservices include a range of options from single incident email and telephonesupport to dedicated “enterprise” level support agreements.  Customers seeking additional technicalsupport directly from us may enter into service agreements that best suit theirneeds.

 

*Other Services.*  Our other services include software developmentand programming, migration tools and services and assisting customers withmodernizing and integrating legacy applications with web services.  We assist our end-user customers and solutionproviders in planning, creating, implementing and deploying businessapplication solutions.

 

##### ***StrategicAlliances***

 

Wehave business alliances with a number of key global industry partners.  These relationships encompass productintegration, two-way technology transfers, product certification, channelpartnerships and revenue generating initiatives in areas of product bundling,OEM agreements and training and education. The objectives of these partnerships include providing complete hardwareand software UNIX solutions and mutually developing our sales and distributionchannel by coordinating marketing initiatives in creating demand for ourproducts.  We also have alliances with anumber of solution providers who write and develop custom applications to runon UNIX operating systems.  Most of oursmall business customers that cannot afford high-end solutions or aninformation technology staff rely on one of our channel partners for theseservices.  Maintaining these strategicalliances in fiscal year 2005 will be critical to the success of our UNIXbusiness, and in particular, to the success of our next OpenServerproduct.  We intend to continue to keeprelationships with key partners in certain vertical markets such as retail,medical/pharmaceutical, manufacturing and accounting where our UNIX operatingsystems have an existing presence.  Ourefforts to maintain or expand industry partnerships may be adversely impactedby our SCOsource initiatives.

 

7

----

 

##### ***Sales andMarketing***

 

Our UNIX sales andmarketing or field operations are organized by geographic area:  our Americas division and our Internationaldivision.  Each division includes a salesorganization, field marketing, pre- and post-sales technical support, and localprofessional services personnel.

 

*Americas. *TheAmericas team has field sales and support personnel located around the UnitedStates, Latin America and Canada.  Thisregion delivered approximately 56 percent of the total UNIX revenue for fiscalyear 2004.  The sales team is organizedinto Area Sales Managers (“ASMs”), who each manage a specific geographic areaand support our resellers and channel partners as well as service our corporateaccount customer base, including OEM partners. ASMs have the following specific roles:

 

•                  Channel Sales – ASMs manage our relationshipswith our resellers and vertical solution providers.  Resellers sell numerous solutions to smallbusiness customers in their geographic territory.  Vertical solution providers provide bundledapplications to specific vertical markets, which include retail point of sale,manufacturing, accounting and medical/pharmaceutical.  Many of our resellers and vertical solutionproviders purchase operating system platform products directly from us.  In order to efficiently support the thousandsof smaller resellers and vertical solution providers, we contract with severalmajor distributors in a two-tier distribution model.

 

•                  Corporate Sales – ASMs also sell directly toour major corporate accounts with branch offices or franchisees and other largecorporations.  Typically, these customershave an existing suite of third-party or internally developed applicationsdesigned to run on our dependable and scalable OpenServer or UnixWare operatingsystems.  In many cases, our operatingsystem and the application are then deployed in an identical fashion acrossthousands of branch offices or franchisees.

 

*International. *TheInternational region delivered approximately 44 percent of our UNIX revenue forfiscal year 2004 and includes EMEA (Europe, the Middle East and Africa) andAsia Pacific.  We have a presence in manymajor countries, including the United Kingdom, Germany, France, Italy, Spain,China, Korea, India, Japan, Australia and Taiwan.

 

The country sales teamsperform the same functions as the Americas sales team, includingchannel sales, corporate account sales and OEM sales.  In the International division, particularlyin smaller countries, one sales representative will manage both channel andmajor account sales within that country. The International division also uses local distributors in each locationto process all channel orders.

 

We consider our indirectsales channel one of our most valuable assets. In addition to the current revenue this channel produces, our resellerpartners are valuable for the influence they possess on the purchasingdecisions of small businesses.  Ourresellers are often not only the primary point of contact for their smallbusinesses customers’ purchasing decisions, but their customers’ outsourcedinformation technology department.  Thereach of our network of resellers into the small business community is broad asevidenced by our large install base of servers running various versions of ourOpenServer and UnixWare operating systems. A critical key to our future success will depend in part on our abilityto provide additional products and services to our reseller channel and tocommunicate our product and corporate strategy to these resellers.

 

Our marketing efforts support our sales anddistribution efforts, promotions and product introductions, and includemarketing activities to promote our UNIX products.  Pull marketing is focused on branding,solutions, advertising, tradeshows, press releases, white papers and marketingliterature.  In particular, our marketingstrategy consists of:

 

8

----

 

•                  branding our UNIX products through publicrelations and advertising activities;

 

•                  creating an effective partner program togenerate brand awareness and promote our UNIX products; and

 

•                  increasing public awareness of our UNIXproducts by participating in strategic tradeshows, conferences and technologyforums.

 

Information regardingfinancial data by geographic regions and long-lived assets is set forth in Part II,Item 8 of this Form 10-K in the notes to consolidated financialstatements.

 

**Software Engineering andDevelopment**

 

Wehave taken steps to improve our UNIX software products to maintain systemreliability, maintain backward compatibility, increase application support,provide broad hardware support, better integrate widely used internetapplications, improve usability, and increase system performance.  While we believe that these productenhancements will extend the life and improve the functionality of our UNIXproducts, they will not result in significant revenue increases in theshort-term due to the long adoption cycle for new operating system purchasesand the length of our operating system product sales cycle.  However, we do believe that theseimprovements will extend the life of our current UNIX products.

 

Technologytrends in the central processing unit (“CPU”) market have enabled our 32-bitoperating systems and associated applications to run on 64-bit hardware.  These developments have significantly reducedthe entry cost into the 64-bit market. We have assigned a limited, but skilled amount of resources to develop a64-bit version of our operating system technology.  Our objective in making this investment is toprovide our current and new customers a long-term product roadmap that willprovide them a seamless upgrade path to 64-bit computing.  We expect this investment to provide futurereturns as we give customers confidence in their commitment to ourtechnologies.

 

Ourproduct development process is modeled to standard, commercial softwareengineering practices and we apply these practices to ensure consistent productquality.  As a result, we are able tooffer our platform products to OEM customers in several configurations withoutsignificant additional effort.

 

##### ***SCOsource Business***

 

##### ***Background***

 

Weacquired our rights relating to the UNIX source code and derivative works andother intellectual property rights when we purchased substantially all of theassets and operations of the server and professional services groups of TheSanta Cruz Operation, Inc. in May 2001.  The Santa Cruz Operation (now known asTarantella, Inc.) had previously acquired such UNIX source code and otherintellectual property rights from Novell in September 1995, whichtechnology was initially developed by AT&T Bell Labs.  Through this process, we acquired all UNIXsource code, source code license agreements with thousands of UNIX vendors, certainUNIX intellectual property, all claims for violation of the above mentionedUNIX licenses and copyrights and other claims, and the control over UNIXderivative works.  The UNIX licenses weobtained have led to the development of several proprietary UNIX-basedoperating systems, including but not limited to our own UnixWare and OpenServerproducts, IBM’s AIX, Sequent’s DYNIX/Ptx, Sun’s Solaris, SGI’s IRIX and Hewlett-Packard’sHPUX.  These operating systems are allderivatives of the original UNIX source code owned by us.

 

The success of our SCOsourcebusiness depends on our ability to protect and enforce our rights toproprietary UNIX source code, copyrights and other intellectual propertyrights.  To protect our

 

9

----

 

proprietary rights, we rely primarily on acombination of copyright laws, contractual rights and a detailed legalstrategy.

 

Infiscal year 2003, we commenced our first SCOsource initiative in which we beganreviewing the status of our existing UNIX license agreements with UNIX vendorsand to identify those in the software industry that may be using our intellectualproperty without obtaining the necessary licenses.  As part of this process, we became aware thatparts of our proprietary UNIX source code and derivative works had beenincluded in the Linux operating system without attribution or our authorizationin violation of our intellectual property rights.  We filed a complaint against IBM in March 2003alleging that IBM breached its license agreement with us related to its effortsto promote and support the Linux operating system.  In addition to our action against IBM, wehave filed other complaints against Novell, AutoZone, and DaimlerChrysler.  In our litigation with Novell, we seek relieffor, among other things, Novell’s alleged bad faith efforts to interfere withour copyrights related to our UNIX source code. A related lawsuit was filed against us by Red Hat, Inc. (“Red Hat”).We describe our legal actions in more detail below under Part I, Item 3 ofthis Form 10-K.

 

**SCOsourceInitiatives**

 

*Reviewing and Evaluating Existing UNIX Licenses.*  Asmentioned above, in fiscal year 2003 we began reviewing the status of ourexisting UNIX license agreements with UNIX vendors and entered into twosignificant vendor license agreements. This review continued in fiscal year 2004 and will continue in fiscalyear 2005.

 

*SCOsource IP License*.  In August 2003, we firstoffered to Linux and other end users a license to use our UNIX intellectualproperty.  The SCOsource IP licensepermits the use of our UNIX intellectual property, in binary form only, ascontained in the Linux operating system. By purchasing the license, customers will properly compensate us for ourUNIX intellectual property as currently found in Linux.  The SCOsource IP license was created inresponse to requests to provide a licensing program for those in the industry usingour UNIX intellectual property to allow them to continue to run theirmission-critical business solutions running in other environments.  We will continue to pursue our SCOsource IPlicensing initiative in fiscal year 2005.

 

**Intellectual Property Protection**

 

OurSCOsource initiatives rely primarily on a combination of contract rights,copyright laws and an aggressive legal strategy.  We also require that our employees andconsultants sign confidentiality and nondisclosure agreements.  We also regulate access to, and distributionof, our documentation and other proprietary information.

 

Wecannot guarantee the success of our SCOsource initiatives and other efforts toprotect and enforce our intellectual property rights, but we will continue toseek to enforce and pursue these rights through the legal system.  Additionally, we cannot be certain that wewill succeed in preventing the future misappropriation of our proprietaryinformation including copyrights and other intellectual property rights or thatwe will be able to prevent the unauthorized future use of our technology.

 

**Current Status and Strategy**

 

In fiscal year 2004, wecontinued to pursue our SCOsource initiatives. The revenue generated from our SCOsource initiatives in fiscal year 2004was significantly less than revenue generated in fiscal year 2003.  Fiscal year 2004 SCOsource revenue wasprimarily generated from SCOsource IP licenses. For fiscal year 2005, we plan to continue to review and evaluate ourUNIX license agreements and pursue large vendor contracts, such as thosecompleted in fiscal year 2003, and plan to further pursue our SCOsourceinitiatives.

 

10

----

 

We also plan to continueto pursue our litigation against IBM, Novell, AutoZone, and DaimlerChrysler anddefend against the claims asserted by Red Hat.

 

***Employees***

 

As of October 31, 2004, we had a total of200 full-time equivalent employees.  Ofthe total employees, 64 were in product development, 46 in sales, 16 in marketing,21 in customer service and technical support, 10 in customer delivery, 7 inSCOsource and 36 in administration (which includes finance, human resources,executive management and information systems). From time to time, we also engage independent contractors to support ourprofessional services, product development, sales and marketingorganizations.  Our employees are notrepresented by any labor union and are not subject to a collective bargainingagreement, and we have never experienced a work stoppage.  In general, we believe our relations with ouremployees are good.

 

**Item 2.  Properties**

 

We are headquartered inLindon, Utah, where we lease administrative, sales and marketingfacilities.  We lease additionalfacilities for administration, sales and marketing and product development inScotts Valley, California and Murray Hill, New Jersey.  The leases for our facilities expire atvarious dates through****fiscal year2008.

 

Our international fieldoperations occupy leased facilities in France, Japan, Germany, India, and theUnited Kingdom among others.  The leasesfor these field operation facilities expire at various dates through fiscalyear 2010.

 

We believe that ourexisting facilities are adequate to meet current business and operatingrequirements and that additional office space will be available to meet ourneeds if required.

 

**Item 3.  LegalProceedings**

 

*IBM Corporation*

 

On or about March 6, 2003, we filed a complaint against IBM.  This action is pending in the United StatesDistrict Court for the District of Utah, under the title The SCO Group, Inc.v. International Business Machines Corporation, Civil No. 2:03CV0294.  The initial complaint included claims forbreach of contract, misappropriation of trade secrets, tortious interference,and unfair competition.  The initialcomplaint also alleged that IBM had used and distributed information concerningthe UNIX source code and derivative works in connection with its efforts topromote the Linux operating system.  As aresult of IBM’s actions, we are requesting damages in an amount to be proven attrial, together with additional damages through and after the time oftrial.  On or about June 13, 2003,we delivered to IBM a notice of termination of IBM’s UNIX license agreement,which underlies IBM’s AIX software.

 

On or about June 16, 2003, we filed an amended complaint in theIBM case.  The amended complaintessentially restated and re-alleged the allegations of the initial complaintand expanded on those claims.  Amongother things, the amended complaint raised new allegations regarding IBM’sbreaches (in ways similar to those set forth above) of a UNIX license agreementinvolving Sequent Computer Systems, Inc. (“Sequent”), which IBM hadacquired.  We have sought damages forbreaches of the Sequent license agreement. We are also seeking injunctive relief on several claims.

 

IBM has filed a response and counterclaims to our complaint, includinga demand for a jury trial.  We have filedan answer to the IBM counterclaims denying the claims and asserting affirmativedefenses.  On February 4, 2004, wefiled a motion for leave to file amended pleadings in the case proposing toamend our complaint against IBM and to modify our affirmative defenses to IBM’scounterclaims.  On February 25,2004, the court granted our motion for leave to amend.

 

11

----

 

Our second amended complaint, which was filed on February 27,2004, alleges nine causes of action that are similar to those set forth above,adds a new claim for copyright infringement and removes the claim formisappropriation of trade secrets.  IBMfiled an answer and fourteen counterclaims. Among other things, IBM has asserted that we do not have the right toterminate IBM’s UNIX license and IBM has claimed that we have breached the GNUGeneral Public License and have infringed certain patents held by IBM.  IBM’s counterclaims include claims for breachof contract, violation of the Lanham Act, unfair competition, intentionalinterference with prospective economic relations, unfair and deceptive tradepractices, promissory estoppel, patent infringement and a declaratory judgmentclaim for non-infringement of copyrights.

 

*On March 3, 2004, the U.S. Magistrate Judge issued anorder addressing certain discovery matters relating to both us and IBM.*

* *

*We thereafter filed motions to amend the scheduling orderand to bifurcate IBM’s patent counterclaims into a separate action.  A hearing on those latter two motions washeld on June 8, 2004.  The courtissued its ruling on June 10, 2004, granting our motion to amend thescheduling order, with certain changes. The court also denied the motion to bifurcate the patent counterclaimswithout prejudice to our right to request bifurcation again at a later date.*

* *

*Following a hearing on October 19, 2004, on January 19,2005, the Magistrate Judge issued a further order granting in part and denyingin part discovery applications that we had made.  In that order, the court ordered IBM toproduce much of the information, including source code and revisioninformation, we had previously requested. The court also struck the Amended Scheduling Order and directed theparties to submit a proposed amended scheduling order which both parties havedone.*

* *

*On February 9, 2005, the U.S. District Judge ruled onseveral pending dispositive motions.  TheCourt denied the three motions for partial summary judgment that IBM had filed– on our contract claims, on IBM’s eighth counterclaim for copyrightinfringement and on IBM’s tenth counterclaim for a declaration ofnon-infringement of our copyrights.  TheCourt denied each of those motions without prejudice to IBM’s renewing orrefiling the motions after discovery is complete.  The Court also denied our motion to stay ordismiss IBM’s tenth counterclaim.  TheCourt ordered that no further dispositive motions could be filed until theclose of discovery, except by stipulation of the parties, and vacated its priororder, dated September 30, 2004, to the extent that order had grantedpermission to file dispositive motions before the close of discovery.*

* *

*In addition to the materials that have been publicly filedwith the court, certain information has been filed under seal in accordancewith the protective order entered in the case. On November 30, 2004, a third party filed a motion to intervene inthe case for the purpose of challenging the sealing of certain documents withthe court.  Additional groups have joinedin that motion.  That motion has beenscheduled for a hearing on April 26, 2005.*

* *

*We have also filed a motion for leave to file a thirdamended complaint to allege an additional copyright violation against IBM inthe case.  We expect that matter to beheard by the court in the next few months. Discovery is continuing in the case.*

* *

*Red Hat, Inc.*

 

On August 4, 2003,Red Hat filed a complaint against us. The action is pending in the UnitedStates District Court for the District of Delaware under the case caption RedHat, Inc. v. The SCO Group, Inc., Civil No. 03–772.  Red Hat asserts that the Linux operatingsystem does not infringe our UNIX intellectual property rights and seeks adeclaratory judgment for non-infringement of copyrights and no misappropriationof trade secrets.  In addition, Red Hatclaims we have engaged in false advertising in violation of the Lanham Act,deceptive trade practices, unfair competition, tortious interference withprospective business opportunities, trade libel, and disparagement.

 

12

----

 

On or about September 15, 2003, we filed a motion to dismiss theRed Hat complaint.  The motion to dismissasserted that Red Hat lacks standing and that no case or controversy existswith respect to the claims seeking a declaratory judgment of non-infringement.  The motion to dismiss further asserted thatRed Hat’s claims under the Lanham Act and related state laws are barred by theFirst Amendment to the U.S. Constitution and the common law privilege ofjudicial immunity.  On April 6,2004, the court issued an order denying our motion to dismiss; however, thecourt stayed the case and requested status reports every 90 days regarding thecase against IBM.  Red Hat has filed amotion for reconsideration.  No rulinghas been issued on that motion.  Weintend to vigorously defend this action.

 

*Novell, Inc.*

 

On January 20,2004, we filed suit in Utah state court against Novell, Inc. for slanderof title seeking relief for its alleged bad faith effort to interfere with ourownership of copyrights related to our UNIX source code and derivative worksand our UnixWare product.  The case,after removal to federal court, is pending in the United States District Courtfor the District of Utah, under the caption The SCO Group, Inc. v. Novell, Inc.,Civil No. 2:04CV00139.  In thelawsuit, we requested preliminary and permanent injunctive relief as well asdamages.  Through these claims we seek torequire Novell to assign to us all copyrights that we believe Novell haswrongfully registered, prevent Novell from representing any ownership interestin those copyrights and require Novell to retract or withdraw allrepresentations it has made regarding its purported ownership of thosecopyrights.

 

Novell removed the caseto federal court and also filed a motion to dismiss our complaint claiming thatit had never transferred the copyrights to The Santa Cruz Operation (nowTarantella, Inc.).  We filed aresponse to Novell’s motion to dismiss and have also filed a motion to remandthe case back to the state court.  On June 10,2004, the court issued a memorandum decision and order which denied our motionto remand the case to state court.  Thememorandum decision also denied in part and granted in part Novell’s motion todismiss.  The court granted Novell’smotion to dismiss regarding our allegations of special damages, but granted usthirty-days leave to amend our complaint to plead special damages with greaterspecificity.  We have filed our amendedcomplaint and Novell has responded with another motion to dismiss claiming,among other things, that Novell’s false statements were not made with maliceand are privileged under the law.  Thatmotion has been briefed by the parties and is scheduled to be argued to thecourt on May 25, 2005.  We plan tocontinue to vigorously pursue our claims against Novell.

 

*DaimlerChrysler Corporation*

 

On or about March 3, 2004, we broughtsuit against DaimlerChrysler Corporation for its alleged violations of its UNIXlicense agreement.  The lawsuit allegesthat DaimlerChrysler breached its UNIX software agreement by failing to providean adequate or timely certification of its compliance with that agreement as werequested.  The lawsuit, filed in OaklandCounty Circuit Court in the State of Michigan, requests the court to declarethat DaimlerChrysler has violated the certification requirements of its UNIXsoftware agreement, permanently enjoin DaimlerChrysler from further violationsof the UNIX software agreement, issue a mandatory injunction requiringDaimlerChrysler to remedy the effects of its past violations of the UNIXsoftware agreement and award us damages in an amount to be determined at trialtogether with costs, attorneys’ fees and any such other or different reliefthat the Court may deem to be equitable and just.

 

On April 15, 2004, DaimlerChrysler fileda motion to dismiss our claims.  DaimlerChrysler’smotion was heard on July 21, 2004, and the court granted DaimlerChrysler’smotion as to the substance of DaimlerChrysler’s certification but denied themotion as to whether the certification was timely.  Based on this ruling, we filed a motion tostay the case pending the clarification of certain issues in the IBMlitigation.  The court denied the motionto stay.  Based on a stipulation of theparties, however, the court signed an order of dismissal withoutprejudice.  The appellate court hasdismissed our appeal of the

 

13

----

 

July 21, 2004 ruling finding that the order was not a final,appealable order; we are evaluating our options regarding the appellate court’sruling.

 

*AutoZone, Inc.*

 

On or about March 2, 2004, we broughtsuit against AutoZone, Inc. for its alleged violations of our UNIXcopyrights through its use of Linux.  Ourlawsuit alleges copyright infringement by AutoZone by, among other things,running versions of the Linux operating system that contain proprietarymaterial from UNIX System V.  Thelawsuit, filed in United States District Court in Nevada, requests injunctiverelief against AutoZone’s further use or copying of any part of our copyrightedmaterials and also requests damages as a result of AutoZone’s infringement inan amount to be proven at trial.  On April 23,2004, AutoZone filed a motion to transfer the case to Tennessee or to stay thecase.  On August 6, 2004, thefederal court in Nevada entered an order granting AutoZone’s motion to stay thecase with 90-day status reports to the court. The court denied without prejudice AutoZone’s motion for a more definitestatement and its motion to transfer the case to Tennessee.  The court is allowing the parties to takelimited expedited discovery relating to the issue of preliminary injunctiverelief.  We are pursuing that discoveryand continuing to evaluate our claims in that regard.

 

*IPO Class Action Matter*

 

We are anissuer defendant in a series of class action lawsuits, involving over 300issuers that have been consolidated under In re Initial Public OfferingSecurities Litigation, 21 MC 92 (SAS). The consolidated complaint alleges, among other things, certainimproprieties regarding the underwriters’ conduct during our initial publicoffering and the failure to disclose such conduct in the registration statementin violation of the Securities Act of 1933, as amended.

 

Theplaintiffs, the issuers and the insurance companies have negotiated anagreement to settle the dispute between the plaintiffs and the issuers.  All parties, including the plaintiffs,issuers and insurance companies, have executed this settlement agreement andthe settlement agreement has been submitted to the court for approval.  If the settlement agreement is approved bythe court, and if no cross-claims, counterclaims or third-party claims arelater asserted, this action will be dismissed with respect to our directors andus.

 

We havenotified our underwriters and insurance companies of the existence of theclaims.  We believe, after consultationwith legal counsel, that the ultimate outcome of this matter will not have amaterial adverse effect on our results of operations or financial position andwill not exceed the $200,000 self-insured retention amount already paid oraccrued by us.

 

*OtherMatters*

 

In April 2003,a former Indian distributor of ours filed a claim in India, requesting summaryjudgment for payment of $1,428,000, and an order that we trade in India onlythrough the distributor and/or give a security deposit until the claim is paid.The distributor claims that we are responsible to repurchase certain softwareproducts and to reimburse the distributor for certain other operatingcosts.  The distributor additionallyrequested that the Indian courts grant interim relief in the form of attachmentof local assets.  We do not believe thatwe are responsible to reimburse the distributor for any operating costs andalso believe that the return rights related to any remaining inventory havelapsed.  Discovery has commenced andhearings on the requests for interim relief have been held and areongoing.  We intend to vigorously defendthis action.

 

We are a party to certain other legal proceedings arising in theordinary course of business including legal proceedings arising from ourSCOsource initiatives.  We believe, afterconsultation with legal counsel, that the ultimate outcome of such legalproceedings will not have a material adverse effect on our results ofoperations or financial position.

 

14

----

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

Therewere no matters submitted to a vote of security holders during the fourthquarter of fiscal year 2004.

 

**PART II**

 

**Item 5.  Market for the Registrant’s Common Equity,Related Stockholder Matters and Issuer Purchases of Equity Securities**

 

**MarketPrice of Our Common Stock**

 

Ourcommon stock initially traded on The Nasdaq National Market beginning in March 2000,but has been traded on The Nasdaq SmallCap Market since February 2003.  In September 2002, we changed ourtrading symbol from “CALD” to “SCOX.”  Asof February 18, 2005, the trading symbol for the common stock was changedfrom “SCOX” to “SCOXE” as a result of our failure to make a timely filing ofthis Form 10-K.  The table below sets forth the range ofhigh and low closing prices of our common stock as reported on The NasdaqNational Market and The Nasdaq SmallCap Market, as applicable, for the last twoyears.

* *
| ** **                          | ** ** | **SCO Common Stock** | ** ** |
|-------------------------------------|------------|----------------------|------------|
| ** **                          | ** ** | **High**             | ** ** | **Low** | ** ** |
| **Fiscal Year 2004**                |       |                 |       |   |   |
| Quarter ended January 31, 2004 |       | $                    | 19.08      |   | $ | 13.65 |   |
| Quarter ended April 30, 2004   |       | 14.40                |       | 6.27 |   |
| Quarter ended July 31, 2004    |       | 6.34                 |       | 4.03 |   |
| Quarter ended October 31, 2004 |       | 5.10                 |       | 2.98 |   |
|                                |       |                 |       |   |   |
| **Fiscal Year 2003**                |       |                 |       |   |   |
| Quarter ended January 31, 2003 |       | $                    | 1.70       |   | $ | 1.22 |   |
| Quarter ended April 30, 2003   |       | 3.27                 |       | 1.09 |   |
| Quarter ended July 31, 2003    |       | 14.84                |       | 3.21 |   |
| Quarter ended October 31, 2003 |       | 20.50                |       | 9.29 |   |

 

 

On March 29, 2005,the closing sales price for our common stock as reported by The Nasdaq SmallCapMarket was $3.52.  As of March 28, 2005,there were 340 holders of common stock of record.

 

**Dividend Policy**

 

We have not historicallydeclared or paid any cash dividends on shares of our common stock and plan toretain our future earnings, if any, to fund the development and growth of ourbusiness.

 

**Equity Compensation Plans**

 

Wemaintain our 1998 Stock Option Plan, our 1999 Omnibus Stock Incentive Plan, our2002 Omnibus Stock Incentive Plan, our 2004 Omnibus Stock Incentive Plan andour 2000 Employee Stock Purchase Plan (the “ESPP”).  We are no longer granting awards under the1998 Stock Option Plan, which was superseded by the 1999 Omnibus StockIncentive Plan.

 

15

----

 

Thefollowing table provides information about equity awards under our equitycompensation plans as of October 31, 2004:

 

 
| **Plan Category**                                       | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding  options, warrants  and rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in the  first column)** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                    |       |                                                                                                |       |                                                                                |       |                                                                                                                                                        |       |
| Equity compensation plans approved by  security holders |       | 3,421,000                                                                                           |       | $                                                                                   | 4.05       |                                                                                                                                                        | 2,077,000  | (1) (2) |
|                                                         |            |                                                                                                     |            |                                                                                     |            |                                                                                                                                                             |            |  |

 

----

(1)          The2004 Omnibus Incentive Plan incorporates an evergreen formula pursuant to whichon each November 1, the aggregate number of shares reserved for issuanceunder the 2004 Plan will increase by a number of shares equal to three percentof the outstanding shares on the day preceding (October 31).  The ESPP incorporates an evergreen formulapursuant to which on January 1 of each year the aggregate number of sharesreserved for issuance under the ESPP will increase by a number of shares equalto one percent of the outstanding shares on the day preceding (December 31).

 

(2)          Ofthese shares, 248,000 shares remain available for purchase under the ESPP.

 

**RecentSales of Unregistered Securities**

 

We have issued shares and granted optionsunder our 1998 Stock Option Plan, 1999 Omnibus Stock Option Plan, the ESPP,2002 Omnibus Stock Incentive Plan, and 2004 Omnibus Stock Incentive Plan(collectively, the “EquityCompensation Plans”) without complying with registration or qualificationrequirements under federal securities laws and the securities laws of certainstates.  As a result, certain planparticipants have a right to rescind their purchases of shares under the EquityCompensation Plans or recover damages if they no longer own the shares or holdunexercised options, subject to applicable statutes of limitations.  Additionally, regulatory authorities mayrequire us to pay fines or impose other sanctions on us.  Although we are evaluating the possibleactions we may take in response to these securities law compliance issues, wemay, subject to obtaining required regulatory approvals, make a rescissionoffer to certain plan participants that hold unexercised options (inCalifornia, Georgia and possibly other states) or shares acquired under theEquity Compensation Plans or that otherwise are entitled to recover damagesfrom us in respect of such shares they have sold.

 

**IssuerPurchases of Equity Securities**

 

During the fourth quarter of fiscal year 2004, we did not purchase any ofour equity securities.

 

**Item 6.  SelectedFinancial Data**

 

The following selected financial data set forth below should be read inconjunction with the consolidated financial statements and the related notesincluded elsewhere in this Form 10-K and in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” appearing in Part II, Item 7 of this Form 10-K.  The selected statement of operations data forthe years ended October 31, 2004, 2003 and 2002 and the selected balancesheet data as of October 31, 2004 and 2003 are derived from, and arequalified by reference to, the audited consolidated financial statements andrelated notes in this Form 10-K.

 

16

----

 

Theselected statement of operations data for the years ended October 31, 2001and 2000 and the selected balance sheet data as of October 31, 2002, 2001and 2000 are derived from audited consolidated financial statements notappearing in this Form 10-K. 

 
| *** ***                                                   | *** *** | **Years  Ended October 31,**         | *** *** |
|----------------------------------------------------------------|--------------|-------------------------------------------|--------------|
| *** ***                                                   | *** *** | **2004**                                  | ** **   | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | *** *** |
| ** **                                                     | ** **   | **(In thousands, except per share data)** | ** **   |
| **Statement of Operations Data:**                              |         |                                      |         |   |   |   |   |   |   |   |   |
| Total revenue                                                  |         | $                                         | 42,809       |   | $ | 79,254 |   | $ | 64,241 |   | $ | 40,441 |   | $ | 4,274 |   |
| Gross margin                                                   |         | 15,711                                    |         | 59,332 |   | 45,925 |   | 25,518 |   | 253 |   |
| Income (loss) from operations                                  |         | (28,573                                   | )            | 3,436 |   | (24,176 | ) | (133,636 | ) | (31,999 | ) |
| Net income available (loss applicable) to  common stockholders |         | (16,227                                   | )            | 5,304 |   | (24,877 | ) | (131,357 | ) | (39,176 | ) |
| Basic net income (loss) per common share                       |         | $                                         | (1.07        | ) | $ | 0.43 |   | $ | (1.93 | ) | $ | (10.92 | ) | $ | (4.76 | ) |
| Diluted net income (loss) per common share                     |         | $                                         | (1.07        | ) | $ | 0.34 |   | $ | (1.93 | ) | $ | (10.92 | ) | $ | (4.76 | ) |
| Weighted average basic common shares                           |         | 15,155                                    |         | 12,261 |   | 12,893 |   | 12,024 |   | 8,231 |   |
| Weighted averaged diluted common shares                        |         | 15,155                                    |         | 15,679 |   | 12,893 |   | 12,024 |   | 8,231 |   |
|                                                                |              |                                           |              |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                         | ** ** | **As of October 31,** | ** ** |
|------------------------------------|------------|----------------------------|------------|
| ** **                         | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                         | ** ** | **(In thousands)**         | ** ** |
| **Balance Sheet Data:**            | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash equivalents          |       | $                          | 12,693     |   | $ | 64,428 |   | $ | 6,589 |   | $ | 20,541 |   | $ | 36,560 |   |
| Working capital (deficit)          |       | 15,413                     |       | 37,168 |   | (6,332 | ) | 14,401 |   | 88,680 |   |
| Total assets                       |       | 55,400                     |       | 94,952 |   | 37,406 |   | 74,859 |   | 107,518 |   |
| Long-term liabilities              |       | 343                        |       | 508 |   | 1,625 |   | 5,925 |   | — |   |
| Redeemable preferred stock         |       | —                     |       | 29,671 |   | — |   | — |   | — |   |
| Common stock subject to rescission |       | 528                        |       | — |   | — |   | — |   | — |   |
| Total stockholders’ equity    |       | 21,702                     |       | 19,516 |   | 8,177 |   | 34,604 |   | 102,215 |   |
|                                    |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Item 7.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*This Management’s Discussion andAnalysis of Financial Condition and Results of Operations and other parts ofthis Form 10-K contain forward-looking statements that involve risks anduncertainties.  Forward-lookingstatements can also be identified by words such as “intends,” “anticipates,” “expects,”“believes,” “plans,” “predicts,” and similar terms.  Forward-looking statements are not guaranteesof future performance and our actual results may differ significantly from theresults discussed in the forward-looking statements.  Factors that might cause such differencesinclude, but are not limited to, those discussed in the subsection entitled“Forward Looking Statements and Factors That May Affect Future Results andFinancial Condition” and the subsection entitled “Risk Factors”below.  The following discussion shouldbe read in conjunction with our consolidated financial statements and notesthereto included in Part II, Item 8 of this Form 10-K.  All information presented herein is based onour fiscal year ended October 31, 2004. We assume no obligation to revise or update any forward-lookingstatements for any reason, except as required by law.*

 

**Overview**

 

*Historical Background. *Weoriginally incorporated as Caldera Systems, Inc., a Utah corporation (aspreviously defined, “Caldera Systems”), on August 21, 1998, andreincorporated as a Delaware corporation on March 6, 2000.  In March 2000, we completed an initialpublic offering of our common stock.  On May 7, 2001, we formed a newholding company in Delaware under the name of Caldera International, Inc.(as previously defined, “Caldera International”) to acquire substantially allof the assets

 

17

----

 

and operations of theserver and professional services groups of The Santa Cruz Operation (now knownas Tarantella, Inc.).  In connectionwith this acquisition, Caldera Systems became a wholly-owned subsidiary ofCaldera International.  Formerholders of shares and options to purchase shares of Caldera Systems received anequal number of shares and options to purchase shares in Caldera International.  On May 16,2003, our stockholders approved our corporate name change to The SCO Group, Inc.

 

*Recent Developments.*** **Asdescribed in the section entitled“Recent Sales of Unregistered Securities” above in Part II, Item 5 of thisForm 10-K, ** **we issued shares and granted options under our Equity CompensationPlans without complying with registration or qualification requirements underfederal securities laws and the securities laws of certain states.  As a result, certain plan participants have aright to rescind their purchases of shares under the Equity Compensation Plansor recover damages if they no longer own the shares or hold unexercisedoptions, subject to applicable statutes of limitations.  Although we are evaluating the possibleactions we may take in response to these securities law compliance issues, wemay make a rescission offer to certain plan participants entitled to rescissionrights subject to obtaining required regulatory approvals.  If our potential rescission offer is made andaccepted by all plan participants holding certain ESPP shares and all sharesacquired from the exercise of stock options, or such participants otherwisemake rescission claims against us, we could be required to make aggregate paymentsto these plan participants of up to $528,000. This amount is based on ESPP shares and shares issued upon the exerciseof stock options that have been retained by plan participants as of October 31,2004 and excludes interest and other charges we may be required to pay.  We may face additional rescission liabilityto plan participants holding unexercised stock options in California, Georgiaand possibly other states, and regulatory authorities also may require us topay fines or impose other sanctions on us.

 

On February 16,2005, we received a notice from the staff of The Nasdaq Stock Market indicatingthat we are subject to potential delisting from The Nasdaq SmallCap Market forfailure to comply with Nasdaq’s requirement to file this Form 10-K for thefiscal year ended October 31, 2004 in a timely fashion.  Receipt of the notice did not result inimmediate delisting of our common stock. Nasdaq stated that, unless we requested a hearing on Nasdaq’s delistingnotice, our securities would be delisted from The Nasdaq SmallCap Market at theopening of business on February 25, 2005.

 

We requested a hearingwith the Nasdaq Listing Qualifications Panel on this matter, which stayed thedelisting pending the hearing and a determination by the Nasdaq Listing QualificationsPanel.  The hearing occurred on March 17,2005.  At the hearing, we outlined forthe Panel our plan for filing this Form 10-K and our Quarterly Report on Form 10-Qfor the first quarter of the current fiscal year (the “Form 10-Q”), whichalso was not filed in a timely fashion. On March 18, 2005, we received another notice from the staff of TheNasdaq Stock Market regarding our potential delisting as a result of ourfailure to file the Form 10-Q in a timely fashion.  The notice informed us that the Panel willconsider the filing delinquency of our Form 10-Q in addition to the filingdelinquency of this Form 10-K in rendering its decision regarding ourlisting status.  We will continue to belisted on The Nasdaq SmallCap Market under the symbol SCOXE pending theissuance of the Panel’s decision.

 

OnOctober 31, 2004, we entered into an engagement agreement (the “EngagementAgreement”) with Boies, Schiller & Flexner LLP, Kevin McBride andBerger Singerman (the “Law Firms”).  TheEngagement Agreement supercedes and replaces the original engagement agreementthat was entered into in February 2003. The Engagement Agreement governs the relationship between us and the LawFirms in connection with their representation of us in our current litigationbetween us and IBM, Novell, Red Hat, AutoZone and DaimlerChrysler (the “SCOLitigation”), through the end of the current litigation between us andIBM.  This litigation is described inmore detail under Part I, Item 3 of this Form 10-K.

 

Ourpurpose in entering into this Engagement Agreement was to limit the cashexpenditures needed to pursue the SCO Litigation.  The Engagement Agreement provides for thepayment of approximately $26,000,000 for certain previously accrued expensestotaling $13,906,000 at October 31,

 

18

----

 

2004 and all futureattorney fees in connection with the SCO Litigation through the end of thecurrent litigation between us and IBM and the escrow of at least $5,000,000 forthe payment of any expert, consulting and other expenses.  As of October 31, 2004, this $5,000,000was classified as a component of restricted cash.  We paid the $13,906,000 subsequent to October 31,2004.

 

Future legal feescovered under the Engagement Agreement will require us to pay to the Law Firms$2,000,000 per quarter for each successive quarter beginning September 1,2004 and ending December 1, 2005 for a total amount of $12,000,000, ofwhich $10,000,000 will be paid in fiscal year 2005.  In the first quarter of fiscal year 2005, wemade the quarterly payments for September 2004 as well as December 2004for a total of $4,000,000.  The paymentof these fees has had and will continue to have a material impact on our cashposition.

 

Inaddition to the cash expenditures mentioned above, we must also pay one or morecontingency fees upon any amount we or our stockholders may receive as arecovery from our litigation, our intellectual property licensing or a sale ofour company.  The contingency fee amountspayable to the Law Firms will be, subject to certain credits and adjustments,as follows:

 

•                  33 percent of any aggregate recoveryamounts received up to $350,000,000;

 

•                  plus 25 percent of any aggregate recoveryamounts above $350,000,000 but less than or equal to $700,000,000;

 

•                  plus 20 percent of any aggregate recoveryamounts in excess of $700,000,000.

 

TheEngagement Agreement specifically provides that, except for the compensationobligations specifically described above, we will not be obligated to pay anylegal fees, whether hourly, contingent or otherwise, to the Law Firms, or anyother law firms that may be engaged by the Law Firms, in connection with theSCO Litigation through the end of the current litigation between us and IBM,including any appeals.

 

**Business Focus**

 

Wegenerate revenue from sales of product and services from our UNIX business and fromsales of SCOsource IP licenses and vendor licenses from our SCOsource business.

 

*UNIX Business. *Our UNIX business serves the needs ofsmall-to-medium sized businesses, including replicated site franchisees ofFortune 1000 companies, by providing reliable, cost effective UNIX operatingsystems and software products to power computers running on Intelarchitecture.  Our largest source of UNIXbusiness revenue is derived from existing customers through our worldwide,indirect, leveraged channel of partners which includes distributors andindependent solution providers.  We havea presence in a number of countries that provide support and services tocustomers and resellers.  The otherprincipal channel for selling and marketing our UNIX products is throughexisting customers that have a large number of replicated sites or franchisees.

 

Weaccess these corporations through their information technology or purchasingdepartments with our ASMs in the United States and through our reseller channelin countries outside the United States. In addition, we also sell our operating system products to OEMs. Our sales of UNIX products and services during the last several fiscal years havebeen primarily to pre-existing UNIX customers and not newly acquiredcustomers.  Our UNIX business revenuedepends significantly on our ability to market and sell our products toexisting customers and to generate upgrades from existing customers.

 

19

----

 

Thefollowing table shows the operating results of the UNIX business for fiscalyears 2004, 2003 and 2002 (in thousands):

 
| ** **                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Revenue                    |       | $        | 41,980     |     | $          | 53,408   |       | $ | 64,241 |   |
| Cost of revenue            |       | 7,355    |       | 10,422   |       | 18,316   |       |
| Gross margin               |       | 34,625   |       | 42,986   |       | 45,925   |       |
| Sales and marketing        |       | 15,806   |       | 24,392   |       | 29,554   |       |
| Research and development   |       | 10,126   |       | 11,012   |       | 17,558   |       |
| General and administrative |       | 7,385    |       | 6,230    |       | 9,307    |       |
| Other (1)                  |       | 9,008    |       | 5,306    |       | 13,682   |       |
| Total operating expenses   |       | 42,325   |       | 46,940   |       | 70,101   |       |
| Loss from operations       |       | $        | (7,700     | )        | $          | (3,954   | )          | $ | (24,176 | ) |

 

----

(1)          Other costs includeamortization of intangibles, stock-based compensation, loss on disposition andwrite-offs of long-lived assets, loss on investments and severance and exitcosts.

 

Revenue fromour UNIX business decreased by $11,428,000, or 21 percent, for fiscal year 2004compared to fiscal year 2003 and decreased by $10,833,000, or 17 percent, forfiscal year 2003 compared to fiscal year 2002. The revenue from this business has been declining over the last severalfiscal years primarily as a result of increased competition from alternativeoperating systems, particularly Linux. If revenue from our UNIX business continues to decline and we are unableto generate positive cash flow, our UNIX business will be adversely impacted.

