**UNITEDSTATESSECURITIES 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 ended October 31,2005**

 

**o****   TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For the transition period from                 to                 .**

 

**Commission file number: 0-29911**

 

**THE SCOGROUP, INC.**

(Exact name of registrant as specified in itscharter)

 
| **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                                      |       | (Registrant’s telephone          |
| offices, including zip  code)                                         |       | 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 $0.001 per share**                          |
| **Preferred Stock Purchase Rights**                                   |

 

Indicate by check mark if the Registrantis a well-known seasoned issuer, as defined in Rule 405 of the SecuritiesAct.  YES o  NO ý

 

Indicate by check mark if the Registrantis not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.  YES o  NO ý

 

Indicate by check mark whether theRegistrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  YES ý  NO o

 

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 theRegistrant is a large accelerated filer, accelerated filer, or anon-accelerated filer.  See definition of‘large accelerated filer and accelerated filer’ in Rule 12b-2 of theExchange Act.  (Check one):  Large Accelerated Filer oAccelerated filer o Non-acceleratedFiler ý

 

Indicate by check mark whether the Registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act)  YES o  NO ý

 

The aggregate market value of the commonstock held by non-affiliates of the Registrant was approximately $35,155,000 basedon the reported last sale price of common stock on April 30, 2005, whichis the last business day of the Registrant’s most recently completed secondfiscal quarter.

 

The number of shares of the Registrant’scommon stock outstanding as of January 20, 2006, was 20,994,219.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portionsof the Registrant’s proxy statement to be filed pursuant to Regulation 14A inconnection with its 2006 annual meeting of stockholders are incorporated byreference into Part III of this Form 10-K.

 

 

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| **PART I.**   |                                                                                                               |   |
|--------------------|--------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.            | Business                                                                                                           |   |
| Item 1A.           | Risk Factors                                                                                                       |   |
| Item 1B.           | Unresolved Staff Comments                                                                                          |   |
| Item 2.            | Properties                                                                                                         |   |
| Item 3.            | Legal Proceedings                                                                                                  |   |
| Item 4.            | Submission of Matters to a  Vote of Security Holders                                                               |   |
|               |                                                                                                               |   |
| **PART II.**  |                                                                                                               |   |
| Item 5.            | Market for 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 and Related Stockholder  Matters                   |   |
| Item 13.           | Certain  Relationships and Related Transactions                                                                    |   |
| Item 14.           | Principal  Accounting Fees and Services                                                                            |   |
|               |                                                                                                               |   |
| **PART IV.**  |                                                                                                               |   |
| Item 15.           | Exhibits and  Financial Statement Schedules                                                                        |   |
| Signatures         |                                                                                                               |   |
|               |                                                                                                               |   |

 

 

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**PART I**

 

#### **Item1.  Business**

 

*The**Business section and other parts of this AnnualReport on Form 10-K (“Form 10-K”) contain**forward-looking statements relating to our business and strategy.  These forward-looking statements involverisks and uncertainties. **Many forward-looking statements are located in “Management’**s**Discussion and Analysis ofFinancial Condition and Results of Operations” in Part II, Item 7 of this Form 10-K.  Forward-looking statements can also beidentified by words such as “intends,” “anticipates,” “expects,” “believes,” “plans,”“predicts,” and similar terms. Forward-looking statements are not guarantees of future performance andour**actual results**may**differ**significantly**from**the results discussed**in**the**forward-looking statements**.  Factors that might cause such differencesinclude**,**but are not limited to,**those set forth**below inthe section entitled**“RiskFactors”**under Part I,**Item**1A of this**Form 10-**K. Weassume no obligation to revise or update any forward**~~-~~**looking statements for any reason, except as requiredby law.*

 

*As used in the Form 10-K, “SCO,” and “OpenServer” aretrademarks or registered trademarks of our Company in the United States andother countries.  “UNIX” and “UnixWare”are registered trademarks of The Open Group in the United States and othercountries.  All other brand or productnames are or may be trademarks of, and are used to identify the products andservices of, their respective owners.  Asused herein, the “Company” or “us,” “we,” “ours,” or similar terms refer to TheSCO Group, Inc. and our operating subsidiaries.*

 

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

 

We own the UNIX operating system and are a providerof UNIX-based products and services.  Ourcore business is to sell and service our UNIX software products to small-to-mediumsized businesses and franchisees or branch offices of Fortune 1000businesses.  Our most significantproducts that drive the majority of our UNIX revenue are OpenServer andUnixWare.  We intend to continue our UNIXresearch and development efforts during the year ending October 31, 2006while at the same time investing in Me Inc., a growing suite of mobilityservices for personal and professional productivity.

 

Wedeveloped our SCOsource business as part of our ongoing efforts to establishand protect our intellectual property rights, particularly relating to ourownership of the UNIX source code.  Inreviewing our intellectual property rights during the year ended October 31,2003, we became aware that parts of, or modifications made to, our proprietaryUNIX source code and derivative works have been included in the Linux operatingsystem without our authorization or appropriate copyright attribution.

 

In March 2003, we filed a complaint againstInternational Business Machines Corporation (“IBM”), alleging, in part, thatIBM had breached its license agreement with us by, among other things,inappropriately contributing UNIX source code and derivative works to the opensource community and seeking to use its knowledge and methods related to UNIXsource code and derivative works and modifications licensed to it to decreasethe value of the UNIX operating system in favor of promoting the Linuxoperating 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.

 

In addition to our action against IBM, we have filedother complaints against such companies as Novell, Inc. (“Novell”),AutoZone Inc. (“AutoZone”), and DaimlerChrysler Corporation (“DaimlerChrysler”).  We describe our legal actions against theseparties and the general status of these cases below under Part I, Item 3of this Form 10-K.

 

**Historical Information**

 

We originally incorporated as Caldera Systems, Inc.,a Utah corporation (“Caldera Systems”), in August 1998, and reincorporatedas a Delaware corporation in March 2000, when we completed an initialpublic offering of our common stock.  In May 2001,we formed a new holding company in Delaware

 

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underthe name of Caldera International, Inc. (“Caldera International”) toacquire substantially all of the assets and operations of the server andprofessional services groups of The Santa Cruz Operation, which changed itsname to Tarantella, Inc. and was subsequently acquired by Sun Microsystems, Inc.(“Sun”).  In connection with thisacquisition, Caldera Systems became a wholly owned subsidiary of CalderaInternational.  Former holders of sharesand options to purchase shares of Caldera Systems received an equal number ofshares and options 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**

 

Our core business focus is to serve the needs ofsmall-to-medium sized businesses and branch offices and franchisees of Fortune1000 companies, by providing reliable, cost-effective UNIX software technology for distributed, embeddedand network-based systems.  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.

 

Our largest source of revenue for our core UNIXbusiness is derived from our worldwide, indirect, leveraged channel ofpartners, which includes distributors and independent solution providers(collectively, “resellers”).  We have resources,employees or contractors in a number of countries that provide support andservices to resellers and end-user customers in those geographic areas.  The other principal channel for selling andmarketing our products is through large corporations, which have a large numberof branch offices or franchisees.  Weaccess these corporations through their information technology or purchasingdepartments.  In addition, we also sellour UNIX products to original equipment manufacturers (“OEMs”).

 

The UNIX operating system, which we own, wasconceived on the premise that an operating system should be easily adapted to abroad range of hardware platforms and should provide a simple way of developingprograms.  Over the years, the UNIXoperating system has been adapted for almost every OEM’s hardware architecture,and today UNIX has achieved the goal of seamlessly sharing data acrossheterogeneous environments.  We own abroad and deep set of intellectual property rights relating to the UNIX operatingsystem, which we intend to continue to enforce and protect through ourSCOsource business.

 

UNIX has had a longhistory of business implementation, and has a large and loyal base of bothcustomers and vendors that provides solutions and applications.  On the Intel platform, our OpenServer andUnixWare products represent a low-cost UNIX operating system available forbusinesses.  Our UNIX product offerings allowour customers to take advantage of the reliability of UNIX at a relatively lowcost.

 

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

 

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

 

We anticipate that our OpenServer andUnixWare products 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 of small-to-mediumbusinesses and enterprise customers and constitute a well-known brand with areputation for quality and reliability.

 

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We also have a seasoned, mature saleschannel of 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 for small-to-mediumsized business customers.

 

During the year ended October 31, 2005, wereleased OpenServer 6, a major upgrade to our existing OpenServer product lineand maintained our UnixWare product. During the year ending October 31, 2006, we plan to focus certainUNIX development resources on augmenting our current UNIX products and ourapplication products.  In addition, we havedeployed engineering resources on Me Inc., a growing suite of mobility servicesfor personal and professional productivity. Me Inc. digital services will enable easy, secure, real-time mobileaccess to all kinds of information stored in enterprise and web-based systemswithout the need for direct connection between end-point devices and thosesystems.  We anticipate releasing variousMe Inc. digital services and a development toolkit during the first half ofcalendar year 2006.