 

Inan effort to try to reach profitability in our UNIX business, we have decreasedour operating costs and increased our gross margin percentage in each of the lastthree fiscal years.  Operating costs forour UNIX business decreased from $70,101,000 for fiscal year 2002 to$46,940,000 for fiscal year 2003, and then further decreased to $42,325,000 forfiscal year 2004.  These cost reductionshave primarily been attributable to reduced headcount and continued operationalefficiencies generated in our UNIX business as well as from the consolidationof certain facilities.  During fiscalyear 2004, we incurred a charge for severance and exit costs of $3,168,000 andincurred a loss on disposition and write-off of long lived assets of$2,355,000.  Both of these chargesnegatively impacted our loss from operations for fiscal year 2004.

 

Inour UNIX business, we have reduced the number of full-time equivalent employeesfrom 340 as of October 31, 2002, to 295 as of October 31, 2003 to 193as of October 31, 2004.  We havetaken these headcount reductions and reduced other discretionary spending whilestill maintaining a worldwide presence. Based on our cost-cutting actions, we anticipate that our UNIX businesswill generate positive cash flow during fiscal year 2005.

 

Thedecline in our UNIX business revenue may be accelerated if industry partnerswithdraw their support as a result of our SCOsource initiatives.  The decline in our UNIX business and ourSCOsource initiatives may cause industry partners, developers and hardware andsoftware vendors to choose not to support or certify to our UNIX operatingsystem products.  This would lead to anaccelerated decline in revenue from our UNIX business.

 

Animportant initiative for our UNIX business for the 2005 fiscal year will be therelease of a new version of our OpenServer operating system in the first halfof calendar year 2005.  This new versionwill provide increased system reliability, backward compatibility with existingapplications and software, increased application and hardware support,integration with widely used internet applications and increased systemperformance.  These enhancements will nothave a direct impact on our short-term OpenServer revenue because of the longadoption cycle for new operating system purchases and our long operating systemproduct sales cycle, but we believe that they will help prolong our OpenServerrevenue stream for future quarters.

 

*SCOsourceBusiness. *During the 2003 fiscal year, we becameaware that our UNIX code and derivative works had been inappropriately includedin the Linux operating system.  Webelieve the inclusion of our UNIX code and derivative works in Linux has been amajor contributor to the decline in

 

20

----

 

our UNIX businessbecause users of Linux generally do not pay for the operating system but payonly minimal fees, if any, for service and maintenance.  The Linux operating system competes directlywith our OpenServer and UnixWare products and has taken significant marketshare from these products.

 

Inan effort to protect our UNIX intellectual property, weinitiated our SCOsource business.  Theseinitiatives now include seeking to enter into license agreements with UNIXvendors and offering SCOsource IP licenses to Linux and other end usersallowing them to continue to use our UNIX source code and derivative worksfound in Linux.  Our SCOsource effortsresulted in the execution of two significant vendor license agreements duringfiscal year 2003, but we did not enter into any significant vendor licenseagreements in fiscal year 2004.  Ourrevenue for fiscal year 2004 was significantly lower than revenue generated infiscal year 2003.  We believe and allegerevenue and related revenue opportunities for fiscal year 2004 were adverselyimpacted by our outstanding dispute with Novell over our UNIX copyrightownership, which may have caused potential customers to delay or forego licensinguntil an outcome in this legal matter has been reached.

 

During fiscal year 2004,we began assigning direct resources to the SCOsource business for sales andmarketing, research and development and general and administrative.  There were no direct costs associated withselling, marketing, research and development and general and administration forthe 2003 fiscal year and our SCOsource business did not exist during fiscalyear 2002.  The following table shows theresults of operations for the SCOsource business (in thousands):

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |     |       |
| Revenue                       |       | $        | 829        |     | $          | 25,846   |       | $ | — |   |
| Cost of revenue               |       | 19,743   |       | 9,500    |       | —   |       |
| Gross margin (deficit)        |       | (18,914  | )          | 16,346   |       | —   |       |
| Sales and marketing           |       | 1,232    |       | —   |       | —   |       |
| Research and development      |       | 486      |       | —   |       | —   |       |
| General and administrative    |       | 241      |       | —   |       | —   |       |
| Other                         |       | —   |       | 8,956    |       | —   |       |
| Total operating expenses      |       | 1,959    |       | 8,956    |       | —   |       |
| Income (loss) from operations |       | $        | (20,873    | )        | $          | 7,390    |       | $ | — |   |
|                               |            |          |            |          |            |          |            |  |  |  |  |  |  |

 

 

Revenuefrom our SCOsource business decreased from $25,846,000 in fiscal year 2003 to$829,000 in fiscal year 2004.  Duringfiscal year 2003, the revenue generated was primarily attributable to two largevendor licenses, and we did not close any similar transactions during fiscalyear 2004.  Revenue in fiscal year 2004was primarily attributable to sales of our SCOsource IP licenses.  Cost of revenue increased from $9,500,000 infiscal year 2003 to $19,743,000 in fiscal year 2004, which was primarilyattributable to increased legal fees incurred in connection with our SCO Litigation.  Operating expenses for sales and marketing,research and development and general and administrative increased in fiscalyear 2004 over fiscal year 2003 as certain employees were dedicated to thisbusiness initiative in fiscal year 2004. The other expense in fiscal year 2003 of $8,956,000 was attributable toa contingency fee payable to the Law Firms incurred in connection with the October 2003issuance of our now retired Series A Convertible Preferred Stock.  This fee was not for attorney’s fees forlegal services which fees have been recorded as cost of SCOsource licensingrevenue.

 

Ourfuture success with our SCOsource initiatives and future revenue from SCOsourceinitiatives will depend on our ability to protect our UNIX intellectualproperty.

 

Because of theuncertainties related to our SCOsource business, we are unable to estimate theamount and timing of future SCOsource licensing revenue.  This uncertainty represents a significantrisk and challenge for us, both in the short and long term.  If we do receive revenue from this source, itmay be sporadic and fluctuate from quarter to quarter.  Our SCOsource initiatives are unlikely toproduce a

 

21

----

 

stable or predictable revenue stream for theforeseeable future.  We are unlikely togenerate significant revenue from our SCOsource business unless and until weprevail in our SCO Litigation. Additionally, the success of these initiatives may depend on thestrength of our intellectual property rights and contractual claims regardingUNIX, including the strength of our claim that unauthorized UNIX source codeand derivative works are contained in Linux.

 

**CriticalAccounting Estimates**

 

The preparation offinancial statements and related disclosures in conformity with generallyaccepted accounting principles in the United States and our discussion andanalysis of our financial condition and results of operations requires us tomake judgments, assumptions and estimates that affect the amounts reported inour consolidated financial statements and accompanying notes.  Note 1 of the notes to consolidated financialstatements in Part II, Item 8 of this Form 10-K describes thesignificant accounting policies and methods used in preparation of ourconsolidated financial statements.  Webase our estimates on historical experience, current trends, futureprojections, and on various other assumptions we believe to be reasonable underthe circumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities.  Actual results may differ from theseestimates.  We believe the following tobe our critical accounting estimates because they are both important to theportrayal of our financial condition and results and they require us to makejudgments and estimates about matters that are inherently uncertain.

 

Ourcritical accounting policies and estimates include the following:

 

•                              Revenue recognition;

 

•                              Deferred income taxes and relatedvaluation allowances;

 

•                              Fair value of derivative financialinstrument and our now retired Series A-1 Convertible Preferred Stock;

 

•                              Severance and exit costs;

 

•                              Impairment of long-lived assets; and

 

•                              Allowances for doubtful accounts.

 

*RevenueRecognition*.  We recognize revenue in accordance withStatement of Accounting Position (“SOP”) 97-2, as modified by SOP 98-9.  Revenue recognition in accordance with thesepronouncements is complex due to the nature and variability of our salestransactions.  We recognize productsrevenue upon shipment if a signed contract exists, the fee is fixed ordeterminable, collection of the resulting receivable is probable and productreturns are reasonably estimable.

 

The majority of ourrevenue transactions relate to product–only sales.  On occasion we have revenue transactions thatinclude multiple elements (such as products, maintenance, technical supportservices and other services).  Forsoftware agreements that have multiple elements, we allocate revenue to eachcomponent of the contract based on vendor specific objective evidence (“VSOE”).  VSOE is established when such elements aresold separately.  We recognize revenuewhen the criteria for product revenue recognition set forth above have beenmet.  If VSOE of all undelivered elementsexists, but VSOE does not exist for one or more delivered elements, thenrevenue is recognized using the residual method.  Under the residual method, the fair value ofthe undelivered elements is deferred and the remaining portion of the licensefee is recognized as revenue in the period when persuasive evidence of anarrangement is obtained assuming all other revenue recognition criteria aremet.  We recognize revenue allocated toundelivered products when the criteria for revenue recognition set forth abovehave been met.

 

22

----

 

Estimates used inrevenue recognition include the determination of credit-worthiness of ourcustomers, verification of sales-out reporting to end users through ourtwo-tier distribution channel and the estimation of potential returns.  In addition to these estimates, we alsoprovide reserves against revenue based on historical trends andexperience.  To the extent our estimatesare incorrect, or we are not able to maintain VSOE, our recognized revenuecould be adversely impacted and would harm our results of operations.  Additionally, if our business conditionschange or our revenue contracts begin to contain more multiple elements, ourrevenue recognition in future periods may be impacted because a largercomponent of revenue may be deferred.

 

*DeferredIncome Taxes and Related Valuation Allowance*.  The amount, and ultimate realization, of ourdeferred income tax assets depends, in part, upon the tax laws in effect, ourfuture earnings and other future events, the effects of which cannot bedetermined.  We have provided a valuationallowance of $66,655,000 against our entire net deferred tax asset as of October 31,2004.  The valuation allowance wasrecorded because of our history of net operating losses and the uncertaintiesregarding our future operating profitability and taxable income.

 

*FairValue of Derivative Financial Instrument and Our Retired Series A-1Convertible Preferred Stock*.  In October 2003, we issued 50,000 sharesof our redeemable Series A Convertible Preferred Stock.  The terms of the preferred stock includedconversion and a number of redemption provisions that represented a derivativefinancial instrument under Statement of Financial Accounting Standards (“SFAS”)No. 133, “Accounting for Derivative Instruments and Hedging Activities,”as amended.  We determined that theconversion feature was an embedded derivative financial instrument.

 

As of October 16,2003, through the assistance of an independent valuation firm, we determinedthe initial fair value of the derivative was classified as a current liability$18,069,000 and the value of the preferred stock was $29,671,000.  We were required to account for theconversion feature as an embedded derivative since the preferred stockinstrument did not entitle the holders to equity features such as voting rightsand board representation.  As of October 31,2003, the fair value of the derivative was $15,224,000 and the decrease in fairvalue of $2,845,000 was recorded as income as a change in fair value ofderivative in other income in the statement of operations for fiscal year2003.  During fiscal year 2004, the fairvalue of the derivative decreased and we recorded a total of $5,924,000 asincome as a change in fair value of the derivative in other income.

 

On February 5,2004, we completed an exchange transaction in which each outstanding Series Ashare was exchanged for one share of redeemable Series A-1 ConvertiblePreferred Stock.  We received noadditional proceeds in the exchange.  Theexchange transaction eliminated the derivative related to the Series Ashares that was initially recorded as a current liability on our balance sheetand eliminated the charge in our quarterly statements of operations for thechange in the fair value of the derivative related to the Series A shares.

 

Through the assistanceof an independent valuation firm, we determined the fair value of the Series A-1shares to be $45,276,000 as of February 5, 2004.  We recorded a dividend in the second quarterof fiscal year 2004 of $6,305,000, which reduced earnings available to commonstockholders, related to the difference between the fair value of the Series A-1shares and the carrying value of the previously issued Series A shares andrelated derivative.  This dividend wasonly one component of the total dividends recorded in fiscal year 2004.

 

The estimated fair valueof the Series A-1 shares as of February 5, 2004 was calculated usinga binomial model.  Specific assumptionsused included:  2.7 years to maturity, 11percent equivalent bond yield, risk-free rate of 2.4 percent and volatility of130 percent.  Had different assumptionsbeen used, the valuation result could have been different than reported, andthat difference could have been material. As described elsewhere in this filing, we repurchased all outstanding Series A-1shares on July 21, 2004.  As of October 31,2004, no Series A-1 shares remain outstanding.

 

23

----

 

*Severance and Exit Costs.*  Since fiscal year 2001, we have undertakensignificant restructuring activities to reduce our ongoing cost ofoperations.  All restructurings thatoccurred prior to fiscal year 2003 were accounted for in accordance withEmerging Issues Task Force (“EITF”) No. 94-3 “Liability Recognition forCertain Employee Termination Benefits and Other Costs to Exit an Activity.”  For restructuring activities initiatedbeginning with fiscal year 2003, we have accounted for the one-time terminationbenefits, contract termination costs and other associated costs in accordancewith SFAS No. 146 “Accounting for Costs Associated with Exit or DisposalActivities.”  Other severance benefitshave been accounted for in accordance with SFAS No. 112 “Employers’Accounting for Postemployment Benefits.” and SFAS No. 88 “Employers’Accounting for Settlements and Curtailments of Defined Benefit Plans and forTermination Benefits.”

 

Each restructuring hasrequired us to make estimates and assumptions related to losses on vacatedfacilities, provisions for termination benefits, outplacement costs and othercosts.  Pursuant to the relevantaccounting literature, we may record an accrual for amounts associated with arestructuring that are not paid in the current period.  We regularly evaluate the adequacy of theaccruals based on changes in estimates. We may incur future charges for new restructuring activities.

 

*Impairmentof Long-lived Assets*.  We review our long-lived assets forimpairment when events or changes in circumstances indicate that the book valueof an asset may not be recoverable.  Weevaluate, at each balance sheet date, whether events and circumstances haveoccurred which indicate possible impairment. The carrying value of a long-lived asset is considered impaired when theanticipated cumulative undiscounted cash flows of the related asset or group ofassets is less than the carrying value. In that event, a loss is recognized based on the amount by which thecarrying value exceeds the estimated fair market value of the long-lived asset.

 

We performed animpairment analysis as of April 30, 2004 in accordance with SFAS No. 142,“Goodwill and Other Intangible Assets” and SFAS No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets,” and determined that thegoodwill and intangible assets related to the Vultus technology, which weacquired from Vultus, Inc. (“Vultus”) in June 2003, had beenimpaired.  We concluded that animpairment-triggering event occurred during the second quarter of fiscal year2004 as we had a reduction in force that impacted our ability to move theVultus initiative forward on a stand-alone basis and an anticipated partnershipthat would have solidified the Vultus revenue and cash flow did notmaterialize.  Consequently, we concludedthat no significant future cash flows related to our Vultus assets would berealized.  As a result of these analyses,we wrote-down the carrying value of our goodwill related to the Vultusacquisition from $1,166,000 to $0 and wrote-down intangible assets related toour Vultus acquisition from $973,000 to $0.

 

Based on continueddeclines in our operating results, we performed an additional impairmentanalysis as of October 31, 2004 and determined that the fair value of ourremaining intangible assets was in excess of the current carrying values andthat no impairment had occurred.  Judgmentfrom management is required to determine if a triggering event has occurred andin forecasting future operating results.

 

Write-downs ofintangible assets may be necessary if the future fair value of these assets isless than carrying value.  If the operatingtrends for our UNIX or SCOsource businesses continue to decline we may berequired to record an impairment charge in a future period related to thecarrying value of our long-lived assets.

 

*Allowancefor Doubtful Accounts*.  We offer credit terms on thesale of our products to a majority of our customers and require no collateralfrom these customers.  We perform ongoingcredit evaluations of our customers’ financial condition and maintain anallowance for doubtful accounts based upon our historical collection experienceand expected collectibility of all accounts receivable and have applied thesepolicies consistently throughout the last three fiscal years.  Our allowance for doubtful accounts,

 

24

----

 

which is determined based on our historicalexperience and a specific review of customer balances, was $136,000 as of October 31,2004.  Our past experience has resultedin minimal differences from the actual amounts provided for bad debts and ourrecorded estimates.  However, our actualbad debts in future periods may differ from our current estimates and thedifferences may be material, which may have an adverseimpact on our future accounts receivable and cash position.

 

**Results of Operations**

 

The following tablepresents our results of operations for the fiscal years ended October 31,2004, 2003 and 2002 (in thousands):

 
| ** **                                                     | ** ** | **Years  Ended October 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------|------------|
| **Statement of Operations Data:**                              | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                     | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                       |       |                              |       |   |   |   |   |
| Products                                                       |       | $                                 | 35,352     |   | $ | 45,028 |   | $ | 52,975 |   |
| SCOsource licensing                                            |       | 829                               |       | 25,846 |   | — |   |
| Services                                                       |       | 6,628                             |       | 8,380 |   | 11,266 |   |
| Total revenue                                                  |       | 42,809                            |       | 79,254 |   | 64,241 |   |
| Cost of revenue:                                               |       |                              |       |   |   |   |   |
| Products                                                       |       | 3,221                             |       | 4,068 |   | 7,558 |   |
| SCOsource licensing                                            |       | 19,743                            |       | 9,500 |   | — |   |
| Services                                                       |       | 4,134                             |       | 6,354 |   | 10,758 |   |
| Total cost of revenue                                          |       | 27,098                            |       | 19,922 |   | 18,316 |   |
| Gross margin                                                   |       | 15,711                            |       | 59,332 |   | 45,925 |   |
| Operating expenses:                                            |       |                              |       |   |   |   |   |
| Sales and marketing                                            |       | 17,038                            |       | 24,392 |   | 29,554 |   |
| Research and development                                       |       | 10,612                            |       | 11,012 |   | 17,558 |   |
| General and administrative                                     |       | 7,626                             |       | 6,230 |   | 9,307 |   |
| Severance and exit costs                                       |       | 3,168                             |       | 498 |   | 6,728 |   |
| Amortization of intangibles                                    |       | 2,566                             |       | 3,190 |   | 2,853 |   |
| Loss on disposition and impairment of  long-lived assets       |       | 2,355                             |       | 164 |   | 1,796 |   |
| Write-off of investments                                       |       | —                            |       | 250 |   | 1,180 |   |
| Stock-based compensation                                       |       | 919                               |       | 1,204 |   | 1,125 |   |
| Compensation to law firms                                      |       | —                            |       | 8,956 |   | — |   |
| Total operating expenses                                       |       | 44,284                            |       | 55,896 |   | 70,101 |   |
| Income (loss) from operations                                  |       | (28,573                           | )          | 3,436 |   | (24,176 | ) |
| Equity in income (losses) of affiliates                        |       | 111                               |       | (62 | ) | (50 | ) |
| Other income (expense), net                                    |       | 6,507                             |       | 2,827 |   | (168 | ) |
| Provision for income taxes                                     |       | (1,395                            | )          | (774 | ) | (483 | ) |
| Net income (loss)                                              |       | (23,350                           | )          | 5,427 |   | (24,877 | ) |
|                                                           |       |                              |       |   |   |   |   |
| Dividends on redeemable convertible  preferred stock           |       | 7,123                             |       | (123 | ) | — |   |
| Net income available (loss applicable) to  common stockholders |       | $                                 | (16,227    | ) | $ | 5,304 |   | $ | (24,877 | ) |

 

**Fiscal Years Ended October 31, 2004, 2003and 2002**

 

### ***Revenue***

 
| ** ** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|       |       |     |       |       |       |     |       |       |       |     |       |
| Revenue    |       | $        | 42,809,000 |       | (46        | )%       | $          | 79,254,000 |       | 23       | %          | $ | 64,241,000 |   |
|            |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Revenuefor fiscal year 2004 decreased by $36,445,000, or 46 percent, from fiscal year2003.  This decrease was primarilyattributable to significantly lower SCOsource licensing revenue in the 2004fiscal

 

25

----

 

year compared to the 2003 fiscal year as wellas a continued decline in our UNIX business. Revenue for fiscal year 2003 increased by $15,013,000, or 23 percent,from fiscal year 2002, and this increase was primarily attributable to vendorlicense fees generated from our SCOsource licensing initiatives offset bydecreases in UNIX products and services revenue.

 

Revenuegenerated from our UNIX business and SCOsource business is as follows:

 
| ** **               | ** ** | **2004** | ** ** | **Change** | ** ** | **2003**   | ** ** | **Change** | ** ** | **2002** | ** ** |
|--------------------------|------------|----------|------------|------------|------------|------------|------------|------------|------------|----------|------------|
|                     |       |     |       |       |       |       |       |       |       |     |       |
| UNIX revenue             |       | $        | 41,980,000 |       | (21        | )%         | $          | 53,408,000 |       | (17      | )%         | $ | 64,241,000 |   |
| Percent of total revenue |       | 98       | %          |       |       | 67         | %          |       |       | 100      | %          |
| SCOsource revenue        |       | 829,000  |       | (97        | )%         | 25,846,000 |       | n/a        |       | —   |       |
| Percent of total revenue |       | 2        | %          |       |       | 33         | %          |       |       | 0        | %          |
|                          |            |          |            |            |            |            |            |            |            |          |            |  |  |  |

 

The decrease in revenue in the UNIX business of $11,428,000 for fiscalyear 2004 compared to fiscal year 2003 and the decrease of $10,833,000 forfiscal year 2003 compared to fiscal year 2002 was primarily attributable tocontinued competition from other operating systems, particularly Linux.  We anticipate that for fiscal year 2005 ourtotal UNIX revenue will decline from UNIX revenue generated in fiscal year2004.

 

Thedecrease in SCOsource licensing revenue of $25,017,000 in fiscal year 2004 fromfiscal year 2003 was primarily attributable to minimal vendor licensing revenuein fiscal year 2004 compared to significant vendor licensing revenue generatedin fiscal year 2003 as a result of two large vendor licenses.

 

Sales of our UNIX products and services during fiscal year 2004 wereprimarily to pre-existing customers.  OurUNIX business revenue depends significantly on our ability to market ourproducts to existing customers and to generate upgrades from existingcustomers.  Our UNIX revenue may be lowerthan currently anticipated if we are not successful with our existing customersor if we lose the support of any of our existing hardware and software vendorsor our key industry partners withdraw their marketing and certification supportor direct their support to our competitors. This may occur as a result of the decline of our UNIX business and ourSCOsource initiatives.

 

*Products Revenue*

 
| ** **               | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|--------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                     |       |     |       |       |       |     |       |       |       |     |       |
| Products revenue         |       | $        | 35,352,000 |       | (21        | )%       | $          | 45,028,000 |       | (15      | )%         | $ | 52,975,000 |   |
| Percent of total revenue |       | 83       | %          |       |       | 57       | %          |       |       | 82       | %          |
|                          |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Ourproducts revenue consists of software licenses for UNIX products such asOpenServer and UnixWare, as well as sales of UNIX-related products.  Products revenue also includes revenuederived from OEMs, distribution partners and large accounts.  We rely heavily on our two-tier distributionchannel and any disruption in our distribution channel could have an adverseimpact on future revenue.

 

Thedecrease in products revenue of $9,676,000 from fiscal year 2004 compared tofiscal year 2003 and the decrease of $7,947,000 from fiscal year 2003 comparedto fiscal year 2002 was primarily attributable to decreased sales ofOpenServer and UnixWare products primarily resulting from increased competitionin the operating system market, particularly Linux.  We believe that this competition from Linuxwill continue in fiscal year 2005 and future periods.

 

Our products revenue was derived primarily from sales of our OpenServerand UnixWare products.  Other products revenueconsists mainly of product maintenance and other UNIX-related products.  Revenue for these products was as follows:

 

26

----

 
| ** **                  | ** ** | **2004**   | ** ** | **Change** | ** ** | **2003**   | ** ** | **Change** | ** ** | **2002**   | ** ** |
|-----------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
|                        |       |       |       |       |       |       |       |       |       |       |       |
| OpenServer revenue          |       | $          | 18,467,000 |       | (17        | )%         | $          | 22,162,000 |       | (24        | )%         | $ | 29,108,000 |   |
| Percent of products revenue |       | 52         | %          |       |       | 49         | %          |       |       | 55         | %          |
| UnixWare revenue            |       | 11,125,000 |       | (21        | )%         | 14,083,000 |       | (0         | )%         | 14,154,000 |       |
| Percent of products revenue |       | 32         | %          |       |       | 31         | %          |       |       | 27         | %          |
| Other products revenue      |       | 5,760,000  |       | (34        | )%         | 8,783,000  |       | (10        | )%         | 9,713,000  |       |
| Percent of products revenue |       | 16         | %          |       |       | 20         | %          |       |       | 18         | %          |
|                             |            |            |            |            |            |            |            |            |            |            |            |  |  |  |

 

The decreases in revenue for OpenServer, UnixWare and other productsare all primarily the result of increased competition, particularly from Linuxoperating system providers.

 

*SCOsourceLicensing Revenue*

 
| ** **                  | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       |       |       |     |       |       |       |     |       |
| SCOsource licensing revenue |       | $        | 829,000    |       | (97        | )%       | $          | 25,846,000 |       | n/a      |       | $ | — |   |
| Percent of total revenue    |       | 2        | %          |       |       | 33       | %          |       |       | —   |       |
|                             |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Weinitiated our SCOsource business for the purpose of protecting our intellectualproperty rights in our UNIX source code and derivative works.  SCOsource licensing revenue was $829,000 infiscal year 2004, down significantly from revenue of $25,846,000 generated infiscal year 2003.  We did not generateany revenue from this source in fiscal year 2002.  The SCOsource revenue in fiscal year 2004 wasprimarily attributable to SCOsource IP license sales and the SCOsourcelicensing revenue in fiscal year 2003 was primarily attributable to feesassociated with two significant vendor licenses.  We believe and allege that our decrease inrevenue in fiscal year 2004 was in part attributable to our outstanding disputewith Novell over our UNIX copyright ownership, which may have caused potential customersto delay or forego licensing until an outcome in this legal matter has beenreached.

 

Weare unable to predict the amount and timing of future SCOsource licensingrevenue, and, when generated, we expect that such revenue will be sporadic.

 

*Services Revenue*

 
| ** **               | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|--------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                     |       |     |       |       |       |     |       |       |       |     |       |
| Services revenue         |       | $        | 6,628,000  |       | (21        | )%       | $          | 8,380,000  |       | (26      | )%         | $ | 11,266,000 |   |
| Percent of total revenue |       | 15       | %          |       |       | 11       | %          |       |       | 18       | %          |
|                          |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Servicesrevenue consists primarily of annual and incident technical support fees,engineering services fees, professional services and consulting fees, andeducation fees.  These fees are typicallycharged and invoiced separately from UNIX products sales.  The decrease in services revenue of$1,752,000, or 21 percent, from fiscal year 2003 as compared to fiscal year2004 as well as the decrease in services revenue in fiscal year 2002, comparedto fiscal year 2003 of $2,886,000, or 26 percent, was in part due to thedecrease in products revenue as well as fewer customers renewing servicesagreements.

 

Themajority of our support and professional services revenue continues to bederived from services for UNIX-based operating system products.  Our future level of services revenue dependsin part on our ability to generate UNIX products revenue from new customers aswell as to renew annual support and services agreements with existing UNIXcustomers.

 

*Cost of Products Revenue*

 
| ** **                     | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|--------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                           |       |     |       |       |       |     |       |       |       |     |       |
| Cost of products revenue       |       | $        | 3,221,000  |       | (21        | )%       | $          | 4,068,000  |       | (46      | )%         | $ | 7,558,000 |   |
| Percentage of products revenue |       | 9        | %          |       |       | 9        | %          |       |       | 14       | %          |
|                                |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

27

----

 

Costof products revenue consists of manufacturing costs, royalties to third-partyvendors, technology costs and overhead costs. Cost of products revenue decreased by $847,000, or 21 percent, in fiscalyear 2004 as compared to fiscal year 2003 and decreased by $3,490,000, or 46percent, in fiscal year 2003 compared to fiscal year 2002.  This decrease in cost of products revenue wasprimarily attributable to lower products revenue, lower manufacturing costs,decreased royalties to third party vendors and lower amortized technologycosts.

 

Forfiscal year 2005, we expect the dollar amount of our cost of products revenueto be less than in fiscal year 2004 and, as a percentage of products revenue,to be consistent with the percentage achieved during fiscal year 2004.

 

*Cost ofSCOsource Licensing Revenue*

 
| ** **                                | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|-------------------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                                      |       |     |       |       |       |     |       |       |       |     |       |
| Cost of SCOsource licensing revenue       |       | $        | 19,743,000 |       | 108        | %        | $          | 9,500,000  |       | n/a      |       | $ | — |   |
| Percentage of SCOsource licensing revenue |       | 2382     | %          |       |       | 37       | %          |       |       | —   |       |
|                                           |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Costof SCOsource licensing revenue includes legal and professional fees incurred inconnection with our SCO Litigation, the salaries and related personnel costs ofSCOsource employees, and an allocation of corporate costs.

 

Costof SCOsource licensing revenue increased by $10,243,000, or 108 percent, duringfiscal year 2004 as compared to fiscal year 2003.  The increase in costs in fiscal year 2004compared to fiscal year 2003 was primarily attributable to increased legalcosts incurred in connection with our SCO Litigation.

 

With the completion of the EngagementAgreement with the Law Firms representing us in our SCO Litigation as describedelsewhere in this filing, we anticipate that the dollar amount of our cost ofSCOsource licensing for fiscal year 2005 will be lower than fiscal year 2004.  However, future legal fees may includecontingency payments made to the Law Firms as a result of a settlement,judgment, certain licensing fees or a sale of our company, which could causecost of SCOsource licensing revenue for fiscal year 2005 to be higher thanfiscal year 2004.

 

*Cost of Services Revenue*

 
| ** **                     | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|--------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                           |       |     |       |       |       |     |       |       |       |     |       |
| Cost of services revenue       |       | $        | 4,134,000  |       | (35        | )%       | $          | 6,354,000  |       | (41      | )%         | $ | 10,758,000 |   |
| Percentage of services revenue |       | 62       | %          |       |       | 76       | %          |       |       | 95       | %          |
|                                |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Costof services revenue includes the salaries and related personnel costs ofemployees delivering services revenue as well as third-party serviceagreements.  Cost of services revenuedecreased by $2,220,000, or 35 percent, for fiscal year 2004 compared to fiscalyear 2003 and decreased by $4,404,000, or 41 percent, for fiscal year 2003 comparedto fiscal year 2002.  This decreasewas attributable to reduced employee and related costs and the elimination ofcertain third-party support contracts.

 

For fiscal year 2005, we expect the dollar amount of our cost ofservices revenue to be less than that incurred in fiscal year 2004 and thatcost of services revenue as a percentage of services revenue will be lower infiscal year 2005 as compared to fiscal year 2004.

 

28

----

 

*Sales and Marketing*

 
| ** **                  | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       |       |       |     |       |       |       |     |       |
| Sales and marketing expense |       | $        | 17,038,000 |       | (30        | )%       | $          | 24,392,000 |       | (17      | )%         | $ | 29,554,000 |   |
| Percentage of total revenue |       | 40       | %          |       |       | 31       | %          |       |       | 46       | %          |
|                             |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Salesand marketing expenses consist of the salaries, commissions and other personnelcosts of employees involved in the revenue generation process, as well asadvertising and corporate allocations. The decrease in sales and marketing expense of $7,354,000, or 30percent, from fiscal year 2003 to fiscal year 2004 and the decrease from fiscalyear 2002 to fiscal year 2003 of $5,162,000, or 17 percent, was primarily attributableto reductions in sales and marketing employees, reduced travel expenses, lesscommissions and lower advertising costs. Sales and marketing expense as a percentage of revenue increased duringfiscal year 2004 as compared to fiscal year 2003 as a result of lower revenuein the 2004 fiscal year.  Our sales andmarketing full-time equivalent employees decreased from 133 as of October 31,2002, to 114 as of October 31, 2003, to 62 as of October 31, 2004.

 

Forfiscal year 2005, we anticipate that the dollar amount of sales and marketingexpense will decrease from fiscal year 2004.

 

*Research and Development*

 
| ** **                       | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|----------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                             |       |     |       |       |       |     |       |       |       |     |       |
| Research and development expense |       | $        | 10,612,000 |       | (4         | )%       | $          | 11,012,000 |       | (37      | )%         | $ | 17,558,000 |   |
| Percentage of total revenue      |       | 25       | %          |       |       | 14       | %          |       |       | 27       | %          |
|                                  |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Researchand development expenses consist of the salaries and benefits of softwareengineers, consulting expenses and corporate allocations.  Research and development expense decreased by$400,000, or 4 percent, from fiscal year 2004 compared to fiscal year2003.  During fiscal year 2004 ourengineering efforts were focused on the release of UnixWare 7.1.4 and thecontinued development of the next release for our OpenServer product.  These development efforts required us tomaintain our research and development infrastructure which limited our abilityto cut costs in this area as significantly as we have done in other areas.  The decrease in research and developmentexpense in fiscal year 2003 of $6,546,000, or 37 percent, compared to fiscalyear 2002 was primarily attributable to work force reductions.  Research and development expense as apercentage of revenue increased in fiscal year 2004 as compared to fiscal year2003 as a result of lower revenue in fiscal year 2004.  Our research and development full-timeequivalent employees decreased from 75 for fiscal years ended October 31,2002 and 2003 to 64 as of October 31, 2004.

 

Forfiscal year 2005, we anticipate that the dollar amount of research anddevelopment expenses will decrease from fiscal year 2004.

 

*General and Administrative*

 
| ** **                         | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|------------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                               |       |     |       |       |       |     |       |       |       |     |       |
| General and administrative expense |       | $        | 7,626,000  |       | 22         | %        | $          | 6,230,000  |       | (33      | )%         | $ | 9,307,000 |   |
| Percentage of total revenue        |       | 18       | %          |       |       | 8        | %          |       |       | 14       | %          |
|                                    |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Generaland administrative expenses consist of the salaries and benefits of finance,human resources, and executive management and expenses for professionalservices such as legal and accounting services and corporate allocations.  General and administrative expense increasedby $1,396,000, or 22 percent, during fiscal year 2004 as compared to fiscalyear 2003.  The increase in general andadministrative expense was primarily attributable to increased legal costs as aresult of corporate and regulatory legal matters not classified as cost ofSCOsource licensing revenue and increased fees from

 

29

----

 

other professional service providers.  The decrease in general and administrativeexpense from fiscal year 2002 to fiscal year 2003 of $3,077,000, or 33 percent,was primarily attributable to staff centralization.  General and administrative expenses as a percentof total revenue increased in fiscal year 2004 as a result of increased costsand lower revenue.  Our general andadministrative full-time equivalent employees decreased from 61 as of October 31,2002, to 55 as of October 31, 2003, to 36 as of October 31, 2004.

 

Forfiscal year 2005, we anticipate that the dollar amount of general andadministrative expenses will decrease from fiscal year 2004.  However, due to the new compliance andreporting regulations under the Sarbanes-Oxley Act and other new regulatoryrequirements, general and administrative expenses may vary as we implementpolicies and procedures to comply with these new requirements.

 

*Severance and ExitCosts*

 
| ** **                  | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       |       |       |     |       |       |       |     |       |
| Severance and exit costs    |       | $        | 3,168,000  |       | 536        | %        | $          | 498,000    |       | (93      | )%         | $ | 6,728,000 |   |
| Percentage of total revenue |       | 7        | %          |       |       | 1        | %          |       |       | 10       | %          |
|                             |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

During fiscal years 2004, 2003 and 2002, werecorded severance and exit costs totaling $3,168,000, $498,000 and $6,728,000,respectively.  The severance and exitcosts for fiscal years 2004, 2003 and 2002 were comprised of terminationpayments made to employees in connection with reductions in headcount, closureof certain facilities and adjustments to previously recorded amounts as actualpayments made were less than recorded accruals. The variation in severance and exit costs from fiscal year 2004 comparedto fiscal year 2003 and from fiscal year 2003 compared to fiscal year 2002 is aresult of the number of terminated employees and the size and number offacilities closed.

 

The detail of the severance and exit costs for fiscal years 2004, 2003and 2002, are as follows (in thousands): 

 
| **Fiscal 2004**             | ** ** | **Balance at  November 1, 2003** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance at  October 31, 2004** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|---------------------------------------|------------|
|                        |       |                                  |       |          |       |            |       |            |       |                                  |       |
| One-time severance          |       | $                                     | —     |          | $          | 309             |       | $               | —     |                                  | $          | (309 | ) | $ | — |   |
| Ongoing severance and other |       | —                                |       | 2,071         |       | —          |       | (1,670          | )          | 401                                   |       |
| Facilities                  |       | 348                                   |       | 788           |       | —          |       | (1,136          | )          | —                                |       |
| Total                       |       | $                                     | 348        |          | $          | 3,168           |       | $               | —     |                                  | $          | (3,115 | ) | $ | 401 |   |

 
| **Fiscal  2003**            | ** ** | **Balance at  November 1, 2002** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance at  October 31, 2003** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|---------------------------------------|------------|
|                        |       |                                  |       |          |       |            |       |            |       |                                  |       |
| One-time severance          |       | $                                     | —     |          | $          | 198             |       | $               | —     |                                  | $          | (198 | ) | $ | — |   |
| Ongoing severance and other |       | 560                                   |       | 1,388         |       | (273            | )          | (1,675          | )          |                                  |       |
| Facilities                  |       | 2,117                                 |       | —        |       | (815            | )*         | (954            | )          | 348                                   |       |
| Total                       |       | $                                     | 2,677      |          | $          | 1,586           |       | $               | (1,088     | )                                     | $          | (2,827 | ) | $ | 348 |   |

 

----

* The facilities adjustment of $815,000 was theresult of successfully negotiating out of lease commitments in connection withour winding down of SCO Group, Ltd. in the United Kingdom.

 
| **Fiscal  2002**    | ** ** | **Balance  at  November 1, 2001** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance  at  October 31, 2002** | ** ** |
|---------------------|------------|----------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|----------------------------------------|------------|
|                |       |                                   |       |          |       |            |       |            |       |                                   |       |
| Severance and other |       | $                                      | 692        |          | $          | 4,053           |       | $               | —     |                                   | $          | (4,185 | ) | $ | 560 |   |
| Facilities          |       | 2,052                                  |       | 4,236         |       | (1,561          | )*         | (2,610          | )          | 2,117                                  |       |
| Total               |       | $                                      | 2,744      |          | $          | 8,289           |       | $               | (1,561     | )                                      | $          | (6,795 | ) | $ | 2,677 |   |

 

30

----

 

----

*****The facilitiesadjustment of $1,561,000 was the result of successfully re-negotiating anexisting lease commitment.

 

Amounts to be paid for severance and exit costs areincluded as accrued liabilities.

 

*Amortization of Intangibles*

 
| ** **                  | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       |       |       |     |       |       |       |     |       |
| Amortization of intangibles |       | $        | 2,566,000  |       | (20        | )%       | $          | 3,190,000  |       | 12       | %          | $ | 2,853,000 |   |
| Percentage of total revenue |       | 6        | %          |       |       | 4        | %          |       |       | 4        | %          |
|                             |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Duringfiscal years 2004, 2003 and 2002, we recorded $2,566,000, $3,190,000 and$2,853,000, respectively, for the amortization of intangible assets with finitelives.  The decrease of $624,000, or 20percent, from fiscal year 2004 compared to fiscal year 2003 was primarilyattributable to reduced amortization expense recorded on certain assetsacquired from Vultus that were written down to $0 during fiscal year 2004 andtherefore were not amortized for the last half of fiscal year 2004.  The increase of $337,000 in fiscal year 2003over fiscal year 2002 was attributed to amortization expense on assets acquiredfrom Vultus.

 

*Loss on Disposition and Impairment of Long-lived Assets*

 
| ** **                                               | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|----------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                                                     |       |     |       |       |       |     |       |       |       |     |       |
| Loss on disposition and write-down of  long-lived assets |       | $        | 2,355,000  |       | 1336       | %        | $          | 164,000    |       | (91      | )%         | $ | 1,796,000 |   |
| Percentage of total revenue                              |       | 6        | %          |       |       | 0        | %          |       |       | 3        | %          |
|                                                          |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Duringfiscal years 2004, 2003 and 2002, we recorded a write down of long-livedassets of $2,355,000, $164,000 and $1,796,000, respectively.  The loss on disposition and write-down oflong-lived assets recorded in fiscal year 2004 primarily related to goodwilland intangible assets acquired in connection with our acquisition of Vultus in June 2003.  We concluded that an impairment triggeringevent occurred during fiscal year 2004 as we had a reduction in force thatimpacted our ability to move the Vultus initiative forward on a stand-alonebasis and because an anticipated partnership that would have solidified theVultus revenue and cash flow opportunities did not materialize.  Consequently, we have concluded that nosignificant future cash flows related to our Vultus assets will be realized.  The loss on disposition and write-down oflong-lived assets recorded in fiscal years 2003 and 2002 were primarilyattributable to assets written off in connection with restructurings thatoccurred during each fiscal year.

 

*Write-offs of Investments*

 
| ** **                  | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       |       |       |     |       |       |       |     |       |
| Write-offs of investments   |       | $        | —     |       | n/a        |     | $          | 250,000    |       | (79      | )%         | $ | 1,180,000 |   |
| Percentage of total revenue |       | 0        | %          |       |       | 0        | %          |       |       | 2        | %          |
|                             |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Management routinely assesses our investmentsfor impairments and adjusts the carrying amounts to estimated realizable valueswhen impairment has occurred.  Duringfiscal year 2004, we did not have any write-offs of investments.  During fiscal year 2003, in connection withthe restructuring of our investment in and relationship with Vista.com, Inc.(“Vista”), we recorded a write-off of our Vista investment and incurred acharge of $250,000.  We had beenaccounting for our investment in Vista under the equity method of accounting.

 

During fiscal year 2002, we determined thatthe current carrying value of $1,180,000 related to our investment in Lineo, Inc.(“Lineo”) would not be recovered and was written off.  This write-off was

 

31

----

 

dueto a significant deterioration in the operating results of Lineo and declinesin general economic conditions.  Thisinvestment had been accounted for under the cost method.

 

*Stock-based Compensation*

 
| ** **                  | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       |       |       |     |       |       |       |     |       |
| Stock-based compensation    |       | $        | 919,000    |       | (24        | )%       | $          | 1,204,000  |       | 7        | %          | $ | 1,125,000 |   |
| Percentage of total revenue |       | 2        | %          |       |       | 2        | %          |       |       | 2        | %          |
|                             |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

Stock-based compensation consisted of the following components forfiscal years 2004, 2003 and 2002 (in thousands):

 
| ** **                                                               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                     |       |     |       |     |       |     |       |
| Amortization of stock-based compensation                                 |       | $        | 325        |     | $          | 866      |       | $ | 986 |   |
| Reversal of previously recorded expense  related to terminated employees |       | —   |       | —   |       | (565     | )          |
| Options, warrants and shares for services                                |       | 502      |       | 296      |       | 631      |       |
| Modifications to options                                                 |       | 92       |       | 42       |       | 73       |       |
| Total                                                                    |       | $        | 919        |     | $          | 1,204    |       | $ | 1,125 |   |

 

As of October 31, 2004, there was a balance of approximately $22,000in deferred compensation that will be amortized to stock-based compensationduring fiscal year 2005.

 

*Compensation to Law Firms*

 
| ** **                  | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** | **Change** | ** ** | **2002** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       |       |       |     |       |       |       |     |       |
| Compensation to law firms   |       | $        | —     |       | n/a        |     | $          | 8,956,000  |       | n/a      |       | $ | — |   |
| Percentage of total revenue |       | 0        | %          |       |       | 11       | %          |       |       | 0        | %          |
|                             |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

During fiscal year 2003,we incurred contingency fees of $8,956,000, or 11 percent of revenue, relatedto our arrangement with the Law Firms representing us in the SCO Litigation inconnection with the issuance of shares of our now retired Series AConvertible Preferred Stock.  Allpayments to the Law Firms for legal fees incurred in connection with the SCOLitigation have been classified as cost of SCOsource licensing revenue.

 

*Equityin Income (Losses) of Affiliate*

 

We account for ourownership interests in companies in which we own at least 20 percent and lessthan 50 percent using the equity method of accounting.  Under the equity method, we record ourportion of the entities’ net income or net loss in our consolidated statementsof operations.  As of October 31,2004, the carrying value of our investments was related to our 30 percentownership in a Chinese company.

 

Duringfiscal years 2004, 2003 and 2002, we recorded $111,000, ($62,000) and($50,000), respectively, that related to net income (losses) in theseentities.  The income reported in fiscalyear 2004 was attributable to our portion of the net income generated by theabove mentioned Chinese company.  Thelosses in the 2003 and 2002 fiscal years were primarily attributable to lossesgenerated from Vista.

 

*OtherIncome (Expense), net*

 

Other income (expense) consisted of the following components for fiscalyears 2004, 2003 and 2002 (in thousands):

 

32

----

 
| ** **                         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                               |       |     |       |     |       |     |       |
| Interest income                    |       | $        | 905        |     | $          | 188      |       | $ | 377 |   |
| Interest expense                   |       | —   |       | (3       | )          | (206     | )          |
| Change in fair value of derivative |       | 5,924    |       | 2,845    |       | —   |       |
| Other expense, net                 |       | (322     | )          | (203     | )          | (339     | )          |
| Total other income (expense), net  |       | $        | 6,507      |     | $          | 2,827    |       | $ | (168 | ) |

 

Interest income increased by $717,000 from fiscal year 2003 to fiscalyear 2004 and decreased by $189,000 from fiscal year 2003 to fiscal year2002.  The changes in interest income arethe result of changes in our cash and available-for-sale securities balances.

 

 Interest expense decreased by$203,000 from fiscal year 2002 compared to fiscal year 2003 as a result ofinterest expense recorded in the 2002 fiscal year on our outstanding notepayable to The Santa Cruz Operation. This note payable was paid during fiscal year 2002.

 

The income recorded on the change in fair value of derivative forfiscal year 2004 and fiscal year 2003 related to the decrease in fair value ofthis instrument and marking it to market at each balance sheet date.  The derivative financial instrument waseliminated during the second quarter of fiscal year 2004.

 

*Provision for Income Taxes*

 

The provision for income taxes was $1,395,000 infiscal year 2004, $774,000 in fiscal year 2003 and $483,000 in fiscal year2002.  The increase in the provision for income taxesof $621,000 in fiscal year 2004 compared to fiscal year 2003 was primarilyattributable to accruals for withholding taxes that are estimated to be paid inconnection with the operations of our Indian operations.  Other than the accrual previously mentioned,our provision for income taxes is primarily related to earnings in foreignsubsidiaries.

 

As of October 31, 2004, we had net operatingloss carry-forwards for U.S. federal and state income tax reporting purposes ofapproximately $121,448,000 that expire at various dates between 2019 and2024.  We had net deferred tax assets,including net operating loss carry-forwards and other temporary differencesbetween book and tax deductions, totaling approximately $67,087,000 as of October 31,2004.  We also had net deferred taxliabilities of approximately $432,000 related to taxes on foreignearnings.  A valuation allowance in theamount of $66,655,000, the difference between our deferred tax assets andliabilities, has been recorded as of October 31, 2004 as a result ofuncertainties regarding the ultimate realizability of the net deferred taxasset balance.

 

### ***DividendsRelated to Series A and Series A-1 Convertible Preferred****Stock*

 

### **In October 2003, we issued 50,000 shares of our Series AConvertible Preferred Stock for $1,000 per share.   In connection with completing the February 5,2004 exchange of shares of Series A-1 Convertible Preferred Stock foroutstanding Series A shares, we removed the carrying value of the Series Ashares and related derivative and recorded the fair value of the Series A-1shares issued in the exchange transaction. The difference between these two amounts was $6,305,000 and was recordedas a non-cash dividend in fiscal year 2004.**

 

With the completion of the repurchase transaction with BayStar Capital II,L.P. (“BayStar”) during fiscal year 2004, as a result of which no Series A-1shares remain outstanding, we will not be required to continue to accrue or payany dividends on the Series A-1 shares. As a result of completing the repurchase transaction with BayStar, werecorded a capital contribution in the amount of $15,475,000, which representedthe difference in the carrying value of the Series A-1 shares and accrueddividends less the fair value of the 2,105,263 shares of common stock and the$13,000,000 in cash.

 

33

----

 

If the repurchase hadnot occurred, dividends on the Series A-1 shares would have been paidafter October 16, 2004, the first anniversary of the original Series Aprivate placement, quarterly at a rate of 8 percent per annum, subject toannual increases of 2 percent per annum, not to exceed 12 percent perannum.  We will no longer accruedividends on preferred stock because the Series A-1 shares wererepurchased.  No dividends were paid onthe Series A or Series A-1 shares.

 

The following tabledetails the components of the dividends for fiscal years 2004, 2003 and 2002(in thousands):

 
| ** **                                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                         |       |     |       |     |       |     |       |
| Accrual of dividends on preferred stock                      |       | $        | (2,047     | )        | $          | (123     | )          | $ | — |   |
| Exchange of Series A shares for  Series A-1 shares |       | (6,305   | )          | —   |       | —   |       |
| Repurchase of Series A-1 shares from  BayStar           |       | 15,475   |       | —   |       | —   |       |
| Total                                                        |       | $        | 7,123      |     | $          | (123     | )          | $ | — |   |

 

**Quarterly Results of Operations**

 

Thefollowing table sets forth certain unaudited quarterly statement of operationsdata for the last eight quarters.  Thisinformation has been derived from our unaudited consolidated financialstatements, which, in management’s opinion, have been prepared on the samebasis as the audited financial statements and include all adjustments,consisting only of normal recurring adjustments, necessary for a fairpresentation of the information for the quarters presented.  This information should be read in conjunctionwith the audited consolidated financial statements and related notes includedelsewhere in this Form 10-K.  Theoperating results for any quarter are not necessarily indicative of theoperating results for any future period.

 
| ** **                                                     | ** ** | **Quarter Ended**                                      | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                     | ** ** | **January 31,  2004**                             | ** ** | **April 30,  2004** | ** ** | **July 31,  2004** | ** ** | **October 31,  2004** | ** ** |
| ** **                                                     | ** ** | **(unaudited)  (In thousands, except per share data)** | ** ** |
| **Fiscal Year 2004**                                           |       |                                                   |       |   |   |   |   |   |   |
| Revenue                                                        |       | $                                                      | 11,392     |   | $ | 10,137 |   | $ | 11,205 |   | $ | 10,075 |   |
| Gross margin                                                   |       | 5,742                                                  |       | 3,679 |   | 2,190 |   | 4,100 |   |
| Loss from operations                                           |       | (5,402                                                 | )          | (9,174 | ) | (7,387 | ) | (6,610 | ) |
| Net income available (loss applicable) to  common stockholders |       | (2,486                                                 | )          | (14,726 | ) | 7,501 |   | (6,516 | ) |
| Net income (loss) per common share                             |       |                                                   |       |   |   |   |   |   |   |
| Basic                                                          |       | $                                                      | (0.18      | ) | $ | (1.04 | ) | $ | 0.49 |   | $ | (0.37 | ) |
| Diluted                                                        |       | $                                                      | (0.18      | ) | $ | (1.04 | ) | $ | 0.38 |   | $ | (0.37 | ) |
| Weighted average basic common shares                           |       | 13,824                                                 |       | 14,100 |   | 15,242 |   | 17,436 |   |
| Weighted average diluted common shares                         |       | 13,824                                                 |       | 14,100 |   | 19,912 |   | 17,436 |   |
|                                                           |       |                                                   |       |   |   |   |   |   |   |
| ** **                                                     | ** ** | **Quarter  Ended**                                     | ** ** |
| ** **                                                     | ** ** | **January 31,  2003**                             | ** ** | **April 30,  2003** | ** ** | **July 31,  2003** | ** ** | **October 31,  2003** | ** ** |
| ** **                                                     | ** ** | **(unaudited)  (In thousands, except per share data)** | ** ** |
| **Fiscal Year 2003**                                           |       |                                                   |       |   |   |   |   |   |   |
| Revenue                                                        |       | $                                                      | 13,540     |   | $ | 21,369 |   | $ | 20,055 |   | $ | 24,290 |   |
| Gross margin                                                   |       | 10,662                                                 |       | 16,222 |   | 15,521 |   | 16,927 |   |
| Income (loss) from operations                                  |       | (738                                                   | )          | 4,925 |   | 3,410 |   | (4,161 | ) |
| Net income available (loss applicable) to  common stockholders |       | (724                                                   | )          | 4,500 |   | 3,096 |   | (1,568 | ) |
| Net income (loss) per common share:                            |       |                                                   |       |   |   |   |   |   |   |
| Basic                                                          |       | $                                                      | (0.06      | ) | $ | 0.39 |   | $ | 0.25 |   | $ | (0.12 | ) |
| Diluted                                                        |       | $                                                      | (0.06      | ) | $ | 0.33 |   | $ | 0.19 |   | $ | (0.12 | ) |
| Weighted average basic common shares                           |       | 11,244                                                 |       | 11,561 |   | 12,469 |   | 13,371 |   |
| Weighted average diluted common shares                         |       | 11,244                                                 |       | 13,663 |   | 16,180 |   | 13,371 |   |

 

34

----

 

# **Fluctuations inQuarterly Results**

 

Factors that may affect quarterly resultsinclude:

 

•                  the interest level of solution providers inrecommending UNIX business solutions to end users;

 

•                  the contingency fees we may pay to the LawFirms representing us in the SCO Litigation;

 

•                  the level, magnitude and timing of SCOsourcelicense revenue;

 

•                  the amount of legal fees incurred inconnection with the SCO Litigation;

 

•                  the introduction, development, timing,competitive pricing and market acceptance of our products and services andthose of our competitors;

 

•                  changes in general economic conditions thatcould affect capital expenditures in the UNIX market; and

 

•                  changing business attitudes toward UNIX as aviable operating system alternative to other competing systems, especiallyLinux.

 

As a result of the factors listed above andelsewhere in the “Forward-Looking Statements and Factors That May AffectFuture Results and Financial Condition” and “Risk Factors” section of thisForm 10-K, it is possible that in some future periods our results of operationsmay fall below management’s expectations as well as the expectations of publicmarket analysts and investors.  Ifrevenue falls below management’s expectations in any quarter and we are unableto reduce expenses, our operating results will be lower than expected.

 

# **Liquidity and CapitalResources**

 

Ourcash and equivalents balance decreased from $64,428,000 as of October 31,2003 to $12,693,000 as of October 31, 2004.  During this same time period, our investmentin available-for-sale securities increased from $4,095,000 to $18,756,000.  Total cash and equivalents and available-forsale securities were $31,449,000 as of October 31, 2004.  We also have $5,000,000 classified as acomponent of restricted cash set aside to cover expert and other costs relatedto our SCO Litigation.  During fiscalyear 2004, we expended a significant amount of cash for our intellectualproperty litigation and for our UNIX business.

 

Duringfiscal year 2003, we generated positive cash flow for the first time in ouroperating history.  This was primarilyachieved through significant license revenue generated from our SCOsourcebusiness.  We also received cash infiscal year 2003 from the sale of 50,000 shares of our now retired Series AConvertible Preferred Stock.

 

Weintend to use the cash and equivalents and available-for-sale securities as of October 31,2004 to maintain our UNIX business and pursue our SCO Litigation.  We believe that we will have sufficient cashresources to fund our current operations for the next 12 months.

 

Ournet cash used in operations during fiscal year 2004 was $22,604,000 and wasattributable to a net loss of $23,350,000, non-cash items of $922,000 andchanges in operating assets and liabilities of $176,000.  Our working capital decreased from $37,168,000as of October 31, 2003 to $15,413,000 as of October 31, 2004.

 

Ournet cash provided by operations during fiscal year 2003 was $12,087,000.  Cash provided by operations was attributableto net income of $5,427,000, non-cash items totaled $11,610,000 and changes inoperating assets and liabilities of $4,950,000. Our long-term liabilities decreased from $1,625,000 to $508,000 duringfiscal year 2003.

 

35

----

 

Cash used in operations during fiscal year 2002was $10,592,000 and was primarily attributable to the net loss of $24,877,000,partially offset by non-cash items of $10,101,000 and cash provided by changesin operating assets and liabilities of $4,184,000.

 

Our investing activities have historically consistedof equipment purchases, investing in strategic partners and the purchase andsale of available-for-sale securities. During fiscal year 2004, cash used in investing activities was$15,443,000, which was primarily a result of purchases, net of sales, ofavailable-for-sale securities of $14,728,000, purchases of equipment of$506,000 and the purchase of the remaining minority interest in our Japanesesubsidiary of $209,000.

 

During fiscal year 2003, cash used in investingactivities was $5,512,000, which was primarily a result of our purchase ofavailable-for-sale securities of $4,095,000, equipment purchases of $467,000and our investment in non-marketable securities of $950,000.

 

During fiscal year 2002, cash provided byinvesting activities was $5,287,000, which was primarily generated from thesale of $5,943,000 of available-for-sale securities, offset by an investment ina non-marketable security of $350,000, cash paid for the purchase of equipmentof $206,000 and payment of $100,000 to The Santa Cruz Operation.

 

Our financing activities used $13,864,000 ofcash in fiscal year 2004.  The primaryuses of cash were $13,000,000 used for the repurchase and retirement of sharesof our Series A-1 Convertible Preferred Stock, $2,414,000 for the purchaseof shares of our common stock on the open market and $211,000 paid inconnection with the issuance of the Series A-1 in exchange for outstandingSeries A shares.  These uses of cashwere offset by proceeds generated from the exercise of options to acquire commonstock of $951,000 and proceeds of $810,000 received from the sale of commonstock through the ESPP.

 

Our financing activities provided $50,888,000of cash during the fiscal year 2003 and consisted primarily of net proceeds of$47,740,000 generated from our issuance of 50,000 now retired Series Ashares.  Additional financing activitiesincluded proceeds received from the exercise of stock options of $2,056,000,proceeds from the purchase of shares of common stock by our employees throughour ESPP of $236,000 and proceeds from the issuance of warrants of $856,000.

 

Our financing activities used $8,998,000 ofcash during fiscal year 2002 and consisted primarily of a $5,000,000 payment toretire the note payable to The Santa Cruz Operation and $4,584,000 for thepurchase of shares of our common stock held by two investors.  These payments were offset by $291,000 ofproceeds received from the exercise of stock options and $295,000 received fromemployees who purchased shares of our common stock through our employee stockpurchase program.

 

Our net accountsreceivable balance decreased from $9,282,000 as of October 31, 2003 to$6,638,000 as of October 31, 2004, primarily as a result of lowerinvoicing and revenue in the fourth quarter of fiscal year 2004 as compared tothe fourth quarter of fiscal year 2003. The majority of our accounts receivable are current and our allowancefor doubtful accounts was $136,000 as of October 31, 2004, whichrepresented approximately 2 percent of our gross accounts receivablebalance.  This percentage of grossaccounts receivable is consistent with our experience in prior periods, and weexpect this trend to continue.  Ourwrite-offs of uncollectible accounts during fiscal years 2004 and 2003 were notsignificant.

 

OnOctober 31, 2004, we entered into the Engagement Agreement the LawFirms.  The Engagement Agreementsupercedes and replaces the original engagement agreement that was entered intoin February 2003.  The EngagementAgreement governs the relationship between us and the Law Firms in connectionwith their representation of us in the SCO Litigation, through the end of thecurrent litigation between us and IBM. This litigation is described in more detail under Part I, Item 3 ofthis Form 10-K.  Our purpose inentering into this Engagement Agreement was to limit the cash expendituresneeded to pursue the SCO Litigation.  TheEngagement Agreement provides for the payment of

 

36

----

 

approximately $26,000,000 for certain previouslyaccrued expenses, totaling $13,906,000 as of October 31, 2004, and allfuture attorney fees in connection with the SCO Litigation through the end ofthe current litigation between us and IBM and the escrow of at least $5,000,000for the payment of any expert, consulting and other expenses.  As of October 31, 2004, this $5,000,000was classified as a component of restricted cash.  We paid the $13,906,000 subsequent to October 31,2004.

 

Future legal feescovered under the Engagement Agreement will require us to pay to the Law Firms$2,000,000 per quarter for each successive quarter beginning September 1,2004 and ending December 1, 2005 for a total amount of $12,000,000, ofwhich $10,000,000 will be paid in fiscal year 2005.  In the first quarter of fiscal year 2005, wemade the quarterly payments for September 2004 as well as December 2004for a total of $4,000,000.  The paymentof these fees has had and will continue to have a material impact on our cashposition.

 

Inaddition to the cash expenditures mentioned above, we must also pay one or morecontingency fees upon any amount we or our stockholders may receive as arecovery from our litigation, our intellectual property licensing or a sale ofour company.  The contingency fee amountspayable to the Law Firms will be, subject to certain credits and adjustments,as follows:

 

•                  33 percent of any aggregate recovery amountsreceived up to $350,000,000;

 

•                  plus 25 percent of any aggregate recoveryamounts above $350,000,000 but less than or equal to $700,000,000;

 

•                  plus 20 percent of any aggregate recoveryamounts in excess of $700,000,000.

 

TheEngagement Agreement specifically provides that, except for the compensationobligations specifically described above, we will not be obligated to pay anylegal fees, whether hourly, contingent or otherwise, to the Law Firms, or anyother law firms that may be engaged by the Law Firms, in connection with theSCO Litigation through the end of the current litigation between us and IBM,including any appeals.

 

Wehave entered into operating leases for our corporate offices located in theUnited States and our international sales offices.  We have commitments under these leases thatextend through fiscal year 2010.

 

Thefollowing table summarizes our contractual operating lease obligations and ourrequired payments to the Law Firms as of October 31, 2004:

 
| ** **                  | ** ** | **Total**  | ** ** | **Less than  1 year** | ** ** | **1 – 3 years** | ** ** | **More than  3 years** | ** ** |
|-----------------------------|------------|------------|------------|-----------------------|------------|----------------------|------------|------------------------|------------|
|                        |       |       |       |                  |       |                 |       |                   |       |
| Operating lease obligations |       | $          | 4,770,000  |                  | $          | 1,714,000            |       | $                      | 2,938,000  |   | $ | 118,000 |   |
| Payments to Law Firms       |       | 24,573,000 |       | 22,573,000            |       | 2,000,000            |       | —                 |       |
| Total obligations           |       | $          | 29,343,000 |                  | $          | 24,287,000           |       | $                      | 4,938,000  |   | $ | 118,000 |   |

 

As of October 31,2004, we did not have any long-term debt obligations, purchase obligations,other long-term liabilities or material capital lease obligations.

 

Our ability to cut coststo offset revenue declines in our UNIX business is limited because ofcontractual commitments to maintain and support our existing UNIXcustomers.  This decline in our UNIX business may be acceleratedif industry partners withdraw their support as a result of our SCOsourceinitiatives.  Our SCOsource initiativesmay cause industry partners, developers and hardware and software vendors tochoose not to support or certify to our UNIX operating system products.  This

 

37

----

 

would lead to an accelerated decline in our UNIXproducts and services revenue.  Ifour UNIX products and services revenue is less than expected, our liquiditywill be adversely impacted.

 

As discussed elsewhere above in Part II, Item7 of this Form 10-K and in thesection entitled “Recent Sales of Unregistered Securities” above in Part II,Item 5 of this Form 10-K, we issued shares and granted options under ourEquity Compensation Plans without complying with registration or qualificationrequirements under federal securities laws and the securities laws of certainstates.  As a result, certain planparticipants have a right to rescind their purchases of shares under the EquityCompensation Plans or recover damages if they no longer own the shares or holdunexercised options, subject to applicable statutes of limitations, and we maymake a rescission offer to certain of such plan participants subject toobtaining required regulatory approvals. Additionally, regulatory authorities may require us to pay fines or theymay impose other sanctions on us, and we may face other claims by participantsother than rescission claims.

 

If our potentialrescission offer is made and accepted by plan participants holding sharesacquired under the Equity Compensation Plans or otherwise entitled to recoverdamages from us in respect of such shares they have sold, or such plan participantsotherwise make rescission claims against us, we could be required to makeaggregate payments to these plan participants of up to $528,000 in theaggregate, excluding interest and other possible fees, based upon sharesoutstanding under the Equity Compensation Plans as of October 31, 2004.

 

We may also faceadditional rescission liability to plan participants holding unexercised stockoptions in California, Georgia and possibly other states.  Regulatory authorities may require us to payfines or impose other sanctions on us. Although we believe that it is reasonably possible that some planparticipants holding unexercised options may accept a rescission offer orpotentially attempt to enforce a rescission right, we are unable to estimatethe number of participants who might pursue rescission or the potentialrescission liability we may have to them. Since any loss is considered reasonably possible but not estimable, wehave not recorded a liability for this contingency.

 

We may also be requiredto pay interest and penalties up to statutory limits in connection with Planparticipants making rescission claims or in connection with any rescissionoffer.  We believe that it is reasonablypossible that we may be required to pay interest and penalties, but are notable to estimate an amount.

 

In the event that cashrequired to fund operations and strategic initiatives exceeds our current cashresources and cash generated from operations, we will be required to reducecosts and perhaps raise additional capital. We may not be able to reduce costs in a manner that does not impair ourability to maintain our UNIX business and pursue our SCOsourceinitiatives.  We may also not be able toraise capital for any number of reasons including those listed under the section “RiskFactors” below.  If additional equityfinancing is available, it may not be available to us on attractive terms andmay be dilutive to our existing stockholders. In addition, if our stock price declines, we may not be able to accessthe public equity markets on acceptable terms, if at all.  Our ability to effect acquisitions for stockwould also be impaired.

 

# **Recent AccountingPronouncements**

 

In December 2004,the FASB issued SFAS No. 123R “Share-Based Payment” (“SFAS 123R”), arevision to SFAS No. 123 “Accounting for Stock-Based Compensation” (“SFAS123”), and superseding APB Opinion No. 25 “Accounting for Stock Issued toEmployees” and its related implementation guidance.  SFAS 123R establishes standards for theaccounting for transactions in which an entity exchanges its equity instrumentsfor goods or services, including obtaining employee services in share-basedpayment transactions.  SFAS 123R appliesto all awards granted after the required effective date and to awards modified,repurchased, or cancelled after that date. Adoption of the provisions of SFAS 123R is effective as of the beginningof the first interim or annual reporting period that begins after

 

38

----

 

June 15,2005.  We have not yet evaluated thepotential impact that the adoption of SFAS 123R will have on our consolidatedfinancial position and results of operations.

 

#### **Forward-LookingStatements and Factors That May Affect Future Results and FinancialCondition**

 

#### **Withthe exception of historical facts, the statements contained in Management’sDiscussion and Analysis of Financial Condition and Results of Operations are “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, which reflect our current expectations and beliefs regarding ourfuture results of operations, performance and achievements.  The section entitled “Business” above inPart I, Item 1 of this Form 10-K also includes forward-lookingstatements.  These statements are subjectto risks and uncertainties and are based upon assumptions and beliefs that mayor may not materialize.  Theseforward-looking statements include, but are not limited to, statementsconcerning:**

 

•                              Our operating strategy to continue tosupport our existing users of our UNIX operating system products and to pursueSCOsource licensing opportunities and protect our intellectual property rights;

 

•                              Our intention to continue to maintain ourcore UNIX business in fiscal year 2005 by continuing our research anddevelopment efforts;

 

•                              Our belief that our OpenServer andUnixWare products will continue to provide a revenue stream in fiscal year 2005and our belief that revenue from such products will continue to decline;

 

•                              Our expectation that our sales channelshould continue to provide reliable UNIX operating systems for small-to-mediumsized business customers;

 

•                              Our intention to focus our developmentresources on our next OpenServer product and maintaining our current UnixWareproducts;

 

•                              Our intention to focus developmentresources on augmenting our current UNIX products with other products that willsolve business problems for our existing installed base of customers;

 

•                              Our expectation that hardware andsoftware vendors, as well as software developments, will continue to turn theircertification and application development efforts toward Linux and elect not tocontinue to support or certify to our UNIX operating system products;

 

•                              Our intention to release OpenServer inthe first half of calendar year 2005 and our expectation that our investment inthis effort will give customers confidence in our technology;

 

•                              Our expectation that developing a 64-bitversion of our operating system technology will give customers confidence intheir commitment to our technologies;

 

•                              Our intention to continue to pursue ourSCOsource initiatives in fiscal year 2005;

 

•                              Our belief that the future success of ourSCOsource initiatives will depend on our ability to protect our intellectualproperty;

 

•                              Our intention to vigorously defend legalclaims and counterclaims brought against us by others;

 

•                              Our intention to continue to pursue ourlitigation against IBM, Novell, AutoZone, and DaimlerChrysler;

 

39

----

 

•                              Our belief that our cash balance will beadequate for us to execute our business strategy as well as to continue topursue our intellectual property claims and that we have sufficient cashreserves to fund our current operations for the next 12 months;

 

•                              Our expectation that maintaining ourstrategic alliances with solution providers in fiscal year 2005 will becritical to the success of our UNIX business and the success of our nextOpenServer product;

 

•                              Our intention to keep our relationshipswith key partners in certain vertical markets;

 

•                              Our expectation of entering into futurevendor license agreements with developers, manufacturers, distributors and endusers of operating systems;

 

•                              Our expectation that product enhancementsto improve our UNIX technology will extend the life and improve thefunctionality of our UNIX products and our belief that such improvements willnot result in significant revenue increases;

 

•                              Our belief that such product enhancementsto our UNIX technology will help prolong our OpenServer revenue stream forfuture quarters;

 

•                              Our intention to continue to review thestatus of our existing UNIX license agreements with UNIX vendors in fiscal year2005;

 

•                              Our intention to continue to pursue ourIP licensing initiative against those that may be violating our UNIXcopyrights;

 

•                              Our expectation that our UNIX businesswill generate positive cash flow during fiscal year 2005;

 

•                              Our belief that our allowance and baddebts for accounts receivable will remain consistent with our prior experience;

 

•                              The strength of our intellectual propertyrights and contractual claims regarding UNIX generally and specifically thestrength of our claim that unauthorized UNIX source code and derivatives ofUNIX source code are contained in Linux;

 

•                              Our expectation that total UNIX revenuefor fiscal year 2005 will decline from UNIX revenue generated in fiscal year2004;

 

•                              Our belief that competition from Linuxwill continue in fiscal year 2005 and future periods;

 

•                              Our expectation that we will continue tobe unable to predict the amount and timing of SCOsource licensing revenue, andwhen generated, the revenue will be sporadic;

 

•                              Our expectation that future servicesrevenue will depend in part on our ability to generate UNIX products revenuefrom new customers as well as the renewal of annual support and servicesagreements from existing UNIX customers;

 

•                              Our expectation for fiscal year 2005 thatthe dollar amount of our cost of products revenue will be lower than fiscalyear 2004;

 

•                              Our expectation for fiscal year 2005 thatthe dollar amount of our cost of SCOsource licensing revenue will be lower thanfiscal year 2004;

 

•                              Our expectation for fiscal year 2005 thatthe dollar amount of our cost of services revenue will be lower than fiscalyear 2004;

 

•                              Our expectation for fiscal year 2005 thatthe dollar amount of our sales and marketing expenses will be lower than fiscalyear 2004;

 

40

----

 

•                              Our expectation for fiscal year 2005 thatthe dollar amount of our research and development expenses will be lower thanfiscal year 2004;

 

•                              Our expectation for fiscal year 2005 thatthe dollar amount of our general and administrative expenses will be lower thanfiscal year 2004;

 

•                              Our belief that our legal costs relatedto our intellectual property litigation will decrease in fiscal year 2005compared to fiscal year 2004, exclusive of any contingent payments;

 

•                              Our belief that our facilities areadequate for our business; and

 

•                              Our belief that certain legal actions towhich we are a party will not have a material adverse effect on us.

 

Wewish to caution readers that our operating results are subject to various risksand uncertainties that could cause our actual results and outcomes to differmaterially from those discussed or anticipated, including the success of ourSCOsource initiatives, competition from other operating systems, particularlyLinux, the amount and timing of SCOsource licensing revenue, our ability toenhance our UNIX operating systems and maintain our UNIX business, and thefactors set forth in the subsection entitled “Risk Factors” below.  We also wish to advise readers not to placeany undue reliance on the forward-looking statements contained in this report,which reflect our beliefs and expectations only as of the date of thisreport.  We assume no obligation to updateor revise these forward-looking statements to reflect new events orcircumstances or any changes in our beliefs or expectations, other than asrequired by law.

 

#### **RiskFactors**

 

*We do not have a history of profitable operations.*

 

Our fiscal year ended October 31,2003 was the first full year we were profitable in our operating history.  Our profitability in fiscal year 2003resulted primarily from our SCOsource licensing initiatives.  For fiscal year 2004, we incurred a net lossfrom operations of $28,573,000 and our accumulated deficit as of October 31,2004 was $224,216,000.  If we do notreceive SCOsource licensing revenue in future quarters and our revenue from thesale of our UNIX products and services continues to decline, we will need tofurther reduce operating expenses to generate positive cash flow.  We may not be able to further reduceoperating expenses without damaging our ability to support our existing UNIXbusiness.  Additionally, we may not beable to achieve profitability through additional cost-cutting actions.

 

Our UNIX products andservices revenue has declined over the last several years primarily as a resultof increased competition from alternative operating systems, particularlyLinux.  In our quarterly results ofoperations, we recognize revenue from agreements for support and maintenancecontracts and other long-term contracts that have been previously invoiced andare included in deferred revenue.  Ourfuture UNIX revenue may be adversely impacted and may continue to decline if weare unable to replenish these deferred revenue balances with long-termmaintenance and support contracts or replace them with other sustainablerevenue streams.  If we are unable togenerate positive cash flow and profitable operations, our operations will beadversely impacted.

 

*We may not prevail in our SCO Litigation, which mayadversely affect our business.*

 

We continue to pursueour SCO Litigation as described in more detail in Item 3 of Part I of thisForm 10-K and believe very strongly in the merits of our cases.  In our action against IBM, we seek damagesfor claims generally relating to our allegation that IBM has inappropriatelyused and distributed our UNIX source code and derivative works in connectionwith its efforts to promote the Linux operating system.  IBM has responded to our claims and broughtcounterclaims against us asserting generally that we do not have the right toassert claims based on our ownership of UNIX intellectual property against IBMor others in the Linux market.  Discoveryis continuing in the case, and several motions are currently

 

41

----

 

pendingbefore the court.  If we do not prevailin our action against IBM, or if IBM is successful in its counterclaims againstus, our business and results of operations would be materially harmed and wemay not be able to continue in business. The litigation with IBM and others will be costly, and our costs forlegal fees have been and will continue to be substantial and may exceed ourcapital resources. Additionally, the market price of our common stock may benegatively affected as a result of developments in our legal action against IBMthat may be, or may be perceived to be, adverse to us.

 

As a result of our SCOLitigation and our other SCOsource initiatives, several participants in theLinux industry and others affiliated with IBM or sympathetic to the Linuxmovement have taken actions attempting to negatively affect our business andour SCOsource efforts.  Linux proponentshave taken a broad range of actions against us, including, for example,attempting to influence participants in the markets in which we sell ourproducts to reduce or eliminate the amount of our products and services theypurchase from us.  We expect that similarefforts likely will continue.  There is arisk that participants in our marketplace will negatively view our actionagainst IBM, Novell, DaimlerChrysler, and AutoZone and our other SCOsourceinitiatives, and we may lose support from such participants.  Any of the foregoing could adversely affectour position in the marketplace, our results of operations and our stock priceand our ability to stay in business.   Wehave also experienced several denial-of-service attacks on our website, whichhave prevented web users from accessing our website and doing business with usfor a period of time.  If such attackscontinue or if our customers and strategic partners are also subjected tosimilar attacks, our business and results of operations could be materiallyharmed.  In addition, some of the moresignificant participants in the Linux industry have made efforts to ease Linuxend users’ concerns that their use of Linux may subject them to potentialcopyright infringement claims from us.

 

As a further response toour SCOsource initiatives and claim that our UNIX source code and derivativeworks have inappropriately been included in Linux, Novell has publicly assertedits belief that it owns certain copyrights in our UNIX source code, and it hasfiled 15 copyright applications with the United States Copyright Office relatedto UNIX.  Novell also claims that it hasa license to UNIX from us and the right to authorize its customers to use UNIXtechnology in their internal business operations.  Specifically, Novell has also claimed to haveretained rights related to legacy UNIX SVRx licenses, including the licensewith IBM.  Novell asserts it has theright to take action on behalf of SCO in connection with such licenses,including termination and waiver rights. Novell has purported to veto our termination of the IBM, Sequent and SGIlicenses. We have repeatedly asserted that we obtained the UNIX business,source code, claims and copyrights when we acquired the assets and operationsof the server and professional services groups from The Santa Cruz Operation(now Tarantella, Inc.) in May 2001, which had previously acquired allsuch assets and rights from Novell in September 1995 pursuant to an assetpurchase agreement, as amended.  In January 2004,in response to Novell’s actions, we brought suit against Novell for slander oftitle seeking relief for Novell’s alleged bad faith effort to interfere withour copyrights and contract rights related to our UNIX source code andderivative works and our UnixWare products. Our lawsuit against Novell is also described in more detail in Item 3 ofPart I of this Form 10-K.

 

Notwithstanding ourassertions of full ownership of UNIX-related intellectual property rights, asset forth above, including copyrights, and even if we are successful in ourlegal action against Novell and end users such as AutoZone and DaimlerChrysler,the efforts of Novell and the other Linux proponents described above may causeLinux end users to be less willing to purchase from us our SCOsource IPlicenses authorizing their use of our intellectual property contained in theLinux operating system, which has and may continue to adversely affect ourrevenue from our SCOsource initiatives. These efforts of Linux proponents also may increase the negative viewsome participants in our marketplace have regarding our SCO Litigation andregarding our SCOsource initiatives and may contribute to creating confusion inthe marketplace about the validity of our claim that the unauthorized use ofour UNIX source code and derivative works in Linux infringes on our copyrights.  Increased negative perception

 

42

----

 

andpotential confusion about our claims in our marketplace could impede ourcontinued pursuit of our SCOsource initiatives and negatively impact ourbusiness.

 

*Ourfailure to timely file this Form 10-K, and our quarterly report on Form 10-Qfor the quarter ended January 31, 2005 (as previously defined, the “Form 10-Q”),could result in the delisting of our common stock on The Nasdaq SmallCapMarket.*

 

We received notice on February 16,2005 from The Nasdaq Stock Market that, due to the delay in filing this Form 10-K,we were not, as of such date, in compliance with the filing requirements forcontinued listing set forth in Marketplace Rule 4310(c)(14), and that ourcommon stock is, therefore, subject to delisting at the opening of business on February 25,2004.  We requested and participated in ahearing with the Nasdaq Listing Qualifications Panel on March 17,2005.  At the hearing, we outlinedfor the Panel our plan for filing this Form 10-K and the Form 10-Q,which also was not filed in a timely fashion. On March 18, 2005, we received a notice from The Nasdaq StockMarket regarding our potential delisting as a result of our failure to file theForm 10-Q in a timely fashion.  Thenotice informed us that the Panel will consider the filing delinquency of our Form 10-Qin addition to the filing delinquency of this Form 10-K in rendering itsdecision regarding our listing status. We will continue to be listed on The Nasdaq SmallCap Market under thesymbol SCOXE pending the issuance of the Panel’s decision.  Althoughwe have filed this Form 10-K, we have not yet filed the Form 10-Q,and there can be no assurance that Nasdaq will not act to delist our common stockfrom The Nasdaq SmallCap Stock Market.

 

*Our Engagement Agreement withthe Law Firms will require us to spend a significant amount of cash duringfiscal year 2005 and could harm our liquidity position.*

 

As of October 31,2004, we had a total of $31,449,000 in cash and cash equivalents andavailable-for-sale securities and an additional $5,000,000 as restricted cashto be used in our operations and pursue the SCO Litigation.  As a result of the Engagement Agreementbetween us and the Law Firms, as described elsewhere in this filing, weanticipate using cash of approximately $27,000,000 in the defense of ourintellectual property litigation during fiscal year 2005, which would leave usapproximately $9,449,000 in cash for our business operations.  We expect that our UNIX business willgenerate sufficient cash in fiscal year 2005 to cover our internal costsrelated to our SCOsource initiatives and intellectual property litigation.  However, if our UNIX business does notgenerate cash or we spend additional cash on the SCO Litigation or additionalmatters, our cash position would be negatively impacted, and our ability topursue our UNIX business objectives and our SCO Litigation would be harmed.

 

*Our future SCOsource licensing revenue is uncertain.*

 

We initiated theSCOsource licensing effort in fiscal year 2003 to review the status of UNIXlicensing and sublicensing agreements. This effort resulted in the execution of two significant vendor licenseagreements during fiscal year 2003 and generated $25,846,000 in revenue.  During fiscal year 2004, our SCOsourcelicensing revenue declined significantly and was only $829,000.  Due to a lack of historical experience andthe uncertainties related to SCOsource licensing revenue, we are unable toestimate the amount and timing of future SCOsource licensing revenue, ifany.  If we do receive revenue from thissource, it may be sporadic and fluctuate from quarter to quarter.  Our SCOsource initiatives are unlikely to producestable, predictable revenue for the foreseeable future.  Additionally, the success of theseinitiatives may depend on the strength of our intellectual property rights andcontractual claims regarding UNIX, including the strength of our claim thatunauthorized UNIX source code and derivatives are prevalent in Linux.

 

*We may lose the support of industry partners leadingto an accelerated decline in our UNIX products and services revenue.*

 

The decline in our UNIX business and our SCOsourceinitiatives may cause industry partners, developers and hardware and softwarevendors to choose not to support or certify to our UNIX operating

 

43

----

 

system products.  This would lead to an accelerated decline inour UNIX products and services revenue and would adversely impact our resultsof operations and liquidity.

 

*Our claims relating to our UNIX intellectual propertymay subject us to additional legal proceedings.*

 

In August 2003, Red Hat brought a lawsuitagainst us asserting that the Linux operating system does not infringe on ourUNIX intellectual property rights and seeking a declaratory judgment fornon-infringement of copyrights and no misappropriation of trade secrets.  In addition, Red Hat claims we have engagedin false advertising in violation of the Lanham Act, deceptive trade practices,unfair competition, tortious interference with prospective businessopportunities, and trade libel and disparagement.  Although this case is currently stayedpending the resolution of our suit against IBM, we intend to vigorously defendthis action.  However, if Red Hat issuccessful in its claim against us, our business and results of operationscould be materially harmed.

 

In addition, regulators or others in the Linuxmarket and some foreign regulators have initiated or in the future may initiatelegal actions against us, all of which may negatively impact our operations andfuture operating performance.

 

*Fluctuations in our operating results or the failureof our operating results to meet the expectations of public market analysts andinvestors may negatively impact our stock price.*

 

Fluctuations in our operating results or our failureto meet the expectations of analysts or investors, even in the short-term,could cause our stock price to decline significantly. Because of the potentialfor significant fluctuations in our SCOsource licensing revenue in anyparticular period, you should not rely on comparisons of our results ofoperations as an indication of future performance.

 

Factors that may affect our results include:

 

•                                          our ability to successfully negotiate andcomplete licensing and other agreements related to our intellectual property;

 

•                                          the interest level of resellers inrecommending our UNIX business solutions to end users;

 

•                                          the introduction, development, timing,competitive pricing and market acceptance of our products and services andthose of our competitors;

 

•                                          changes in general economic conditions, suchas recessions, that could affect capital expenditures in the software industry;

 

•                                          results of, or developments in our SCOLitigation;

 

•                                          changes in business attitudes toward UNIX asa viable operating system compared to other competing systems, especiallyLinux;

 

•                                          the contingency and other legal fees we maypay to the Law Firms representing us in our efforts to establish ourintellectual property rights; and

 

•                                          changes in attitudes of customers andpartners due to the decline in our UNIX business and our aggressive positionagainst the inclusion of our UNIX code and derivative works in Linux.

 

We also experience fluctuations in operating resultsin interim periods in Europe and the Asia Pacific regions due to seasonalslowdowns and economic conditions in these areas.  Seasonal slowdowns in these regions typicallyoccur during the summer months.