 

Our research and development efforts aredescribed in more detail below in the subsection entitled “SoftwareEngineering and Development.”

 

##### ***Competition***

 

We face direct competition in the operating systemmarket from Linux operating system providers, other non-UNIX operating systemproviders and other UNIX-based operating system providers.  In the operating system market, some of ourcompetitors include IBM, Red Hat Inc. (“Red Hat”), Novell, Hewlett-Packard (“HP”),Microsoft Corporation (“Microsoft”), and Sun. Operating systems, primarily Linux, are aggressively taking market shareaway from UNIX and our UNIX revenue has declined 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 and networkingcapability.  Notwithstanding thesefactors, our revenue has declined over the last several years.  Many of our competitors are significantlylarger than we are and have much greater access to funding, technicalexpertise, 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 to some degree, hampered ourability to compete favorably.

 

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 for the year ended October 31,2005, and we believe that it will continue during the year ending October 31,2006.  If this trend does continue asexpected, our competitive position will be adversely impacted and our futurerevenue from our UNIX business will decline, possibly at an even faster ratethan it has declined over the last several years.  The decline in our UNIX business may beaccelerated if industry partners withdraw their support from us as a result ofour SCO Litigation.

 

##### ***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

 

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*OpenServer, keeping the operating system current withhardware platforms available in the market. The latest release, OpenServer 6, began shipping in June 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, reliabilityand affordability are critical.  UnixWareincludes enhancements and refinements to the UNIX platform, representingsignificant added value for existing UnixWare customers.  The latest release of UnixWare, UnixWare7.1.4, began shipping in May 2004.

 

*Other Products.*  In addition to the OpenServer and UnixWare,we offer product maintenance and additional UNIX-related products.

 

*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.

 

We also provide technical support to our partners,including resellers, hardware and software vendors and solution providers, aswell as directly supporting our end-user customers.  Our partners have the option to direct theircustomers to us for technical support or to provide first-level customersupport themselves and utilize our technical expertise for second-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.

 

*OtherServices.*  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***

 

We have business alliances with a number of keyglobal industry partners.  Theserelationships encompass product integration, two-way technology transfers,product certification, channel partnerships and revenue generating initiativesin areas of product bundling, OEM agreements and training and education.  The objectives of these partnerships includeproviding complete hardware and software UNIX solutions and mutually developingour sales and distribution channel by coordinating marketing initiatives increating demand for our products.  Wealso have alliances with a number of solution providers who write and developcustom applications to run on UNIX operating systems.  Most of our small business customers thatcannot afford high-end solutions or an information technology staff rely on oneof our channel partners for these services. Maintaining these strategic alliances for the year ending October 31,2006 will be critical to the success of our UNIX business, and in particular,to the success of our recently released version of OpenServer.  We intend to continue to keep relationshipswith 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 SCO Litigation.

 

##### ***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 52% of the total UNIX revenue

 

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for the year ended October 31,2005.  The sales team is organized intoArea Sales Managers (“ASMs”), who each manage a specific geographic area andsupport 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 applications are then deployed in an identical fashion acrossthousands of branch offices or franchisees.

 

*International. *TheInternational region delivered approximately 48% of our UNIX revenue for theyear ended October 31, 2005 and includes EMEA (Europe, the Middle East andAfrica) and Asia Pacific.  We have resources,employees or contractors in 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 key to our future success will be our ability to provide additionalproducts and services to our reseller channel and to communicate our productand corporate strategy to these resellers.

 

Our marketing efforts support our salesand distribution 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:

 

•                  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 UNIX productsby participating in strategic tradeshows, conferences and technology forums.

 

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Information regardingfinancial data by segments, geographic regions and long-lived assets is setforth in Part II, Item 8 of this Form 10-K in Note 15 to the consolidatedfinancial statements.

 

**Software Engineering andDevelopment**

 

We have taken steps to improve our UNIX softwareproducts to maintain system reliability, maintain backward compatibility,increase application support, provide broad hardware support, better integratewidely used internet applications, improve usability, and increase systemperformance.  While we believe that theseproduct enhancements will extend the lives and improve the functionality of ourUNIX products, 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.

 

Technology trends in the central processing unit (“CPU”)market have enabled our 32-bit operating systems and associated applications torun on 64-bit hardware.  Thesedevelopments have significantly reduced the entry cost into the 64-bitmarket.  We have assigned a limited, butskilled set of resources to develop a 64-bit version of our operating systemtechnology.  Our objective in making thisinvestment is to provide our current and new customers a long-term productroadmap that will provide them a seamless upgrade path to 64-bitcomputing.  We expect this investment toprovide future returns as we give customers confidence in their commitment toour technologies.

 

We are also deploying engineering resources on MeInc., a growing suite of mobility services for personal and professionalproductivity, as well as custom services for business, government and consumerusers.  Me Inc. digital services willenable easy, secure, real-time mobile access to all kinds of information storedin enterprise and web-based systems without the need for direct connectionbetween end-point devices and those systems.

 

Our product development process is modeled tostandard, commercial software engineering practices and we apply thesepractices to ensure consistent product quality. As a result, we are able to offer our platform products to OEM customersin several configurations without significant additional effort.  We have incurred $8,329,000, $10,612,000, and$11,012,000 in research and development expense during the years ended October 31,2005, 2004, and 2003, respectively.

 

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

 

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

 

We acquired our rights relating to the UNIX sourcecode and derivative works and other intellectual property rights when wepurchased substantially all of the assets and operations of the server andprofessional services groups of The Santa Cruz Operation, Inc. in May 2001.  The Santa Cruz Operation had previouslyacquired such UNIX source code and other intellectual property rights fromNovell in 1995, which technology 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,certain UNIX intellectual property, all claims for violation of the abovementioned UNIX licenses and copyrights and other claims, and the control overUNIX derivative works.  The UNIX licenseswe obtained 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 andHewlett-Packard’s HPUX.  These operatingsystems are all derivatives 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 proprietaryrights, we rely primarily on a combination of copyright laws, contractualrights and an aggressive legal strategy.

 

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During the year ended October 31, 2003, wecommenced our first SCOsource initiative in which we began reviewing the statusof our existing UNIX license agreements with UNIX vendors and to identify thosein the software industry that may be using our intellectual property withoutobtaining the necessary licenses.  Aspart of this process, we became aware that parts of our proprietary UNIX sourcecode and derivative works had been included in the Linux operating systemwithout attribution or our authorization in violation of our intellectualproperty rights.  We filed a complaintagainst IBM in March 2003 alleging that IBM breached its license agreementwith us related to its efforts to promote and support the Linux operatingsystem.  In addition to our actionagainst IBM, we have filed other complaints against Novell, AutoZone, andDaimlerChrysler.  In our litigation withNovell, we seek relief for, among other things, Novell’s alleged bad faithefforts to interfere with our ownership and enforcement of our copyrightsrelated to our UNIX source code.  Arelated lawsuit was filed against us by Red Hat.  We describe our legal actions in more detailbelow under Part I, Item 3 of this Form 10-K.

 

In August 2003, we offered to Linux and otherend users a license to use our UNIX intellectual property.  The SCOsource intellectual property (“IP”)license permits the use of our UNIX intellectual property, in binary form only,as contained 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 industryusing our UNIX intellectual property to allow them to continue to run theirmission-critical business solutions running in other environments.

 

**Intellectual PropertyProtection**

 

Our intellectual property protection relies primarilyon a combination of contract rights, copyright laws and an aggressive legalstrategy.  We also require that ouremployees and consultants sign confidentiality and nondisclosureagreements.  We also regulate access to,and distribution of, our documentation and other proprietary information.

 

We cannot guarantee the success of our SCO Litigationand other efforts to protect and enforce our intellectual property rights, butwe will continue to seek to enforce and pursue these rights through the judicialsystem.  Additionally, we cannot becertain that we will succeed in preventing the future misappropriation of ourproprietary information including copyrights and other intellectual propertyrights or that we will be able to prevent the unauthorized future use of ourtechnology.

 

***Employees***

 

As of October 31, 2005, we had atotal of 166 full-time equivalent employees. Of the total employees, 49 were in product development, 55 in sales andmarketing, 21 in customer service and technical support, 10 in customerdelivery and manufacturing, 3 in SCOsource and 28 in administration (whichincludes finance, human resources, executive management and informationsystems).  From time to time, we alsoengage independent contractors to support our professional services, productdevelopment, sales and marketing organizations. Our employees are not represented by any labor union and are not subjectto a collective bargaining agreement, and we have never experienced a workstoppage.  In general, we believe ourrelations with our employees are good.

 

**Item1A.  Risk Factors**

 

Because of the following factors, as well as othervariables affecting our operating results, past financial performance may notbe a reliable indicator of future performance, and historical trends should notbe used to anticipate results or trends in future periods.