 

44

----

 

As a result of the factorslisted above and elsewhere, it is possible that our results of operations maybe below the expectations of public market analysts and investors in anyparticular period. This could cause our stock price to decline. If revenue fallsbelow our expectations and we are unable to quickly reduce our spending inresponse, our operating results will be lower than expected.  Our stock price may fall in response to theseevents.

 

*We operate in a highly competitive market and facesignificant competition from a variety of current and potential sources; manyof our current and potential competitors have greater financial and technicalresources than we do; thus, we may fail to compete effectively.*

 

In the operating system market, our competitorsinclude IBM, Red Hat, Novell, Hewlett-Packard, Sun, Microsoft and other Linuxdistributors.  These and othercompetitors are aggressively pursuing the current UNIX operating systemmarket.  Many of these competitors haveaccess to substantially greater resources than we do.  The major competitive alternative to our UNIXproducts is Linux.  The expansion of ourcompetitors’ offerings may restrict the overall market available for our UNIXproducts, including some markets where we have been successful in the past.

 

Our future success may depend in part on our abilityto continue to meet the increasing needs of our customers by supportingexisting and emerging technologies.  Ifwe do not enhance our products to meet these evolving needs, we may not remaincompetitive and be able to grow our business. Additionally, because technological advancement in the UNIX operatingsystem market and alternative operating system markets is progressing at anadvanced pace, we will have to develop and introduce enhancements to ourexisting products and any new products on a timely basis to keep pace withthese developments, evolving industry standards and changing customerrequirements.  Our failure to meet any ofthese and other competitive pressures may render our existing products andservices obsolete, which would have an adverse impact on our revenue andoperations.

 

The success of our UNIX business will depend on thelevel of commitment and certification we receive from industry partners anddevelopers.  In recent years, we haveseen hardware and software vendors as well as software developers turn theircertification and application development efforts toward Linux and elect not tocontinue to support or certify to our UNIX operating system products.  If this trend continues, our competitiveposition will be adversely impacted and our future revenue from our UNIXbusiness will decline.  The decline inour UNIX business may be accelerated if industry partners withdraw theirsupport from us for any reason, including our SCOsourceinitiatives.

 

*If the market for UNIX continues to contract, ourbusiness will be harmed.*

 

Our revenue from the sale of UNIX products hasdeclined over the last several years. This decrease in revenue has been attributable primarily to increased competitionfrom other operating systems, particularly Linux.  Our sales of UNIX products and services areprimarily to existing customers.  If thedemand for UNIX products continues to decline, and we are unable to developUNIX products and services that successfully address a market demand, our UNIXrevenue will continue to decline, industry participants may not certify to ouroperating system and products, we may not be able to attract new customers orretain existing customers and our business and results of operations will beadversely affected.  Because of the longadoption cycle for operating system purchases and the long sales cycle of ouroperating system products, we may not be able to reverse these revenue declinesquickly.

 

*We rely on our indirect sales channel fordistribution of our products, and any disruption of our channel at any levelcould adversely affect the sales of our products.*

 

We have a two-tiered distribution channel. Therelationships we have developed with resellers allow us to offer our productsand services to a much larger customer base than we would otherwise be able toreach through our own direct sales and marketing efforts.  Some solution providers also purchasesolutions through our resellers, and we anticipate they will continue to doso.  Because we usually sell

 

45

----

 

indirectly through resellers, we cannotcontrol the relationships through which resellers, solution providers orequipment integrators purchase our products. In turn, we do not control the presentation of our products to endusers.  Therefore, our sales could beaffected by disruptions in the relationships between us and our resellers,between our resellers and solution providers, or between solution providers andend users.  Also, resellers and solutionproviders may choose not to emphasize our products to their customers.  Any of these occurrences could diminish theeffectiveness of our distribution channel and lead to decreased sales.

 

*Our Engagement Agreement with the Law Firmsrepresenting us to enforce our intellectual property rights may reduce ourability to raise additional financing.*

 

Our Engagement Agreement with the Law Firms couldinhibit our ability to raise additional funding if needed.  Although under the Engagement Agreement ourobligations to the Law Firms are limited to approximately $26,000,000 relatedto certain previously accrued and all future attorney fees and the escrow of$5,000,000 for the payment of any expert, consulting and other expenses topursue the SCO Litigation, the agreement providesthat the Law Firms will receive a contingency fee that may range from20 to 33 percent of the proceeds from specified events related to theprotection of our intellectual property rights. Events triggering a contingency fee may include settlements or judgmentsrelated to the SCO Litigation, certain licensingfees, subject to certain exceptions, and a sale of our company.  Future payments payable to the Law Firmsunder this arrangement will be significant. The Law Firms’ right to receive such contingent payments could causeprospective investors to choose not to invest in our company or limit the priceat which new investors would be willing to provide additional funds to ourcompany.

 

*Our foreign-based operations and sales create specialproblems, including the imposition of governmental controls and taxes andfluctuations in currency exchange rates that could hurt our results.*

 

We have foreign operations, including developmentfacilities, sales personnel and customer support operations in Europe, LatinAmerica and Asia.  These foreignoperations are subject to certain inherent risks, including:

 

•                                          potential loss of developed technologythrough piracy, misappropriation, or more lenient laws regarding intellectualproperty protection;

 

•                                          imposition of governmental controls,including trade restrictions and other tax requirements;

 

•                                          fluctuations in currency exchange rates andeconomic instability;

 

•                                          longer payment cycles for sales in foreigncountries; and

 

•                                          seasonal reductions in business activity.

 

In addition, certain of our operating expenses aredenominated in local currencies, creating risk of foreign currency translationlosses that could harm our financial results and cash flows. When we generateprofits in foreign countries, our effective income tax rate is increased.

 

In Latin America and Asia in particular, severalcountries have suffered and may be especially susceptible to recessions andeconomic instability, which may lead to increased governmental ownership orregulation of the economy, higher interest rates, increased barriers to entrysuch as higher tariffs and taxes, and reduced demand for goods manufactured inthe United States, resulting in lower revenue.

 

During the second quarter of fiscal year 2004, ourIndian office was given a withholding tax assessment from the Government ofIndia Income Tax Department.  The TaxDepartment assessed a 15 percent withholding tax on certain revenue transactionsin India that the Tax Department deemed royalty revenue under the Income TaxAct.  We have filed an appeal with theTax Department and believe that our

 

46

----

 

packaged software does not qualify fortreatment as royalties and therefore would not be subject to withholdingtax.  However, we may be unsuccessful inour appeal against the Tax Department and be obligated to pay the assessedtaxable amounts.  If other countries inwhich we have international operations, such as India, continue to develop andbegin enforcing their tax regimes, we may be subject to withholding or othertaxes.

 

*If we are unable to retain key personnel in anintensely competitive environment, our operations could be adversely affected.*

 

We need to retain our management, technical, andsupport personnel.  Competition forqualified professionals in the software industry is intense, and departures ofexisting personnel could be disruptive to our business and might result in thedeparture of other employees.  The lossor departure of any officers or key employees could harm our ability toimplement our business plan and could adversely affect our operations.  Our future success depends to a significantextent on the continued service and coordination of our management team,particularly Darl C. McBride, our President and ChiefExecutive Officer.

 

*Wehave issued shares and options under our Equity Compensation Plans that werenot exempt from registration or qualification under federal and statesecurities laws, and, as a result, we may incur liability to repurchase suchshares and options and may face additional potential claims under federal andstate securities laws.*

 

We have issued certain shares and grantedoptions under the Equity Compensation Plans without complying with registrationor qualification requirements under federal securities laws and the securitieslaws of certain states.  As a result,certain plan participants that have acquired shares issued under the EquityCompensation Plans have rescission rights against us, subject to applicablestatutes of limitations, and we may, subject to obtaining required regulatoryapprovals, make a rescission offer to certain of such plan participants.  Additionally, regulatory authorities mayrequire us to pay fines or they may impose other sanctions on us, and we mayface other claims by plan participants other than rescission claims.

 

If our potential rescission offer is made andaccepted by plan participants holding shares acquired under the EquityCompensation Plans or otherwise entitled to recover damages from us in respectof such shares they have sold, or such plan participants otherwise makerescission claims against us, we could be liable to make aggregate payments tothese plan participants of up to $528,000 in the aggregate, excluding interestand other possible fees, based upon shares outstanding under the Plans as ofOctober 31, 2004.

 

We may face additional rescission liabilityto plan participants holding unexercised stock options in California, Georgiaand possibly other states.  Additionally,federal securities laws do not provide that a rescission offer will terminate aplan participant’s right to rescind a sale of stock that was not registered asrequired, and our possible rescission offer may not terminate a plan participant’sright to rescind a sale of stock that was not registered as required under federallaw.  If we do not make the plannedrescission offer to all plan participants, or any or all of the offerees reject the rescission offer, we may continue to besubject to rescission risk under federal and state securities laws.

 

*Our stock price is volatile.*

 

The trading price forour common stock has been volatile, ranging from a low closing sales price of$1.09 in mid-February 2003, to a high closing sales price of $20.50 pershare in October 2003, to a current sales price of $3.52 on March 29, 2005.  The share price has changed dramatically overshort periods.  We believe that thechanges in our stock price are affected by changing public perceptionsconcerning the strength of our intellectual property claims and other factorsbeyond our control.  Public perceptioncan change quickly and without any change or development in our underlyingbusiness or litigation position.  Aninvestment in our stock is subject to such volatility and, consequently, issubject to significant risk.

 

47

----

 

*There are risks associated with the potentialexercise of our outstanding options.*

 

As of March 15, 2005, we have issued and outstandingoptions to purchase up to approximately 3,481,000 shares of common stock withan average exercise price of $4.18 per share. The existence of such rights to acquire common stock at fixed prices mayprove a hindrance to our efforts to raise future equity and debt funding, andthe exercise of such rights will dilute the percentage ownership interest ofour stockholders and may dilute the value of their ownership.  The possible future sale of shares issuable on the exercise of outstanding options couldadversely affect the prevailing market price for our common stock.  Further, the holders of the outstandingrights may exercise them at a time when we would otherwise be able to obtainadditional equity capital on terms more favorable to us.

 

*The resale of common shares by BayStarmay have an adverse impact on the market value of our stock and the existingholders of our common stock.*

 

We previously had an effective registrationstatement on Form S-3 relating to the sale or distribution by BayStar as a selling stockholder of the 2,105,263 shares ofcommon stock issued to BayStar in connection with ourrepurchase completed in July 2004 of all Series A-1 shares previously held by BayStar.  When wefailed to file this Form 10-K in a timely fashion, we became ineligible to useForm S-3, our registration statement ceased to be effective and BayStar’s ability to resell shares pursuant to thatregistration statement terminated.  Weare currently in the process of preparing a new registration statement for theresale of BayStar’s shares on Form S-1.  Upon that registration statement being declaredeffective by the SEC, BayStar will again be able toresell its shares.  We will not receiveany proceeds from the sales of the shares covered by such registrationstatement.  The shares that may be soldor distributed pursuant to such registration statement, upon being declaredeffective by the SEC, will represent approximately 8 percent of our issued andoutstanding common stock.  The sale ofthe block of stock to be covered by such registration statement, or even thepossibility of its sale, may adversely affect the trading market for our commonstock and reduce the price available in that market.

 

*Our stock price could decline further because of theactivities of short sellers.*

 

Our stock has attractedthe interest of short sellers.  Theactivities of short sellers could further reduce the price of our stock orinhibit increases in our stock price.

 

*The right of our board of directors to authorizeadditional shares of preferred stock could adversely impact the rights ofholders of our common stock.*

 

Our board of directors currently has the right, withrespect to the 5,000,000 shares of our preferred stock, to authorize theissuance of one or more additional series of our preferred stock with suchvoting, dividend and other rights as our directors determine.  The board of directors can designate newseries of preferred stock without the approval of the holders of our commonstock. The rights of holders of our common stock may be adversely affected bythe rights of any holders of additional shares of preferred stock that may beissued in the future, including without limitation, further dilution of theequity ownership percentage of our holders of common stock and their votingpower if we issue preferred stock with voting rights. Additionally, theissuance of preferred stock could make it more difficult for a third party toacquire a majority of our outstanding voting stock.

 

*Our Stockholder Rights Plan could make it more difficult for a hostilebid for the Company or a change of control transaction to succeed at currentmarket prices for our stock.*

 

Wehave adopted a Stockholder Rights Plan (“Rights Plan”).  The power given to the Board of Directors bythe Rights Plan may make it more difficult for a change of control of ourcompany to occur or for the Company to be acquired when the acquisition isopposed by our Board of Directors.

 

48

----

 

**Item 7A.****  Quantitative andQualitative Disclosures About Market Risk**

 

*ForeignCurrency Risk. *We haveforeign offices and operations in Europe and Asia.  As a result, a portion of our revenue isderived from sales to customers outside the United States.  Our international revenue is denominated inU.S. dollars, Euros and United Kingdom Pounds. Most of the operating expenses related to our foreign-based operationsare denominated in foreign currencies and therefore operating results areaffected by changes in the U.S. dollar exchange rate in relation to foreigncurrencies such as the Euro, among others. If the U.S. dollar further weakens compared to the Euro, our operatingexpenses for foreign operations will be higher when translated back into U.S.dollars.  Our revenue can also beaffected by general economic conditions in the United States, Europe and otherinternational markets.  Our results ofoperations may be affected in the short term by fluctuations in foreigncurrency exchange rates.

 

We have in the pastutilized foreign currency forward exchange contracts for market exposures ofunderlying assets and liabilities.  We donot use forward exchange contracts for speculative or trading purposes.  Our accounting policies for foreign exchangecontracts are based on our designation of each contract.  The criteria we use for designating eachcontract include such contract’s effectiveness in risk reduction and one-to-onematching of forward exchange contracts to underlying assets andliabilities.  Gains and losses oncurrency forward contracts that are firm commitments are deferred andrecognized in income in the same period that the underlying transactions aresettled.  Gains and losses on currencyforward contracts that are designated and effective for existing transactionsare recognized in income in the same period as losses and gains on theunderlying transactions are recognized and generally offset.  Gains and losses on any instruments notmeeting the above criteria are recognized in income in the current period.  As of October 31, 2004, we had no outstandinginstruments classified as hedges.

 

*Interest Rate Risk. *Theprimary objective of our cash management strategy is to invest available fundsin a manner that assures maximum safety and liquidity and maximizes yieldwithin such constraints.  We believe thata hypothetical movement in interest rates, either up or down, would not have amaterial adverse impact on our cash and equivalent sand available-for-salesecurities.  We do not borrow money forshort-term investment purposes.

 

*Investment Risk. *Wehave invested in equity instruments of privately held and public companies inthe technology industry for business and strategic purposes.  Investments are accounted for under the costmethod if our ownership is less than 20 percent and we are not able to exerciseinfluence over operations.  Ourinvestment policy is to regularly review the assumptions and operatingperformance of these companies and to record impairment losses when events andcircumstances indicate that these investments may be impaired.  As of October 31, 2004, our investmentsbalance was approximately $561,000 and was related to our investment in a 30percent owned Chinese company.

 

The stock market in general, and the market forshares of technology companies in particular, has experienced price fluctuations.  In addition, factors such as new productintroductions by our competitors or developments in the litigation related toour SCOsource initiatives may have a significantimpact on the market price of our common stock. Furthermore, quarter-to-quarter fluctuations in our results ofoperations may have a significant impact on the market price of our commonstock.  These conditions could cause theprice of our common stock to fluctuate substantially over short periods oftime.

 

49

----

 

**Item 8****.  Financial Statementsand Supplementary Data**

 

*Index to Consolidated FinancialStatements and Financial Statement Schedule*

 
| **Consolidated Financial Statements:** | ** **                                                                                                                  |
|----------------------------------------|-----------------------------------------------------------------------------------------------------------------------------|
|                                   | Report of Independent Registered Public  Accounting Firm                                                                    |   |
|                                   | Consolidated Balance Sheets as of October 31, 2004 and 2003                                                                 |   |
|                                   | Consolidated Statements of Operations and  Comprehensive Income (Loss) for the years ended October 31, 2004, 2003 and  2002 |   |
|                                   | Consolidated Statements of Stockholders’  Equity for the years ended October 31, 2004, 2003 and 2002                   |   |
|                                   | Consolidated Statements of Cash Flows for  the years ended October 31, 2004, 2003 and 2002                                  |   |
|                                   | Notes to Consolidated Financial Statements                                                                                  |   |
|                                   |                                                                                                                        |   |
| **Financial Statement Schedule:**      | ** **                                                                                                                  |
|                                   | Schedule II – Valuation and Qualifying  Accounts                                                                       |   |

 

50

----

 

**Report of Independent Registered Public AccountingFirm**

 

The Board ofDirectors and Stockholders of

The SCO Group, Inc.:

 

Wehave audited the consolidated balance sheets of The SCOGroup, Inc. and subsidiaries as of October 31, 2004 and 2003, and the relatedconsolidated statements of operations and comprehensive income (loss),stockholders’ equity and cash flows for each of the years in the three-yearperiod ended October 31, 2004.  Inconnection with our audits of the consolidated financial statements, we havealso audited the financial statement schedule. These consolidated financial statements and financial statement scheduleare the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements and financial statement schedulebased on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimates madeby management, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of The SCO Group, Inc. and subsidiaries as of October 31, 2004 and2003, and the results of their operations and their cash flows for each of theyears in the three-year period ended October 31, 2004 in conformity withaccounting principles generally accepted in the United States of America.  Also in our opinion, the related financialstatement schedule, when considered in relation to the basic consolidatedfinancial statements taken as a whole, presents fairly, in all materialrespects, the information set forth therein.

 

 
| /s/KPMG LLP                                                              |   |
|--------------------------------------------------------------------------|--------|
|                                                                     |
| Salt Lake  City, Utah                                                    |
| February 18, 2005,  except as to Note 16,  which is as of March 11, 2005 |

 

51

----

 

**THE SCO GROUP, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED BALANCE SHEETS**

**(inthousands)**

 
| ** **                                                                                                                                             | ** ** | **October 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                                                             | ** ** | **2004**             | ** ** | **2003** | ** ** |
|                                                                                                                                                   |       |                 |       |   |   |
| **ASSETS**                                                                                                                                             | ** ** | ** **           | ** ** | ** ** | ** ** |
|                                                                                                                                                   |       |                 |       |   |   |
| CURRENT ASSETS:                                                                                                                                        |       |                 |       |   |   |
| Cash and cash equivalents                                                                                                                              |       | $                    | 12,693     |   | $ | 64,428 |   |
| Restricted cash                                                                                                                                        |       | 8,283                |       | 2,025 |   |
| Available-for-sale securities                                                                                                                          |       | 18,756               |       | 4,095 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $136 and $230, respectively                                                            |       | 6,638                |       | 9,282 |   |
| Other current assets                                                                                                                                   |       | 1,870                |       | 2,450 |   |
| Total current assets                                                                                                                                   |       | 48,240               |       | 82,280 |   |
|                                                                                                                                                   |       |                 |       |   |   |
| PROPERTY AND EQUIPMENT:                                                                                                                                |       |                 |       |   |   |
| Computer and office equipment                                                                                                                          |       | 2,991                |       | 3,482 |   |
| Leasehold improvements                                                                                                                                 |       | 406                  |       | 608 |   |
| Furniture and fixtures                                                                                                                                 |       | 103                  |       | 189 |   |
|                                                                                                                                                   |       | 3,500                |       | 4,279 |   |
| Less accumulated depreciation and  amortization                                                                                                        |       | (2,851               | )          | (3,131 | ) |
| Net property and equipment                                                                                                                             |       | 649                  |       | 1,148 |   |
|                                                                                                                                                   |       |                 |       |   |   |
| OTHER ASSETS:                                                                                                                                          |       |                 |       |   |   |
| Goodwill, net                                                                                                                                          |       | —               |       | 1,166 |   |
| Intangibles, net                                                                                                                                       |       | 5,413                |       | 9,286 |   |
| Other assets                                                                                                                                           |       | 1,098                |       | 1,072 |   |
| Total other assets                                                                                                                                     |       | 6,511                |       | 11,524 |   |
|                                                                                                                                                   |       |                 |       |   |   |
| Total assets                                                                                                                                           |       | $                    | 55,400     |   | $ | 94,952 |   |
|                                                                                                                                                   |       |                 |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                          | ** ** | ** **           | ** ** | ** ** | ** ** |
|                                                                                                                                                   |       |                 |       |   |   |
| CURRENT LIABILITIES:                                                                                                                                   |       |                 |       |   |   |
| Accounts payable                                                                                                                                       |       | $                    | 7,854      |   | $ | 1,978 |   |
| Payable to Novell, Inc.                                                                                                                           |       | 3,283                |       | 2,025 |   |
| Accrued compensation to law firms                                                                                                                      |       | 7,956                |       | 10,556 |   |
| Accrued payroll and benefits                                                                                                                           |       | 3,369                |       | 4,752 |   |
| Accrued liabilties                                                                                                                                     |       | 3,855                |       | 3,754 |   |
| Derivative related to redeemable  convertible preferred stock                                                                                          |       | —               |       | 15,224 |   |
| Deferred revenue                                                                                                                                       |       | 4,877                |       | 5,501 |   |
| Other royalties payable                                                                                                                                |       | 354                  |       | 523 |   |
| Taxes payable                                                                                                                                          |       | 1,279                |       | 799 |   |
| Total current liabilities                                                                                                                              |       | 32,827               |       | 45,112 |   |
|                                                                                                                                                   |       |                 |       |   |   |
| LONG-TERM LIABILITIES                                                                                                                                  |       | 343                  |       | 508 |   |
|                                                                                                                                                   |       |                 |       |   |   |
| MINORITY INTEREST                                                                                                                                      |       | —               |       | 145 |   |
|                                                                                                                                                   |       |                 |       |   |   |
| COMMITMENTS AND CONTINGENCIES (Note 10)                                                                                                                |       |                 |       |   |   |
|                                                                                                                                                   |       |                 |       |   |   |
| SERIES A REDEEMABLE CONVERTIBLE PREFERRED  STOCK,  $0.001 par value; 5,000 shares authorized, 0 and 50 shares outstanding,  respectively (Note 6) |       | —               |       | 29,671 |   |
|                                                                                                                                                   |       |                 |       |   |   |
| COMMON STOCK SUBJECT TO RESCISSION (Note 7)                                                                                                            |       | 528                  |       | — |   |
|                                                                                                                                                   |       |                 |       |   |   |
| STOCKHOLDERS’ EQUITY:                                                                                                                             |       |                 |       |   |   |
| Common stock, $0.001 par value; 45,000  shares authorized, 17,956 and 13,824 shares outstanding, respectively                                          |       | 18                   |       | 14 |   |
| Additional paid-in capital                                                                                                                             |       | 246,273              |       | 218,690 |   |
| Common stock held in treasury                                                                                                                          |       | (2,414               | )          | — |   |
| Warrants outstanding                                                                                                                                   |       | 1,099                |       | 1,099 |   |
| Deferred compensation                                                                                                                                  |       | (22                  | )          | (347 | ) |
| Accumulated other comprehensive income                                                                                                                 |       | 964                  |       | 926 |   |
| Accumulated deficit                                                                                                                                    |       | (224,216             | )          | (200,866 | ) |
| Total stockholders’ equity                                                                                                                        |       | 21,702               |       | 19,516 |   |
|                                                                                                                                                   |       |                 |       |   |   |
| Total liabilities and stockholders’ equity                                                                                                        |       | $                    | 55,400     |   | $ | 94,952 |   |

 

See accompanying notes to consolidated financial statements.

 

52

----

 

**THE SCO GROUP, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVEINCOME (LOSS)**

**(inthousands, except per share data)**

 
| ** **                                                                                                | ** ** | **Year Ended October 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                | ** ** | **2004**                        | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                                                      |       |                            |       |   |   |   |   |
| REVENUE:                                                                                                  |       |                            |       |   |   |   |   |
| Products                                                                                                  |       | $                               | 35,352     |   | $ | 45,028 |   | $ | 52,975 |   |
| SCOsource  licensing                                                                                      |       | 829                             |       | 25,846 |   | — |   |
| Services                                                                                                  |       | 6,628                           |       | 8,380 |   | 11,266 |   |
| Total revenue                                                                                             |       | 42,809                          |       | 79,254 |   | 64,241 |   |
|                                                                                                      |       |                            |       |   |   |   |   |
| COST OF REVENUE:                                                                                          |       |                            |       |   |   |   |   |
| Products                                                                                                  |       | 3,221                           |       | 4,068 |   | 7,558 |   |
| SCOsource  licensing (inclusive of amortization of intangibles of $334, $337 and $0,  respectively)       |       | 19,743                          |       | 9,500 |   | — |   |
| Services                                                                                                  |       | 4,134                           |       | 6,354 |   | 10,758 |   |
| Total cost of revenue                                                                                     |       | 27,098                          |       | 19,922 |   | 18,316 |   |
|                                                                                                      |       |                            |       |   |   |   |   |
| GROSS MARGIN                                                                                              |       | 15,711                          |       | 59,332 |   | 45,925 |   |
|                                                                                                      |       |                            |       |   |   |   |   |
| OPERATING EXPENSES:                                                                                       |       |                            |       |   |   |   |   |
| Sales and marketing (exclusive of  stock-based compensation of $75, $129, and $89, respectively)          |       | 17,038                          |       | 24,392 |   | 29,554 |   |
| Research and development (exclusive of  stock-based compensation of $49, $112, and $45, respectively)     |       | 10,612                          |       | 11,012 |   | 17,558 |   |
| General and administrative (exclusive of  stock-based compensation of $795, $963, and $991, respectively) |       | 7,626                           |       | 6,230 |   | 9,307 |   |
| Severance and exit costs                                                                                  |       | 3,168                           |       | 498 |   | 6,728 |   |
| Amortization of intangibles                                                                               |       | 2,566                           |       | 3,190 |   | 2,853 |   |
| Loss on disposition and impairment of  long-lived assets                                                  |       | 2,355                           |       | 164 |   | 1,796 |   |
| Write-off of investments                                                                                  |       | —                          |       | 250 |   | 1,180 |   |
| Stock-based compensation                                                                                  |       | 919                             |       | 1,204 |   | 1,125 |   |
| Compensation to law firms                                                                                 |       | —                          |       | 8,956 |   | — |   |
| Total operating expenses                                                                                  |       | 44,284                          |       | 55,896 |   | 70,101 |   |
|                                                                                                      |       |                            |       |   |   |   |   |
| INCOME (LOSS) FROM OPERATIONS                                                                             |       | (28,573                         | )          | 3,436 |   | (24,176 | ) |
|                                                                                                      |       |                            |       |   |   |   |   |
| EQUITY IN INCOME (LOSSES) OF AFFILIATES                                                                   |       | 111                             |       | (62 | ) | (50 | ) |
|                                                                                                      |       |                            |       |   |   |   |   |
| OTHER INCOME (EXPENSE):                                                                                   |       |                            |       |   |   |   |   |
| Interest income                                                                                           |       | 905                             |       | 188 |   | 377 |   |
| Interest expense                                                                                          |       | —                          |       | (3 | ) | (206 | ) |
| Change in fair value of derivative (Note 6)                                                               |       | 5,924                           |       | 2,845 |   | — |   |
| Other expense, net                                                                                        |       | (322                            | )          | (203 | ) | (339 | ) |
| Total other income (expense), net                                                                         |       | 6,507                           |       | 2,827 |   | (168 | ) |
|                                                                                                      |       |                            |       |   |   |   |   |
| INCOME (LOSS) BEFORE INCOME TAXES                                                                         |       | (21,955                         | )          | 6,201 |   | (24,394 | ) |
|                                                                                                      |       |                            |       |   |   |   |   |
| PROVISION FOR INCOME TAXES                                                                                |       | (1,395                          | )          | (774 | ) | (483 | ) |
|                                                                                                      |       |                            |       |   |   |   |   |
| NET INCOME (LOSS)                                                                                         |       | (23,350                         | )          | 5,427 |   | (24,877 | ) |
|                                                                                                      |       |                            |       |   |   |   |   |
| CONTRIBUTIONS FROM (DIVIDENDS ON)  REDEEMABLE CONVERTIBLE PREFERRED STOCK                                 |       | 7,123                           |       | (123 | ) | — |   |
|                                                                                                      |       |                            |       |   |   |   |   |
| NET INCOME AVAILABLE (LOSS APPLICABLE) TO  COMMON STOCKHOLDERS                                            |       | $                               | (16,227    | ) | $ | 5,304 |   | $ | (24,877 | ) |
|                                                                                                      |       |                            |       |   |   |   |   |
| BASIC NET INCOME (LOSS) PER COMMON SHARE                                                                  |       | $                               | (1.07      | ) | $ | 0.43 |   | $ | (1.93 | ) |
| DILUTED NET INCOME (LOSS) PER COMMON SHARE                                                                |       | $                               | (1.07      | ) | $ | 0.34 |   | $ | (1.93 | ) |
|                                                                                                      |       |                            |       |   |   |   |   |
| WEIGHTED AVERAGE BASIC COMMON SHARES  OUTSTANDING                                                         |       | 15,155                          |       | 12,261 |   | 12,893 |   |
| WEIGHTED AVERAGE DILUTED COMMON SHARES  OUTSTANDING                                                       |       | 15,155                          |       | 15,679 |   | 12,893 |   |
|                                                                                                      |       |                            |       |   |   |   |   |
| OTHER COMPREHENSIVE INCOME (LOSS)                                                                         |       |                            |       |   |   |   |   |
| Net income (loss)                                                                                         |       | $                               | (23,350    | ) | $ | 5,427 |   | $ | (24,877 | ) |
| Unrealized gain (loss) on available-for-sale  securities                                                  |       | (67                             | )          | 23 |   | — |   |
| Foreign currency translation adjustment                                                                   |       | 105                             |       | 393 |   | 423 |   |
| COMPREHENSIVE INCOME (LOSS)                                                                               |       | $                               | (23,312    | ) | $ | 5,843 |   | $ | (24,454 | ) |

 

See accompanying notes to consolidated financial statements.

 

53

----

 

**THE SCO GROUP, INC. ANDSUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

(inthousands)

 
| ** **                                                                                              | ** ** | ** **        | ** ** | ** **  | ** ** | **Additional**      | ** ** | ** **   | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | **Accumulated**    | ** ** | ** **   | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------|------------|---------------------|------------|--------------|------------|--------------|------------|-------------------|------------|------------------|------------|--------------------|------------|--------------|------------|------------|------------|
| ** **                                                                                              | ** ** | **Common  Stock** | ** ** | **Paid-in** | ** ** | **Treasury  Stock** | ** ** | **Warrants** | ** ** | **Deferred** | ** ** | **Comprehensive** | ** ** | **Accumulated**  | ** ** | ** **         | ** ** |
| ** **                                                                                              | ** ** | **Shares**        | ** ** | **Amount**  | ** ** | **Capital**         | ** ** | **Shares**   | ** ** | **Amount**   | ** ** | **Outstanding**   | ** ** | **Compensation** | ** ** | **Income  (Loss)** | ** ** | **Deficit**  | ** ** | **Total**  | ** ** |
| **Balance,  October 31, 2001**                                                                     | ** ** | **14,266**        | ** ** | **$**       | **14**     | ** **          | **$**      | **217,209**  | ** ** | **—**   | ** ** | **$**             | **—** | ** **       | **$**      | **—**         | ** ** | **$**        | **(1,290** | **)**      | **$**      | **87** | ** ** | **$** | **(181,416** | **)** | **$** | **34,604** | ** ** |
| Issuance of  common shares for services                                                                 |       | 30                |       | —      |       | 113                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 113        |       |
| Compensation  expense for modifications made to certain option grants                                   |       | —            |       | —      |       | 73                  |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 73         |       |
| Amortization of  deferred compensation                                                                  |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | 986              |       | —             |       | —       |       | 986        |       |
| Removal of  deferred compensation related to termination of option holders                              |       | —            |       | —      |       | (155                | )          | —       |       | —       |       | —            |       | 155              |       | —             |       | —       |       | —     |       |
| Reversal of  compensation expense previously recorded related to termination of option  holders         |       | —            |       | —      |       | (565                | )          | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | (565       | )          |
| Issuance of  common stock for services to officers and key employees                                    |       | 450               |       | 1           |       | 494                 |       | —       |       | —       |       | —            |       | (495             | )          | —             |       | —       |       | —     |       |
| Issuance of  common stock for prior services to former Chief Executive Officer                          |       | 175               |       | —      |       | 105                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 105        |       |
| Issuance of common  stock for the cancellation of change in control agreements                          |       | 105               |       | —      |       | 119                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 119        |       |
| Issuance of  common shares upon exercise of stock options                                               |       | 215               |       | —      |       | 295                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 295        |       |
| Issuance of  common shares under employee stock purchase program                                        |       | 175               |       | —      |       | 291                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 291        |       |
| Acquisition of  common shares from stockholders                                                         |       | (4,804            | )          | (5          | )          | (4,579              | )          | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | (4,584     | )          |
| Issuance of  common shares for a note receivable                                                        |       | 800               |       | 1           |       | 899                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 900        |       |
| Issuance of a  warrant                                                                                  |       | —            |       | —      |       | —              |       | —       |       | —       |       | 294               |       | —           |       | —             |       | —       |       | 294        |       |
| Cumulative  translation adjustment                                                                      |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | —           |       | 423                |       | —       |       | 423        |       |
| Net loss                                                                                                |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | —           |       | —             |       | (24,877      | )          | (24,877    | )          |
| **Balance,  October 31, 2002**                                                                     | ** ** | **11,412**        | ** ** | **11**      | ** ** | **214,299**         | ** ** | **—**   | ** ** | **—**   | ** ** | **294**           | ** ** | **(644**         | **)**      | **510**            | ** ** | **(206,293** | **)**      | **8,177**  | ** ** |
| Issuance of  common shares to officers, key employees and directors for services, net of  cancellations |       | 357               |       | 1           |       | 726                 |       | —       |       | —       |       | —            |       | (569             | )          | —             |       | —       |       | 158        |       |
| Issuance of  common shares upon exercise of stock options                                               |       | 1,305             |       | 1           |       | 2,055               |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 2,056      |       |
| Issuance of  common shares under employee stock purchase program                                        |       | 345               |       | —      |       | 236                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 236        |       |
| Issuance of  common shares in connection with business combination                                      |       | 305               |       | 1           |       | 2,460               |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 2,461      |       |
| Compensation  expense for modifications made to certain option grants                                   |       | —            |       | —      |       | 42                  |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 42         |       |
| Stock-based  compensation for services                                                                  |       | —            |       | —      |       | 296                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 296        |       |
| Issuance of  warrants                                                                                   |       | —            |       | —      |       | —              |       | —       |       | —       |       | 1,099             |       | —           |       | —             |       | —       |       | 1,099      |       |
| Exercise of a  warrant                                                                                  |       | 200               |       | —      |       | 294                 |       | —       |       | —       |       | (294              | )          | —           |       | —             |       | —       |       | —     |       |
| Acquisition of  common shares from stockholder                                                          |       | (100              | )          | —      |       | (1,718              | )          | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | (1,718     | )          |
| Amortization of  stock-based compensation                                                               |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | 866              |       | —             |       | —       |       | 866        |       |
| Cumulative  translation adjustment                                                                      |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | —           |       | 393                |       | —       |       | 393        |       |
| Unrealized gain  on available-for-sale securities                                                       |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | —           |       | 23                 |       | —       |       | 23         |       |
| Net income                                                                                              |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | —           |       | —             |       | 5,427        |       | 5,427      |       |
| **Balance,  October 31, 2003**                                                                     | ** ** | **13,824**        | ** ** | **14**      | ** ** | **218,690**         | ** ** | **—**   | ** ** | **—**   | ** ** | **1,099**         | ** ** | **(347**         | **)**      | **926**            | ** ** | **(200,866** | **)**      | **19,516** | ** ** |
| Amortization of  stock-based compensation                                                               |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | 325              |       | —             |       | —       |       | 325        |       |
| Compensation  expense for modifications made to certain option grants                                   |       | —            |       | —      |       | 92                  |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 92         |       |
| Stock-based  compensation on options to non-employees                                                   |       | —            |       | —      |       | 502                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 502        |       |
| Unrealized gain  (loss) on available-for-sale securities                                                |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | —           |       | (67                | )          | —       |       | (67        | )          |
| Dividend recorded  on exchange of Series A-1 Preferred Stock for Series A Preferred  Stock    |       | —            |       | —      |       | (6,305              | )          | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | (6,305     | )          |
| Capital  contribution recorded on repurchase of Series A-1 Convertible Preferred  Stock            |       | —            |       | —      |       | 15,475              |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 15,475     |       |
| Conversion of  Series A-1 Preferred Stock                                                          |       | 2,846             |       | 3           |       | 18,757              |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 18,760     |       |
| Dividends on  Series A and Series A-1 Convertible Preferred Stock                             |       | —            |       | —      |       | (2,170              | )          | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | (2,170     | )          |
| Cumulative  translation adjustment                                                                      |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | —           |       | 105                |       | —       |       | 105        |       |
| Acquisition of  common shares                                                                           |       | —            |       | —      |       | —              |       | (290         | )          | (2,414       | )          | —            |       | —           |       | —             |       | —       |       | (2,414     | )          |
| Cancellation of  restricted stock awards for terminated employees                                       |       | (11               | )          | —      |       | —              |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | —     |       |
| Issuance of  common shares upon exercise of stock options                                               |       | 606               |       | 1           |       | 950                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 951        |       |
| Issuance of  common shares under employee stock purchase program                                        |       | 691               |       | —      |       | 810                 |       | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 810        |       |
| Common stock  subject to rescission                                                                     |       | —            |       | —      |       | (528                | )          | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | (528       | )          |
| Net loss                                                                                                |       | —            |       | —      |       | —              |       | —       |       | —       |       | —            |       | —           |       | —             |       | (23,350      | )          | (23,350    | )          |
| **Balance,  October 31, 2004**                                                                     | ** ** | **17,956**        | ** ** | **$**       | **18**     | ** **          | **$**      | **246,273**  | ** ** | **(290**     | **)**      | **$**             | **(2,414** | **)**            | **$**      | **1,099**          | ** ** | **$**        | **(22**    | **)**      | **$**      | **964** | ** ** | **$** | **(224,216** | **)** | **$** | **21,702** | ** ** |

 

See accompanying notes to consolidated financial statements.

 

54

----

 

**THE SCO GROUP, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

 
| ** **                                                                                          | ** ** | **Year Ended October 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                          | ** ** | **2004**                        | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                                                |       |                            |       |   |   |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                               |       |                            |       |   |   |   |   |
| Net income (loss)                                                                                   |       | $                               | (23,350    | ) | $ | 5,427 |   | $ | (24,877 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |                            |       |   |   |   |   |
| Issuance of common shares as compensation  to law firms                                             |       | —                          |       | 7,956 |   | — |   |
| Amortization of intangibles                                                                         |       | 2,900                           |       | 3,527 |   | 3,187 |   |
| Stock-based compensation                                                                            |       | 919                             |       | 1,204 |   | 1,125 |   |
| Depreciation and amortization                                                                       |       | 783                             |       | 1,049 |   | 2,555 |   |
| Write-downs of investments                                                                          |       | —                          |       | 250 |   | 1,180 |   |
| Issuance of a warrant (classified as cost  of SCOsource licensing revenue)                          |       | —                          |       | 243 |   | — |   |
| Loss on disposition and write-downs of  long-lived assets                                           |       | 2,355                           |       | 164 |   | 1,796 |   |
| Equity in (income) losses of affiliates                                                             |       | (111                            | )          | 62 |   | 50 |   |
| Change in fair value of derivative                                                                  |       | (5,924                          | )          | (2,845 | ) | — |   |
| Amortization of debt discount                                                                       |       | —                          |       | — |   | 208 |   |
| Changes in operating assets and  liabilities, net of effects of acquisitions:                       |       |                            |       |   |   |   |   |
| Restricted cash                                                                                     |       | (5,000                          | )          | — |   | — |   |
| Accounts receivable, net                                                                            |       | 2,644                           |       | (837 | ) | 8,120 |   |
| Other current assets                                                                                |       | 580                             |       | 1,269 |   | (145 | ) |
| Other assets                                                                                        |       | 84                              |       | 1,501 |   | (1,387 | ) |
| Accounts payable                                                                                    |       | 5,876                           |       | (217 | ) | (414 | ) |
| Payable to The Santa Cruz Operation                                                                 |       | —                          |       | — |   | 27 |   |
| Accrued payroll and benefits                                                                        |       | (1,383                          | )          | 1,115 |   | (2,924 | ) |
| Compensation to law firms                                                                           |       | (2,600                          | )          | 2,600 |   | — |   |
| Accrued liabilities                                                                                 |       | 101                             |       | (4,091 | ) | 411 |   |
| Deferred revenue                                                                                    |       | (624                            | )          | (4,555 | ) | 1,815 |   |
| Other royalties payable                                                                             |       | (169                            | )          | (146 | ) | (503 | ) |
| Taxes payable                                                                                       |       | 480                             |       | 90 |   | (240 | ) |
| Other long-term liabilities                                                                         |       | (165                            | )          | (1,679 | ) | (576 | ) |
| Net cash provided by (used in) operating  activities                                                |       | (22,604                         | )          | 12,087 |   | (10,592 | ) |
|                                                                                                |       |                            |       |   |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                               |       |                            |       |   |   |   |   |
| Purchase of property and equipment                                                                  |       | (506                            | )          | (467 | ) | (206 | ) |
| Acquisitions, net of acquisition costs and  cash received                                           |       | —                          |       | — |   | (100 | ) |
| Purchase of available-for-sale securities                                                           |       | (59,224                         | )          | (4,095 | ) | — |   |
| Proceeds from available-for-sale securities                                                         |       | 44,496                          |       | — |   | 5,943 |   |
| Purchase of minority interest in Japanese  subsidiary                                               |       | (209                            | )          | — |   | — |   |
| Investment in non-marketable securities                                                             |       | —                          |       | (950 | ) | (350 | ) |
| Net cash provided by (used in) investing  activities                                                |       | (15,443                         | )          | (5,512 | ) | 5,287 |   |
|                                                                                                |       |                            |       |   |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                               |       |                            |       |   |   |   |   |
| Proceeds from sale of common stock through  employee stock purchase program                         |       | 810                             |       | 236 |   | 291 |   |
| Proceeds from exercise of common stock  options                                                     |       | 951                             |       | 2,056 |   | 295 |   |
| Repurchase of common stock                                                                          |       | (2,414                          | )          | — |   | (4,584 | ) |
| Net proceeds from the issuance of warrants                                                          |       | —                          |       | 856 |   | — |   |
| Repayments of long-term debt                                                                        |       | —                          |       | — |   | (5,000 | ) |
| Costs incurred in connection with  Series A-1 Convertible Preferred Stock issuance             |       | (211                            | )          | — |   | — |   |
| Repurchase and retirement of Series A-1  Convertible Preferred Stock                           |       | (13,000                         | )          | — |   | — |   |
| Net proceeds from issuance of Series A  Convertible Preferred Stock                            |       | —                          |       | 47,740 |   | — |   |
| Net cash provided by (used in) financing  activities                                                |       | (13,864                         | )          | 50,888 |   | (8,998 | ) |
|                                                                                                |       |                            |       |   |   |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                                               |       | (51,911                         | )          | 57,463 |   | (14,303 | ) |
| EFFECT OF FOREIGN EXCHANGE RATES ON CASH                                                            |       | 176                             |       | 376 |   | 351 |   |
| CASH AND CASH EQUIVALENTS, beginning of  year                                                       |       | 64,428                          |       | 6,589 |   | 20,541 |   |
| CASH AND CASH EQUIVALENTS, end of year                                                              |       | $                               | 12,693     |   | $ | 64,428 |   | $ | 6,589 |   |

 

See accompanying notes to consolidated financial statements.