 

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

 

Our year ended October 31, 2003 was the firstfull year we were profitable in our operating history.  Our profitability for the year ended October 31,2003 resulted primarily from our SCOsource

 

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business.  For the years ended October 31, 2005 and2004, we incurred net losses to common stockholders of $10,726,000 and$16,227,000, respectively, and our accumulated deficit as of October 31,2005 was $234,942,000.

 

If our revenue from the sale of our UNIX productsand services continues to decline, we will need to further reduce operatingexpenses 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 be able to achieve profitability throughadditional cost-cutting actions.

 

Our UNIX products and services revenue has declinedover the last several years primarily as a result of continued competition fromalternative operating systems, particularly Linux. In our 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. Our future UNIX revenue may be adverselyimpacted and may continue to decline if we are unable to replenish thesedeferred revenue balances with long-term maintenance and support contracts orreplace them with other sustainable revenue streams. If we are unable togenerate positive cash flow and profitable operations, our business will beadversely impacted.

 

*We may not prevail in our SCO Litigation, which may adversely affectour ability to continue in business.*

 

We continue to pursue the SCO Litigation and believein the merits of our cases.  In ouraction against IBM, we seek damages for claims generally relating to ourallegation that IBM has inappropriately used and distributed our UNIX sourcecode and derivative works in connection with its efforts to promote the Linuxoperating system.  IBM has responded toour claims and brought counterclaims against us asserting generally that we donot have the right to assert claims based on our ownership of UNIX intellectualproperty against IBM or others in the Linux market.  Discovery is continuing in the case.  If we do not prevail in our action againstIBM, or if IBM is successful in its counterclaims against us, our business andresults of operations would be materially harmed and we may not be able tocontinue in business.  The litigationwith IBM and others will be costly, and our costs for legal fees and relatedexpenses have been and will continue to be substantial and may exceed ourcapital resources.  Additionally, themarket price of our common stock may be negatively affected as a result ofdevelopments in our legal action against IBM that may be, or may be perceivedto be, adverse to us.

 

As a result of the SCO Litigation, participants inthe Linux marketplace and others affiliated with IBM or sympathetic to theLinux movement have taken actions attempting to negatively affect our businessand our SCOsource efforts.  Linuxproponents have taken a broad range of actions against us, including, forexample, attempting to influence participants in the markets in which we sellour products to reduce or eliminate the amount of our products and servicesthey purchase from us.  We expect thatsimilar efforts likely will continue.  Thereis a risk that additional participants in our marketplace will negatively view theSCO Litigation, 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.

 

As a response to our claim that our UNIX source codeand derivative works have inappropriately been included in Linux, Novell haspublicly asserted its belief that it owns certain copyrights in our UNIX sourcecode, and it has filed 15 copyright applications with the United States CopyrightOffice related to UNIX.  Novell hasclaimed to have retained rights related to UNIX source code licenses, includingthe license with IBM.  Novell asserts ithas the right to take action on behalf of SCO in connection with such licenses,including termination rights.  Novell haspurported to veto our termination of the IBM, Sequent and SGI licenses.  We have asserted that we obtained the UNIXbusiness, source code, claims and copyrights when we acquired the assets andoperations of the server and professional services groups from The Santa CruzOperation in May 2001, which had previously acquired all such assets andrights from Novell in 1995 pursuant to an asset purchase agreement, as amended. In January 2004, in response

 

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toNovell’s actions, we brought suit against Novell for slander of title seekingrelief for Novell’s alleged bad faith effort to interfere with our rightsrelated to our UNIX source code and derivative works and our UnixWare products. Novell twice unsuccessfully sought tohave the case dismissed.

 

On July 29, 2005, Novell filed its Answer andCounterclaims against us, asserting counterclaims for our alleged breaches ofthe Asset Purchase Agreement between Novell and our predecessor-in-interest,The Santa Cruz Operation, Inc., for slander of title, restitution/unjustenrichment, and accounting, and for declaratory relief regarding Novell’salleged rights under the Asset Purchase Agreement.  On or about December 30, 2005, we filed amotion for leave to amend our complaint to assert additional claims againstNovell, including copyright infringement, unfair competition and a breach ofNovell’s limited license to use our UNIX source code.

 

Notwithstanding our assertions of full ownership of criticalUNIX-related intellectual property rights, as set forth above, includingcopyrights, and even if we are successful in our legal action against Novelland end users such as AutoZone and DaimlerChrysler, the efforts of Novell andthe other Linux proponents described above may cause further damage to ourbusiness including our ability to monetize our UNIX assets.  These efforts of Linux proponents also mayincrease the negative view some participants in our marketplace have regardingour SCO Litigation and may contribute to creating confusion in the marketplaceabout the validity of our claim that the unauthorized use of our UNIX sourcecode and derivative works in Linux violates our contracts and copyrights.  Increased negative perception and potentialconfusion about our claims in our marketplace could impede our continuedpursuit of the SCO Litigation and negatively impact our business.  For example, we believe that our decrease inSCOsource revenue for the years ended October 31, 2005 and 2004 was inpart attributable to Novell’s claim of UNIX copyright ownership, which may havecaused potential customers to delay or forego licensing until an outcome inthis legal matter has been reached.

 

*We operate in a highly competitive market and face significantcompetition from a variety of current and potential sources; many of ourcurrent 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, HP, Sun, Microsoft and other Linuxdistributors.  These and othercompetitors are aggressively pursuing the current UNIX operating system market.Many of these competitors have access to substantially greater resources thanwe do.  The major competitive alternativeto our UNIX products is Linux.  Theexpansion of our competitors’ offerings may restrict the overall marketavailable for our UNIX products, including some markets where we have beensuccessful 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 sustain or grow our business. Additionally, becausetechnological advancement in the UNIX operating system market and alternativeoperating system markets is progressing at an advanced pace, we will have todevelop and introduce enhancements to our existing products and any newproducts on a timely basis to keep pace with these developments, evolvingindustry standards and changing customer requirements.  Our failure to meet any of these and othercompetitive pressures may render our existing products and services obsolete,which would have an adverse impact on our revenue and operations.

 

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

 

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ourUNIX business will decline.  The declinein our UNIX business may be accelerated if industry partners withdraw theirsupport from us for any reason, including our SCO Litigation.

 

*If the market for UNIX continues to contract, our business will beharmed.*

 

Our revenue from the sale of UNIX products hasdeclined over the last several years. This decrease in revenue has been attributable primarily to increasedcompetition from other operating systems, particularly Linux.  Our sales of UNIX products and services areprimarily to existing customers. If the demand for UNIX products continues todecline, and we are unable to develop UNIX products and services thatsuccessfully address a market demand, our UNIX revenue will continue todecline, industry participants may not certify to our operating system andproducts, we may not be able to attract new customers or retain existingcustomers and our business and results of operations will be adverselyaffected.  Because of the long adoptioncycle for operating system purchases and the long sales cycle of our operatingsystem products, we may not be able to reverse these revenue declines quickly.

 

*We may lose the support of industry partners leading to an accelerateddecline in our UNIX products and services revenue.*

 

The decline in our UNIX business and our SCOLitigation may cause industry partners, developers and hardware and softwarevendors to choose not to support or certify to our UNIX operating systemproducts.  This would lead to anaccelerated decline in our UNIX products and services revenue and wouldadversely impact our results of operations and liquidity.

 

*Our claims relating to our UNIX intellectual property may subject us toadditional 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.

 

*We rely on our indirect sales channel for distribution of our products,and any disruption of our channel at any level could adversely affect the salesof our products.*

 

We have a two-tiered distribution channel.  The relationships we have developed withresellers allow us to offer our products and services to a much larger customerbase than we would otherwise be able to reach through our own direct sales andmarketing efforts.  Some solutionproviders also purchase solutions through our resellers, and we anticipate theywill continue to do so.  Because weusually sell indirectly through resellers, we cannot control the relationshipsthrough which resellers, solution providers or equipment integrators purchaseour products.  In turn, we do not controlthe presentation of our products to end users. Therefore, our sales could be affected by disruptions in therelationships between us and our resellers, between our resellers and solutionproviders, or between solution providers and end users.  Also, resellers and solution providers maychoose not to emphasize our products to their customers.  Any of these occurrences could diminish theeffectiveness of our distribution channel and lead to decreased sales.

 

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*Our future SCOsource licensing revenue is uncertain.*

 

We initiated the SCOsource licensing effort in theyear ended October 31, 2003 to review the status of UNIX licensing andsublicensing agreements.  This effortresulted in the execution of two significant vendor license agreements andgenerated $25,846,000 in revenue during the year ended October 31, 2003.  During the year ended October 31, 2004,our SCOsource licensing revenue declined significantly to only $829,000 andduring the year ended October 31, 2005, our SCOsource licensing revenue declinedfurther to $166,000.  Because of a lackof historical experience and the uncertainties related to SCOsource licensingrevenue, we are unable to estimate the amount and timing of future SCOsourcelicensing revenue, if any.  If we doreceive revenue from this source, it may be sporadic and fluctuate from quarterto quarter.  Additionally, the success ofthese initiatives may depend on the strength of our intellectual propertyrights and contractual claims regarding UNIX, including the strength of ourclaim that unauthorized UNIX source code and derivative works are prevalent inLinux.

 

*Fluctuations in our operating results or the failure of our operatingresults to meet the expectations of public market analysts and investors maynegatively 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 potential for significantfluctuations in our SCOsource licensing revenue in any particular period, youshould not rely on comparisons of our results of operations as an indication offuture performance.

 

Factors that may affect our results include:

 

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

 

•                                          the activities of short sellers;

 

•                                          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.

 

As a result of the factors listed above andelsewhere, it is possible that our results of operations may be below theexpectations of public market analysts and investors in any particularperiod.  This could cause our stock priceto decline. If revenue falls below our expectations, and we are unable to

 

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quicklyreduce our spending in response, our operating results will be lower thanexpected. Our stock price may fall in response to these events.

 

*Our foreign-based operations and sales create special problems,including the imposition of governmental controls and taxes and fluctuations incurrency 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 foreign operations are subject to certain inherentrisks, 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 generate profits in foreigncountries, our effective income tax rate is increased.

 

During the three months ended April 30, 2004,our Indian office was given a withholding tax assessment from the Government ofIndia Income Tax Department.  The TaxDepartment assessed a 15 percent withholding tax on certain revenuetransactions in India that the Tax Department deemed royalty revenue under theIncome Tax Act. We have filed an appeal with the Tax Department and believethat revenue from our packaged software does not qualify for royalty treatmentand therefore would not be subject to withholding tax.  However, we may be unsuccessful in our appealagainst the Tax Department and be obligated to pay the assessed taxableamounts.  Because of our internationaloperations, we may be subject to additional withholding or taxes from otherinternational jurisdictions.

 

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

 

We need to retain our key 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 Chief Executive Officer.

 

*Our Engagement Agreement with the law firms representing us in the SCOLitigation requires us to pay for expert, consulting and other costs, whichcould harm our liquidity position if these costs are higher than anticipated.*

 

As of October 31, 2005, we had a total of$10,437,000 in cash and cash equivalents and available-for-sale securities andan additional $2,875,000 of restricted cash to be used in our operations andpursue the SCO Litigation.  Since October 31,2004, we have spent $2,125,000 for expert, consulting and other costs as agreedin the Engagement Agreement with our legal counsel in the SCO Litigation.  As we continue with discovery and other trialpreparations during the year ending October 31, 2006, we believe

 

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thatwe will spend the $2,875,000 remaining in escrow and we may be required toplace additional amounts into the escrow account, which could harm ourliquidity position.

 

*We have issued options under our equity compensation plans withoutcomplying with registration or qualification requirements under the securitieslaws of California, Georgia and possibly other states, and, as a result, we mayincur rescission liability for such options and may face additional potentialclaims under state securities laws.*

 

In addition to the shares issued under the ESPP, wehave granted options under our 1999 Omnibus Stock Incentive Plan and 2002Omnibus Stock Incentive Plan without complying with the registration orqualification requirements under the securities laws of California, Georgia andpossibly other states.  We may facerescission liability to plan participants holding unexercised stock options inthese states.  Additionally, regulatoryauthorities may require us to pay fines or they may impose other sanctions uponus, and we may face other claims by plan participants other than rescissionclaims.

 

*Our stock price is volatile.*

 

The trading price for our common stock has beenvolatile during the last several years and our share price has changeddramatically over short periods.  Webelieve that changes in our stock price are affected by the factors mentionedabove under the caption entitled *“Fluctuations in ouroperating results or the failure of our operating results to meet theexpectations of public market analysts and investors may negatively impact ourstock price”*as well as from changing public perceptions concerningthe strength of our intellectual property claims and other factors beyond ourcontrol.  Public perception can changequickly and without any change or development in our underlying business orlitigation position.  An investment inour stock is subject to such volatility and, consequently, is subject tosignificant risk.

 

*There are risks associated with the potential exercise of ouroutstanding options.*

 

As of December 31, 2005, we have issued andoutstanding options to purchase up to approximately 3,811,000 shares of commonstock with an average exercise price of $4.17 per share.  The existence of such rights to acquirecommon stock at fixed prices may prove a hindrance to our efforts to raisefuture equity and debt funding, and the exercise of such rights will dilute thepercentage ownership interest of our stockholders and may dilute the value oftheir ownership.  The possible futuresale of shares issuable on the exercise of outstanding options could adverselyaffect the prevailing market price for our common stock.  Further, the holders of the outstanding stockoptions may exercise them at a time when we would otherwise be able to obtainadditional equity capital on terms more favorable to us.

 

*Common stock available for resale may depress the market price of ourcommon stock.*

 

We have filed a registration statement with theSecurities and Exchange Commission (“SEC”), which has been declared effective,covering the potential resale by one of our shareholders of up to 2,105,163 sharesof common stock, or 10.0% of our outstanding common stock.  In addition, we have filed a registrationstatement with the SEC, which has not been declared effective, covering thepotential resale by some of our shareholders of up to 2,852,449 shares of ourcommon stock, or 13.6% of our outstanding common stock.  The existence of a substantial number ofshares of common stock subject to immediate resale could depress the marketprice for our common stock and impair our ability to raise needed capital.

 

*Our stock price could decline further because of the activities ofshort sellers.*

 

Our stock has attracted significant interest from shortsellers.  The activities of short sellerscould further reduce the price of our stock or inhibit increases in our stockprice.

 

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*The right of our Board of Directors to authorize additional shares ofpreferred stock could adversely impact the rights of holders of our commonstock.*

 

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 ourcommon stock may be adversely affected by the rights of any holders ofadditional shares of preferred stock that may be issued in the future,including without limitation, further dilution of the equity ownershippercentage of our holders of common stock and their voting power if we issuepreferred stock with voting rights. Additionally, the issuance of preferred stock could make it moredifficult for a third party to acquire a majority of our outstanding votingstock.

 

*Our stockholder rights plan could make it more difficult for a hostilebid for our company or a change of control transaction to succeed at currentmarket prices for our stock.*

 

We have adopted a stockholder rights plan.  The power given to the Board of Directors bythe stockholder rights plan may make it more difficult for a change of controlof our company to occur or for our company to be acquired when the acquisitionis opposed by our Board of Directors.

 

**Item1B.  Unresolved Staff Comments**

 

Not applicable as we are not an accelerated filer ora well-known seasoned issuer.

 

**Item2.  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****our fiscalyear ending October 31, 2008.

 

Our international fieldoperations occupy leased facilities in France, Japan, Germany, India, and theUnited Kingdom.  The leases for thesefield operation facilities expire at various dates through our fiscal year endingOctober 31, 2008.

 

As indicated in Item 1,we have two business segments: UNIX and SCOsource.  These segments use substantially all of theproperties, at least in part, and we retain the flexibility to use each of ourproperties in whole or in part for each of our segments.

 

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.

 

**Item3.  Legal Proceedings**

 

*IBM Corporation*

 

On or about March 6, 2003, we filed a civilcomplaint against IBM in the United States District Court for the District ofUtah, under the title The SCO Group, Inc. v. International BusinessMachines Corporation, Civil No. 2:03CV0294.  In this action we claim, among other things,that IBM breached its UNIX source code licenses (both the IBM and SequentComputer Systems, Inc. “Sequent” licenses) by disclosing restricted informationconcerning the UNIX source code and derivative works and related information inconnection with its efforts to promote the Linux operating system.  Our complaint includes, among other things,claims for breach of contract, unfair competition, tortious interference andcopyright infringement.  As a result ofIBM’s actions, we are requesting damages in an amount to be proven at trial andseeking injunctive relief.

 

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On or about March 6, 2003, we notifiedIBM that they were not in compliance with our UNIX source code license agreementand on or about June 13, 2003, we delivered to IBM a notice of terminationof their UNIX source code license agreement, which underlies IBM’s AIXsoftware.  On or about August 11,2003 we sent a similar notice terminating the Sequent source code license.  IBM disputes our right to terminate thoselicenses.  In the event our terminationof those licenses is valid we believe IBM is exposed to substantial damages andinjunctive relief based on its continued use and distribution of the AIXoperating system.  On June 9, 2003, Novellsent us a notice purporting to waive our claims against IBM regarding its licensebreaches.  We do not believe that Novellhad the right to take any such action relative to our UNIX source code rights.

 

On February 27, 2004, we filed a secondamended complaint which alleges nine causes of action that are similar to thoseset forth above, adds a new claim for copyright infringement and removes theclaim for misappropriation of trade secrets. IBM filed an answer and fourteen counterclaims.  Among other things, IBM has asserted that wedo not have the right to terminate IBM’s UNIX license and IBM has claimed thatwe have breached the GNU General Public License and have infringed certainpatents held by IBM.  IBM’s counterclaimsinclude claims for breach of contract, violation of the Lanham Act, unfaircompetition, intentional interference with prospective economic relations,unfair and deceptive trade practices, promissory estoppel, patent infringementand a declaratory judgment claim for non-infringement of copyrights.  On October 6, 2005, IBM voluntarilydismissed with prejudice its claims for patent infringement.