 

55

----

 
| ** **                                                                                                                                                          | ** ** | **Year Ended October 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                          | ** ** | **2004**                        | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:                                                                                                                  |       |                            |       |   |   |   |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| Cash paid for taxes                                                                                                                                                 |       | $                               | 957        |   | $ | 413 |   | $ | 877 |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:                                                                                           |       |                            |       |   |   |   |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| Accretion of dividends                                                                                                                                              |       | $                               | 2,047      |   | $ | 123 |   | $ | — |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| Capital contribution in connection with  repurchase and cancellation of Series A-1 shares                                                                      |       | $                               | (15,475    | ) | $ | — |   | $ | — |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| Dividend in connection with exchange of  Series A-1 for Series A                                                                                          |       | $                               | 6,305      |   | $ | — |   | $ | — |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| Common stock subject to rescission                                                                                                                                  |       | $                               | 528        |   | $ | — |   | $ | — |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| Deferred compensation for issuance of  common shares                                                                                                                |       | $                               | —     |   | $ | 569 |   | $ | 495 |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| Acquisition of Vultus, Inc.:                                                                                                                                   |       |                            |       |   |   |   |   |
| Intangible assets                                                                                                                                                   |       | $                               | —     |   | $ | 1,555 |   | $ | — |   |
| Goodwill                                                                                                                                                            |       | $                               | —     |   | $ | 1,166 |   | $ | — |   |
| Common stock issued                                                                                                                                                 |       | $                               | —     |   | $ | (2,461 | ) | $ | — |   |
| Accrued liabilities assumed                                                                                                                                         |       | $                               | —     |   | $ | (215 | ) | $ | — |   |
| Acquisition costs                                                                                                                                                   |       | $                               | —     |   | $ | (45 | ) | $ | — |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| Settlement of notes receivable from Vista  and NextEStage:                                                                                                          |       |                            |       |   |   |   |   |
| SCO shares  acquired                                                                                                                                                |       | $                               | —     |   | $ | 1,718 |   | $ | — |   |
| Investment write-off and other                                                                                                                                      |       | $                               | —     |   | $ | 500 |   | $ | — |   |
| Notes receivable, royalties and investment                                                                                                                          |       | $                               | —     |   | $ | (2,218 | ) | $ | — |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| Settlement related to the acquisition of  the server and professional services groups of The Santa Cruz Operation  reflected as an adjustment to the purchase price |       | $                               | —     |   | $ | — |   | $ | 3,341 |   |
|                                                                                                                                                                |       |                            |       |   |   |   |   |
| Issuance of common shares for a note  receivable                                                                                                                    |       | $                               | —     |   | $ | — |   | $ | 900 |   |

 

See accompanying notes to consolidated financial statements.

 

56

----

 

**THE SCO GROUP, INC. ANDSUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

## ***(1) ORGANIZATION AND DESCRIPTION OF BUSINESS AND LIQUIDITY***

## * *

The Company was originally incorporated as Caldera Systems, Inc. (“CalderaSystems”), a Utah corporation, on August 21, 1998, and reincorporated as aDelaware corporation on March 6, 2000. In March 2000, Caldera Systems completed an initial public offering ofits common stock.  On March 6, 2000,Caldera Systems reincorporated in Delaware.

 

OnMay 7, 2001, Caldera International, Inc. (“Caldera”) was formed as a holdingcompany to own Caldera Systems and to acquire substantially all of the assets,liabilities and operations of the server and professional services groups ofThe Santa Cruz Operation, now known as Tarantella, Inc.  The acquired operations from The Santa CruzOperation developed and marketed server software related to networked businesscomputing and were one of the leading providers of UNIX server operatingsystems.  In addition, these operationsprovided professional services related to implementing and maintaining UNIXsystem software products.  Theacquisition provided Caldera with international offices and a distributionchannel with resellers throughout the world. Subsequent to this acquisition, the Company has primarily sold UNIXbased products and services.

 

OnMay 16, 2003, Caldera’s stockholders approved an amendment to Caldera’scertificate of incorporation that changed Caldera’s name to The SCO Group, Inc. (the “Company”).

 

TheCompany’s business focuses on marketing reliable, cost-effective UNIX softwareproducts and related services for the small-to-medium sized businessmarket.  In 2003 the Company establishedits SCOsource division and launched its first ofseveral SCOsource initiatives to review and enforceits intellectual property surrounding the UNIX operating system which itacquired from The Santa Cruz Operation.

 

During the year endedOctober 31, 2004, the Company used cash of $22,604,000 in its operations.  A significant portion of this cash was usedto pursue the Company’s intellectual property litigation.  As of October 31, 2004, the Company had atotal of $31,449,000 in cash and cash equivalents and available-for-salesecurities and an additional $5,000,000 as restricted cash to be used in itsoperations and pursue its intellectual property litigation.  As a result of the Engagement Agreementbetween the Company and its Law Firms (see Note 10), the Company anticipates usingcash of approximately $27,000,000 in the defense of its intellectual propertylitigation during the year ending October 31, 2005, which would leave theCompany approximately $9,449,000 in cash for its business operations.  The Company expects that its UNIX businesswill generate sufficient cash in the year ending October 31, 2005 to cover itsinternal costs related to its SCOsource initiativesand intellectual property litigation, and believes that it will have sufficientcash resources to fund its operations for the next twelve months.

 

**(2) SIGNIFICANT ACCOUNTING POLICIES**

 

### **Use of Estimates in the Preparation ofFinancial Statements**

###  

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during the reportingperiod.  Actual results could differ fromthese estimates.  Key estimates in theaccompanying consolidated financial statements include, among others, revenuerecognition, allowances for doubtful accounts receivable, determination of fairvalue of the derivative associated with the now retired

 

57

----

 

ConvertiblePreferred Stock, impairment of long-lived assets, and valuation allowancesagainst deferred income tax assets.

 

**Reclassifications**

 

Certain reclassificationshave been made to the 2003 and 2002 fiscal year amounts to conform to thecurrent year presentation.  Thereclassifications had no effect on net loss for the prior years.

 

**Principles of Consolidation**

 

The consolidatedfinancial statements include the accounts of the Company and its wholly-ownedand majority-owned operating subsidiaries after all intercompanybalances and transactions have been eliminated.

 

The following tablelists the Company’s subsidiaries, location and ownership interest:

 
| **Subsidiary**                   | ** ** | **Location**   | ** ** | **Ownership Interest** |
|----------------------------------|------------|----------------|------------|------------------------|
|                             |       |           |       |                   |
| SCO Operations,  Inc.            |       | United States  |       | Wholly-owned           |
| SCO Global,  Inc.                |       | United States  |       | Wholly-owned           |
| SCO Software  (Ireland) Ltd.     |       | Ireland        |       | Wholly-owned           |
| SCO Software  (UK) Ltd.          |       | United Kingdom |       | Wholly-owned           |
| SCO Japan, Ltd.                  |       | Japan          |       | Wholly-owned           |
| The SCO Group Korea, Inc.        |       | Korea          |       | Wholly-owned           |
| SCO Canada,  Inc.                |       | Canada         |       | Wholly-owned           |
| The SCO Group (Deutschland) GmbH |       | Germany        |       | Wholly-owned           |
| The SCO Group (France) Sarl      |       | France         |       | Wholly-owned           |
| The SCO Group (Italia) Srl       |       | Italy          |       | Wholly-owned           |

 

**Fair Value of Financial Instruments**

 

The carrying amounts reported in the accompanying consolidated financialstatements for cash and cash equivalents, accounts receivable and accountspayable approximate fair values because of the immediate or short-termmaturities of these financial instruments. The fair values of available-for-sale securities are determined usingquoted market prices for these securities. The fair value of the Series A Convertible Preferred Stock derivativeand Series A Convertible Preferred Stock as of October 31, 2003 were determinedusing a binomial pricing model (see Note 6).

 

**Foreign Currency Translation**

 

The functional currencyof the Company’s foreign subsidiaries is the local foreign currency.  All assets and liabilities denominated inforeign currencies are translated into U.S. dollars at the exchange rateprevailing on the balance sheet date. Revenue and expenses are translated at average exchange rates prevailingduring the period.  Translationadjustments resulting from translation of the subsidiaries’ accounts arerecorded in accumulated other comprehensive income.  Gains and losses resulting from foreigncurrency transactions are included as a component of other income in theconsolidated statements of operations.

 

**Cash and Cash Equivalents**

 

The Company considersall investments purchased with original maturities of three or fewer months tobe cash equivalents.  Cash equivalentswere $2,633,000 and $61,701,000 as of October 31, 2004 and 2003, respectively.  Cash was $10,060,000 and $2,727,000 as ofOctober 31, 2004 and 2003, respectively.

 

58

----

 

**Available-for-Sale Securities**

 

The following table shows the cost, unrealized gain or loss and fairmarket value of the Company’s cash equivalents and available-for-salesecurities as of October 31, 2004 and 2003 (in thousands):

** **
| ** **               | ** ** | **October 31, 2004** |
|--------------------------|------------|----------------------|
| ** **               | ** ** | **Cost**             | ** ** | **Unrealized Gains  (Losses), net** | ** ** | **Fair Market  Value** | ** ** |
|                     |       |                 |   |   |   |   |   |
| Corporate notes          |       | $                    | 2,000 |   | $ | — |   | $ | 2,000 |   |
| U.S. Government agencies |       | 16,800               |   | (44 | ) | 16,756 |   |
| Total                    |       | $                    | 18,800 |   | $ | (44 | ) | $ | 18,756 |   |

 
| ** **               | ** ** | **October 31, 2003** | ** ** |
|--------------------------|------------|----------------------|------------|
| ** **               | ** ** | **Cost**             | ** ** | **Unrealized Gains (Losses), net** | ** ** | **Fair Market  Value** | ** ** |
|                     |       |                 |       |   |   |   |   |
| Corporate notes          |       | $                    | 1,874      |   | $ | 16 |   | $ | 1,890 |   |
| U.S. Government agencies |       | 2,198                |       | 7 |   | 2,205 |   |
| Total                    |       | $                    | 4,072      |   | $ | 23 |   | $ | 4,095 |   |

 

Available-for-salesecurities are recorded at fair market value, based on quoted market prices,and unrealized gains and losses are recorded as a component of comprehensiveincome (loss).  Realized gains and losses,which are calculated based on the specific-identification method, are recordedin operations as incurred.  As of October31, 2004 and 2003, available-for-sale securities at amortized cost and fairvalue consisted of the following (in thousands):

 
| ** **     | ** ** | **2004**           | ** ** | **2003**       | ** ** |
|----------------|------------|--------------------|------------|----------------|------------|
| ** **     | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
| Maturity date  |       |               |       |           |       |   |   |   |   |
| 3 - 12 months  |       | $                  | —     |           | $          | — |   | $ | 701 |   | $ | 703 |   |
| > 12 months |       | 18,800             |       | 18,756         |       | 3,371 |   | 3,392 |   |
| Total          |       | $                  | 18,800     |           | $          | 18,756 |   | $ | 4,072 |   | $ | 4,095 |   |

 

All U.S. Governmentagencies in an unrealized loss position as of October 31, 2004 were notimpaired at acquisition and the decline in fair value is primarily attributableto interest rate fluctuations.  A declinein the market value of any available-for-sale security below cost that isdeemed other than temporary results in a charge to earnings and establishes anew basis for the security.

 

**Restricted Cash and Payable toNovell, Inc.**

 

Pursuant to the 1995 Asset Purchase Agreement and the Company’sacquisition of assets and operations of The Santa Cruz Operation, theCompany acts as an administrative agent in the collection of payments from alimited number of pre-existing Novell, Inc. (“Novell”) customers who continueto deploy SVRx technology.  Under the agency agreement, the Companycollects payments from such customers and receives 5 percent as anadministrative fee.  The Company recordsthe 5 percent administrative fee as revenue in its consolidated statements ofoperations.  The accompanyingconsolidated balance sheets as of October 31, 2004 and 2003 reflect amountscollected related to this agency agreement but not yet remitted to Novell of$3,283,000 and $2,025,000, respectively, as restricted cash and payable toNovell.  The Company’s obligation to actas an administrative agent for Novell is unrelated to the Company’s SCOsource initiatives related to its intellectual propertyrights or the

 

59

----

 

Company’slawsuit against Novell for slander of title alleging Novell’s bad faith effortto interfere with the Company’s copyrights in its UNIX source code andderivative works and its UnixWare product.

 

**Allowance for Doubtful Accounts Receivable**

 

The Company offerscredit terms on the sale of the Company’s products to a significant majority ofthe Company’s customers and require no collateral from these customers.  The Company performs ongoing creditevaluations of the Company’s customers’ financial condition and maintains anallowance for doubtful accounts receivable based upon the Company’s historicalexperience and a specific review of accounts receivable at the end of eachperiod.  As of October 31, 2004 and 2003,the allowance for doubtful accounts was $136,000 and $230,000, respectively.

 

**Inventories**

 

Inventories consist primarilyof completed software products. Inventories are stated at the lower of cost (using the first-in,first-out method) or market value.  As ofOctober 31, 2004 and 2003, inventories amounted to $248,000 and $298,000,respectively.  Inventories are includedin other current assets in the accompanying consolidated balance sheets.

 

Provisions, whenrequired, are made to reduce excess and obsolete inventories to their estimatednet realizable value.  Due to competitivepressures and technological innovation, it is possible that estimates of thenet realizable value could change in the near term.

 

**Capitalized Software Costs**

 

In accordance withFinancial Accounting Standards Board (“FASB”)Statement of Financial Accounting Standards (“SFAS”)No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or OtherwiseMarketed,” development costs incurred in the research and development of newsoftware products to be sold, leased or otherwise marketed are expensed asincurred until technological feasibility in the form of a detail programdesign.  Software development costsincurred after technological feasibility was established and prior to productrelease were not material for fiscal years 2004, 2003 and 2002.  The Company has charged its softwaredevelopment costs to research and development expense in the accompanyingconsolidated statements of operations.

 

**Impairment of Long-Lived Assets**

 

The Company reviews itslong-lived assets for impairment when events or changes in circumstancesindicate that the book value of an asset may not be recoverable.  The Company evaluates, at each balance sheetdate, whether events and circumstances have occurred which indicate possibleimpairment.  The carrying value of along-lived asset is considered impaired when the anticipated cumulativeundiscounted cash flows of the related asset or group of assets is less thanthe carrying value.  In that event, aloss is recognized based on the amount by which the carrying value exceeds theestimated fair market value of the long-lived asset.

 

**Property and Equipment**

 

Property and equipmentare stated at cost, less accumulated depreciation and amortization.  Computer equipment is depreciated using thestraight-line method over the estimated useful life of the asset, which istypically three years.  Furniture andfixtures and office equipment are depreciated using the straight-line methodover the estimated useful life of the asset, typically three to five years.  Leasehold improvements are amortized usingthe straight-line method over the shorter of the estimated useful life of theimprovement or the remaining term of the applicable lease.

 

60

----

 

Expenditures for repairsand maintenance are charged to expense when incurred.  Expenditures for major renewals andbetterments that extend the useful lives of existing equipment are capitalizedand depreciated.  Upon retirement ordisposition of property and equipment, the cost and related accumulateddepreciation are removed from the accounts and any resulting gain or loss isrecognized in the consolidated statements of operations.

 

Depreciation andamortization expense was $783,000, $1,049,000 and $2,555,000 during the yearsended October 31, 2004, 2003 and 2002, respectively.

 

### **RevenueRecognition**

###  

The Company recognizesrevenue in accordance with Statement of Position (“SOP”) 97-2, as modified bySOP 98-9.  The Company’s revenue isprimarily from three sources: (i) product licenserevenue, primarily from product sales to distributors, end users and originalequipment manufacturers (“OEMs”); (ii) technical support service revenue,primarily from providing technical support and consulting services to endusers; and (iii) licensing revenue from its SCOsourceintellectual property initiative.

 

The Company recognizesproduct revenue upon shipment if a signed contract exists, the fee is fixed ordeterminable, collection of the resulting receivable is probable and productreturns are reasonably estimable.

 

The majority of theCompany’s revenue transactions relate to product-only sales.  On occasion, the Company has revenuetransactions that have multiple elements (such as software products,maintenance, technical support services, and other services).  For software agreements that have multipleelements, the Company allocates revenue to each component of the contract basedon the relative fair value of the elements. The fair value of each element is based on vendor specific objectiveevidence (“VSOE”). VSOE is established when such elements are soldseparately.  The Company recognizesrevenue when the criteria for product revenue recognition set forth above havebeen met.  If VSOEof all undelivered elements exists, but VSOE does notexist for one or more delivered elements, then revenue is recognized using theresidual method.  Under the residualmethod, the fair value of the undelivered elements is deferred and theremaining portion of the license fee is recognized as revenue in the periodwhen persuasive evidence of an arrangement is obtained assuming all otherrevenue recognition criteria are met.

 

The Company recognizesproduct revenue from OEMs when the software is sold by the OEM to an end-usercustomer.  Payments for fees aregenerally made in advance and are non-refundable.  Revenue from technical support services andconsulting services is recognized as the related services are performed.  Revenue for maintenance is recognized ratablyover the maintenance period.

 

The Company considers anarrangement with payment terms longer than the Company’s normal businesspractice, which do not extend beyond 12 months, not to be fixed anddeterminable and revenue is recognized when the fee becomes due.  The Company typically provides stock rotationrights for sales made through its distribution channel and sales todistributors are recognized upon shipment by the distributor to end users.  For direct sales not through the Company’sdistribution channel, sales are typically non-refundable andnon-cancelable.  The Company estimatesits product returns based on historical experience and maintains an allowancefor estimated returns, which is recorded as a reduction to accounts receivable.

 

The Company’s SCOsource licensing revenue to date has been primarilygenerated from license agreements to utilize the Company’s UNIX source code aswell as from intellectual property compliance licenses.  The Company recognizes revenue from SCOsource licensing agreements when a signed contractexists, the fee is fixed and determinable, collection of the receivable isprobable and delivery has

 

61

----

 

occurred.  If the payment terms extend beyond theCompany’s normal payment terms, revenue is recognized as the payments becomedue.

 

**Royalty Costs**

 

Royalties paid by theCompany on applications licensed from third parties that are incorporated intothe software products sold by the Company are expensed as cost of revenue on aper unit basis as software products are sold. Royalties paid in advance of product sales are included in other currentassets and recorded as cost of revenue when the related products are sold.  During fiscal years 2004, 2003 and 2002, theCompany incurred $1,262,000, $1,464,000 and $1,552,000, respectively, inroyalty expense.

 

**Advertising**

 

The Company expenses thecost of advertising as incurred. Advertising expenses totaled $350,000, $665,000 and $1,698,000,respectively, for fiscal years 2004, 2003 and 2002, respectively.

 

**Stock-based Compensation**

 

The Company accounts forstock options issued to directors, officers and employees under AccountingPrinciples Board (“APB”) No. 25, “Accounting for Stock Issued to Employees, andRelated Interpretations.”  Under APB No.25, compensation expense is recognized if an option’s exercise price on themeasurement date is below the fair market value of the Company’s commonstock.  The Compensation expense, if any,is amortized to expense over the vesting period.

 

SFASNo. 148, “Accounting for Stock-Based Compensation,” requires pro formainformation regarding netincome (loss) as if the Company had accounted for its stock options grantedunder the fair value method prescribed by SFAS No.123, “Accounting for Stock-Based Compensation.” The fair value for the Company’s stock options is estimated on the dateof grant using the Black-Scholes option-pricingmodel.

 

Withrespect to stock options and restricted stock awards granted and employee stockpurchase program (“ESPP”) shares purchased during theyears ended October 31, 2004, 2003 and 2002, the assumptions used in the Black-Scholes option-pricing model are as follows:  

 
| ** **                        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free interest rate           |       | 2.8      | %          | 2.9      | %          | 3.0      | %          |
| Expected dividend yield           |       | 0.0      | %          | 0.0      | %          | 0.0      | %          |
| Volatility                        |       | 79.5     | %          | 126.0    | %          | 161.0    | %          |
| Expected exercise life (in years) |       | 3.0      |       | 2.7      |       | 2.5      |       |

 

Forpurposes of the pro forma disclosure, the estimated fair value of stockoptions, restricted stock awards and ESPP shares areamortized over the vesting period of the award. The following is the pro forma disclosure and the related impact on netincome (loss) to common stockholders and the net income (loss) to commonstockholders per diluted common share for the years ended October 31, 2004,2003 and 2002 (in thousands, except per share amounts):

 
| ** **                                                                               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income available (loss applicable) to  common stockholders:                          |       |     |       |     |       |     |       |
| As reported                                                                              |       | $        | (16,227    | )        | $          | 5,304    |       | $ | (24,877 | ) |
| Stock-based compensation included in  reported net income (loss)                         |       | 919      |       | 1,204    |       | 1,125    |       |
| Stock-based compensation under fair value  method                                        |       | (2,082   | )          | (1,855   | )          | (6,814   | )          |
| Pro forma net income available (loss  applicable) to common stockholders                 |       | $        | (17,390    | )        | $          | 4,653    |       | $ | (30,566 | ) |
| Net income available (loss applicable) to  common stockholders per basic common share:   |       |     |       |     |       |     |       |
| As reported                                                                              |       | $        | (1.07      | )        | $          | 0.43     |       | $ | (1.93 | ) |
| Pro forma                                                                                |       | $        | (1.15      | )        | $          | 0.38     |       | $ | (2.37 | ) |
| Net income available (loss applicable) to  common stockholders per diluted common share: |       |     |       |     |       |     |       |
| As reported                                                                              |       | $        | (1.07      | )        | $          | 0.34     |       | $ | (1.93 | ) |
| Pro forma                                                                                |       | $        | (1.15      | )        | $          | 0.30     |       | $ | (2.37 | ) |

 

62

----

 

**Income Taxes**

 

The Company recognizes aliability or asset for the deferred tax consequences of all temporarydifferences between the tax bases of assets and liabilities and their reportedamounts in the consolidated financial statements that will result in taxable ordeductible amounts in future years when the reported amounts of the assets andliabilities are recovered or settled. These deferred tax assets or liabilities are measured using the enactedtax rates that will be in effect when the differences are expected toreverse.  The effect on deferred taxassets and liabilities of a change in tax rates is recognized in income in theperiod that includes the enactment date. Deferred tax assets are reviewed periodically for recoverability, andvaluation allowances are provided when it is more likely than not that some orall of the deferred tax assets may not be realized.  The Company has provided a valuationallowance against the entire net deferred tax asset because of its history ofnet operating losses and the uncertainties regarding future operatingprofitability and taxable income.

 

**Comprehensive Income (Loss)**

 

Comprehensive income(loss) consists of net income (loss), foreign currency translation adjustmentsand unrealized gain (loss) on available-for-sale securities and is presented inthe accompanying consolidated statements of operations and comprehensive income(loss).

 

**Hedging of Foreign CurrencyTransactions**

 

The Company has in thepast utilized foreign currency forward exchange contracts for market exposuresof underlying assets and liabilities. The Company has not used forward exchange contracts for speculative ortrading purposes.  The Company’saccounting policies for foreign exchange contracts are based on the Company’sdesignation of each contract.  Thecriteria used for designating each contract include such contract’seffectiveness in risk reduction and one-to-one matching of forward exchangecontracts to underlying assets and liabilities. Gains and losses on currency forward contracts that are firm commitmentsare deferred and recognized in income in the same period that the underlyingtransactions are settled.  Gains andlosses on currency forward contracts that are designated and effective for existingtransactions are recognized in income in the same period as gains and losses onthe underlying transactions are recognized and generally offset.  Gains and losses on any instruments notmeeting the above criteria are recognized in income in the current period.  As of October 31, 2004, the Company had nooutstanding instruments classified as hedges.

 

**Net Income (Loss) per Common Share**

 

 Basic net income (loss) per common share (“BasicEPS”) is computed by dividing net income (loss) by the weighted average numberof common shares outstanding.  Dilutednet income (loss) per common share (“Diluted EPS”) is computed by dividing netincome by the sum of the weighted average number of common shares outstandingand the dilutive potential common share equivalents then outstanding.  Potential common share equivalents consist ofthe weighted average of shares issuable upon theexercise of outstanding stock options, restricted stock awards, warrants toacquire common stock and preferred stock convertible into common shares.  If dilutive, the Company computes Diluted EPSusing the treasury stock method.

 

63

----

 

The following table is areconciliation of the numerator and denominator of Basic EPS to the numeratorand denominator of Diluted EPS (in thousands, except per share amounts): 

 
| ** **                                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                           |       |     |       |     |       |     |       |
| Numerator:                                                     |       |     |       |     |       |     |       |
| Net income available (loss applicable) to  common stockholders |       | $        | (16,227    | )        | $          | 5,304    |       | $ | (24,877 | ) |
| Denominator:                                                   |       |     |       |     |       |     |       |
| Weighted average common shares outstanding                     |       | 15,155   |       | 12,256   |       | 12,893   |       |
| Series A Convertible Preferred Stock                           |       | —   |       | 5        |       | —   |       |
| Weighted average basic common shares  outstanding              |       | 15,155   |       | 12,261   |       | 12,893   |       |
| Stock options                                                  |       | —   |       | 2,833    |       | —   |       |
| Restricted stock                                               |       | —   |       | 471      |       | —   |       |
| Warrants                                                       |       | —   |       | 114      |       | —   |       |
| Weighted average diluted common shares  outstanding            |       | 15,155   |       | 15,679   |       | 12,893   |       |
| Basic EPS                                                      |       | $        | (1.07      | )        | $          | 0.43     |       | $ | (1.93 | ) |
| Diluted EPS                                                    |       | (1.07    | )          | 0.34     |       | (1.93    | )          |
|                                                           |       |     |       |     |       |     |       |
| Excluded anti-dilutive common share  equivalents               |       | 3,161    |       | 387      |       | 4,374    |       |

 

The excludedanti-dilutive common share equivalents are not included in the computation ofDiluted EPS as their effect would have decreased Diluted EPS.

 

**(3) ACQUISITIONS**

 

**Vultus**

 

Under the terms of an Asset Acquisition Agreement (the “Vultus Agreement”) dated June 6, 2003, the Company acquiredsubstantially all of the assets of Vultus, Inc. (“Vultus”), a corporation engaged in the web servicesinterface business.  As consideration forthe assets acquired, the Company issued approximately 167,000 shares of theCompany’s common stock, of which The Canopy Group, Inc. (“Canopy”), the Company’sprincipal stockholder as of October 31, 2004, received approximately 37,000shares.  The Company also assumedapproximately $215,000 in accrued liabilities of Vultus.  In addition, the Company assumed theobligations of Vultus under two secured notes payableto Canopy totaling $1,073,000.  Inconnection with the assumption of the notes payable to Canopy, Canopy agreed toaccept the issuance of approximately 138,000 shares of the Company’s commonstock in full satisfaction of the obligations. Canopy was a stockholder and significant debt holder of Vultus.  NeitherCanopy nor any of its officers or directors participated in the Company’sapproval of this transaction.

 

The following table summarizes the components of the consideration paidto Vultus (in thousands, except per share data):

 
| Consideration paid:                                                    | * * | * * | * * |
|------------------------------------------------------------------------|----------|----------|----------|
| Fair value of common stock issued (305,000  shares at $8.06 per share) |     | $        | 2,461    |   |
| Assumed liabilities                                                    |     | 215      |     |
| Direct expenses                                                        |     | 45       |     |
| Total consideration                                                    |     | $        | 2,721    |   |

 

The $8.06 per sharevalue of the common stock issued was determined based on the average marketprice of the Company’s common stock for the two days before and the day ofsigning the Vultus Agreement.

 

64

----

 

The Company accounted for the acquisition ofVultus as a business combination in accordance with SFAS No. 141.  SFAS No. 141 requires that the totalpurchase price, including direct fees and expenses, be allocated to the assetsacquired based upon their respective fair values.  No current assets or tangible assets ofsignificant value were acquired.  Basedon the nature and status of the research and development projects at the dateof acquisition, none of the purchase price has been allocated to in-processresearch and development.  The purchaseprice has been allocated to the intangible assets acquired as follows (inthousands):

 
| Purchase price allocation:                                | * * | * * | * * |
|-----------------------------------------------------------|----------|----------|----------|
| Acquired technology (estimated useful life  of two years) |     | $        | 1,555    |   |
| Goodwill                                                  |     | 1,166    |     |
| Total                                                     |     | $        | 2,721    |   |

 

**Pro Forma Financial Information**

 

The following table setsforth certain pro forma financial information had the Vultus acquisition beencompleted as of November 1, 2002 (unaudited, in thousands, except pershare amounts):

 
| ** **                                                     | ** ** | **Year Ended October 31,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                     | ** ** | **2003**                        | ** ** | **2002** | ** ** |
|                                                           |       |                            |       |   |   |
| Revenue                                                        |       | $                               | 79,254     |   | $ | 64,296 |   |
| Net income (loss) from operations                              |       | 2,133                           |       | (26,142 | ) |
| Net income available (loss) applicable to  common stockholders |       | 3,998                           |       | (26,877 | ) |
| Basic net income (loss) per common share                       |       | $                               | 0.32       |   | $ | (2.04 | ) |
| Diluted net income (loss) per common share                     |       | $                               | 0.25       |   | $ | (2.04 | ) |

 

As discussed in more detail in Note 4, theCompany recorded an asset impairment related to Vultus during the year ended October 31,2004.

 

**(4) GOODWILL ANDINTANGIBLE ASSETS**

 

The following tableshows the activity related to amortized intangible assets for the years ended October 31,2003 and 2004 as well as the remaining unamortized balances as of October 31,2004 (in thousands):

 
| ** **                     | ** ** | **As of  October 31, 2002** | ** ** | **Year Ended  October 31, 2003** | ** ** | **As of  October 31, 2003** | ** ** |
|--------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **Net Book Value**               | ** ** | **Amortization  Expense**             | ** ** | **Additions**                    | ** ** | **Net Book Value** | ** ** |
| Amortizable intangible assets: |       |                             |       |                                  |       |                             |       |   |   |
| Distribution/reseller channel  |       | $                                | 9,273      |                                  | $          | (2,319                           | )          | $ | — |   | $ | 6,954 |   |
| Acquired technology            |       | 1,777                            |       | (1,157                                | )          | 1,555                            |       | 2,175 |   |
| Trade name                     |       | 208                              |       | (51                                   | )          | —                           |       | 157 |   |
| Total intangible assets        |       | $                                | 11,258     |                                  | $          | (3,527                           | )          | $ | 1,555 |   | $ | 9,286 |   |
|                                |            |                                  |            |                                       |            |                                  |            |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **As of  October 31, 2003** | ** ** | **Year  Ended  October 31, 2004** | ** ** | **As of  October 31, 2004** | *** *** |
|--------------------------------|------------|----------------------------------|------------|----------------------------------------|------------|----------------------------------|--------------|
| ** **                     | ** ** | **Net Book  Value**              | ** ** | **Amortization  Expense**              | ** ** | **Impairment  Loss**             | ** **   | **Net Book  Value** | *** *** |
| Amortizable intangible assets: |       |                             |       |                                   |       |                             |         |   |   |
| Distribution/reseller channel  |       | $                                | 6,954      |                                   | $          | (2,318                           | )            | $ | — |   | $ | 4,636 |   |
| Acquired technology            |       | 2,175                            |       | (529                                   | )          | (973                             | )            | 673 |   |
| Trade name                     |       | 157                              |       | (53                                    | )          | —                           |         | 104 |   |
| Total intangible assets        |       | $                                | 9,286      |                                   | $          | (2,900                           | )            | $ | (973 | ) | $ | 5,413 |   |
|                                |            |                                  |            |                                        |            |                                  |              |  |  |  |  |  |  |  |

 

65

----

 

Of the $2,900,000 inamortization expense for the year ended October 31, 2004, $334,000 wasclassified as cost of SCOsource licensing revenue and the remaining $2,566,000was classified as amortization of intangible assets in operating expenses.  Of the $3,527,000 in amortization expense forthe year ended October 31, 2003, $337,000 was classified as cost ofSCOsource licensing revenue and the remaining $3,190,000 was classified asamortization of intangible assets in operating expenses.  Amortization expense was $3,187,000 for theyear ended October 31, 2002 and $2,853,000 was classified as an operatingexpense.

 

During the year ended October 31,2004, the Company recorded a loss on impairment of long-lived assets totaling$2,139,000, which related to an impairment loss on intangible assets of$973,000 and an impairment of goodwill of $1,166,000.  The intangible assets and goodwill wereincluded as part of the UNIX segment.

 

The impairment lossrelated to goodwill and intangible assets acquired in connection with theacquisition of Vultus in June 2003. The Company concluded that an impairment-triggering event occurredduring the three months ended April 30, 2004 as the Company had a reductionin force that impacted the Company’s ability to move the Vultus initiativeforward on a stand-alone basis and because an impending partnership that wouldhave solidified the Vultus revenue and cash flow opportunities did notmaterialize.  Consequently, the Companyconcluded that no significant future cash flows related to its Vultus assetswould be realized.  The Company performedan impairment analysis of its recorded goodwill related to the Vultus reportingunit using a present value of future cash flows model.  Additionally, an impairment analysis of theintangible assets was performed in accordance with SFAS No. 144.  As a result of these analyses, the Companywrote-down the carrying value of its goodwill related to the Vultus acquisitionfrom $1,166,000 to $0 and wrote-down intangible assets related to its Vultusacquisition from $973,000 to $0.

 

Future amortizationexpense for the above intangible assets as of October 31, 2004, is asfollows (in thousands):

 
| ** **                   | ** ** | **Amortization** | ** ** |
|------------------------------|------------|------------------|------------|
| ** **                   | ** ** | **Expense**      | ** ** |
| Year ending October 31, |       |             |       |
| 2005                         |       | $                | 2,706      |   |
| 2006                         |       | 2,707            |       |
| Total                        |       | $                | 5,413      |   |

 

Pursuant to SFAS No. 142,the Company is required to test its intangible assets for impairment at leastannually.  The Company performed a testas of October 31, 2004 and concluded that no impairment had occurred.

 

**(5) INVESTMENTS IN NON-MARKETABLE SECURITIES**

 

The Company accounts for each of its investments in non-marketablesecurities under the cost method, if the Company owns less than 20 percent ofthe outstanding voting securities or under the equity method if the Companyowns more than 20 percent but less than 50 percent of the outstanding votingsecurities.

 

In connection with the Company’s acquisition of the server andprofessional services groups from The Santa Cruz Operation, it acquired a 30percent ownership interest in SCO Software, China; a 

 

66

----

 

joint venture in China.  This investment is being accounted for usingthe equity method.  As of October 31,2004, the Company had a balance of $561,000 for its China investment, which isincluded as a component of other assets. The Company’s other investments in non-marketable securities have beenfully impaired in prior fiscal years and did not have a book value as of October 31,2004.

 

Income or loss recorded on the Company’s investments is recorded asequity in income (losses) of affiliates in the consolidated statements ofoperations and amounted to $111,000, ($62,000) and ($50,000) for the fiscalyears ended October 31, 2004, 2003 and 2002, respectively.

 

**Investment Impairments and Write-offs**

 

Management routinely assesses the Company’s investments for impairmentand adjusts the carrying amount to estimated realizable values when impairmenthas occurred.  During the years ended October 31,2003 and 2002, management determined that the carrying value of certain of itsinvestments would most likely not be recoverable and incurred write-offs of$250,000 and $1,180,000, respectively. The necessary write-offs were due to declines in general economicconditions and the impact of such declines in the operations of these companiesas well as a decline in overall market valuations.

 

**(6) REDEEMABLE CONVERTIBLE PREFERRED STOCK**

 

On October 16,2003, the Company issued 50,000 shares of its redeemable Series AConvertible Preferred Stock (the “Series A”) for $1,000 per share.  The net proceeds from the sale of the Series Awere $47,740,000.  The value of the Series Awas classified outside of permanent equity because of certain redemptionfeatures that were outside the control of the Company.

 

The terms of the Series Aincluded a number of conversion provisions that represented a derivativefinancial instrument under SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities.”  TheCompany determined that the conversion feature allowing Series A holdersto acquire common shares was an embedded derivative requiring separateaccounting.  This required the Company torecord the derivative at fair value and mark to fair value at each reportingperiod.  Changes in the fair value of thederivative were recorded in the Company’s statement of operations.  As of October 16, 2003, the Company,through the assistance of an independent valuation firm, determined the initialfair value of the derivative was $18,069,000. As of October 31, 2003, the fair value of the derivative was$15,224,000 and the decrease in fair value of $2,845,000 was recorded as a gainas a change in fair value of derivative in other income in the statement ofoperations for fiscal year 2003.

 

As of January 31,2004, the fair value of the derivative was $11,600,000, and the decrease infair value of $3,624,000 was recorded as a gain as a change in fair value ofderivative in other income in the statement of operations for three monthsended January 31, 2004.  On February 5,2004, all outstanding Series A shares were exchanged for shares of theCompany’s Series A-1 Convertible Preferred Stock (the “Series A-1”),and, as a result, no Series A shares remained outstanding as of February 5,2004.  The exchange did not result in theCompany receiving any additional proceeds. As of February 5, 2004, the fair value of the derivative was$9,300,000 and the decrease in fair value of $2,300,000 from January 31,2004 was recorded as a gain as a change in fair value of derivative in otherincome in the statement of operations.

 

As of February 5,2004, the Company, through the assistance of an independent valuation firm,determined the fair value of the Series A-1 was $45,276,000.  The Company incurred $211,000 in offeringcosts in connection with the issuance of the Series A-1 in the exchangefor Series A, resulting in a net fair value of $45,065,000.  The difference of $6,305,000 in the fairvalue of the Series A-1 and the combined carrying value of the Series Aand the related derivative was recorded as a non-cash dividend in thestatements of operations for the three months ended April 30, 2004.

 

67

----

 

**Conversionof Series A-1 Shares and Transfer of Series A-1 Shares to BayStar**

 

OnMay 5, 2004, the Company received a notice from Royal Bank of Canada (“RBC”),one of the holders of the Series A-1 shares that RBC had elected toconvert 10,000 Series A-1 shares into a total of 740,740 shares of the Company’scommon stock.  The converted Series A-1shares were purchased at a price of $1,000 per share and were converted intoshares of common stock based on a conversion price of $13.50 per share.  A total of $9,013,000 was recorded aspermanent equity as a result of this conversion.  Additionally, RBC informed the Company thatit had sold its remaining 20,000 Series A-1 shares to BayStar Capital II,L.P. (“BayStar”), which following such transfer held a total of 40,000 Series A-1shares.

 

**Agreementto Repurchase BayStar Capital Series A-1 Shares**

 

On May 31, 2004,the Company entered into an agreement with BayStar to repurchase and retireBayStar’s 40,000 Series A-1 shares, including accrued dividends.  Terms of the agreement required the Companyto pay to BayStar $13,000,000 in cash and issue 2,105,263 shares of the Company’scommon stock.  The repurchase price waspayable and issuable upon the effectiveness of a shelf registration statementcovering the resale of the shares of common stock that would be issued toBayStar upon the closing of the repurchase. On July 21, 2004, the SEC declared the Company’s registrationstatement on Form S-3 effective, and, in accordance with the terms of therepurchase agreement, the closing of the repurchase with BayStar closed on thatdate.  The fair value of the cash andcommon shares delivered to BayStar was less than the carrying value of theremaining value of the Series A-1 shares and the Company recorded acapital contribution as a dividend for this difference as outlined in thefollowing table (in thousands):

 
| Fair value of 2,105,263 common shares                  |   | $      | 9,747   |   |
|--------------------------------------------------------|--------|--------|---------|--------|
| Cash consideration                                     |   | 13,000 |    |
| Total value to BayStar                                 |   | 22,747 |    |
| Carrying value of Series A-1 including  dividends |   | 38,222 |    |
| Capital contribution                                   |   | $      | (15,475 | )      |

 

**Dividends**

 

If the repurchase hadnot occurred, dividends on the Series A-1 shares would have been paidafter October 16, 2004, the first anniversary of the original Series Aprivate placement, quarterly at a rate of 8 percent per annum, subject toannual increases of 2 percent per annum, not to exceed 12 percent perannum.  Although the Company accrueddividends of $2,047,000 and $123,000 for the years ended October 31, 2004and 2003, respectively, which reduced earnings to common stockholders, theCompany will no longer accrue dividends on preferred stock because therepurchase transaction with BayStar closed. The Company never paid any dividends on the Series A or Series A-1shares.