 

On February 9, 2005, the Court denied threemotions for partial summary judgment that IBM had filed on our contract claims,on IBM’s eighth counterclaim for copyright infringement, and on IBM’s tenthcounterclaim for a declaration of non-infringement of our copyrights.  The Court denied each of those motionswithout prejudice to IBM’s renewing or refiling the motions after discovery iscomplete.  The Court also denied ourmotion to stay or dismiss IBM’s tenth counterclaim. The Court ordered that nofurther dispositive motions could be filed until the close of discovery.

 

On July 1, 2005, the Court issued a revised SchedulingOrder establishing, among other things, discovery and motion deadlines over thenext 18 months with a five-week jury trial to commence on February 26,2007.

 

Pursuant to the Court’s July 1, 2005 SchedulingOrder, we filed our Interim Disclosure of Material Misused by IBM on October 28,2005.  Our report includes a matrix thatidentifies 217 separate technology disclosures that we contend IBM improperlymade to enhance Linux in violation of one or more contractual prohibitionsgoverning IBM’s use of our proprietary material.  We continued to review relevant materials includingevidence IBM has produced in discovery and filed an updated report on December 22,2005 detailing IBM’s misuse of our proprietary material.  Our December 22 report includes 293total disclosures which we claim violate our contractual rights and copyrights.  These reports and the disclosures identifiedare the result of analysis from experienced outside technical consultants.  Discovery is ongoing in the case as theparties prepare for trial.

 

*Novell, Inc.*

 

On January 20, 2004, we filed suit in Utahstate court against Novell, Inc. for slander of title seeking relief forits alleged bad faith effort to interfere with our ownership of copyrightsrelated to our UNIX source code and derivative works and our UnixWare product.  After removal to federal court, the case is nowpending 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, we requested preliminaryand permanent injunctive relief as well as damages.  Through these claims, we seek to requireNovell to assign to us all copyrights that we believe Novell has wrongfullyregistered, prevent Novell from representing any ownership interest in thosecopyrights and require Novell to retract or withdraw all representations it hasmade regarding its purported ownership of those copyrights and UNIX itself.

 

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*Novellhas filed two motions to dismiss claiming, among other things, that Novell’sfalse statements were not uttered with malice and are privileged under the law. The Court denied both of Novell’smotions to dismiss.  On July 29,2005, Novell filed its Answer and Counterclaims against us, assertingcounterclaims for our alleged breaches of the Asset Purchase Agreement betweenNovell and our predecessor-in-interest, The Santa Cruz Operation, Inc.,for slander of title, restitution/unjust enrichment, and accounting, and fordeclaratory relief regarding Novell’s alleged rights under the Asset PurchaseAgreement.  On December 6, 2005, ascheduling order was entered by the Court setting a schedule of discoveryand motions leading up to a trial in June 2007.  On or about December 30, 2005, we filed amotion for leave to amend our complaint to assert additional claims againstNovell including copyright infringement, unfair competition and a breach ofNovell’s limited license to use our UNIX code. Novell has consented to our filing of these additional claims.  Discovery is commencing in the case.*

 

*DaimlerChryslerCorporation*

* *

On or about March 3, 2004, we brought suitagainst DaimlerChrysler Corporation for its alleged violations of its UNIXlicense agreement with us. The lawsuit alleges that DaimlerChrysler breachedits UNIX software agreement by failing to provide an adequate or timelycertification of its compliance with that agreement as we requested. Thelawsuit, filed in Oakland County Circuit Court in the State of Michigan,requests the court to declare that DaimlerChrysler has violated thecertification requirements of its UNIX software agreement, permanently enjoinDaimlerChrysler from further violations of the UNIX software agreement, issue amandatory injunction requiring DaimlerChrysler to remedy the effects of itspast violations of the UNIX software agreement and award us damages in anamount to be determined at trial together with costs, attorneys’ fees and anysuch other or different relief that the court may deem to be equitable andjust.

 

In response to DaimlerChrysler’s motion to dismiss,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, we filed a motion to stay the case pending the clarification of certainissues in the IBM litigation. The Court denied the motion to stay and based ona stipulation of the parties, the Court signed an order of dismissal withoutprejudice.  The Appellate Court hasdismissed our appeal of the July 21, 2004 ruling finding that the orderwas not a final, appealable order.

 

*AutoZone, Inc.*

 

On or about March 2, 2004, we brought suitagainst AutoZone, Inc. for its alleged violations of our UNIX copyrightsthrough its use of Linux. The lawsuit alleges copyright infringement byAutoZone by, among other things, running versions of the Linux operating systemthat contain proprietary material from UNIX System V. The lawsuit, filed inUnited States District Court in Nevada, requests injunctive relief againstAutoZone’s further use or copying of any part of our copyrighted materials andalso requests damages as a result of AutoZone’s infringement in an amount to beproven at trial. In response to AutoZone’s motion to transfer the case to Tennesseeor stay the case, the federal court in Nevada granted AutoZone’s motion to staythe case, with 90-day status reports to the court, and denied without prejudiceAutoZone’s motion to transfer the case to Tennessee. The federal court allowedthe parties to take limited expedited discovery relating to the issue ofpreliminary injunctive relief which discovery was concluded in May 2005.

 

We have concluded the initial discovery allowed bythe court and filed our report with the court on May 27, 2005.  Contrary to AutoZone’s own statements to thecourt, we found through discovery, including depositions and other admissionsof AutoZone, many instances of copying of programs containing our OpenServercode.  AutoZone has represented that ithas now removed all of our code and proprietary information it copied or usedin its migration to Red Hat Linux. Because AutoZone represents it has removed or otherwise is not using ourcode and proprietary information, we currently do not intend to move for apreliminary injunction. AutoZone does not admit that it violated our rights or

 

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causedus damage in that migration process, which are still points of dispute betweenthe parties.  Given the stay issued bythe Court in the case, we reserve the right to pursue infringement and damagesin the future based on these issues and other issues stayed by the Court.

 

*IPO Class Action Matter*

 

We are an issuer defendant in a series of classaction lawsuits involving over 300 issuers that have been consolidated under Inre Initial Public Offering Securities Litigation, 21 MC 92 (SAS). Theconsolidated complaint alleges, among other things, certain improprietiesregarding the underwriters’ conduct during our initial public offering and thefailure to disclose such conduct in the registration statement in violation ofthe Securities Act of 1933, as amended.

 

The plaintiffs, the issuers and the insurancecompanies have negotiated an agreement to settle the dispute between theplaintiffs and the issuers.  All parties,including the plaintiffs, issuers and insurance companies, have executed thissettlement agreement and the settlement agreement has been submitted to thecourt for approval.  If the settlementagreement is approved by the court, and if no cross-claims, counterclaims orthird-party claims are later asserted, this action will be dismissed withrespect to us and our directors.

 

We have notified our underwriters and insurancecompanies of the existence of the claims. Management believes, afterconsultation with legal counsel, that the ultimate outcome of this matter willnot have a material adverse effect on our results of operations or financialposition and will not exceed the $200,000 self-insured retention already paidor accrued by us.

 

*Red Hat, Inc.*

 

On August 4, 2003, Red Hat, Inc. filed acomplaint against us. The action is pending in the United States District Courtfor the District of Delaware under the case caption Red Hat, Inc. v. TheSCO Group, Inc., Civil No. 03-772. Red Hat asserts that the Linuxoperating system does not infringe on our UNIX intellectual property rights andseeks a declaratory judgment for non-infringement of copyrights and nomisappropriation of trade secrets. In addition, Red Hat claims that we haveengaged in false advertising in violation of the Lanham Act, deceptive tradepractices, unfair competition, tortious interference with prospective businessopportunities, trade libel and disparagement. On April 6, 2004, the courtdenied our motion to dismiss this case; however, the court stayed the case andrequested status reports every 90 days regarding the case against IBM. RedHat filed a motion for reconsideration, which the Court denied on March 31,2005. We intend to vigorously defend this action. In the event the stay islifted and Red Hat is allowed to pursue its claims, we will likely assertcounterclaims against Red Hat.

 

*Indian Distributor Matter*

 

In April 2003, a former Indian distributor ofour company filed a claim in India, requesting summary judgment for payment of$1,428,000, and an order that we trade in India only through the distributorand/or give a security deposit until the claim is paid.  The distributor claims that we areresponsible to repurchase certain software products and to reimburse thedistributor for certain other operating costs. Management does not believe that we are responsible to reimburse thedistributor for any operating costs and also believes that the return rightsrelated to any remaining inventory have lapsed. The distributor additionally requested that the Indian courts grantinterim relief in the form of attachment of local assets.  These requests for interim relief have failedin the court, and discovery has commenced and hearings on the main claims havebeen held and are ongoing.  We intend tovigorously defend this action.

 

Pursuit and defense of the above-mentioned matterswill continue to be costly, and management expects the costs for legal fees andrelated expenses will be substantial.

 

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The ultimate outcome or potential negative effect onour results of operations or financial position of each of the Red Hat, Inc.,IPO Class Action, and the Indian Distributor matters is neither probablenor estimable.

 

We are a party tocertain other legal proceedings arising in the ordinary course of business.Management believes, after consultation with legal counsel, that the ultimateoutcome of such legal proceedings will not have a material adverse effect onour results of operations, liquidity or financial position.

 

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

 

Therewere no matters submitted to a vote of security holders during the three monthsended October 31, 2005.

 

**PART II**

 

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

 

**Market Price of Our Common Stock**

 

Ourcommon stock initially traded on The Nasdaq National Market beginning in March 2000,but has been traded on The Nasdaq Capital Market (formerly known as the NasdaqSmallCap Market) since February 2003. In September 2002, we changed our trading symbol from “CALD” to “SCOX.”  The table below sets forth the range of highand low closing prices of our common stock as reported on the Nasdaq Capital Market,as applicable, for the last two years.

 
| *** ***                          | *** *** | **SCO Common Stock** | ** ** |
|---------------------------------------|--------------|----------------------|------------|
| *** ***                          | *** *** | **High**             | ** ** | **Low** | ** ** |
| **Year  Ended October 31, 2005** |         |                 |       |   |   |
| Quarter ended January 31, 2005   |         | $                    | 4.99       |   | $ | 2.85 |   |
| Quarter ended April 30, 2005     |         | 4.60                 |       | 3.42 |   |
| Quarter ended July 31, 2005      |         | 4.22                 |       | 3.50 |   |
| Quarter ended October 31, 2005   |         | 4.93                 |       | 3.75 |   |
|                                  |         |                 |       |   |   |
| **Year  Ended October 31, 2004** |         |                 |       |   |   |
| Quarter ended January 31, 2004   |         | $                    | 19.08      |   | $ | 13.65 |   |
| Quarter ended April 30, 2004     |         | 14.40                |       | 6.26 |   |
| Quarter ended July 31, 2004      |         | 6.34                 |       | 4.03 |   |
| Quarter ended October 31, 2004   |         | 5.10                 |       | 2.98 |   |

 

On January 20, 2006,the closing sales price for our common stock as reported by The Nasdaq Capital Marketwas $3.78.  As of January 20, 2006,there were 394 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.

 

**IssuerPurchases of Equity Securities**

 

During the three months ended October 31, 2005, we did not purchaseany of our equity securities.

 

20

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**Item 6.  Selected Financial Data**

 

The following selected financial data setforth below should be read in conjunction with the consolidated financialstatements and the related notes included elsewhere in this Form 10-K andin conjunction with “Management’s Discussion and Analysis of FinancialCondition 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, 2005, 2004 and 2003 and the selected balancesheet data as of October 31, 2005 and 2004 are derived from, and arequalified by reference to, the audited consolidated financial statements andrelated notes in this Form 10-K.

 

The selected statement of operations data for theyears ended October 31, 2002 and 2001 and the selected balance sheet dataas of October 31, 2003, 2002 and 2001 are derived from auditedconsolidated financial statements not appearing in this Form 10-K.

 
| *** ***                                                   | *** *** | **Years Ended October 31,**          | *** *** |
|----------------------------------------------------------------|--------------|-------------------------------------------|--------------|
| *** ***                                                   | *** *** | **2005**                                  | ** **   | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | *** *** |
| ** **                                                     | ** **   | **(In thousands, except per share data)** | ** **   |
| ** **                                                     | * *     | * *                                  | * *     | * * | * * | * * | * * | * * | * * | * * | * * |
| **Statement of Operations Data:**                              |         |                                      |         |   |   |   |   |   |   |   |   |
| Total revenue                                                  |         | $                                         | 36,004       |   | $ | 42,809 |   | $ | 79,254 |   | $ | 64,241 |   | $ | 40,441 |   |
| Gross margin                                                   |         | $                                         | 17,691       |   | $ | 15,711 |   | $ | 59,332 |   | $ | 45,925 |   | $ | 25,518 |   |
| Income (loss) from operations                                  |         | $                                         | (11,899      | ) | $ | (28,573 | ) | $ | 3,436 |   | $ | (24,176 | ) | $ | (133,636 | ) |
| Net income available (loss applicable) to  common stockholders |         | $                                         | (10,726      | ) | $ | (16,227 | ) | $ | 5,304 |   | $ | (24,877 | ) | $ | (131,357 | ) |
| Basic net income (loss) per common share                       |         | $                                         | (0.60        | ) | $ | (1.07 | ) | $ | 0.43 |   | $ | (1.93 | ) | $ | (10.92 | ) |
| Diluted net income (loss) per common share                     |         | $                                         | (0.60        | ) | $ | (1.07 | ) | $ | 0.34 |   | $ | (1.93 | ) | $ | (10.92 | ) |
| Weighted average basic common shares                           |         | 17,924                                    |         | 15,155 |   | 12,261 |   | 12,893 |   | 12,024 |   |
| Weighted averaged diluted common shares                        |         | 17,924                                    |         | 15,155 |   | 15,679 |   | 12,893 |   | 12,024 |   |

 
| *** ***                       | *** *** | **As of October 31,** | ** ** |
|------------------------------------|--------------|----------------------------|------------|
| *** ***                       | *** *** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                         | ** **   | **(In thousands)**         | ** ** |
| ** **                         | * *     | * *                   | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| **Balance  Sheet Data:**           |         |                       |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents          |         | $                          | 4,272      |   | $ | 12,693 |   | $ | 64,428 |   | $ | 6,589 |   | $ | 20,541 |   |
| Working capital (deficit)          |         | 8,669                      |       | 15,413 |   | 37,168 |   | (6,332 | ) | 14,401 |   |
| Total assets                       |         | 28,948                     |       | 55,400 |   | 94,952 |   | 37,406 |   | 74,859 |   |
| Long-term liabilities              |         | 338                        |       | 343 |   | 508 |   | 1,625 |   | 5,925 |   |
| Redeemable preferred stock         |         | —                     |       | — |   | 29,671 |   | — |   | — |   |
| Common stock subject to rescission |         | 1,018                      |       | 528 |   | — |   | — |   | — |   |
| Total stockholders’ equity    |         | 11,337                     |       | 21,702 |   | 19,516 |   | 8,177 |   | 34,604 |   |
|                                    |              |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

*ThisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations and other parts of this Form 10-K contain forward-lookingstatements that involve risks and uncertainties.  Forward-looking statements can also beidentified by words such as “intends,” “anticipates,” “expects,” “believes,” “plans,”“predicts,” and similar terms. Forward-looking statements are not guarantees of future performance andour actual results may differ significantly from the results discussed in theforward-looking statements.  Factors thatmight cause such differences include, but are not limited to, those discussedin the subsection entitled “Forward-Looking Statements and Factors That May AffectFuture Results and Financial Condition” and the subsection entitled “RiskFactors” under Part I, Item 1A of this Form 10-K.  The following discussion should be read inconjunction with our consolidated financial statements and notes theretoincluded in Part II, Item 8 of this Form 10-K.  All information*

 

21

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*presented herein is based on ourfiscal year ended October 31, 2005. We assume no obligation to revise or update any forward-looking statementsfor 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 and operations of the server and professional services groups ofThe Santa Cruz Operation.  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.

 

*RecentDevelopments.*** **We discovered in 2005 that we had offered and sold shares of our commonstock under our 2000 Employee Stock Purchase Plan, or ESPP, without complyingwith registration or qualification requirements under federal securities laws andthe securities laws of California, Utah and possibly other states.  As a result, those current and formeremployees had a right to rescind their purchases of shares under the ESPP orrecover damages if they no longer owned the shares, subject to applicablestatutes of limitations.

 

In December 2005, weoffered to rescind a total of 337,289 shares of common stock issued under ourESPP to current and former employees while they resided in California,Connecticut, Illinois, New Jersey, Utah, Texas or Washington.  These shares represented all of the ESPPshares we issued to residents of these states for which a purchaser could claima rescission right.  The rescission offerwas intended to address our rescission liability relating to our federal andstate securities laws compliance issues by allowing the holders of the sharescovered by the rescission offer to rescind the underlying securitiestransactions and sell those securities back to us or recover damages, as thecase may be.

 

Our rescission offer concludedon January 20, 2006.  As of thatdate, 14 offerees had accepted our offer to rescind the purchase of approximately7,300 shares issued under our ESPP.  We planto make aggregate payments to such offerees of approximately $41,500, whichincludes approximately $9,700 in applicable statutory interest and damages.  As a result of the rescission offer, webelieve we have extinguished our state rescission liability and mitigated ourfederal rescission liability to anyone to whom the rescission offer was made fornoncompliance with the registration or qualification requirements of federaland state securities laws as they relate to the shares issued under our ESPP.