 

**(7) COMMON STOCK SUBJECT TO RESCISSION**

 

The Company believescertain shares and options granted under the Equity Compensation Plans wereissued without complying with registration or qualification requirements underfederal securities laws and the securities laws of certain states.  As a result, certain Plan participants have aright to rescind their purchases of shares under the Plans or recover damagesif they no longer own the shares or hold unexercised options, subject toapplicable statutes of limitations. Additionally, regulatory authorities may require the Company to pay finesor impose other sanctions.  Although theCompany continues to evaluate the possible actions it may take, the Company maymake a rescission offer to certain Plan participants entitled to rescissionrights subject to obtaining required regulatory approvals.

 

68

----

 

Accounting Series Release(“ASR”) No. 268 and Emerging Issues Task Force (“EITF”) Topic D-98 requirethat stock subject to rescission or redemption requirements outside the controlof the Company to be classified outside of permanent equity.  Theexercise of the rescission right is at the holders’ discretion, but exercise ofthat right may depend in part on the fair value of the Company’s common stockwhich is outside of the Company’s and the holders’ control.  Consequently, common stock subject torescission is classified as temporary equity. If the Company’s possible rescission offer is made and accepted by planparticipants holding shares acquired under the Equity Compensation Plans orotherwise entitled to recover damages from the Company in respect of suchshares they have sold, or such plan participants otherwise make rescissionclaims against the Company, the Company could be required to make aggregatepayments to these plan participants of up to $528,000 in the aggregate,excluding interest and other possible fees, based upon approximately 499,000 sharesoutstanding under the Plans as of October 31, 2004.

 

In the event the Companycompletes a rescission offer or plan participants otherwise exercise rescissionrights, any amounts the Company may pay to plan participants, excludinginterest and other possible charges, will be deducted from common stock subjectto rescission, and, in the event a plan participant declines a rescission offeror otherwise is determined to no longer have a rescission right, any remainingamounts recorded to common stock subject to rescission will be recorded aspermanent equity.

 

**(8) STOCKHOLDERS’ EQUITY**

 

**Reverse Stock Split**

 

On December 17,2001, the Company’s board of directors approved a one-for-four reverse stocksplit for holders of common stock.  On March 4,2002, the stockholders approved this reverse stock split and the Company’sauthorized shares were reduced from 200,000,000 shares to 50,000,000 sharesconsisting of 5,000,000 shares of preferred stock and 45,000,000 shares ofcommon stock.  The outstanding commonshares were reduced from 57,715,000 shares to 14,428,750 shares.  The reverse stock split of common shares hasbeen retroactively reflected in the accompanying consolidated financialstatements and notes for all periods presented, unless otherwise indicated.

 

**Stock Options**

 

 During the year ended October 31, 1998,the Company adopted the 1998 Stock Option Plan (the “1998 Plan”) that providedfor the granting of nonqualified stock options to purchase shares of commonstock.  On December 1, 1999, theCompany’s board of directors approved the 1999 Omnibus Stock Incentive Plan(the “1999 Plan”), which was intended to serve as the successor equityincentive program to the 1998 Plan.  The1999 Plan allows for the grant of awards in the form of incentive andnon-qualified stock options, stock appreciation rights, restricted shares,phantom stock and stock bonuses.  Awardsmay be granted to individuals in the Company’s employ or service.

 

OnMay 16, 2003, the Company’s stockholders approved the 2002 Omnibus StockIncentive Plan (the “2002 Plan”) upon the recommendation of the board ofdirectors.  The 2002 Plan permits theaward of stock options, stock appreciation rights, restricted stock, phantomstock rights, and stock bonuses.  Stockoptions may have an exercise price equal to, less than, or greater than thefair market value of the common stock on the date of grant, except that theexercise price of incentive stock options must be equal to or greater than thefair market value of the common stock as of the date of grant.

 

OnApril 20, 2004, the Company’s stockholders approved the 2004 Omnibus StockIncentive Plan (the “2004 Plan”) upon the recommendation of the board ofdirectors.  The 2004 Plan allows for theaward of up to 1,500,000 shares of the Company’s common stock and permits theaward of stock options, stock appreciation rights, restricted stock, phantomstock rights, and stock bonuses.  The2004 Plan is administered by the Compensation Committee of the Company’s boardof directors.  The Compensation Committeehas the ability to determine the terms of the option, the exercise price, thenumber of shares 

 

69

----

 

subject to each option, and theexercisability of the options.  Stockoptions may have an exercise price equal to, less than, or greater than thefair market value of the common stock on the date of grant, except that theexercise price of incentive stock options must be equal to or greater than thefair market value of the common stock as of the date of grant.  Shares issued pursuant to the 2004 Plan maybe authorized and unissued shares, treasury shares or shares acquired by theCompany for purposes of the 2004 Plan.

 

Underthe terms of the 1998, 1999, 2002 and 2004 Plans, options generally expire 10years from the date of grant or within 90 days of termination.  Options granted under these plans generallyvest at 25 percent after the completion of one year of service and then 1/36per month for the remaining three years and would be fully vested at the end offour years.

 

Theboard may suspend, revise, terminate or amend any of the option plans at anytime; provided, however, that stockholder approval must be obtained if and tothe extent that the board deems it appropriate to satisfy Section 162(m)of the Code, Section 422 of the Code or the rules of any stockexchange on which the common stock is listed. No action under the option plans may, without the consent of theparticipant, reduce the participant’s rights under any outstanding award.

 

Asof October 31, 2004, 232,000 shares were available for issuance under the1999 Plan, 452,000 shares were available for issuance under the 2000 Plan, and1,145,000 shares were available for issuance under the 2004 Plan.  A summary of stock option activity under the1998, 1999,  2002 and 2004 Plans for theyears ended October 31, 2004, 2003 and 2002 is as follows (in thousands,except per share amounts):

 
| ** **                     | ** ** | ** **  | ** ** | **Weighted Average** | ** ** |
|--------------------------------|------------|-------------|------------|----------------------|------------|
| ** **                     | ** ** | **Options** | ** ** | **Exercise Price**   | ** ** |
|                           |       |        |       |                 |       |
| Balance, October 31, 2001 |       | 3,108       |       | $                    | 10.12      |   |
| Granted                        |       | 3,910       |       | 0.98                 |       |
| Exercised                      |       | (215        | )          | 1.37                 |       |
| Cancelled                      |       | (2,537      | )          | 7.54                 |       |
| Balance, October 31, 2002 |       | 4,266       |       | 3.78                 |       |
| Granted                        |       | 1,755       |       | 5.56                 |       |
| Exercised                      |       | (1,305      | )          | 1.57                 |       |
| Cancelled                      |       | (1,055      | )          | 9.34                 |       |
| Balance, October 31, 2003 |       | 3,661       |       | 3.74                 |       |
| Granted                        |       | 939         |       | 7.31                 |       |
| Exercised                      |       | (606        | )          | 1.57                 |       |
| Cancelled                      |       | (833        | )          | 7.62                 |       |
| Balance, October 31, 2004 |       | 3,161       |       | $                    | 4.18       |   |

 

The weighted average fair value of options granted for the years ended October 31,2004 2003 and 2002 was $7.31, $5.56 and $0.98, respectively.

 

During the years ended October 31, 2004, 2003 and 2002, the Companydid not grant any stock options with exercise prices that were less than thequoted market price of the Company’s common stock.  A summary of stock options outstanding andexercisable under the Company’s 1998, 1999, 2002 and 2004 Plans as of October 31,2004 is as follows (in thousands, except per share amounts):

 

70

----

 
| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** **  |
|--------------------------|------------|-------------------------|------------|-------------------------|-------------|
| ** **               | ** ** | ** **              | ** ** | **Weighted**            | ** **  | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **              | ** ** | **Average**             | ** **  | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **               | ** ** | **Options**             | ** ** | **Contractual**         | ** **  | **Exercise** | ** ** | **Options** | ** ** | **Exercise** | ** ** |
| **Exercise Prices**      | ** ** | **Outstanding**         | ** ** | **Life**                | ** **  | **Price** | ** ** | **Exercisable** | ** ** | **Price** | ** ** |
|                     |       |                    |       |                    |        |   |   |   |   |   |   |
| $ 0.66 – $0.76 |       | 600                     |       | 7.66                    |  years |   | $ | 0.76 |   | 283 |   | $ | 0.76 |   |
| $ 0.77 – $1.10 |       | 397                     |       | 7.68                    |        |   | 0.90 |   | 322 |   | 0.87 |   |
| $ 1.12 – $2.00 |       | 407                     |       | 7.21                    |        |   | 1.21 |   | 282 |   | 1.15 |   |
| $ 2.07 – $4.05 |       | 770                     |       | 8.30                    |        |   | 2.59 |   | 365 |   | 2.34 |   |
| $ 4.50 – $9.12 |       | 658                     |       | 9.13                    |        |   | 6.57 |   | 99 |   | 7.37 |   |
| $ 9.12 and above    |       | 329                     |       | 8.21                    |        |   | 16.99 |   | 131 |   | 18.90 |   |
|                     |       | 3,161                   |       | 8.12                    |  years |   | $ | 4.18 |   | 1,482 |   | $ | 3.29 |   |

 

**2000 Employee Stock Purchase Plan**

 

The 2000 Employee StockPurchase Plan, as amended, is designed to allow eligible employees of theCompany and its participating subsidiaries to purchase shares of the Company’scommon stock, at semi-annual intervals, through periodic payrolldeductions.  A participant may contributeup to 10 percent of his or her cash earnings through payroll deductions and theaccumulated payroll deductions will be applied to the purchase of shares on theparticipant’s behalf on each semi-annual purchase date (the last business dayin May and November).  The purchaseprice per share will be 85 percent of the lower of the fair market value of theCompany’s common stock on the participant’s entry date into the offering periodor the fair market value on the semi-annual purchase date.

 

The board may at anytime amend or modify the plan.  The planwill terminate no later than the last business day in April 2010.

 

During the year ended October 31,2004, 691,000 shares were purchased at prices ranging from $0.66 to $5.21 pershare.  During the year ended October 31,2003, 345,000 shares were purchased at prices ranging from $0.66 to $1.38 pershare and during the year ended October 31, 2002, 175,000 shares werepurchased at prices ranging from $0.71 to $2.62 per share.

 

**Stock-based Compensation**

 

 Stock-based compensation was $919,000,$1,204,000 and $1,125,000 during the years ended October 2004, 2003 and2002, respectively.  The following tablesummarizes the components of stock-based compensation (in thousands):

 
| *** ***                                                             | *** *** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------------------|--------------|----------|------------|----------|------------|----------|------------|
|                                                                     |         |     |       |     |       |     |       |
| Amortization of stock-based compensation                                 |         | $        | 325        |     | $          | 866      |       | $ | 986 |   |
| Options, warrants and shares for services                                |         | 502      |       | 296      |       | 631      |       |
| Option modifications                                                     |         | 92       |       | 42       |       | 73       |       |
| Reversal of previously recorded expense  related to terminated employees |         | —   |       | —   |       | (565     | )          |
| Total                                                                    |         | $        | 919        |     | $          | 1,204    |       | $ | 1,125 |   |

 

**Restricted Stock Awards**

 

During the year ended October 31,2004, the Company did not grant any shares of restricted stock.  During the year ended October 31, 2003,the Company issued 180,000 shares of restricted stock to certain keyemployees.  The restrictions on therestricted stock awards granted to key employees lapse over a period of 24months.  The fair value of the restrictedstock awards granted was approximately $374,000.  The fair value of the restricted stock awardswas recorded as a component of deferred compensation and is amortized tostock-based compensation as the restrictions lapse.  Additionally in 2003, the Company’s board ofdirectors approved a resolution to receive remaining amounts owed to them forservices provided during the year ended October 31, 2002 fiscal year inthe form of restricted stock awards.  TheCompany issued 27,500 shares of common stock with a fair value of $36,000 thatwas expensed as a component of options and shares for services in the abovetable.  Finally, the Company

 

71

----

 

granted150,000 shares of restricted common stock to members of the Company’s board ofdirectors with a fair value of $195,000 and was recorded as a component ofdeferred compensation.  The restrictedcommon stock issued to the board of directors was in lieu of cash compensationfor their services to the Company during fiscal year 2003 and the restrictionslapsed on October 31, 2003.

 

During the year ended October 31,2002, the Company issued 450,000 shares of restricted stock to certain keyemployees.  The restrictions related tothe restricted stock awards lapse over a period of 24 months.  The fair value of the restricted stock awardsgranted of $495,000 was recorded as a component of deferred compensation and isamortized to stock-based compensation as the restrictions lapse.

 

**Warrants**

 

In August 2002, the Company entered into an agreement with MorganKeegan & Company (“Morgan Keegan”) to act as an exclusive financialadvisor to assist the Company in its analysis, consideration and if appropriate,execution of various financial and strategic alternatives including, but notlimited to, securing additional equity and/or debt capital and potentialstrategic transactions including mergers, acquisitions and joint ventures.  During the year ended October 31, 2003,the Company paid a fee to Morgan Keegan of $2,000,000 in connection with theCompany’s Series A private placement.

 

In consideration for the services provided, in August 2002, theCompany issued to Morgan Keegan a warrant to purchase 200,000 shares of theCompany’s common stock at an exercise price of $0.01 per share.  Morgan Keegan was granted demand registrationrights to have the Company use its best efforts to register the shares uponexercise of the warrant.  The Companyexpensed the fair value of thewarrant of $294,000, determined using the Black-Scholes option-pricing model. In January 2003, Morgan Keegan exercised the warrant.

 

During the year ended October 31,2003, the Company issued three warrants to Sun Microsystems, Inc. (“Sun”).  The warrants allow Sun to acquire a total of235,000 shares of the Company’s common stock at an exercise price of $1.83 pershare for a term of five years from the date of grant.  The warrants were issued in connection with aSCOsource revenue transaction with Sun, and the Company has recorded the fairvalue of the warrants of $856,000, as determined using the Black-Scholesoption-pricing model, as a warrant outstanding and reduced SCOsource licenserevenue.  The Company received the$856,000 in cash from Sun in connection with payments received under the termsof the revenue transaction.  As of October 31,2004, all warrants to Sun remained outstanding and unexercised.

 

During the year ended October 31,2003, the Company issued a warrant to a consultant, as part of an agreement toassist the Company with its SCOsource licensing initiative.  The warrant allows the consultant to acquire25,000 shares of the Company’s common stock at an exercise price of $8.50 pershare for a term of two years from the date of the agreement.  The Company has recorded the fair value ofthe warrant of $243,000, as determined using the Black-Scholes option-pricingmodel, as a warrant outstanding and included this cost as a cost of SCOsourcelicensing revenue.  As of October 31,2004, the warrant remains outstanding and unexercised.

 

**Repurchase of Common Stock**

 

On March 10, 2004,the Company’s board of directors authorized management, in its discretion, topurchase up to 1,500,000 shares of the Company’s common stock over the 24-monthperiod following March 10, 2004, the time at which the repurchase programwas effective.  Any repurchased shareswill be held in treasury and will be available for general corporatepurposes.  The repurchase program willallow the Company to repurchase its shares from time to time in accordance withthe requirements of the Securities and Exchange Commission on the open market,in block trades and in privately negotiated transactions, depending on marketconditions and other factors.  During theyear ended October 31, 2004, 

 

72

----

 

theCompany purchased approximately 290,000 shares of its common stock at a totalcost of approximately $2,414,000.

 

**Stockholder Rights Plan**

 

On August 10, 2004, the Company’s Board of Directors adopted aStockholder Rights Plan (the “Rights Plan”) designed to deter coercive takeovertactics, including accumulation of shares in the open market or through privatetransactions and to prevent an acquirer from gaining control of the Companywithout offering a fair price to all of the Company’s stockholders.

 

Under the terms of the Rights Plan, Series A Junior ParticipatingPreferred Stock purchase rights will be distributed as a dividend at the rateof one right for each share of common stock of the Company held by stockholdersof record as of the close of business on August 30, 2004.  The Rights Plan would be triggered if aperson or group acquired beneficial ownership of 15 percent or more of theCompany’s common stock other than pursuant to a board-approved tender orexchange offer or commences, or publicly announces an intention to commence, atender or exchange offer upon consummation of which such person or group wouldbeneficially own 15 percent or more of the Company’s common stock.  The value of the purchase rights is immaterialas of October 31, 2004.

 

**Stock Buyback from The SantaCruz Operation and MTI Technology Corp. (“MTI”)**

 

During the year ended October 31,2002, the Company bought back an aggregate of 3,615,000 shares of itsoutstanding common stock from The Santa Cruz Operation in twotransactions.  The Company paid anaggregate of $3,514,000 for these shares, or an average of $0.97 pershare.  In connection with therepurchase, the Company received and accepted a resignation letter from one ofthe directors representing The Santa Cruz Operation on the Company’s board ofdirectors.

 

During the year ended October 31,2002, the Company purchased 1,189,000 shares of its outstanding common stockfrom MTI for $1,070,000, or $0.90 per share, which represented a premium fromthe quoted market price.

 

The Company has electedto retire the acquired shares and has accordingly reflected the amounts paid asa reduction to stockholders’ equity.

 

**(9) INCOMETAXES**

 

The net income (loss)before income taxes consisted of the following components for the years ended October 31,2004, 2003 and 2002 (in thousands):

 
| ** **               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
|                     |       |     |       |     |       |     |       |
| Domestic U.S. operations |       | $        | (21,875    | )        | $          | 8,546    |       | $ | (25,371 | ) |
| Foreign operations       |       | (80      | )          | (2,345   | )          | 977      |       |
| Total                    |       | $        | (21,955    | )        | $          | 6,201    |       | $ | (24,394 | ) |

 

The components of theprovision for income taxes for the years ended October 31, 2004, 2003 and2002 are as follows (in thousands):

 
| ** **                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                         |       |     |       |     |       |     |       |
| U.S. State                       |       | $        | 27         |     | $          | 16       |       | $ | — |   |
| Non – U.S.                  |       | 1,368    |       | 758      |       | 483      |       |
|                             |       | 1,395    |       | 774      |       | 483      |       |
| Deferred:                        |       |     |       |     |       |     |       |
| U.S. Federal                     |       | (13,248  | )          | 1,114    |       | (8,894   | )          |
| U.S. State                       |       | (499     | )          | 42       |       | (335     | )          |
| Change in valuation allowance    |       | 13,747   |       | (1,156   | )          | 9,229    |       |
|                             |       |     |       |     |       |     |       |
| Total provision for income taxes |       | $        | 1,395      |     | $          | 774      |       | $ | 483 |   |

 

73

----

 

Deferred tax assets andliabilities are determined based on the differences between the financialreporting and tax bases of assets and liabilities.  They are measured by applying the enacted taxrates and laws in effect for the years in which such differences are expectedto reverse.

 

The significantcomponents of the Company’s deferred income tax assets and liabilities at October 31,2004 and 2003 are as follows (in thousands):

 
| ** **                                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred income tax assets:                                   |       |     |       |     |       |
| Net operating loss carry-forwards                             |       | $        | 45,580     |     | $          | 33,534 |   |
| Intangible assets                                             |       | 7,299    |       | 7,326    |       |
| Tax basis in excess of book basis related  to acquired assets |       | 4,491    |       | 4,313    |       |
| Reserves and accrued expenses                                 |       | 4,862    |       | 2,129    |       |
| Book depreciation in excess of tax                            |       | 425      |       | 1,356    |       |
| Deferred revenue                                              |       | 270      |       | 514      |       |
| Basis difference in investments                               |       | 151      |       | 451      |       |
| Capital loss carry-forward                                    |       | 4,009    |       | 3,851    |       |
| Total deferred income tax assets                              |       | 67,087   |       | 53,474   |       |
| Deferred tax liabilities:                                     |       |     |       |     |       |
| Tax on foreign earnings                                       |       | (432     | )          | (566     | )          |
| Total deferred income tax liabilities                         |       | (432     | )          | (566     | )          |
| Valuation allowance                                           |       | (66,655  | )          | (52,908  | )          |
| Net deferred income tax assets                                |       | $        | —     |     | $          | — |   |

 

The amount, and ultimaterealization, of the deferred income tax assets is dependent, in part, upon thetax laws in effect, the Company’s future earnings, and other future events, theeffects of which cannot be determined. The Company has established a full valuation allowance against its netdeferred income tax assets.  Managementbelieves that as of October 31, 2004, based on a number of factors, theavailable objective evidence creates sufficient uncertainty regarding theultimate realizability of these deferred income tax assets, that it is morelikely than not that those assets will not be realized.

 

As of October 31,2004, the Company had net operating loss carry-forwards for federal income taxreporting purposes totaling approximately $121,448,000 that expire between 2019and 2024.  Approximately $18,848,000 ofthis amount is a result of the exercise of employee stock options.  When recognized the tax benefit of theseexercises will be accounted for as a credit to stockholders’ equity.

 

The Internal RevenueCode contains provisions that likely could reduce or limit the availability andutilization of net operating loss carry-forwards if certain changes inownership have taken place or will take place. Ownership changes have occurred and utilization of the Company’s netoperating loss carry-forwards may be limited pursuant to Internal Revenue Code Section 382as a result of these ownership changes.

 

The differences betweenthe provision for income taxes at the U.S. statutory rate and the Company’seffective tax rate are as follows:

 

74

----

 
| ** **                                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |     |       |
| Provision (benefit) at statutory rate     |       | (34.0    | )%         | 34.0     | %          | (34.0    | )%         |
| Other permanent book to tax differences   |       | 1.9      | %          | 0.2      | %          | 0.2      | %          |
| State income taxes, net of federal effect |       | 0.0      | %          | 0.3      | %          | (3.9     | )%         |
| Foreign income taxes                      |       | 6.4      | %          | 12.3     | %          | 2.0      | %          |
| Change in fair value of derivative        |       | (9.1     | )%         | (15.6    | )%         | —   |       |
| Other                                     |       | —   |       | —   |       | (0.1     | )%         |
| Change in valuation allowance             |       | 41.2     | %          | (18.7    | )%         | 37.8     | %          |
| Total provision for income taxes          |       | 6.4      | %          | 12.5     | %          | 2.0      | %          |

 

**(10) COMMITMENTSAND CONTINGENCIES**

 

**Litigation**

 

*IBMCorporation*

 

On or about March 6,2003, the Company filed a complaint against IBM Corporation (“IBM”).  This action is pending in the United StatesDistrict Court for the District of Utah, under the title The SCO Group, Inc.v. International Business Machines Corporation, Civil No. 2:03CV0294.  The initial complaint included claims forbreach of contract, misappropriation of trade secrets, tortious interference,and unfair competition.  The initialcomplaint also alleged that IBM had used and distributed information concerningthe UNIX source code and derivative works in connection with its efforts topromote the Linux operating system.  As aresult of IBM’s actions, the Company is requesting damages in an amount to beproven at trial, together with additional damages through and after the time oftrial.  On or about June 13, 2003,the Company delivered to IBM a notice of termination of IBM’s UNIX licenseagreement with the Company, which license underlies IBM’s AIX software.

 

On or about June 16, 2003, the Company filed an amended complaintin the IBM case.  The amended complaintessentially restated and re-alleged the allegations of the initial complaintand expanded on those claims.  Amongother things, the amended complaint raised new allegations regarding IBM’sbreaches (in ways similar to those set forth above) of a UNIX license agreementinvolving Sequent Computer Systems, Inc. (“Sequent”), which IBM hadacquired.  The Company has sought damagesfor breaches of the Sequent license agreement. The Company is also seeking injunctive relief on several claims.

 

*IBM has filed a response and counterclaims to the complaint,including a demand for a jury trial.  TheCompany has filed an answer to the IBM counterclaims denying the claims andasserting affirmative defenses.  On February 4,2004, the Company filed a motion for leave to file amended pleadings in thecase proposing to amend its complaint against IBM and to modify its affirmativedefenses to IBM’s counterclaims.  On February 25,2004, the court granted the Company’s motion for leave to amend.*

* *

*The second amended complaint, which was filed on February 27,2004, alleges nine causes of action that are similar to those set forth above,adds a new claim for copyright infringement and removes the claim formisappropriation of trade secrets.  IBMfiled an answer and fourteen counterclaims. Among other things, IBM has asserted that the Company does not have theright to terminate IBM’s UNIX license and IBM has claimed that the Company hasbreached the GNU General Public License and has infringed certain patents heldby IBM.  IBM’s counterclaims includeclaims for breach of contract, violation of the Lanham Act, unfair competition,intentional interference with prospective economic relations, unfair anddeceptive trade practices,*promissory estoppel, patentinfringement for a declaratory judgment claim for non-infringement ofcopyrights.

* *

*On March 3, 2004, the U.S. Magistrate Judge issued anorder addressing certain discovery matters relating to both the Company andIBM.*

* *

*The Company thereafter filed motions to amend the schedulingorder and to bifurcate IBM’s patent counterclaims into a separate action.  A hearing on those latter two motions washeld on June 8,*

 

75

----

 

*2004.  The court issued its ruling on June 10,2004, granting the Company’s motion to amend the scheduling order, with certainchanges.  The court also denied theCompany’s motion to bifurcate IBM’s patent counterclaims without prejudice tothe Company’s right to request a bifurcation again at a later date.*

* *

*Following a hearing on October 19, 2004, on January 19,2005, the Magistrate Judge issued a further order granting in part and denyingin part discovery applications that the Company had made.  In that order, the court ordered IBM toproduce much of the information, including source code and revision informationthe Company had previously requested. The court also struck the Amended Scheduling Order and directed theparties to submit a proposed amended scheduling order which both parties havedone.*

* *

*On February 9, 2005, the U.S. District Judge ruled onseveral pending dispositive motions.  TheCourt denied the three motions for partial summary judgment that IBM had filed– on the Company’s contract claims, on IBM’s eighth counterclaim for copyrightinfringement and on IBM’s tenth counterclaim for a declaration ofnon-infringement of the Company’s copyrights. The Court denied each of those motions without prejudice to IBM’s renewingor refiling the motions after discovery is complete.  The Court also denied the Company’s motion tostay or dismiss IBM’s tenth counterclaim. The Court ordered that no further dispositive motions could be fileduntil the close of discovery, except by stipulation of the parties, and vacatedits prior order, dated September 30, 2004, to the extent that order hadgranted permission to file dispositive motions before the close of discovery.*

* *

*In addition to the materials that have been publicly filedwith the court, certain information has been filed under seal in accordancewith the protective order entered in the case. On November 30, 2004, a third party filed a motion to intervene inthe case for the purpose of challenging the sealing of certain documents withthe court.  Additional groups have joinedin that motion.  That motion has beenscheduled for a hearing on April 26, 2005.*

* *

*The Company has also filed a motion for leave to file athird amended complaint to allege an additional copyright violation against IBMin the case.  The Company expects thatmatter to be heard by the court in the next few months.  Discovery is continuing in the case.*

* *

*Red Hat, Inc.*

 

On August 4, 2003,Red Hat, Inc. (“Red Hat”) filed a complaint against the Company.  The action is pending in the United StatesDistrict Court for the District of Delaware under the case caption Red Hat, Inc.v. The SCO Group, Inc., Civil No. 03-772.  Red Hat asserts that the Linux operatingsystem does not infringe on the Company’s UNIX intellectual property rights andseeks a declaratory judgment for non-infringement of copyrights and nomisappropriation of trade secrets.  Inaddition, Red Hat claims the Company has engaged in false advertising inviolation of the Lanham Act, deceptive trade practices, unfair competition,tortious interference with prospective business opportunities, trade libel anddisparagement.

 

On or about September 15,2003, the Company filed a motion to dismiss the Red Hat complaint.  The motion to dismiss asserted that Red Hatlacks standing and that no case or controversy exists with respect to theclaims seeking a declaratory judgment of non-infringement.  The motion to dismiss further asserted thatRed Hat’s claims under the Lanham Act and related state laws are barred by theFirst Amendment to the U.S. Constitution and the common law privilege ofjudicial immunity.  On April 6,2004, the court issued an order denying the Company’s motion to dismiss;however, the court stayed the case and requested status reports every 90 daysregarding the case against IBM.  Red Hathas filed a motion for reconsideration. No ruling has been issued on that motion.  The Company intends to vigorously defend thisaction.

 

76

----

 

*Novell, Inc.*

 

On January 20, 2004,the Company filed suit in Utah state court against Novell, Inc. (“Novell”)for slander of title seeking relief for its alleged bad faith effort tointerfere with the Company’s ownership of copyrights related to its UNIX sourcecode and derivative works and its UnixWare product.  The case, after removal to federal court, ispending in the United States District Court for the District of Utah, under thecaption The SCO Group, Inc. v. Novell, Inc., Civil No. 2:04CV00139.  In the lawsuit, the Company requestedpreliminary and permanent injunctive relief as well as damages.  Through these claims, the Company seeks torequire Novell to assign to the Company all copyrights that it believes Novellhas wrongfully registered, prevent Novell from representing any ownershipinterest in those copyrights and require Novell to retract or withdraw allrepresentations it has made regarding its purported ownership of thosecopyrights.

 

Novell removed the caseto federal court and also filed a motion to dismiss the Company’s complaintclaiming that it had never transferred the copyrights to The Santa CruzOperation (now Tarantella, Inc.). The Company filed a response to Novell’s motion to dismiss and has alsofiled a motion to remand the case back to the state court.  On June 10, 2004, the court issued amemorandum decision and order which denied the Company’s motion to remand thecase to state court.  The memorandumdecision also denied in part and granted in part Novell’s motion todismiss.  The court granted Novell’smotion to dismiss regarding the Company’s allegations of special damages, butgranted the Company 30 days leave to amend its complaint to plead specialdamages with greater specificity.  TheCompany has filed its amended complaint and Novell has responded with anothermotion to dismiss claiming, among other things, that Novell’s false statementswere not made with malice and are privileged under the law.  That motion has been briefed by the partiesand is scheduled to be argued to the court on May 25, 2005.  The Company intends to continue to vigorouslypursue its claims against Novell.

 

*DaimlerChrysler Corporation*

 

On or about March 3,2004, the Company brought suit against DaimlerChrysler Corporation (“DaimlerChrysler”)for its alleged violations of its UNIX license agreement with the Company.  The lawsuit alleges that DaimlerChryslerbreached its UNIX software agreement by failing to provide an adequate ortimely certification of its compliance with that agreement as the Companyrequested.  The lawsuit, filed in OaklandCounty Circuit Court in the State of Michigan, requests the court to declarethat DaimlerChrysler has violated the certification requirements of its UNIXsoftware agreement, permanently enjoin DaimlerChrysler from further violationsof the UNIX software agreement, issue a mandatory injunction requiringDaimlerChrysler to remedy the effects of its past violations of the UNIXsoftware agreement and award the Company damages in an amount to be determinedat trial together with costs, attorneys’ fees and any such other or differentrelief that the Court may deem to be equitable and just.

 

On April 15, 2004,DaimlerChrysler filed a motion to dismiss the Company’s claims.  DaimlerChrysler’s motion was heard on July 21,2004, and the court granted DaimlerChrysler’s motion as to the substance ofDaimlerChrysler’s certification, but denied the motion as to whether thecertification was timely.  Based on thisruling, the Company filed a motion to stay the case pending the clarificationof certain issues in the IBM litigation. The court denied the motion to stay. Based on a stipulation of the parties, however, the court signed anorder of dismissal without prejudice. The appellate court has dismissed the Company’s appeal of the July 21,2004 ruling finding that the order was not a final, appealable order; theCompany is evaluating its options regarding the appellate court’s ruling.

 

*AutoZone, Inc.*

 

On or about March 2,2004, the Company brought suit against AutoZone, Inc. (“AutoZone”) for itsalleged violations of the Company’s UNIX copyrights through its use ofLinux.  The lawsuit alleges copyrightinfringement by AutoZone by, among other things, running versions of the Linuxoperating 

 

77

----

 

systemthat contain proprietary material from UNIX System V.  The lawsuit, filed in United States DistrictCourt in Nevada, requests injunctive relief against AutoZone’s further use orcopying of any part of the Company’s copyrighted materials and also requests damagesas a result of AutoZone’s infringement in an amount to be proven at trial.  On April 23, 2004, AutoZone filed amotion to transfer the case to Tennessee or to stay the case.  On August 6, 2004, the federal court inNevada entered an order granting AutoZone’s motion to stay the case with 90-daystatus reports to the court.  The courtdenied without prejudice AutoZone’s motion for a more definite statement andits motion to transfer the case to Tennessee. The court is allowing the parties to take limited expedited discoveryrelating to the issue of preliminary injunctive relief.  The Company is currently pursuing thatdiscovery and continuing to evaluate its claims in that regard.

 

*IPO Class Action Matter*

 

The Company isan issuer defendant in a series of class action lawsuits involving over 300issuers that have been consolidated under In re Initial Public OfferingSecurities Litigation, 21 MC 92 (SAS). The consolidated complaint alleges, among other things, certainimproprieties regarding the underwriters’ conduct during the Company’s initialpublic offering and the failure to disclose such conduct in the registrationstatement in violation of the Securities Act of 1933, as amended.

 

Theplaintiffs, the issuers and the insurance companies have negotiated anagreement to settle the dispute between the plaintiffs and the issuers.  All parties, including the plaintiffs,issuers and insurance companies, have executed this settlement agreement andthe settlement agreement has been submitted to the court for approval.  If the settlement agreement is approved bythe court, and if no cross-claims, counterclaims or third-party claims arelater asserted, this action will be dismissed with respect to the Company andits directors.

 

The Companyhas notified its underwriters and insurance companies of the existence of theclaims.  Management believes, afterconsultation with legal counsel, that the ultimate outcome of this matter willnot have a material adverse effect on the Company’s results of operations orfinancial position and will not exceed the $200,000 self-insured retentionalready paid or accrued by the Company.

 

*OtherMatters*

 

In April 2003,a former Indian distributor of the Company filed a claim in India, requestingsummary judgment for payment of $1,428,000, and an order that the Company tradein India only through the distributor and/or give a security deposit until theclaim is paid.  The distributor claimsthat the Company is responsible to repurchase certain software products and toreimburse the distributor for certain other operating costs.  The distributor additionally requested thatthe Indian courts grant interim relief in the form of attachment of localassets.  Management does not believe thatthe Company is responsible to reimburse the distributor for any operating costsand also believes that the return rights related to any remaining inventoryhave lapsed.  Discovery has commenced andhearings on the requests for interim relief have been held and are ongoing.  The Company intends to vigorously defend thisaction.

 

Pursuit anddefense of the above-mentioned matters will be costly, and management expectsthe costs for legal fees and related expenses will be substantial.  The ultimate outcome or potential effect onthe Company’s results of operations or financial position of theabove-mentioned matters is not currently known or determinable.

 

The Company isa party to certain other legal proceedings arising in the ordinary course ofbusiness including legal proceedings arising from its SCOsource initiatives.  Management believes, after consultation withlegal counsel, that the ultimate outcome of such legal proceedings will nothave a material adverse effect on the Company’s results of operations orfinancial position.

 

78

----

 

**Operating Lease Agreements**

 

TheCompany has entered into operating leases for its offices located in the UnitedStates and for international sales offices. The Company has commitments under these leases that extend throughfiscal year 2010.  Future minimum lease payments undernon-cancelable operating leases as of October 31, 2004 were as follows (inthousands):

 
| ** **                   | ** ** | **Operating** | *** *** |
|------------------------------|------------|---------------|--------------|
| ** **                   | ** ** | **Leases**    | *** *** |
| Year ending October 31, |       |          |         |
| 2005                         |       | $             | 1,714        |   |
| 2006                         |       | 1,578         |         |
| 2007                         |       | 1,066         |         |
| 2008                         |       | 294           |         |
| 2009                         |       | 102           |         |
| Thereafter                   |       | 16            |         |
| Total minimum payments       |       | $             | 4,770        |   |

 

Total rent expense forall of the Company’s operating leases were $3,097,000, $3,170,000 and$3,799,000 for the years ended October 31, 2004, 2003 and 2002,respectively.

 

**Arrangementwith Law Firms**

 

OnOctober 31, 2004, the Company entered into an engagement agreement (the “EngagementAgreement”) with Boies, Schiller & Flexner LLP, Kevin McBride andBerger Singerman (the “Law Firms”).  ThisEngagement Agreement supercedes and replaces the original engagement agreementthat was entered into in February 2003. The Engagement Agreement governs the relationship between the Companyand the Law Firms in connection with their representation of the Company in theCompany’s current litigation between it and IBM, Novell, Red Hat, AutoZone andDaimlerChrysler (the “SCO Litigation”). The Company’s purpose in entering into the Engagement Agreement was tolimit the cash expenditures needed to pursue the above litigation.  The Engagement Agreement provides for thepayment of approximately $26,000,000 for certain previously accrued expensestotaling $13,906,000 as of October 31, 2004, and all future attorney feesin connection with the SCO Litigation through the end of the current litigationbetween the Company and IBM and the escrow of at least $5,000,000 for thepayment of any expert, consulting and other expenses.  As of October 31, 2004, the $5,000,000was classified as a component of restricted cash.  The Company paid the $13,906,000 subsequentto October 31, 2004.

 

Future legal feescovered under the Engagement Agreement will require the Company to pay to theLaw Firms $2,000,000 per quarter for each successive quarter beginning September 1,2004 and ending December 1, 2005 for a total amount of $12,000,000, of which$10,000,000 will be paid in the year ending October 31, 2005.  In the three months ending January 31,2005, the Company made the quarterly payments for September 2004 as wellas December 2004 for a total of $4,000,000.  The payment of these fees has had and willcontinue to have a material impact on the Company’s cash position.

 

Inaddition, the Company must also pay one or more contingency fees upon anyamount the Company or its stockholders may receive as a recovery from thelitigation, the Company’s intellectual property licensing or a sale of thecompany.  The contingency fee amountspayable to the Law Firms will be, subject to certain credits and adjustments,as follows:

 

•                  33 percent of any aggregate recoveryamounts received up to $350,000,000;

 

79

----

 

•                  plus 25 percent of any aggregate recoveryamounts above $350,000,000 but less than or equal to $700,000,000;

 

•                  plus 20 percent of any aggregate recoveramounts in excess of $700,000,000.

 

TheEngagement Agreement specifically provides that, except for the compensationobligations specifically described above, the Company will not be obligated topay any legal fees, whether hourly, contingent or otherwise, to the Law Firms,or any other law firms that may be engaged by the Law Firms, in connection withthe Company’s SCO Litigation through the end of the current litigation betweenit and IBM, including any appeals.

 

During the year ended October 31,2003, the Company incurred $8,956,000 related to the prior arrangement ascontingency fees in connection with the issuance of shares of the Company’s Series AConvertible Preferred Stock.  This chargeconsisted of a non-cash charge of $7,956,000 related to the issuance of 400,000shares of the Company’s common stock and a $1,000,000 cash payment.  As part of the consideration to be paid tothe Law Firms in connection with the Engagement Agreement, the Company agreedto pay to the Law Firms $7,956,000 in lieu of issuing the 400,000 shares ofcommon stock.  This payment was madesubsequent to October 31, 2004 and is included as accrued compensation tolaw firms as of October 31, 2004.

 

**Grants of Unregistered Stock Options; PotentialInterest and Penalties Related to Rescission Rights**

 

The Company believescertain shares and options granted under its Equity Compensation Plans wereissued without complying with registration or qualification requirements underfederal securities laws and the securities laws of certain states.  As a result, certain plan participants have aright to rescind their purchases of shares under the Equity Compensation Plansor recover damages if they no longer own the shares or hold unexercisedoptions, subject to applicable statutes of limitations.  Additionally, regulatory authorities may requirethe Company to pay fines or impose other sanctions.  Although the Company continues to evaluatethe possible actions it may take, the Company may make a rescission offer tocertain plan participants entitled to rescission rights subject to obtaining requiredregulatory approvals.

 

The Company believescertain of its stock option grants made since February 2003 may have alsoviolated applicable securities laws in California, Georgia and possibly otherstates even though holders have not exercised such options.  Although the Company is continuing toevaluate its potential rescission risk to option holders, the Company isconsidering making a rescission offer to certain option holders.  Because the options in question have not beenexercised, no amounts are recorded in permanent equity.  There are a number of factors that must beconsidered in determining what a rescission offer to option holders mayinvolve.  At the current time, theCompany is unable to determine and quantify all of the key factors for a potentialrescission offer.

 

The Company believesthat it is reasonably possible that some option holders may accept a rescissionoffer, but the Company is unable to estimate the number of participants whomight accept a rescission offer and the amount of potential damages that it wouldbe required to pay under a rescission offer. Since any loss is considered reasonably possible but not estimable, theCompany has not recorded a liability for this contingency.

 

The Company may also berequired to pay interest and penalties up to statutory limits in connectionwith Plan participants making rescission claims or in connection with anyrescission offer.  The Company believesthat it is reasonably possible that it may be required to pay interest andpenalties, but it is not able to estimate an amount.

 

80

----

 

**(11)SEVERANCE AND EXIT COSTS**

 

Since fiscal year 2001,the Company has undertaken significant restructuring activities to reduce itsongoing cost of operations.  Allrestructurings that occurred prior to fiscal year 2003 were accounted for inaccordance with Emerging Issues Task Force (“EITF”) No. 94-3 “LiabilityRecognition for Certain Employee Termination Benefits and Other Costs to Exitan Activity.”  For restructuringactivities initiated beginning with fiscal year 2003, the Company has accountedfor one-time termination benefits, contract termination costs and otherassociated costs in accordance with SFAS No. 146 “Accounting for CostsAssociated with Exit or Disposal Activities.” Other severance benefits under ongoing severance plans have beenaccounted for in accordance with SFAS No. 112 “Employers’ Accounting forPostemployment Benefits.” and SFAS No. 88 “Employers’ Accounting forSettlements and Curtailments of Defined Benefit Plans and for TerminationBenefits.”

 

During the three monthsended April 30, 2004, the Company entered into a plan to reduce operatingexpenses in its UNIX business and eliminated a total of 48 positions and closedone facility.  The total cost associatedwith this activity was $682,000.  Duringthe three months ended October 31, 2004, the Company entered into anotherplan to reduce consolidated operating expenses. Actions in this plan included eliminating a total of 50 positions and closingcertain international offices.  The totalcost associated with this activity was $2,486,000.