 

The rescission offer did notaddress stock options that may have been issued without registration orqualification requirements under the securities laws of California, Georgia andpossibly other states.  We may still facerescission liability to plan participants holding unexercised stock options inthese states.

 

**Business Focus**

 

*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 softwaretechnology for distributed, embedded and network-based systems.  Our largest source of UNIX business revenue isderived from existing customers through our worldwide, indirect, leveragedchannel of partners, which includes distributors and independent solutionproviders.  We have a presence in anumber of countries that provide support and services to customers andresellers.  The other principal channelfor selling and marketing our UNIX products is through existing customers thathave a large number of replicated sites or franchisees.

 

22

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Weaccess these corporations through their information technology or purchasingdepartments with our Area Sales Managers (“ASMs”) in the United States andthrough our reseller channel in countries outside the United States.  In addition, we also sell our operatingsystem products to original equipment manufacturers (“OEMs”).  Our sales of UNIX products and servicesduring the last several years have been primarily to pre-existing UNIXcustomers and not newly acquired customers.  Our UNIX business revenue dependssignificantly on our ability to market and sell our products to existingcustomers and to generate upgrades from existing customers.

 

Thefollowing table and footnote shows the operating results of the UNIX businessfor the years ended October 31, 2005, 2004 and 2003 (in thousands):

 
| *** ***                  | *** *** | **2005** | ** ** | **2004** | ** ** | **2003** | *** *** |
|-------------------------------|--------------|----------|------------|----------|------------|----------|--------------|
|                          |         |     |       |     |       |     |         |
| Revenue                       |         | $        | 35,838     |     | $          | 41,980   |         | $ | 53,408 |   |
| Cost of  revenue              |         | 5,466    |       | 7,355    |       | 10,422   |         |
| Gross margin                  |         | 30,372   |       | 34,625   |       | 42,986   |         |
| Sales and  marketing          |         | 11,666   |       | 15,806   |       | 24,392   |         |
| Research and  development     |         | 7,940    |       | 10,126   |       | 11,012   |         |
| General and  administrative   |         | 6,604    |       | 7,385    |       | 6,230    |         |
| Other (1)                     |         | 2,394    |       | 9,008    |       | 5,306    |         |
| Total operating expenses      |         | 28,604   |       | 42,325   |       | 46,940   |         |
| Income (loss) from operations |         | $        | 1,768      |     | $          | (7,700   | )            | $ | (3,954 | ) |

 

----

(1)                      For the year ended October 31, 2005,other costs included $2,372 of amortization of intangibles and $22 of stock-basedcompensation.  For the year ended October 31,2004, other costs included $3,168 of severance and exit costs, $2,566 of amortizationof intangibles, $2,355 of losses on disposition and impairment of long-livedassets, and $919 of stock-based compensation. For the year ended October 31, 2003, other costs included $3,190 ofamortization of intangibles, $1,204 of stock-based compensation, $498 of severanceand exit costs, $250 of write-offs of investments, and $164 of losses ondisposition and impairment of long-lived assets.

 

Revenuefrom our UNIX business decreased by $6,142,000, or 15%, for the year ended October 31,2005 compared to the year ended October 31, 2004 and decreased by$11,428,000, or 21%, for the year ended October 31, 2004 compared to theyear ended October 31, 2003.  Therevenue from our UNIX business has been declining over the last several yearsprimarily as a result of continued competition from alternative operatingsystems, particularly Linux.  We believethat the inclusion of our UNIX code and derivative works in Linux has been acontributor to the decline in our UNIX business revenue because users of Linux generallydo not pay for the operating system itself, but for services and maintenance.

 

Inan effort to attain profitability in our UNIX business, we have decreased ourcosts in each of the last three years. Operating costs for our UNIX business decreased from $46,940,000 for theyear ended October 31, 2003, to $42,325,000 for the year ended October 31,2004, and then further decreased to $28,604,000 for the year ended October 31,2005.  These cost reductions haveprimarily been attributable to reduced headcount and consolidation of certainfacilities.

 

Inour UNIX business, we have reduced the number of full-time equivalent employeesfrom 295 as of October 31, 2003, to 193 as of October 31, 2004, andto 163 as of October 31, 2005.  Wehave taken these headcount reductions and reduced other discretionary spendingwhile still maintaining a worldwide presence. Based on our cost-cutting actions, we have planned that our UNIXbusiness will continue to generate positive cash flow during the year ending October 31,2006.

 

Thedecline in our UNIX business revenue may be accelerated if industry partnerswithdraw their support as a result of our SCO Litigation.  The decline in our UNIX business and the SCOLitigation may cause industry partners, developers and hardware and softwarevendors to choose not to support or

 

23

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certifyto our UNIX operating system products. This would lead to an accelerated decline in revenue from our UNIXbusiness.

 

*SCOsourceBusiness. *During the year ended October 31,2003, we became aware that our UNIX code and derivative works had beeninappropriately included by others in the Linux operating system.  We believe the inclusion of our UNIX code andderivative works in Linux has been a contributor to the decline in our UNIXbusiness because users of Linux generally do not pay for the operating system itself,but pay for services and maintenance. The Linux operating system competes directly with our OpenServer andUnixWare products and has taken significant market share from these products.

 

Inan effort to protect our UNIX intellectual property, weinitiated our SCOsource business.  OurSCOsource revenue for the years ended October 31, 2004 and 2005 wassignificantly lower than revenue generated during the year ended October 31,2003 and we believe and allege our revenue and related revenue opportunitieshave been adversely impacted by Novell’s claim of UNIX copyright ownership,which may have caused potential customers to delay or forego licensing until anoutcome in this legal matter has been reached.

 

The following tableshows the results of operations for the SCOsource business (in thousands):

 
| *** ***                  | *** *** | **2005** | ** ** | **2004** | ** ** | **2003** | *** *** |
|-------------------------------|--------------|----------|------------|----------|------------|----------|--------------|
|                          |         |     |       |     |       |     |         |
| Revenue                       |         | $        | 166        |     | $          | 829      |         | $ | 25,846 |   |
| Cost of  revenue              |         | 12,847   |       | 19,743   |       | 9,500    |         |
| Gross margin (deficit)        |         | (12,681  | )          | (18,914  | )          | 16,346   |         |
| Sales and  marketing          |         | 154      |       | 1,232    |       | —   |         |
| Research and  development     |         | 389      |       | 486      |       | —   |         |
| General and  administrative   |         | 443      |       | 241      |       | —   |         |
| Compensation  to law firms    |         | —   |       | —   |       | 8,956    |         |
| Total operating expenses      |         | 986      |       | 1,959    |       | 8,956    |         |
| Income (loss) from operations |         | $        | (13,667    | )        | $          | (20,873  | )            | $ | 7,390 |   |
|                               |              |          |            |          |            |          |              |  |  |  |  |

 

Revenuefrom our SCOsource business decreased from $25,846,000 for the year ended October 31,2003, to $829,000 for the year ended October 31, 2004, and to $166,000 forthe year ended October 31, 2005. During the year ended October 31, 2003, SCOsource revenue wasprimarily attributable to two large vendor licenses.  We did not close similar transactions duringthe years ended October 31, 2005 and 2004. Revenue for the years ended October 31, 2005 and 2004 was primarilyattributable to sales of our SCOsource IP agreements.

 

Costof revenue increased from $9,500,000 for the year ended October 31, 2003to $19,743,000 for the year ended October 31, 2004, which was primarilyattributable to increased legal fees incurred in connection with our SCOLitigation.  Cost of revenue decreased to$12,847,000 for the year ended October 31, 2005 and this decrease wasprimarily attributable to our modified fee agreement with the law firms (the “LawFirms”) representing us in the SCO Litigation that has significantly reducedour ongoing costs.  The decrease inoperating expenses was primarily attributable to decreased personnel andrelated costs.

 

Operatingexpenses for sales and marketing, research and development and general andadministrative decreased from $1,959,000 during the year ended October 31,2004 to $986,000 during the year ended October 31, 2005.  The decrease in operating expenses wasprimarily attributable to decreased personnel and related costs.  The other expense for the year ended October 31,2003 of $8,956,000 was attributable to a contingency fee payable to the LawFirms incurred in connection with the October 2003 issuance of our nowretired 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 and was paid in November 2004.

 

24

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Because of theuncertainties related to our SCOsource business, we are unable to estimate theamount and timing of future SCOsource licensing revenue.  We are unlikely to generate significantrevenue from our SCOsource business unless and until we prevail in our SCOLitigation.  Additionally, the success ofthe SCOsource business may depend on the strength of our intellectual propertyrights and claims regarding UNIX, including our claims against Novell and thestrength of our claim that unauthorized UNIX source code and derivative worksare contained in Linux.