 

Each of the Company’srestructurings have required it to make estimates and assumptions related tolosses on vacated facilities, provisions for termination benefits, outplacementcosts, and other costs.  The Companyrecords an accrual for any amounts associated with a restructuring that are notpaid in the current period and regularly evaluates the adequacy of the accrualsbased on changes in estimates.

 

In connection with theCompany’s restructuring activities, the Company incurred the following (inthousands):

 
| **Fiscal 2004**             | *** *** | **Balance at  November 1, 2003** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance at  October 31, 2004** | *** *** |
|-----------------------------|--------------|---------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|---------------------------------------|--------------|
|                        |         |                                  |       |          |       |            |       |            |       |                                  |         |
| One-time severance          |         | $                                     | —     |          | $          | 309             |       | $               | —     |                                  | $            | (309 | ) | $ | — |   |
| Ongoing severance and other |         | —                                |       | 2,071         |       | —          |       | (1,670          | )          | 401                                   |         |
| Facilities                  |         | 348                                   |       | 788           |       | —          |       | (1,136          | )          | —                                |         |
| Total                       |         | $                                     | 348        |          | $          | 3,168           |       | $               | —     |                                  | $            | (3,115 | ) | $ | 401 |   |

 
| **Fiscal  2003**            | ** ** | **Balance  at  November 1, 2002** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance  at  October 31, 2003** | ** ** |
|-----------------------------|------------|----------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|----------------------------------------|------------|
|                        |       |                                   |       |          |       |            |       |            |       |                                   |       |
| One-time severance          |       | $                                      | —     |          | $          | 198             |       | $               | —     |                                   | $          | (198 | ) | $ | — |   |
| Ongoing severance and other |       | 560                                    |       | 1,388         |       | (273            | )          | (1,675          | )          | —                                 |       |
| Facilities                  |       | 2,117                                  |       | —        |       | (815            | )*         | (954            | )          | 348                                    |       |
| Total                       |       | $                                      | 2,677      |          | $          | 1,586           |       | $               | (1,088     | )                                      | $          | (2,827 | ) | $ | 348 |   |

 

----

* The facilities adjustment of $815,000 was theresult of successfully negotiating out of lease commitments in connection withthe Company’s winding down of SCO Group, Ltd.

 
| **Fiscal 2002**     | ** ** | **Balance at  November 1, 2001** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance at  October 31, 2002** | *** *** |
|---------------------|------------|---------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|---------------------------------------|--------------|
|                |       |                                  |       |          |       |            |       |            |       |                                  |         |
| Severance and other |       | $                                     | 692        |          | $          | 4,053           |       | $               | —     |                                  | $            | (4,185 | ) | $ | 560 |   |
| Facilities          |       | 2,052                                 |       | 4,236         |       | (1,561          | )*         | (2,610          | )          | 2,117                                 |         |
| Total               |       | $                                     | 2,744      |          | $          | 8,289           |       | $               | (1,561     | )                                     | $            | (6,795 | ) | $ | 2,677 |   |

 

81

----

 

----

*****The facilitiesadjustment of $1,561,000 was the result of successfully re-negotiating anexisting lease commitment.

 

Amounts to be paid for restructurings are recorded as accruedliabilities.  The $401,000 accrued as of October 31,2004 is anticipated to be paid in the quarter ended January 31, 2005.

 

**(12)RELATED PARTY TRANSACTIONS**

 

**Canopy**

 

As of October 31,2004, the chairman of the Company’s board of directors was the president andchief executive officer and a director of Canopy.  Additionally, another director of the Companywas the chief financial officer of Canopy.  As of October 31,2004, Canopy owned approximately 31 percent of the Company’s issued andoutstanding common stock.  As described inmore detail in Note 16, Canopy transferred all of its shares of common stockeffective March 11, 2005.

 

In connection with theCompany’s acquisition of Vultus (see Note 3), the Company assumed theobligations of Vultus under two secured notes payable to Canopy totaling$1,073,000.  In connection with theassumption of the notes payable to Canopy, Canopy agreed to accept the issuanceof approximately 138,000 shares of the Company’s common stock in fullsatisfaction of the obligations.  TheCompany also issued Canopy approximately 37,000 shares of its common stock aspart of the purchase price for the acquisition. Canopywas a stockholder and significant debt holder of Vultus.

 

On April 30, 2003,the Company and Center 7, Inc. (“C7”) entered into a Marketing andDistribution Master Agreement (the “Marketing Agreement”) and an AssignmentAgreement.  On October 2, 2003, C7assigned the Assignment Agreement to Vintela, Inc. (“Vintela”) and Vintelaand the Company entered into a new marketing agreement (the “Vintela Agreement”).  Both C7 and Vintela are majority owned byCanopy.  Under the Vintela Agreement, theCompany was appointed as a worldwide distributor for Vintela products toco-brand, market and distribute these products.

 

Under the AssignmentAgreement, the Company assigned the copyright applications, patents andcontracts related to Volution Manager, Volution Authentication, Volution Onlineand Volution Manager Update Service (collectively, the “Assigned Software”).  As consideration for this assignment, C7issued and Vintela assumed, a $500,000 non-recourse promissory note payable tothe Company, secured by the Assigned Software. This note was originally due on April 30, 2005 with interestpayable at a rate of one percent above the prime rate as reported in the WallStreet Journal.

 

In November 2004,the Company and Vintela began discussions to cancel the Vintela Agreement andto pay the promissory note early.  On December 1,2004, the Company agreed with Vintela, the successor to C7, to forego any interestcharges on the promissory note in return for an immediate payment of the$500,000 and the cancellation of the Vintela Agreement.  On December 9, 2004, the Companyreceived the $500,000 payment from Vintela and will record the transactionduring the three months ending January 31, 2005.

 

During the time theCompany was developing the Assigned Software, it had expensed all amounts forits research and development efforts.  Asa result, at the time the promissory note was executed, the Company had no recordedbasis in the Assigned Software.  Becausethe transfer of the Assigned Software was to a related party in exchange for apromissory note and there was substantial doubt as to the ability of C7 to paythe note, no gain was recognized by the Company until payment was received on December 9,2004.

 

During 2002, the Companyentered into an operating lease agreement with Canopy for office space for itsheadquarters in Utah.  The lease extendsthrough December 2007 and the Company pays Canopy for rent and relatedexpenses.  During the years ended October 31,2004, 2003 and 2002, the Company paid Canopy approximately $657,000, $639,000and $348,000, respectively, for this space.

 

82

----

 

**(13)EMPLOYEE BENEFIT PLAN**

 

TheCompany maintains a 401(k) plan through which eligible participants may electto make contributions to the plan, subject to certain limitations under theInternal Revenue Code.  Under the termsof the plan, the Company may make discretionary matching contributions up topredetermined limits to partially match employee contributions to theplan.  During the years ended October 31,2004, 2003 and 2002, the Company contributed $217,000, $206,000 and $597,000,respectively, to the plan for matching contributions.

 

**(14)CONCENTRATION OF RISK**

 

Asof October 31, 2004 and 2003, the Company had no customers who made upmore than 10 percent of the ending accounts receivable balance.

 

Duringthe year ended October 31, 2004, the Company did not have any singlecustomer that accounted for more than 10 percent of total revenue.

 

Duringthe year ended October 31, 2003, two significant customers, Microsoft andSun, accounted for approximately 21 percent and 12 percent of the Company’srevenue.  During fiscal year 2002, nosingle customer accounted for more than ten percent of the Company’s totalrevenue.

 

**(15) SEGMENT INFORMATION AND GEOGRAPHIC REGIONS**

 

**Segments**

 

The Company’s resourcesare allocated and operating results managed to the operating income (loss)level for each of the Company’s segments: UNIX and SCOsource.  Both segments are based on the Company’s UNIXintellectual property.  The UNIX businesssells and distributes UNIX products and services through an extensivedistribution channel and to corporate end-users and the SCOsource businessenforces and protects the Company’s UNIX intellectual property.

 

During fiscal year 2004,in an effort to maximize the assets and resources of the UNIX and SCOsourcebusiness segments and to best represent management’s view of businessoperations, the Company directed resources and reviewed financial informationfor its UNIX and SCOsource segments.  Thefollowing table presents the results of the SCOsource segment had it existedduring the year ended October 31, 2003. All costs associated with the SCOsource segment were classified as costof revenue for the year ended October 31, 2003 and there were no directsales or marketing efforts for that year. The SCOsource segment did not exist during the year ended October 31,2002.  Segment disclosures for theCompany are as follows (in thousands):

 
| ** **                 | ** ** | **Year Ended October 31, 2004** | ** ** |
|----------------------------|------------|--------------------------------------|------------|
| ** **                 | ** ** | **UNIX**                             | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                       |       |                                 |       |   |   |   |   |
| Revenue                    |       | $                                    | 41,980     |   | $ | 829 |   | $ | 42,809 |   |
| Cost of revenue            |       | 7,355                                |       | 19,743 |   | 27,098 |   |
| Gross margin (deficit)     |       | 34,625                               |       | (18,914 | ) | 15,711 |   |
| Sales and marketing        |       | 15,806                               |       | 1,232 |   | 17,038 |   |
| Research and development   |       | 10,126                               |       | 486 |   | 10,612 |   |
| General and administrative |       | 7,385                                |       | 241 |   | 7,626 |   |
| Other                      |       | 9,008                                |       | — |   | 9,008 |   |
| Total operating expenses   |       | 42,325                               |       | 1,959 |   | 44,284 |   |
| Loss from operations       |       | $                                    | (7,700     | ) | $ | (20,873 | ) | $ | (28,573 | ) |

 

83

----

 
| ** **                    | ** ** | **Year Ended October 31, 2003** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|
| ** **                    | ** ** | **UNIX**                             | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                          |       |                                 |       |   |   |   |   |
| Revenue                       |       | $                                    | 53,408     |   | $ | 25,846 |   | $ | 79,254 |   |
| Cost of revenue               |       | 10,422                               |       | 9,500 |   | 19,922 |   |
| Gross margin                  |       | 42,986                               |       | 16,346 |   | 59,332 |   |
| Sales and marketing           |       | 24,392                               |       | — |   | 24,392 |   |
| Research and development      |       | 11,012                               |       | — |   | 11,012 |   |
| General and administrative    |       | 6,230                                |       | — |   | 6,230 |   |
| Other                         |       | 5,306                                |       | 8,956 |   | 14,262 |   |
| Total operating expenses      |       | 46,940                               |       | 8,956 |   | 55,896 |   |
| Income (loss) from operations |       | $                                    | (3,954     | ) | $ | 7,390 |   | $ | 3,436 |   |

 
| ** **                 | ** ** | **Year  Ended October 31, 2002** | ** ** |
|----------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **UNIX**                              | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                       |       |                                  |       |   |   |   |   |
| Revenue                    |       | $                                     | 64,241     |   | $ | — |   | $ | 64,241 |   |
| Cost of revenue            |       | 18,316                                |       | — |   | 18,316 |   |
| Gross margin               |       | 45,925                                |       | — |   | 45,925 |   |
| Sales and marketing        |       | 29,554                                |       | — |   | 29,554 |   |
| Research and development   |       | 17,558                                |       | — |   | 17,558 |   |
| General and administrative |       | 9,307                                 |       | — |   | 9,307 |   |
| Other                      |       | 13,682                                |       | — |   | 13,682 |   |
| Total operating expenses   |       | 70,101                                |       | — |   | 70,101 |   |
| Loss from operations       |       | $                                     | (24,176    | ) | $ | — |   | $ | (24,176 | ) |

 

Intangible assets, whichconsist of the Company’s reseller channel, trade name and technology, have beenassigned to the Company’s UNIX and SCOsource segments and consist of thefollowing as of October 31, 2004 (in thousands): 

 
| ** **                                                 | ** ** | **October 31,  2004** | ** ** | **October 31,  2003** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Intangible assets and goodwill:                            |       |                       |       |                       |       |
| UNIX (reseller channel, trade name and  Vultus technology) |       | $                          | 4,740      |                       | $          | 8,276 |   |
| SCOsource (UNIX technology)                                |       | 673                        |       | 1,010                      |       |
| Goodwill                                                   |       | —                     |       | 1,166                      |       |
| Total intangible assets and goodwill                       |       | $                          | 5,413      |                       | $          | 10,452 |   |

 

 

**Geographic Regions**

 

The Company’s twogeographic regions consist of the Americas and International.  The International division consists ofoperations in Europe and Asia.  Anyfinancial amounts not directly attributable to either the Americas orInternational geographic region are included in the corporate column.  The following tables present the Company’sresults of operations by geographic region (in thousands):

 

84

----

 
| ** **                 | ** ** | **Year  Ended October 31, 2004** | ** ** |
|----------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **Americas**                          | ** ** | **International** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                       |       |                                  |       |   |   |   |   |   |   |
| Revenue                    |       | $                                     | 24,531     |   | $ | 18,278 |   | $ | — |   | $ | 42,809 |   |
| Cost of revenue            |       | 24,031                                |       | 3,067 |   | — |   | 27,098 |   |
| Gross margin               |       | 500                                   |       | 15,211 |   | — |   | 15,711 |   |
| Sales and marketing        |       | 8,072                                 |       | 8,966 |   | — |   | 17,038 |   |
| Research and development   |       | 6,215                                 |       | 4,397 |   | — |   | 10,612 |   |
| General and administrative |       | 4,077                                 |       | 3,549 |   | — |   | 7,626 |   |
| Other                      |       | —                                |       | — |   | 9,008 |   | 9,008 |   |
| Total operating expenses   |       | 18,364                                |       | 16,912 |   | 9,008 |   | 44,284 |   |
| Loss from operations       |       | $                                     | (17,864    | ) | $ | (1,701 | ) | $ | (9,008 | ) | $ | (28,573 | ) |
|                            |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                    | ** ** | **Year Ended October 31, 2003** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|
| ** **                    | ** ** | **Americas**                         | ** ** | **International** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                          |       |                                 |       |   |   |   |   |   |   |
| Revenue                       |       | $                                    | 55,130     |   | $ | 24,124 |   | $ | — |   | $ | 79,254 |   |
| Cost of revenue               |       | 15,435                               |       | 4,487 |   | — |   | 19,922 |   |
| Gross margin                  |       | 39,695                               |       | 19,637 |   | — |   | 59,332 |   |
| Sales and marketing           |       | 9,724                                |       | 14,668 |   | — |   | 24,392 |   |
| Research and development      |       | 6,200                                |       | 4,812 |   | — |   | 11,012 |   |
| General and administrative    |       | 3,513                                |       | 2,717 |   | — |   | 6,230 |   |
| Other                         |       | 8,956                                |       | — |   | 5,306 |   | 14,262 |   |
| Total operating expenses      |       | 28,393                               |       | 22,197 |   | 5,306 |   | 55,896 |   |
| Income (loss) from operations |       | $                                    | 11,302     |   | $ | (2,560 | ) | $ | (5,306 | ) | $ | 3,436 |   |
|                               |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                 | ** ** | **Year  Ended October 31, 2002** | ** ** |
|----------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **Americas**                          | ** ** | **International** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                       |       |                                  |       |   |   |   |   |   |   |
| Revenue                    |       | $                                     | 32,973     |   | $ | 31,268 |   | $ | — |   | $ | 64,241 |   |
| Cost of revenue            |       | 11,160                                |       | 7,156 |   | — |   | 18,316 |   |
| Gross margin               |       | 21,813                                |       | 24,112 |   | — |   | 45,925 |   |
| Sales and marketing        |       | 12,837                                |       | 16,717 |   | — |   | 29,554 |   |
| Research and development   |       | 9,001                                 |       | 8,557 |   | — |   | 17,558 |   |
| General and administrative |       | 4,767                                 |       | 4,540 |   | — |   | 9,307 |   |
| Other                      |       | —                                |       | — |   | 13,682 |   | 13,682 |   |
| Total operating expenses   |       | 26,605                                |       | 29,814 |   | 13,682 |   | 70,101 |   |
| Loss from operations       |       | $                                     | (4,792     | ) | $ | (5,702 | ) | $ | (13,682 | ) | $ | (24,176 | ) |
|                            |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

Long-lived assets, whichinclude property and equipment, intangible assets and goodwill, by geographicregion consist of the following as of October 31, 2004 and October 31,2003 (in thousands):

 
| ** **              | ** ** | **October 31,  2004** | ** ** | **October 31,  2003** | ** ** |
|-------------------------|------------|----------------------------|------------|----------------------------|------------|
| Long-lived assets:      |       |                       |       |                       |       |
| Americas                |       | $                          | 5,953      |                       | $          | 11,234 |   |
| International           |       | 109                        |       | 366                        |       |
| Total long-lived assets |       | $                          | 6,062      |                       | $          | 11,600 |   |

 

85

----

 

**(16) SUBSEQUENT EVENTS**

 

**Change in Control Agreements**

 

  OnDecember 10, 2004, theCompany entered in Change inControl Agreements with the following officers: Darl C. McBride;Bert B. Young; Christopher Sontag;Jeff F. Hunsaker; and Ryan E. Tibbitts (each, an “Officer”).  Each agreement is effective as of December 10,2004.

 

Pursuant to the terms ofeach Agreement, the Officer agrees that he or she will not voluntarily leave theemploy of the Company in the event any individual, corporation, partnership,company or other entity takes certain steps to effect a Change in Control (asdefined in the Agreement) of the Company, until the attempt to effect a Changein Control has terminated, or until a Change in Control occurs.

 

If the Officer is stillemployed by the Company when a Change in Control occurs, any stock, stockoption or restricted stock granted to the Officer by the Company that wouldhave become vested upon continued employment by the Officer shall immediatelyvest in full and become exercisable notwithstanding any provision to thecontrary of such grant and shall remain exercisable until it expires orterminates in accordance with its terms.

 

Each Officer shall besolely responsible for any taxes that arise or become due pursuant to theacceleration of vesting that occurs pursuant to the Agreement.

 

**Transfer of Stock Ownership byCanopy to Ralph Yarro**

 

Effective March 11,2005, Canopy transferred all of its shares of the Company’s common stock toRalph Yarro, the Chairman of the Company’s Board of Directors.

 

86

----

 

**THE SCOGROUP, INC.**

**ANDSUBSIDIARIES**

 

**SCHEDULE II – VALUATION AND QUALIFYING ACCOUNTS**

 

**(inthousands)**

 
| **Description**                      | ** ** | **Balance at  Beginning of  Period** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Deductions** | ** ** | **Balance at End of  Period** | *** *** |
|--------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|----------------|------------|-------------------------------|--------------|
|                                 | * *   | * *                             | * *   | * *                            | * *   | * *       | * *   | * *                      | * *     |
| **Allowance for doubtful accounts:** | * *   | * *                             | * *   | * *                            | * *   | * *       | * *   | * *                      | * *     |
| Year ended October 31, 2004     |       | $                                    | 230        |                                | $          | 11             |       | $                             | (105         | )(a) | $ | 136 |   |
| Year ended October 31, 2003     |       | 348                                  |       | 296                                 |       | (414           | )(a)       | 230                           |         |
| Year ended October 31, 2002     |       | 362                                  |       | 198                                 |       | (212           | )(a)       | 348                           |         |
| **Inventory reserves:**              |       |                                 |       |                                |       |           |       |                          |         |
| Year ended October 31, 2004     |       | 19                                   |       | 59                                  |       | (22            | )(b)       | 56                            |         |
| Year ended October 31, 2003     |       | 115                                  |       | —                              |       | (96            | )(b)       | 19                            |         |
| Year ended October 31, 2002     |       | 269                                  |       | 18                                  |       | (172           | )(b)       | 115                           |         |
| **Allowance for sales returns:**     |       |                                 |       |                                |       |           |       |                          |         |
| Year ended October 31, 2004     |       | 819                                  |       | 489                                 |       | (1,050         | )(c)       | 258                           |         |
| Year ended October 31, 2003     |       | 1,055                                |       | 1,958                               |       | (2,194         | )(c)       | 819                           |         |
| Year ended October 31, 2002     |       | 2,199                                |       | 2,602                               |       | (3,746         | )(c)       | 1,055                         |         |
|                                      |            |                                      |            |                                     |            |                |            |                               |              |  |  |  |  |

 

----

(a)   Representswrite-offs of uncollectible accounts receivable

 

(b)   Representsinventory destroyed or scrapped

 

(c)   Representsproduct returns

 

87

----

 

**Item 9.  Changes in andDisagreements with Accountants on Accounting and Financial Disclosure**

 

None.

 

**Item 9A.  Controls andProcedures**

 

Under the supervisionand with the participation of our management, including our Chief ExecutiveOfficer and Chief Financial Officer, we evaluated the effectiveness of thedesign and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based upon that evaluation, and subsequentevaluations, the Chief Executive Officer and Chief Financial Officer concludedthat, as of the end of the period covered by this report and as a result of thematerial weakness in our internal controls described below, our disclosurecontrols and procedures were noteffective to ensure that information required to be disclosed by us in thereports we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in applicable rules andforms.

 

We have a materialweakness with respect to accounting for capital stock and stock optiontransactions.  We have issued certainshares of our common stock under our equity compensation plans withoutcomplying with the registration requirements of federal and applicable statesecurities laws.  As a result, theholders of such shares may have a rescission right, and, consequently, certainamounts the Company received upon purchase of such shares must be reclassifiedfrom permanent equity to temporary equity. As of October 31, 2004 we recorded temporary equity of $528,000 relatedto certain shares of common stock issued under the Company’s equitycompensation plans that are subject to rescission.  We determined that we lacked procedures toreconcile shares issued with shares available under registration statements ina timely manner.

 

In addition, weincorrectly accounted for dividends on Series A Convertible PreferredStock by not recording dividends payable as of January 31, 2004 and April 30,2004.  We also incorrectly accounted forcompensation expense by not properly accounting for a non-routine stock optiongrant to a non-employee.  Neither of theabove mentioned matters impacted the financial statements as of and for theyear ended October 31, 2004.  Wedetermined that we lacked resources with proper experience to review theCompany’s accounting for capital stock and stock option transactions.

 

Our internal controlsover financial reporting did not identify the preceding error prior to thecompletion of the financial statements. We have discussed these matters with the Audit Committee of the Board ofDirectors and with KPMG LLP, our independent auditors.  In response, we have implemented in ourinternal control procedures additional detail transactional controls, an equitycompliance checklist and additional review and approval procedures.

 

During the most recent quarter ended October 31,2004, there has been no change in our internal control over financial reporting(as defined in Rule 13a-15(f) and 15d-15(f) under the ExchangeAct) that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.  However, as discussed above, changes havebeen implemented subsequent to the period covered by this Form 10-K to addadditional controls to correct the material weakness in internal control overfinancial reporting.

 

**Item 9B.  OtherInformation**

 

None.

 

**PART III**

 

**Item 10.  Directors andExecutive Officers of the Registrant**

 

**Directors**

 

88

----

 

Our Board of Directors currently consists of seven directors and hasone vacancy.  Directors are elected ateach annual meeting of stockholders to serve until the next annual meeting ofstockholders or until their successors are duly elected and qualified.  There are no family relationships among anyof our directors, officers or key employees. The names of our directors, their ages and their respective businessbackgrounds are set forth below.

 
| **Name**             | ** ** | **Position(s) With the Company**                 | ** ** | **Age** | ** ** | **Director  Since** |
|----------------------|------------|--------------------------------------------------|------------|---------|------------|---------------------|
| Ralph  J. Yarro III  |       | Chairman  of the Board of Directors and Director |       | 40      |       | 1998                |
| Edward  E. Iacobucci |       | Director                                         |       | 51      |       | 2000                |
| R.  Duff Thompson    |       | Director                                         |       | 54      |       | 2001                |
| Darcy  G. Mott       |       | Director                                         |       | 52      |       | 2002                |
| Darl  C. McBride     |       | Chief  Executive Officer, Director               |       | 45      |       | 2002                |
| K.  Fred Skousen     |       | Director                                         |       | 62      |       | 2003                |
| Daniel  W. Campbell  |       | Director                                         |       | 50      |       | 2003                |

 

Ralph J. Yarro III has served as the Chairman of the Board of Directorsof the Company since August 1998.  Mr. Yarrohas served as an independent investor and business consultant since December 2004.  Mr. Yarro previously served as thePresident and Chief Executive Officer of The Canopy Group, Inc., amanagement and resource company (“Canopy”), from August 1998 to December 2004.  Mr. Yarro also served as a director ofCanopy from August 1998 to March 2005.  Mr. Yarro holds a B.A. degree inPolitical Science from Brigham Young University.

 

Edward E. Iacobucci has served as a member of the Board of Directorssince January 2000.  In 1989, Mr. Iacobuccico-founded Citrix Systems, Inc., a supplier of products and technologiesthat enable enterprise-wide deployment of software applications, and held thepositions of Chief Technical Officer and Vice President of Strategy andTechnology.  Mr. Iacobucci alsoserved as Chairman of the Board of Citrix from September 1991 to June 2000.  Mr. Iacobucci holds a B.S. degree inSystems Engineering from the Georgia Institute of Technology.

 

R. Duff Thompson has served as a member of the Board of Directors sinceMay 2001.  Mr. Thompson hasserved as a Managing General Partner of EsNet, Ltd., an investment group thatis active in both technology and real estate ventures, from 1996 to thepresent.  From June 1994 to January 1996,Mr. Thompson served as Senior Vice President of the Corporate DevelopmentGroup of Novell, Inc.  Prior to thattime, he served as Executive Vice President and General Counsel for WordPerfectCorporation, and before joining WordPerfect Corporation in 1986, he was apartner with the Salt Lake City law firm of Callister Duncan &Nebeker.  Mr. Thompson holds a B.S.degree in Economics, a masters degree in Business Administration and a J.D.degree, all from Brigham Young University.

 

Darcy G. Mott has served as a member of the Board of Directors since March of2002.  Mr. Mott has served as anindependent investor and business consultant since December 2004.  Mr. Mott previously served as VicePresident, Treasurer and Chief Financial Officer of Canopy from May 1999to December 2004.  Mr. Mott isa certified public accountant and holds a B.S. degree in Accounting fromBrigham Young University.

 

Darl C. McBride has served as the Company’s President and ChiefExecutive Officer and as a member of the Board of Directors since June 2002.  Before joining the Company, Mr. McBridewas the president of Franklin Covey Co.’s online planning business from May 2000to May 2002.  From April 1999to July 2000, Mr. McBride was the CEO of Pointserve.  From November 1997 to August 1998, Mr. McBridewas the Chairman, President and CEO of SBI. From February 1996 to October 1997, Mr. McBride served 

 

89

----

 

as the Senior Vice President of IKON Office Solutions.  From 1988 to 1996, Mr. McBride heldseveral positions at Novell, Inc. and concluded his service as VicePresident and General Manager of Novell’s Embedded Systems Division(NEST).  Mr. McBride holds a B.S.degree from Brigham Young University and received a masters degree in Labor &Industrial Relations from the University of Illinois at Urbana-Champaign.

 

K. Fred Skousen has served as amember of the Company’s Board of Directors since June 2003.  He has served as Advancement Vice Presidentat Brigham Young University since May 1998.  From September 1989 until May 1998,he was Dean of the Marriott School of Management and, prior to that, Directorof the School of Accountancy at Brigham Young University.  Mr. Skousen has been a consultant to theFinancial Executive Research Foundation, the Controller General of the UnitedStates, the Federal Trade Commission and to several large companies.  Mr. Skousen has been a visitingprofessor at the University of California, Berkeley, and University ofMissouri, as well as a faculty resident on the staff of the Securities andExchange Commission and a faculty fellow at Price Waterhouse &Co.  Mr. Skousen is a certifiedpublic accountant and has a B.S. degree in Accounting from Brigham YoungUniversity and has M.A.S. and Ph.D. degrees in Accounting from the Universityof Illinois.

 

Daniel W. Campbell has served as a member of the Company’s Board ofDirectors since November 2003.  Mr. Campbellhas served as a Managing General Partner of EsNet, Ltd., an investment groupthat is active in both technology and real estate ventures, from July 1994to the present.  From 1992 to July 1994,Mr. Campbell worked at WordPerfect Corporation as Senior Vice Presidentand Chief Financial Officer.  Prior tothat, Mr. Campbell was a partner with Price Waterhouse, an internationalaccounting firm.  Mr. Campbell alsoserves as a director of Nu Skin Enterprises, Inc., where he is theChairman of the Audit Committee.  Mr. Campbellreceived an Accounting degree from Brigham Young University in 1979.

 

**Affirmative Determinations Regarding DirectorIndependence**

 

The Board of Directors has determined each of the following directorsto be an “independent director” as such term is defined in Marketplace Rule 4200(a)(15)of the National Association of Securities Dealers (the “NASD”):  Edward E. Iacobucci, R. Duff Thompson, K.Fred Skousen and Daniel W. Campbell.

 

**Audit Committee**

 

We have an Audit Committee which assists the Board in the oversight ofour financial statements, legal compliance, qualifications of independentauditors, and engagement and oversight of our independent auditors.  The Audit Committee acts pursuant to awritten charter adopted by the Board. The members of the Audit Committee are Messrs. Campbell (CommitteeChair)**,** Thompson and Skousen.  The Audit Committee has determined that Mr. Campbelland Mr. Skousen are audit committee financial experts, as such term isdefined in Item 401(h) of Regulation S-K promulgated by the Securities andExchange Commission.  All members of theAudit Committee are independent directors.

 

**Executive Officers**

 

Thefollowing table presents information regarding the current executive officersof the Company:

 
| **Name**            | ** ** | **Age**    | ** ** | **Position**                                           |
|---------------------|------------|------------|------------|--------------------------------------------------------|
| ** **          | ** ** | ** ** | ** ** | ** **                                             |
| Darl  C. McBride    |       | 45         |       | Chief  Executive Officer, Director                     |
| Bert B. Young       |       | 50         |       | Chief  Financial Officer                               |
| Christopher  Sontag |       | 41         |       | Sr.  Vice President Business Development               |
| Jeff  F. Hunsaker   |       | 39         |       | Sr.  Vice President and General Manager, UNIX Division |
| Ryan  E. Tibbitts   |       | 49         |       | General  Counsel and Corporate Secretary               |

 

90

----

 

Set forth below is the business background of each of our executiveofficers.  Information on the businessbackground of Darl C. McBride is set forth above under the caption “Directors.”

 

Bert B. Young has served as Chief Financial Officer since April 2004.  Mr. Young is responsible for allfinance, accounting, and administration of our worldwide operations.  From November 2002 to April 2004, Mr. Youngworked as Chief Financial Officer at LANDesk Software Inc. and from September 2000to November 2002 was the Chief Financial Officer of Talk2 TechnologyInc.  Prior to that, Mr. Young wasthe Chief Financial Officer at marchFIRST Inc. Mr. Young holds a B.S. degree in Accounting from Utah StateUniversity.

 

Christopher Sontag has served as Senior Vice President, BusinessDevelopment, since January 2005 and prior to that was the Senior VicePresident of our SCOsource Division since September 2002.  From April 2000 to October 2002, Mr. Sontagwas the President of Sontag Consulting. From January 1996 to April 2000, Mr. Sontag was theco-founder, President and Chief Technology Officer of emWare, Inc.  Before his service at emWare, Mr. Sontagdeveloped marketing and engineering strategies for Novell, Inc., where heworked as the Director of Marketing and Product Development.  Mr. Sontag earned a B.S. degree inInformation Management from Brigham Young University.

 

Jeff F. Hunsaker has served as Senior Vice President and GeneralManager, UNIX Division, since January 2004.  From February 2003 to December 2003,Mr. Hunsaker served as Senior Vice President of Worldwide Sales and Marketingfor the Company and prior to that Mr. Hunsaker served as Vice Presidentand General Manager, Americas Division, from January 2000 to January 2003.  Upon joining the Company, Mr. Hunsakerwas the Sales Director for North America from January 2000 to January 2001.  From January 1998 to December 1999,Mr. Hunsaker was Director of Channel Sales for the Baan Company.  Prior to that, Mr. Hunsaker spent eightyears working in a senior sales and marketing capacity for the WordPerfectsuite of products for WordPerfect Corporation, Novell, Inc. and CorelCorporation.  Mr. Hunsaker holds aB.S. degree in Business Finance from Utah State University.

 

Ryan E. Tibbitts joined the Company in June 2003 as GeneralCounsel and became the Corporate Secretary in September 2003.  Mr. Tibbitts is responsible for alllegal aspects of the Company’s worldwide operations.  Prior to joining the Company, Mr. Tibbittsworked as General Counsel at Center 7, Inc. from October 2001 to June 2003and Lineo, Inc. from January 2001 to September 2001.  Mr. Tibbitts worked in private practicewith a law firm in Utah from 1985 until 2001. Mr. Tibbitts is a member of the Utah State Bar and American BarAssociation and received his J.D. and B.S. degrees from Brigham YoungUniversity.

 

**Section 16(a) BeneficialOwnership Reporting and Compliance**

 

Section 16(a) of the Securities Exchange Act of 1934, asamended, requires our directors and officers, and persons who own more than tenpercent of a registered class of our equity securities, to file with theSecurities and Exchange Commission initial reports of ownership and reports ofchanges in ownership of our equity securities. Officers, directors, and greater than ten percent stockholders arerequired to furnish us with copies of all Section 16(a) forms theyfile.  We believe that during the yearended October 31, 2004, all reporting persons complied with all applicablefiling requirements, with the exception that each of the following reportingpersons filed one Form 4 after the required filing date with respect toone transaction for each:  Steven M.Cakebread, Ryan E. Tibbitts, Edward E. Iacobucci, Darcy G. Mott, Thomas P.Raimondi, R. Duff Thompson and Ralph J. Yarro III.

 

91

----

 

**Code of Ethics**

 

We have adopted a code of ethics that applies to all employees,including employees of our subsidiaries, as well as each member of theBoard.  The code of ethics is available atour website at:

 

http://www.sco.com/images/company/SCO_Code_of_Conduct_and_Ethics_Policy-Final.pdf.

 

**Item 11****. Executive Compensation**

 

The following table presents compensation information for our lastthree fiscal years for our Chief Executive Officer and our four most highlycompensated executive officers other than our Chief Executive Officer.

 

## ***Summary Compensation Table***

 
| ** **              | ** ** | ** ** | ** ** | ** **          | ** ** | ** **               | ** ** | **Long-Term Compensation**   | ** ** |
|-------------------------|------------|------------|------------|---------------------|------------|--------------------------|------------|------------------------------|------------|
| ** **              | ** ** | ** ** | ** ** | **Annual**          | ** ** | **Awards**               | ** ** | ** **                   | ** ** | **Payouts** | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** ** | ** ** | **Compensation(1)** | ** ** | ** **               | ** ** | **Securities**               | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **Year**   | ** ** | **Salary**          | ** ** | **Bonus /   Commission** | ** ** | **Restricted  Stock awards** | ** ** | **Underlying  Options** | ** ** | **LTIP  Payouts** | ** ** | **All Other  Compensation** | ** ** |
|                    |       |       |       |                |       |                     |       |                         |       |   |   |   |   |   |   |
| Darl C. McBride(2)      |       | 2004       |       | $                   | 257,498    |                     | $          | 35,000                       |       | $ | — |   | — |   | $ | — |   | $ | — |   |
| Chief Executive Officer |       | 2003       |       | 230,769             |       | 755,278                  |       | 78,511                       |       | 200,000 |   | — |   | — |   |
|                    |       | 2002       |       | 80,525              |       | —                   |       | —                       |       | 600,000 |   | — |   | — |   |
|                    |       |       |       |                |       |                     |       |                         |       |   |   |   |   |   |   |
| Bert B. Young(3)        |       | 2004       |       | $                   | 84,346     |                     | $          | 30,000                       |       | $ | — |   | 150,000 |   | — |   | — |   |
| Chief Financial Officer |       |       |       |                |       |                     |       |                         |       |   |   |   |   |   |   |
|                    |       |       |       |                |       |                     |       |                         |       |   |   |   |   |   |   |
| Christopher Sontag(4)   |       | 2004       |       | $                   | 160,000    |                     | $          | 20,000                       |       | $ | — |   | — |   | — |   | — |   |
| Sr. Vice President,     |       | 2003       |       | 153,000             |       | 281,746                  |       | 64,340                       |       | 100,000 |   |   |   |   |   |
| Business Development    |       | 2002       |       | 6,231               |       | —                   |       | —                       |       | 110,000 |   |   |   |   |   |
|                    |       |       |       |                |       |                     |       |                         |       |   |   |   |   |   |   |
| Jeff F. Hunsaker(5)     |       | 2004       |       | $                   | 160,000    |                     | $          | 133,981                      |       | $ | — |   | — |   | — |   | — |   |
| Sr. Vice President,     |       | 2003       |       | 142,889             |       | 95,932                   |       | —                       |       | 100,000 |   |   |   |   |   |
| UNIX Division           |       | 2002       |       | 147,922             |       | 88,084                   |       | 21,980                       |       | 38,750 |   |   |   |   |   |
|                    |       |       |       |                |       |                     |       |                         |       |   |   |   |   |   |   |
| Ryan E. Tibbitts(6)     |       | 2004       |       | $                   | 130,384    |                     | $          | 50,000                       |       | $ | — |   | 110,000 |   | — |   | — |   |
| General Counsel and     |       | 2003       |       | 45,153              |       | 13,500                   |       | 2,500                        |       | 65,000 |   |   |   |   |   |
| Corporate Secretary     |       |       |       |                |       |                     |       |                         |       |   |   |   |   |   |   |
|                         |            |            |            |                     |            |                          |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)   Thecolumn for “Other Annual Compensation” has been omitted because there is nocompensation required to be reported in that column.  The aggregate amount of perquisites and otherpersonal benefits provided to each executive officer listed above is less thanthe lesser of $50,000 and ten percent of the named executive officer’s totalannual salary and bonus.

 

(2)   Mr. McBridewas hired as our President and Chief Executive Officer in June 2002.  With respect to 200,000 options issued to Mr. McBrideduring fiscal year 2002, vesting commences five years after the date of grant,subject to acceleration of vesting if certain performance objectives areachieved.  One such objective was ourbecoming profitable before the fourth quarter of fiscal year 2003, which infact occurred.  Accordingly, Mr. McBrideis now vested as to 50,000 shares related to such grant.  The bonus of $35,000 earned by Mr. McBridein fiscal year 2004 was paid during fiscal year 2005.  Of the $755,278 bonus earned by Mr. McBridein fiscal year 2003, $480,134 was paid during fiscal year 2003 and theremaining $275,144 was paid during fiscal year 2004.

 

(3)   Mr. Youngwas hired as the Company’s Chief Financial Officer in April 2004.  The bonus of $30,000 earned by Mr. Youngin fiscal year 2004 was paid during fiscal year 2005.

 

92

----

 

(4)   Mr. Sontagwas hired as the Company’s Senior Vice President and General Manager,SCOsource, in September 2002. The bonus of $20,000 earned by Mr. Sontagin fiscal year 2004 was paid during fiscal year 2005.  Of the $281,746 bonus earned by Mr. Sontagin fiscal year 2003, $181,590 was paid during fiscal year 2003 and theremaining $100,156 was paid during fiscal year 2004.

 

(5)   Ofthe $133,981 in commission earned by Mr. Hunsaker in fiscal year 2004,$82,177 was paid during fiscal year 2004 and the remaining $51,804 was paidduring fiscal year 2005.  Of the $95,932commission earned by Mr. Hunsaker in fiscal year 2003, $76,820 was paidduring fiscal year 2003 and the remaining $19,112 was paid during fiscal year2004.

 

(6)   Mr. Tibbittswas hired as our General Counsel in June 2003 and became the Corporate Secretaryin September 2003.  The bonus of$50,000 earned by Mr. Tibbitts in fiscal year 2004 was paid during fiscalyear 2005.  Of the $13,500 bonus earnedby Mr. Tibbitts in fiscal year 2003, $7,500 was paid during fiscal year2003.  The remaining $6,000 was paidduring fiscal year 2004.

 

# **Option Grants in Last Fiscal Year**

# ** **

The following table presents the grants of stock options, under ouroption plans during fiscal year 2004, to each of the executive officers namedin the Summary Compensation Table.

 

All option grants under each of the plans are nonqualified stockoptions.  Options expire ten years fromthe date of grant.

 

The exercise price of each option granted is equal to the fair marketvalue of our common stock as determined by the Board of Directors on the dateof grant.  In fiscal year 2004, wegranted to our employees options to purchase a total of 939,000 shares of ourcommon stock.

 

Potential realizable values are computed by:

 

•      Multiplyingthe number of shares of common stock subject to a given option by the exerciseprice per share;

•      Assumingthat the aggregate option exercise price derived from that calculationcompounds at the annual five percent or ten percent rates shown in the tablefor the entire 10-year term of the option; and

•      Subtractingthe aggregate option exercise price from that result.

 

*The five percent and ten percent assumed annual rates ofstock price appreciation are required by the rules of the Securities andExchange Commission and do not represent our estimate or projection of futurecommon stock prices.*

 
| ** **         | ** ** | **Number of  Securities  Underlying** | ** ** | **Percent  of Total  Options  Granted to** | ** ** | **Exercise  Price Per** | ** ** | ** **           | ** ** | **Potential Realizable Value at Assumed  Annual Rates of Stock Price  Appreciation for Option Term** | ** ** |
|--------------------|------------|---------------------------------------|------------|--------------------------------------------|------------|-------------------------|------------|----------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| ** **         | ** ** | **Options  Granted(1)**               | ** ** | **Employees in  Fiscal Year**              | ** ** | **Share  ($/Share)**    | ** ** | **Expiration  Date** | ** ** | ** **                                                                                           |
| ** **         | ** ** | ** **                            | ** ** | ** **                                 | ** ** | **0%**                  | ** ** | **5%**               | ** ** | **10%**                                                                                              | ** ** |
|               |       |                                  |       |                                       |       |                    |       |                 |       |                                                                                                 |       |   |   |   |   |
| Darl C. McBride    |       | —                                |       | 0                                          | %          | —                  |       | —               |       | $                                                                                                    | —     |   | $ | — |   | $ | — |   |
|               |       |                                  |       |                                       |       |                    |       |                 |       |                                                                                                 |       |   |   |   |   |
| Bert B. Young      |       | 150,000                               |       | 19.0                                       | %          | $                       | 7.18       |                 | 4/19/2014  |                                                                                                 | $          | — |   | $ | 677,320 |   | $ | 1,760,461 |   |
|               |       |                                  |       |                                       |       |                    |       |                 |       |                                                                                                 |       |   |   |   |   |
| Christopher Sontag |       | —                                |       | 0                                          | %          | —                  |       | —               |       | $                                                                                                    | —     |   | $ | — |   | $ | — |   |
|               |       |                                  |       |                                       |       |                    |       |                 |       |                                                                                                 |       |   |   |   |   |
| Jeff F. Hunsaker   |       | —                                |       | 0                                          | %          | —                  |       | —               |       | $                                                                                                    | —     |   | $ | — |   | $ | — |   |
|               |       |                                  |       |                                       |       |                    |       |                 |       |                                                                                                 |       |   |   |   |   |
| Ryan E. Tibbitts   |       | 100,000                               |       | 12.7                                       | %          | $                       | 4.05       |                 | 7/26/2014  |                                                                                                 | $          | — |   | $ | 254,702 |   | $ | 645,466 |   |
|               |       | 10,000                                |       | 1.3                                        | %          | 5.05                    |       | 5/25/2014            |       | $                                                                                                    | —     |   | $ | 31,759 |   | $ | 80,483 |   |

 

93

----

 

----

(1)   Unlessotherwise provided in an award agreement, all options granted become exercisable with respect to 25 percentof the shares covered thereby on the first anniversary of the date of grant andvest 1/36th per month thereafter.  Options are granted for a termof ten years, subject to earlier termination in certain events, and are nottransferable.  The Compensation Committeeretains discretion, subject to certain restrictions, to modify the terms ofoutstanding options.

 

On December 8, 2004, each of the abovenamed executive officers received an option grant to acquire common shares atan exercise price of $4.85 per share.  Mr. McBridereceived a grant of 100,000 shares; Mr. Young received a grant of 150,000shares; Mr. Sontag received a grant of 25,000 shares; Mr. Hunsakerreceived a grant of 25,000 shares; and Mr. Tibbitts received a grant of150,000 shares.

 

**Aggregated Option Exercises inFiscal Year 2004 and Year-end Option Values**

 
| ** **         | ** ** | **Shares Acquired  on Exercise** | ** **      | **Value  Realized** | ** **        | **Number of Shares  Underlying  Unexercised Options at  October 31, 2004** | ** **      | **Value of Unexercised  In-the-Money Options at   October 31, 2004** | ** **        |
|--------------------|------------|----------------------------------|-----------------|---------------------|-------------------|---------------------------------------------------------------------------------|-----------------|---------------------------------------------------------------------------|-------------------|
| ** **         | ** ** | ** **                       | **Exercisable** | ** **          | **Unexercisable** | ** **                                                                      | **Exercisable** | ** **                                                                | **Unexercisable** | ** ** |
|               |       |                             |            |                |              |                                                                            |            |                                                                      |              |   |   |   |   |
| Darl C. McBride    |       | —                           |            | $                   | —            |                                                                            | 362,499         |                                                                      | 437,501           |   | $ | 701,040 |   | $ | 812,960 |   |
|               |       |                             |            |                |              |                                                                            |            |                                                                      |              |   |   |   |   |   |   |   |
| Bert B. Young      |       | —                           |            | $                   | —            |                                                                            | —          |                                                                      | 150,000           |   | $ | — |   | $ | — |   |
|               |       |                             |            |                |              |                                                                            |            |                                                                      |              |   |   |   |   |   |   |   |
| Christopher Sontag |       | —                           |            | $                   | —            |                                                                            | 94,583          |                                                                      | 115,417           |   | $ | 139,421 |   | $ | 158,379 |   |
|               |       |                             |            |                |              |                                                                            |            |                                                                      |              |   |   |   |   |   |   |   |
| Jeff F. Hunsaker   |       | —                           |            | $                   | —            |                                                                            | 108,969         |                                                                      | 24,781            |   | $ | 121,254 |   | $ | 32,521 |   |
|               |       |                             |            |                |              |                                                                            |            |                                                                      |              |   |   |   |   |   |   |   |
| Ryan E. Tibbitts   |       | —                           |            | $                   | —            |                                                                            | 20,104          |                                                                      | 154,896           |   | $ | — |   | $ | — |   |

 

**DirectorCompensation**

 

Thecompensation and benefits for service as a member of the Board of Directors isdetermined by the Nominations Committee. Directors employed by us or one of our subsidiaries are not compensatedfor service on the Board or on any Committee of the Board.  Our non-employee directors currently receive$25,000 for each year of service as a director plus an additional $5,000 peryear for each committee of the Board on which such non-employee directorsserve.  Additionally, the chairpersons ofeach of the Compensation Committee and the Nominations Committee receive anadditional $5,000 per year and the chairpersons of each of the Audit Committeeand the Litigation Oversight Committee receive an additional $10,000 peryear.  In addition, Board members arereimbursed for expenses incurred in connection with attendance at Board andcommittee meetings.  Non-employeedirectors also receive stock option awards under the our stock option plans,which awards currently include an initial option to purchase 45,000 shares ofcommon stock upon joining the Board as a director and thereafter eachnon-employee director who continues to serve on the Board automaticallyreceives an annual grant of an option to acquire 15,000 shares upon his or herelection at the annual meeting.

 

**EmploymentAgreements**

 

The Company has not entered into any employmentagreements with its executive officers or any other employees.

 

94

----

 

**Change in Control Agreements**

 

On December 10,2004, we entered into Change in Control Agreements with the followingofficers:  Darl C. McBride; Bert B. Young;Christopher Sontag; Jeff F. Hunsaker; and Ryan E. Tibbitts (each, an “Officer”).  Each agreement is effective as of December 10,2004.

 

Pursuant to the terms ofthese agreements, each Officer agrees that he or she will not voluntarily leavethe employ of our company in the event any individual, corporation,partnership, company or other entity takes certain steps to effect a change incontrol of our company, until the attempt to effect a change in control hasterminated, or until a change in control occurs.

 

If the Officer is stillemployed by us when a change in control occurs, any stock, stock option orrestricted stock granted to the Officer by us that would have become vestedupon continued employment by the Officer shall immediately vest in full andbecome exercisable notwithstanding any provision to the contrary of such grantand shall remain exercisable until it expires or terminates in accordance withits terms.

 

Each Officer shall besolely responsible for any taxes that arise or become due pursuant to theacceleration of vesting that occurs pursuant to the Change in ControlAgreement.

 

**CompensationCommittee Interlocks and Insider Participation**

 

Themembers of the Compensation Committee for our last fiscal year were Messrs. Mott,Iacobucci, and Thompson.  None of themembers of our Compensation Committee has at any time been an officer oremployee of us or any of our subsidiaries or parent.  None of our executive officers currentlyserves or in the past year has served as a member of the board of directors orcompensation committee of any entity that has one or more executive officersserving on our Board or Compensation Committee.

 

# **Compensation Committee Report on Executive Compensation**

# ** **

Itis the duty of the Compensation Committee to review and determine the salaries,bonuses and equity compensation of executive officers of the Company, includingthe Chief Executive Officer, and to establish the general compensation policiesfor such individuals.  The CompensationCommittee also has the authority to make discretionary option grants to theCompany’s executive officers under the 1999, 2002 and 2004 Omnibus StockIncentive Plans.  In November 2004,Thomas P. Raimondi, Jr. resigned as a director and a member of theCompensation Committee.  In February 2005,R. Duff Thompson, a director, replaced Mr. Raimondi as a member of theCompensation Committee.

 

*TheCompensation Committee believes that the compensation programs for the Company’sexecutive officers should reflect the Company’s performance and the valuecreated for its stockholders.  Inaddition, the compensation programs should support the short-term and long-termstrategic goals and values of the Company and should reward individual contributionto the Company’s success.  The Company isengaged in a very competitive industry, and the Company’s success depends uponits ability to attract and retain qualified executives through competitivecompensation packages.*

* *

General Compensation Policy.  The Compensation Committee’spolicy is to provide the Company’s executives with compensation opportunitiesthat are based upon their personal performance, the financial performance ofthe Company and their contribution to that performance and that are competitiveenough to attract and retain highly skilled individuals.  Each executive’s compensation package iscomprised of three elements:  (i) basesalary that is competitive with the market and reflects individual performance;(ii) quarterly and annual performance awards tied to the Company’sattainment of financial performance objectives; and (iii) long-termstock-based incentive awards designed to strengthen the mutuality of interestsbetween the executives and it’s the Company’s stockholders.  As an executive’s level of responsibilityincreases, a greater proportion of his or her total compensation is tied to theCompany’s financial performance and stock price appreciation rather than basesalary.

 

95

----

 

Factors.  The principal factors that were taken intoaccount in establishing each executive officer’s compensation package for the2004 fiscal year are described below. However, the Compensation Committee has reserved the ability to exerciseits discretion in applying entirely different factors, such as differentmeasures of financial performance, for future fiscal years.

 

Base Salary.  The base salary levels for the executiveofficers were established for the 2004 fiscal year on the basis of thefollowing factors:  personal performanceand experience and the estimated salary levels in effect for similar positionswithin and outside the Company’s industry with which the Company competes forexecutive talent and internal comparability considerations.  The Compensation Committee made its decisionas to the appropriate market level of base salary for each executive officer onthe basis of its understanding of the salary levels in effect for similarpositions at those companies with which the Company competes for executive talent.  In completing this analysis, the CompensationCommittee reviewed national and regional independent executive compensationsurveys for technology companies.  TheCompensation Committee reviews executive base salaries at least annually andmakes adjustments in accordance with the factors indicated above.

 

Quarterly and Annual Performance Awards. Certain executives (other than the Chief Executive Officer, whosequarterly and annual performance awards are described below under “CEOcompensation”) were eligible to earn quarterly and annual performance awardsbased on (i) operating results for the Company’s UNIX division, (ii) managementof the Company’s intellectual property litigation and (iii) objectivesrelated to simplifying the Company’s capital structure.  During the 2004 fiscal year, the Company’sexecutives (other than the Chief Executive Officer) received quarterly andannual performance awards of approximately $234,000, based on the attainment ofthe corporate objectives specified for each executive.

 

Equity Incentives. Executives have received equity incentives from stock option grantsand restricted stock awards under the 1999, 2002 and 2004 Omnibus StockIncentive Plans.  The grants and awardshave been designed to align the interests of each executive officer with thoseof the stockholders and provide each executive with a significant incentive tomanage the Company from the perspective of an owner with an equity stake in thebusiness.  Each grant allows the executiveto acquire shares of the Company’s common stock at a fixed price per share (themarket price of the grant date) over a specified period of time (up to tenyears).  The shares subject to eachoption vest in installments, contingent upon the executive officer’s continuedemployment with the Company. Accordingly, each award provides a return to the executive only if theexecutive remains employed by the Company during the applicable vesting period,and then only if the market price of the underlying shares appreciates over theoption term.

 

TheCompensation Committee sets the number of shares subject to each option grantor restricted stock award at a level intended to create a meaningfulopportunity for stock ownership based on (i) the executive’s currentposition with the Company, (ii) the base salary associated with theposition, (iii) the size of comparable awards made to individuals insimilar positions within the industry, and (iv) the executive’s personalperformance in recent periods.  TheCompensation Committee also takes into account the executive’s existingholdings of the Company’s common stock and the number of vested and unvestedoption shares exercisable by the executive in order to maintain an appropriatelevel of equity incentive to keep the executives’ interests aligned with theCompany’s stockholders.

 

Duringfiscal year 2004, the Compensation Committee did not grant equity awards toexecutives except for (i) a stock option grant to an executive who washired during such fiscal year and (ii)  a stock option grant to anotherexecutive in response to such executive’s increased responsibilities assumedduring such fiscal year.  However, in thefirst quarter of fiscal year 2005, the Compensation Committee granted stockoptions for a total of 350,000 shares of the Company’s common stock toexecutives (other than the Chief Executive Officer) upon an analysis of theexecutives’ current equity holdings in the 

 

96

----

 

Companyand the vesting status of their equity awards to maintain alignment ofinterests with the Company’s stockholders.

 

CEO Compensation.  In reviewing and setting the totalcompensation of the Company’s Chief Executive Officer for the 2004 fiscal year,the Compensation Committee sought to make that compensation competitive, whileat the same time assuring that a significant percentage of compensation wastied to the Company’s performance.  TheCompensation Committee reviewed the national and regional compensation surveysdescribed above for chief executive officers of comparable software companiesto determine an appropriate compensation level. During fiscal year 2004, the base salary for Darl McBride, the Company’sChief Executive Officer, was $257,498.  Mr. McBridereceived an annual performance bonus of $35,000 for fiscal year 2004 that waspaid in the first quarter of fiscal year 2005. Mr. McBride earned this bonus as a result of attaining specificobjectives focused on the Company’s intellectual property litigation beingmanaged effectively, resolving and simplifying the Company’s capital structureand restoring the Company’s UNIX division to operating profitability.

 

Mr. McBridedid not receive an option grant in fiscal year 2004.  However, in the first quarter of fiscal year2005, he was awarded an option to purchase 100,000 shares of the Company’scommon stock at an exercise price of $4.85 per share. This option vests overfour years, although vesting accelerates upon a change in control of theCompany.  As was the case for the otherexecutives, this award was determined based upon Mr. McBride’s currentequity holdings in the Company and related vesting to maintain alignment of hisinterests with the stockholders generally.

 

Change in Control Agreements.  As described in more detailunder the section above of Part III, Item 11, entitled “Change inControl Agreements,” the Company entered into Change in Control Agreements withits executives including Mr. McBride. The Change in Control Agreements provide that if an executive remainsemployed by the Company when a change in control of the Company occurs, thevesting will accelerate of any unvested tock, stock option or any restrictedstock granted to the executive.  TheCompany’s purpose in entering into the Change in Control Agreements was toattempt to increase the alignment of the interests of the executives with theinterests of the Company’s stockholders in connection with any potential changein control of the Company.

 

Compliance with Internal Revenue Code Section 162(m).  Section 162(m)of the Internal Revenue Code disallows a tax deduction to publicly heldcompanies for compensation paid to certain of their executive officers, to theextent that compensation exceeds $1 million per covered officer in any fiscalyear.  The limitation applies only tocompensation which is not considered to be performance-based.  Non-performance based compensation paid tothe Company’s executive officers for the 2004 fiscal year did not exceed the $1million limit per officer, and the Compensation Committee does not anticipatethat the non-performance based compensation to be paid to the Company’sexecutive officers for fiscal year 2005 will exceed that limit.  The Company’s 1999, 2002 and 2004 OmnibusStock Incentive Plans have been structured so that any compensation deemed paidin connection with the exercise of option grants made under that plan with anexercise price equal to the fair market value of the options shares on thegrant date will qualify as performance-based compensation which will not besubject to the $1 million limitation. Because it is unlikely that the cash compensation payable to any of theCompany’s executive officers in the foreseeable future will approach the $1million limit, the Compensation Committee has decided at this time not to takeany action to limit or restructure the elements of cash compensation payable tothe Company’s executive officers.  TheCompensation Committee will reconsider this decision should the individualnon-performance based cash compensation of any executive officer ever approachthe $1 million level.

 

Itis the opinion of the Compensation Committee that the executive compensationpolicies and plans provide the necessary total remuneration program to properlyalign the Company’s performance and the interest of its stockholders through theuse of competitive and equitable executive compensation in a balanced andreasonable manner, for both the short- and long-term.

 

97

----

 
|   | Submitted  by:                         |
|--------|----------------------------------------|
|   | Darcy  Mott (chair)                    |
|   | Edward  E. Iacobucci                   |
|   | R.  Duff Thompson                      |
|   | Members  of the Compensation Committee |

 

**Stock Performance**

 

Thefollowing graph shows a comparison of cumulative total stockholder return onthe Company’s common stock, based on the market price of our common stock,assuming reinvestment of dividends, with the cumulative total return on TheNasdaq Stock Market (U.S.) Index as reported by Media General FinancialServices and the MG Group Index for internet software and services as reportedby Media General Financial Services for the period beginning March 21,2000 (the date of the Company’s initial public offering) through October 31,2004.

 

 

Assumes $100 Invested on March 21, 2000Assumes Dividend ReinvestedFiscal Year Ending October 31, 2004

 
| ** **               | ** ** | **3/21/00** | ** ** | **10/31/00** | ** ** | **10/31/01** | ** ** | **10/31/02** | ** ** | **10/31/03** | ** ** | **10/31/04** | ** ** |
|--------------------------|------------|-------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|
| The SCO Group, Inc. |       | 100.00      |       | 11.89        |       | 1.02         |       | 1.11         |       | 14.35        |       | 2.53         |       |
| MG Group Index           |       | 100.00      |       | 44.01        |       | 11.80        |       | 9.42         |       | 19.63        |       | 21.49        |       |
| NASDAQ Market Index      |       | 100.00      |       | 73.50        |       | 36.86        |       | 29.66        |       | 43.07        |       | 44.02        |       |

 

**Item 12. Security Ownership of Certain Beneficial Owners and Management**

 

The following table setsforth, as of March 15, 2005, the number of shares of common stock held ofrecord or beneficially by each person who held of record, or who had the rightto acquire shares of common stock within 60 days, or was known by us to ownbeneficially, more than five percent of our common stock, and the name andholdings of each director and named executive officer and of all executiveofficers and directors as a group.

 

98

----

 

 
| **Name of Person or Group**                                                                          | ** ** | **Number of Shares  Beneficially Owned** | ** ** | **Percent of  Class** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|-----------------------|------------|
|                                                                                                 |       |                                     |       |                  |       |
| **Principal Stockholders:**                                                                          |       |                                     |       |                  |       |
|                                                                                                 |       |                                     |       |                  |       |
| Ralph J.  Yarro III  355 South 520 West  Suite 100  Lindon, Utah 84042                          |       | 5,629,355                                | (1)        | 31.4                  | %          |
|                                                                                                 |       |                                     |       |                  |       |
| BayStar  Capital II, LLP  80 East Sir Francis Drake Blvd.  Suite 2B  Larkspur, California 94939 |       | 1,746,453                                |       | 9.7                   | %          |
|                                                                                                 |       |                                     |       |                  |       |
| Royce &  Associates, LLC  1414 Avenue of the Americas  New York, NY 10019                   |       | 1,299,700                                |       | 7.3                   | %          |
|                                                                                                 |       |                                     |       |                  |       |
| Capital  Guardian Trust Company  11100 Santa Monica Boulevard  Los Angeles, CA 90025                 |       | 1,459,900                                |       | 8.1                   | %          |
|                                                                                                 |       |                                     |       |                  |       |
| **Named Executive Officers And Directors:**                                                          |       |                                     |       |                  |       |
|                                                                                                 |       |                                     |       |                  |       |
| Ralph J. Yarro III                                                                                   |       | 5,629,355                                | (1)        | 31.4                  | %          |
|                                                                                                 |       |                                     |       |                  |       |
| Edward E. Iacobucci                                                                                  |       | 121,923                                  | (2)        | *                     |       |
|                                                                                                 |       |                                     |       |                  |       |
| Darcy G. Mott                                                                                        |       | 93,799                                   | (3)        | *                     |       |
|                                                                                                 |       |                                     |       |                  |       |
| R. Duff Thompson                                                                                     |       | 76,923                                   | (4)        | *                     |       |
|                                                                                                 |       |                                     |       |                  |       |
| K. Fred Skousen                                                                                      |       | 30,000                                   | (5)        | *                     |       |
|                                                                                                 |       |                                     |       |                  |       |
| Daniel W. Campbell                                                                                   |       | 30,000                                   | (6)        | *                     |       |
|                                                                                                 |       |                                     |       |                  |       |
| Darl C. McBride                                                                                      |       | 456,217                                  | (7)        | 2.4                   | %          |
|                                                                                                 |       |                                     |       |                  |       |
| Bert B. Young                                                                                        |       | 0                                        | (8)        | *                     |       |
|                                                                                                 |       |                                     |       |                  |       |
| Christopher Sontag                                                                                   |       | 128,863                                  | (9)        | *                     |       |
|                                                                                                 |       |                                     |       |                  |       |
| Jeff F. Hunsaker                                                                                     |       | 147,094                                  | (10)       | *                     |       |
|                                                                                                 |       |                                     |       |                  |       |
| Ryan E. Tibbitts                                                                                     |       | 32,666                                   | (11)       | *                     |       |
|                                                                                                 |       |                                     |       |                  |       |
| **All Officers and Directors as a Group (11  Persons)**                                              |       | 6,746,840                                | (12)       | 37.7                  | %          |

 

----

* Does not exceed one percent.

 

(1)     Consistsof options to purchase 97,500 shares of common stock, 10,000 shares of commonstock acquired through an open-market purchase, 175 shares of common stock, 28,846shares of common stock received for service on the Board, and 5,492,834 sharesof common stock previously held by The Canopy Group, Inc. (“Canopy”).  On March 11, 2005, Canopy transferredall of its shares of our common stock to Mr. Yarro.

 

(2)     Consistsof options to purchase 85,000 shares of common stock, 10,000 shares of commonstock acquired through an open-market purchase and 26,923 shares of commonstock received for service on the Board.

 

(3)     Consistsof 337 shares of common stock, options to purchase 60,000 shares of commonstock and 33,462 shares of common stock received for service on the Board.

 

(4)     Consistsof options to purchase 60,000 shares of common stock and 16,923 shares ofcommon stock received for service on the Board.

 

99

----

 

(5)     Consistsof options to purchase 30,000 shares of common stock.

 

(6)     Consistsof options to purchase 30,000 shares of common stock.

 

(7)     Consistsof 7,003 shares of restricted common stock, 8,000 shares of common stockacquired in an open-market purchase, 3,615 shares of common stock acquiredthrough our Employee Stock Purchase Plan, 100 shares of common stock, andoptions to purchase 437,499 shares of common stock.

 

(8)     Mr. Youngreceived an option to acquire 150,000 shares on April 20, 2004 at anexercise price of $7.18 per share.

 

(9)     Consistsof 5,739 shares of restricted common stock and options to purchase 123,124shares of common stock.

 

(10)   Consistsof 15,000 shares of restricted common stock, 3,189 shares of common stockacquired through our Employee Stock Purchase Plan, and options to purchase 128,905shares of common stock.

 

(11)   Consistsof 223 shares of restricted common stock, 2,485 shares of common stock acquiredthrough our Employee Stock Purchase Plan, 1,000 shares of common stock acquiredin open market purchases prior to joining the Company, and options to purchase 28,958shares of common stock.

 

(12)   Seenotes (1) through (11) as applicable.

 

**Item 13.  Certain Relationshipsand Related Transactions**

 

Other than the transactions described below, during fiscal year 2004there has not been, nor is there currently proposed, any transaction or seriesof similar transactions to which we were or will be a party:

 

•      inwhich the amount exceeds $60,000; and

•      inwhich any director, executive officer, holder of more than five percent of ourcommon stock or any member of their immediate family had or will have a director indirect material interest.

 

*The Canopy Group, Inc.*

 

As of October 31,2004, Ralph J. Yarro III, the Chairman of our Board, was the President andChief Executive Officer and a director of Canopy.  Additionally, another of our directors, DarcyG. Mott, was the Chief Financial Officer of Canopy.  As of October 31,2004, Canopy owned approximately 31 percent of our issued and outstandingcommon stock.  As described elsewhere inthis Form 10-K, on March 11, 2005 Canopy transferred all of itsshares of our common stock to Mr. Yarro. Additionally, in December 2004, Mr. Yarro’s and Mr. Mott’semployment at Canopy terminated.

 

In connection with ouracquisition of Vultus, we assumed the obligations of Vultus under two securednotes payable to Canopy totaling $1,073,000. In connection with the assumption of the notes payable to Canopy, Canopyagreed to accept the issuance of approximately 138,000 shares of our commonstock in full satisfaction of the obligations. We also issued Canopy approximately 37,000 shares of its common stock aspart of the purchase price for the acquisition. Canopywas a stockholder and significant debt holder of Vultus.

 

On April 30, 2003,we entered into a Marketing and Distribution Master Agreement (the “MarketingAgreement”) and an Assignment Agreement with Center 7, Inc. (“C7”).  On October 2, 2003, C7 assigned theAssignment Agreement to Vintela, Inc. (“Vintela”) and we entered into anew marketing agreement with Vintela (the “Vintela Agreement”).  Both C7 and Vintela are majority owned byCanopy.  

 

100

----

 

Under the Vintela Agreement, we were appointedas a worldwide distributor for Vintela products to co-brand, market anddistribute these products.

 

Under the AssignmentAgreement, we assigned the copyright applications, patents and contractsrelated to Volution Manager, Volution Authentication, Volution Online andVolution Manager Update Service (collectively, the “Assigned Software”).  As consideration for this assignment, C7issued and Vintela assumed, a $500,000 non-recourse promissory note payable tous, secured by the Assigned Software. This note was originally due on April 30, 2005 with interestpayable at a rate of one percent above the prime rate as reported in the WallStreet Journal.

 

In November 2004,we began discussions with Vintela to cancel the Vintela Agreement and to paythe promissory note early.  On December 1,2004, we agreed with Vintela, the successor to C7, to forego any interestcharges on the promissory note in return for an immediate payment of the$500,000 and the cancellation of the Vintela Agreement.  On December 9, 2004, we received the$500,000 payment from Vintela and will record the transaction during the threemonths ending January 31, 2005.

 

During the time we weredeveloping the Assigned Software, it had expensed all amounts for its researchand development efforts.  As a result, atthe time the promissory note was executed, we had no recorded basis in theAssigned Software.  Because the transferof the Assigned Software was to a related party in exchange for a promissorynote and there was substantial doubt as to the ability of C7 to pay the note,no gain was recognized by us until payment was received on December 9,2004.

 

During2002, we entered into an operating lease agreement with Canopy for office spacefor its headquarters in Utah.  The leaseextends through December 2007 and we pay Canopy for rent and relatedexpenses.  During the years ended October 31,2004, 2003 and 2002, we paid Canopy approximately $657,000, $639,000 and$348,000, respectively, for this space.

 

**Item 14.  Principal Accounting Fees and Services**

 

Thefollowing table presents fees for professional audit services rendered by KPMGLLP for the audit of our annual financial statements for the fiscal yearsending October 31, 2004 and October 31, 2003 and fees billed forother services rendered by KPMG LLP during those periods (in thousands):

 
| ** **            | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------|------------|----------|------------|----------|------------|
| Audit fees(1)         |       | $        | 393        |     | $          | 185 |   |
| Audit-related fees(2) |       | 94       |       | 69       |       |
| Tax fees(3)           |       | 101      |       | 52       |       |
| All other fees(4)     |       | 95       |       | —   |       |
| Total                 |       | $        | 683        |     | $          | 306 |   |

 

----

(1)   Audit Fees consist of fees billed for the annualaudits and quarterly reviews.

 

(2)   Audit-Related Fees consist of fees billed forvarious SEC filings and accounting research.

 

(3)   TaxFees consist of fees billed for tax consultation and assistance in thepreparation of tax returns.

 

(4)     All other fees principally include fees for thepreparation of statutory accounts for the Company’s international subsidiaries.

 

TheAudit Committee pre-approved all audit, audit-related and non-audit servicesperformed by our independent auditors and subsequently reviewed the actual feesand expenses paid to KPMG.  The AuditCommittee has determined that the fees paid to KPMG for non-audit services arecompatible with maintaining KPMG’s independence as our auditors.

 

101

----

 

**PART IV.**

 

#### **Item 15. Exhibits, Financial Statement Schedules**

#### ** **

(a)           The following documents are filed as part ofthis report:

 

(1)           Consolidated Financial Statements:  See Index to Consolidated FinancialStatements at Item 8 on page 50 of this report.

 

(2)           Financial Statement Schedule:  See Index to Consolidated FinancialStatements at Item 8 on page 50 of this report.

 

(3)           Exhibits are incorporated herein by reference orare filed with this report as indicated below:

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                      |
|-------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                 |
| 2.1                     |       | Agreement and Plan of Reorganization by and  among Caldera Systems, Inc., Caldera International, Inc., now known  as The SCO Group, Inc. (the “Registrant”), and The Santa Cruz  Operation, Inc., and related amendments (incorporated by reference to  Exhibit 2.1 to the Registrant’s Registration Statement on Form S-4  (File No. 333-45936)). |
| 3.1                     |       | Amended and Restated Certificate of  Incorporation of Caldera International, Inc. (incorporated by reference  to Exhibit 3.1 to the Registrant’s Registration Statement on Form 8-A12G/A  (File No. 000-29911)).                                                                                                                                                            |
| 3.2                     |       | Certificate of Amendment to Amended and  Restated Certificate of Incorporation regarding consolidation of outstanding  shares (incorporated by reference to Exhibit 3.2 to the Registrant’s  Registration Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                                      |
| 3.3                     |       | Certificate of Amendment to Amended and  Restated Certificate of Incorporation regarding change of name to The SCO  Group, Inc. (incorporated by reference to Exhibit 3.3 to the  Registrant’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                               |
| 3.4                     |       | Amended and Restated Bylaws (incorporated by  reference to Exhibit 3.4 to the Registrant’s Registration Statement on  Form 8-A12G/A (File No. 000-29911)).                                                                                                                                                                                                                       |
| 3.5                     |       | Certificate of Designation of Series A  Junior Participating Preferred Stock (incorporated by reference to  Exhibit 4.1 to the Registrant’s Current Report on Form 8-K filed on  September 1, 2004 (File No. 000-29911)).                                                                                                                                              |
| 3.6                     |       | Certificate of Correction correcting the  Certificate of Designation of Series A Junior Participating Preferred  Stock (incorporated by reference to Exhibit 4.2 to the Registrant’s  Current Report on Form 8-K filed on September 1, 2004 (File  No. 000-29911)).                                                                                                    |
| 4.1                     |       | Specimen Common Stock Certificate  (incorporated by reference to Exhibit 4.1 to the Registrant’s  Registration Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                                                                                                                                 |
| 4.2                     |       | Rights Agreement dated as of August 10,  2004 by and between the Company and Computershare Trust Company, Inc.  (incorporated by reference to Exhibit 4.3 to the Registrant’s Current  Report on Form 8-K filed on September 1, 2004 (File No. 000-29911)).                                                                                                       |
| 10.1                    |       | 1998 Stock Option Plan (incorporated by  reference to Exhibit 10.3 to the Registrant’s Registration Statement on  Form S-1 (File No. 333-94351)).                                                                                                                                                                                                                                |
| 10.2                    |       | Amendment No. 1 to 1998 Stock Option  Plan.                                                                                                                                                                                                                                                                                                                                                     |
| 10.3                    |       | Form Notice of Grant of Stock Options for  1998 Stock Option Plan.                                                                                                                                                                                                                                                                                                                              |
| 10.4                    |       | 1999 Omnibus Stock Incentive Plan, as amended  (incorporated by reference                                                                                                                                                                                                                                                                                                                            |

 

102

----

 
|   |   | to Exhibits 10.4 through 10.8 of the  Registrant’s Registration Statement on Form S-4 (File No. 333-45936)).                                                                                                                                                                                                                  |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5   |   | Amendment No. 5 to 1999 Omnibus Stock  Incentive Plan.                                                                                                                                                                                                                                                                                  |
| 10.6   |   | Amendment No. 6 to 1999 Omnibus Stock  Incentive Plan.                                                                                                                                                                                                                                                                                  |
| 10.7   |   | Form Notice of Grant of Stock Options for  1999 Omnibus Stock Incentive Plan.                                                                                                                                                                                                                                                           |
| 10.8   |   | 2000 Employee Stock Purchase Plan, as amended  (incorporated by reference to Exhibit 10.9 to the Registrant’s Registration  Statement on Form S-4 (File No. 333-45936)).                                                                                                                                                 |
| 10.9   |   | Amendment No. 2 to 2000 Employee Stock  Purchase Plan.                                                                                                                                                                                                                                                                                  |
| 10.10  |   | Amendment No. 3 to 2000 Employee Stock  Purchase Plan.                                                                                                                                                                                                                                                                                  |
| 10.11  |   | Amendment No. 4 to 2000 Employee Stock  Purchase Plan (incorporated by reference to Exhibit 10.2 to the  Registrant’s Quarterly Report on Form 10-Q for the fiscal quarter ended  July 31, 2003 (File No. 000-29911)).                                                                                         |
| 10.12  |   | 2002 Omnibus Stock Incentive Plan  (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly  Report on Form 10-Q for the fiscal quarter ended July 31, 2003  (File No. 000-29911)).                                                                                                                 |
| 10.13  |   | Form Notice of Grant of Stock Options for  2002 Omnibus Stock Incentive Plan.                                                                                                                                                                                                                                                           |
| 10.14  |   | Office Sublease Agreement by and among the  Registrant, Canopy Properties, Inc. and Gateway Technology Center, LLC,  dated January 10, 2002 (incorporated by reference to Exhibit 10.6  to the Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2003 (File No. 000-29911)). |
| 10.15  |   | First Amendment to Office Sublease Agreement  by and among the Registrant and Canopy Properties, Inc., dated  September 15, 2003 (incorporated by reference to Exhibit 10.7 to  the Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2003 (File No. 000-29911)).            |
| 10.16  |   | Engagement Letter by and among the Registrant  and Morgan Keegan & Company, Inc., dated August 16, 2002  (incorporated by reference to Exhibit 10.8 to the Registrant’s Annual  Report on Form 10-K for the fiscal year ended October 31, 2003  (File No. 000-29911)).                           |
| 10.17  |   | First Amendment to Engagement Letter by and  among the Registrant and Morgan Keegan & Company, Inc., dated  February 13, 2003 (incorporated by reference to Exhibit 10.9 to the  Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2003 (File No. 000-29911)).      |
| 10.18  |   | Second Amendment to Engagement Letter by and  among the Registrant and Morgan Keegan & Company, Inc., dated  August 16, 2003 (incorporated by reference to Exhibit 10.10 to the  Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2003 (File No. 000-29911)).      |
| 10.19  |   | Warrant to Purchase Shares of Common Stock  issued by the Registrant to Morgan Keegan & Company, Inc.,  dated August 16, 2002 (incorporated by reference to Exhibit 10.11  to the Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2003 (File No. 000-29911)).     |
| 10.20  |   | Common Stock Warrant issued by the Registrant  to, and accepted and agreed to by, Sun Microsystems, Inc., dated  March 11, 2003 (incorporated by reference to Exhibit 10.12 to the  Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2003 (File No. 000-29911)).            |
| 10.21  |   | Common Stock Warrant issued by the Registrant  to, and accepted and agreed to by, Sun Microsystems, Inc., dated  July 31, 2003 (incorporated by reference to Exhibit 10.13 to the  Registrant’s Annual Report on Form 10-K                                                                                          |

 

103

----

 
|   |   | for the fiscal year ended October 31,  2003 (File No. 000-29911)).                                                                                                                                                                                                                                                                         |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.22  |   | Common Stock Warrant issued by the Registrant  to, and accepted and agreed to by, Sun Microsystems, Inc., dated  October 31, 2003 (incorporated by reference to Exhibit 10.14 to the  Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2003 (File No. 000-29911)).                  |
| 10.23  |   | Independent Contractor Agreement by and among  the Registrant and S2 Strategic Consulting, LLC, dated July 1, 2003  (incorporated by reference to Exhibit 10.15 to the Registrant’s Annual  Report on Form 10-K for the fiscal year ended October 31, 2003  (File No. 000-29911)).                                     |
| 10.24  |   | Common Stock Warrant issued by the Registrant  to, and accepted and agreed to by, S2 Strategic Consulting, LLC, dated  July 1, 2003 (incorporated by reference to Exhibit 10.16 to the  Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2003 (File No. 000-29911)).                     |
| 10.25  |   | Severance Agreement between Ransom H. Love and  Caldera International, Inc. (incorporated by reference to  Exhibit 10.16 to the Registrant’s Annual Report on Form 10-K for the  fiscal year ended October 31, 2002 (File No. 000-29911)).                                                                             |
| 10.26  |   | Securities Purchase Agreement dated as of  October 16, 2003 between the Registrant and the persons listed therein  as Purchasers (incorporated by reference to Exhibit 10.1 to the  Registrant’s Current Report on Form 8-K filed on October 17, 2003  (File No. 000-29911)).                                          |
| 10.27  |   | Registration Rights Agreement dated as of  October 16, 2003 between the Registrant and the persons listed therein  as Purchasers (incorporated by reference to Exhibit 10.2 to the  Registrant’s Current Report on Form 8-K filed on October 17, 2003  (File No. 000-29911)).                                          |
| 10.28  |   | Letter Agreement dated December 8, 2003  among the Registrant, BayStar Capital II, L.P., Royal Bank of Canada and  Acknowledged by Boies, Schiller & Flexner LLP (incorporated by  reference to Exhibit 99.3 to the Registrant’s Current Report on  Form 8-K filed on December 9, 2003 (File No. 000-29911)). |
| 10.29  |   | Asset Purchase Agreement dated June 6,  2003 between the Registrant and Vultus, Inc. (incorporated by reference  to Exhibit 2.1 to Amendment No. 1 to the Registrant’s Registration  Statement on Form S-3 (File No. 333-106885)).                                                                                |
| 10.30  |   | Exchange Agreement dated as of  February 5, 2004 among SCO, BayStar Capital II, L.P. and Royal Bank of  Canada (incorporated by reference to Exhibit 99.1 to SCO’s Current  Report on Form 8-K filed on February 9, 2004 (File No. 000-29911)).                                                                        |
| 10.31  |   | Stock Repurchase Agreement dated as of  May 31, 2004 between the Registrant and BayStar (incorporated by  reference to Exhibit 99.1 to the Registrant’s Current Report on  Form 8-K filed on June 2, 2004 (File No. 000-29911)).                                                                                       |
| 10.32  |   | Letter Agreement dated October 31, 2004  among Boies, Schiller & Flexner LLP, Kevin McBride, Berger Singerman  and SCO (incorporated by reference to Exhibit 99.1 to the Registrant’s  Current Report on Form 8-K filed on November 4, 2004 (File  No. 000-29911)).                                           |
| 10.33  |   | Summary of Director Compensation.                                                                                                                                                                                                                                                                                                                    |
| 10.34  |   | 2004 Omnibus Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                   |
| 10.35  |   | Form Notice of Grant of Stock Options for  2004 Omnibus Stock Incentive Plan.                                                                                                                                                                                                                                                                   |
| 21.1   |   | Subsidiaries of the Registrant.                                                                                                                                                                                                                                                                                                                      |

 

104

----

 
| 23.1 |   | Consent of KPMG LLP, Independent Registered  Public Accounting Firm.                                                                                                                                                           |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1 |   | Certification of Darl C. McBride, President  and Chief Executive Officer, pursuant to Rule 13a-14(a) of the  Securities Exchange Act, as adopted pursuant Section 302 of the  Sarbanes-Oxley Act of 2002.       |
| 31.2 |   | Certification of Bert B. Young, Chief  Financial Officer, pursuant to Rule 13a-14(a) of the Securities  Exchange Act, as adopted pursuant Section 302 of the Sarbanes-Oxley Act  of 2002.                       |
| 32.1 |   | Certification of Darl C. McBride, President  and Chief Executive Officer, pursuant to Section 1350, Chapter 63 of  Title 18, United States Code, as adopted pursuant Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2 |   | Certification of Bert B. Young, Chief  Financial Officer, pursuant to Section 1350, Chapter 63 of Title 18,  United States Code, as adopted pursuant Section 906 of the  Sarbanes-Oxley Act of 2002.                 |

 

105

----

 

**Signatures**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused the report to be signed on itsbehalf by the undersigned, thereunto duly authorized, on April 1, 2005.

 
|   | THE SCO GROUP, INC. |
|--------|---------------------|
|   |                |   |
|   | By:                 | /s/ Bert B. Young |   |
|   |                | Bert B. Young |
|   |                | Chief Financial  Officer |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.

 

 
| **Signature**                                     | ** ** | **Title**                  | ** ** | **Date**           |
|---------------------------------------------------|------------|----------------------------|------------|--------------------|
| ** **                                        | ** ** | ** **                 | ** ** | ** **         |
| **Principal Executive Officer:**                  | ** ** | ** **                 | ** ** | ** **         |
|                                              |       |                       |       |               |
| /s/ Darl C. McBride                               |       | President, Chief Executive |       | April 1, 2005 |
| Darl C. McBride                                   |       | Officer and Director       |       |               |
|                                              |       |                       |       |               |
| **Principal Financial  and  Accounting Officer:** | ** ** | ** **                 | ** ** | ** **         |
|                                              |       |                       |       |               |
| /s/ Bert B. Young                                 |       | Chief Financial Officer    |       | April 1, 2005 |
| Bert B. Young                                     |       |                       |       |               |
|                                              |       |                       |       |               |
| **Additional  Directors:**                        | ** ** | ** **                 | ** ** | ** **         |
|                                              |       |                       |       |               |
| /s/ Ralph J. Yarro III                            |       | Chairman of the Board      |       | April 1, 2005 |
| Ralph J. Yarro III                                |       |                       |       |               |
|                                              |       |                       |       |               |
| /s/ Darcy G. Mott                                 |       | Director                   |       | April 1, 2005 |
| Darcy G. Mott                                     |       |                       |       |               |
|                                              |       |                       |       |               |
| /s/ Edward E. Iacobucci                           |       | Director                   |       | April 1, 2005 |
| Edward E. Iacobucci                               |       |                       |       |               |
|                                              |       |                       |       |               |
| /s/ R. Duff Thompson                              |       | Director                   |       | April 1, 2005 |
| R. Duff Thompson                                  |       |                       |       |               |
|                                              |       |                       |       |               |
| /s/ K. Fred Skousen                               |       | Director                   |       | April 1, 2005 |
| K. Fred Skousen                                   |       |                       |       |               |
|                                              |       |                       |       |               |
| /s/ Daniel W. Campbell                            |       | Director                   |       | April 1, 2005 |
| Daniel W. Campbell                                |       |                       |       |               |

 

106

----