 

**Critical Accounting Estimates**

 

The preparation offinancial statements and related disclosures in conformity with U.S. generallyaccepted accounting principles and our discussion and analysis of our financialcondition and results of operations requires us to make judgments, assumptionsand estimates that affect the amounts reported in our consolidated financialstatements and accompanying notes.  Note 2of the notes to consolidated financial statements in Part II, Item 8 ofthis Form 10-K describes the significant accounting policies and methodsused in preparation of our consolidated financial statements.  We base our estimates on historicalexperience, current trends, future projections, and on various otherassumptions we believe to be reasonable under the circumstances, the results ofwhich form the basis for making judgments about the carrying values of assetsand liabilities.  Actual results maydiffer from these estimates.  We believethe following to be our critical accounting estimates because they are bothimportant to the portrayal of our financial condition and results and theyrequire us to make judgments and estimates about matters that are inherentlyuncertain.

 

Ourcritical accounting policies and estimates include the following:

 

•                            Revenue recognition;

 

•                            Deferred income taxes and relatedvaluation allowances;

 

•                            Severance and exit costs;

 

•                            Impairment of long-lived assets; and

 

•                            Allowances for doubtful accounts.

 

*RevenueRecognition*.  We recognize revenue in accordance withStatement of 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 reasonably assured andproduct returns 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.

 

Estimates used inrevenue recognition include the determination of credit-worthiness of ourcustomers, verification of sales-out reporting to end users through our two-tierdistribution channel and

 

 

25

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the estimation ofpotential returns.  In addition to theseestimates, we also provide reserves against revenue based on historical trendsand experience.  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, if any, and other future events, the effects of which cannotbe determined.  We have provided avaluation allowance of $69,239,000 against our entire net deferred tax asset asof October 31, 2005.  The valuationallowance was recorded because of our history of net operating losses and theuncertainties regarding our future operating profitability and taxable income.

 

*Severance and Exit Costs.*  Since 2001, we have undertaken significantrestructuring activities to reduce our ongoing cost of operations.  All restructurings that occurred prior to theyear ended October 31, 2003 were accounted for in accordance with EmergingIssues Task Force (“EITF”) No. 94-3, “Liability Recognition for CertainEmployee Termination Benefits and Other Costs to Exit an Activity.”  For restructuring activities initiatedbeginning with the year ended October 31, 2003, we have accounted for theone-time termination benefits, contract termination costs and other associatedcosts in accordance with SFAS No. 146, “Accounting for Costs Associatedwith Exit or Disposal Activities.”  Otherseverance benefits have 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 carryingvalue of an asset may not be recoverable. We evaluate, at each balance sheet date, whether events andcircumstances have occurred which indicate possible impairment.  The carrying value of a long-lived asset isconsidered impaired when the anticipated cumulative undiscounted cash flows ofthe related asset or group of assets is less than the carrying value.  In that event, a loss is recognized based onthe amount by which the carrying value exceeds the estimated fair market valueof the long-lived asset.

 

We performed animpairment analysis as of October 31, 2005 and determined that the fairvalue of our remaining long-lived assets was in excess of the current carryingvalues and that no impairment had occurred. Judgment from management is required to determine if a triggering eventhas occurred and in forecasting future operating results.

 

Write-downs ofintangible assets may be necessary if the future fair value of these assets isless than carrying value.  If theoperating trends for our UNIX or SCOsource businesses continue to decline wemay be required to record an impairment charge in a future period related tothe carrying 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, 

 

26

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which is determined based on our historical experience and a specificreview of customer balances, was $144,000 as of October 31, 2005.  Our past experience has resulted in minimaldifferences from the actual amounts provided for bad debts and our recordedestimates.  However, our actual bad debtsin future periods may differ from our current estimates and the differences maybe material, which may have an adverseimpact on our future accounts receivable and cash position.

 

**Resultsof Operations**

 

The following tablepresents our results of operations for the years ended October 31, 2005,2004 and 2003 (in thousands):

 
|                                                                      | *** *** | **Years Ended October 31,** | ** ** |
|---------------------------------------------------------------------------|--------------|----------------------------------|------------|
| **Statement of Operations Data:**                                         | *** *** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                      |         |                             |       |   |   |   |   |
| Revenue:                                                                  |         |                             |       |   |   |   |   |
| Products                                                                  |         | $                                | 30,190     |   | $ | 35,352 |   | $ | 45,028 |   |
| SCOsource licensing                                                       |         | 166                              |       | 829 |   | 25,846 |   |
| Services                                                                  |         | 5,648                            |       | 6,628 |   | 8,380 |   |
| Total revenue                                                             |         | 36,004                           |       | 42,809 |   | 79,254 |   |
| Cost of  revenue:                                                         |         |                             |       |   |   |   |   |
| Products                                                                  |         | 2,544                            |       | 3,221 |   | 4,068 |   |
| SCOsource licensing                                                       |         | 12,847                           |       | 19,743 |   | 9,500 |   |
| Services                                                                  |         | 2,922                            |       | 4,134 |   | 6,354 |   |
| Total cost of revenue                                                     |         | 18,313                           |       | 27,098 |   | 19,922 |   |
| Gross margin                                                              |         | 17,691                           |       | 15,711 |   | 59,332 |   |
| Operating expenses:                                                       |         |                             |       |   |   |   |   |
| Sales and marketing                                                       |         | 11,820                           |       | 17,038 |   | 24,392 |   |
| Research and development                                                  |         | 8,329                            |       | 10,612 |   | 11,012 |   |
| General and administrative                                                |         | 7,047                            |       | 7,626 |   | 6,230 |   |
| Severance and exit costs                                                  |         | —                           |       | 3,168 |   | 498 |   |
| Amortization of intangibles                                               |         | 2,372                            |       | 2,566 |   | 3,190 |   |
| Loss on disposition and impairment of  long-lived assets                  |         | —                           |       | 2,355 |   | 164 |   |
| Write-off of investments                                                  |         | —                           |       | — |   | 250 |   |
| Stock-based compensation                                                  |         | 22                               |       | 919 |   | 1,204 |   |
| Compensation to law firms                                                 |         | —                           |       | — |   | 8,956 |   |
| Total operating expenses                                                  |         | 29,590                           |       | 44,284 |   | 55,896 |   |
| Income (loss) from operations                                             |         | (11,899                          | )          | (28,573 | ) | 3,436 |   |
| Equity in income (losses) of affiliates                                   |         | 47                               |       | 111 |   | (62 | ) |
| Other income, net                                                         |         | 1,399                            |       | 6,507 |   | 2,827 |   |
| Provision for income taxes                                                |         | (273                             | )          | (1,395 | ) | (774 | ) |
| Net income (loss)                                                         |         | (10,726                          | )          | (23,350 | ) | 5,427 |   |
| Contributions from (dividends on)  redeemable convertible preferred stock |         | —                           |       | 7,123 |   | (123 | ) |
| Net income available (loss applicable) to  common stockholders            |         | $                                | (10,726    | ) | $ | (16,227 | ) | $ | 5,304 |   |
|                                                                           |              |                                  |            |  |  |  |  |  |  |  |  |

 

**Years EndedOctober 31, 2005, 2004 and 2003**

 

### ***Revenue***

 
| ** ** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|       |       |     |       |       |       |     |       |       |       |     |         |
| Revenue    |       | $        | 36,004,000 |       | (16        | )%       | $          | 42,809,000 |       | (46      | )%           | $ | 79,254,000 |   |
|            |            |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

Revenue for the year ended October 31, 2005decreased by $6,805,000, or 16%, from the year ended October 31,2004.  This decrease was primarilyattributable to a decrease in UNIX products and

 

27

----

 

servicesrevenue as a result of continued competition from other operating systems,primarily Linux.  Revenue for the yearended October 31, 2004 decreased by $36,445,000, or 46%, from the yearended October 31, 2003.  Thisdecrease was primarily attributable to significantly lower SCOsource licensingrevenue in the year ended October 31, 2004 compared to the year ended October 31,2003 as well as a continued decline in our UNIX business.

 

Revenue generated from our UNIX business andSCOsource business is as follows:

 
| *** ***              | *** *** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003**   | *** *** |
|---------------------------|--------------|----------|------------|------------|------------|----------|------------|------------|------------|------------|--------------|
|                      |         |     |       |       |       |     |       |       |       |       |         |
| UNIX revenue              |         | $        | 35,838,000 |       | (15        | )%       | $          | 41,980,000 |       | (21        | )%           | $ | 53,408,000 |   |
| Percent of  total revenue |         | 100      | %          |       |       | 98       | %          |       |       | 67         | %            |
| SCOsource  revenue        |         | 166,000  |       | (80        | )%         | 829,000  |       | (97        | )%         | 25,846,000 |         |
| Percent of  total revenue |         | 0        | %          |       |       | 2        | %          |       |       | 33         | %            |
|                           |              |          |            |            |            |          |            |            |            |            |              |  |  |  |

 

The decrease in revenue in the UNIX businessof $6,142,000 for the year ended October 31, 2005 compared to the yearended October 31, 2004 and the decrease in revenue of $11,428,000 for theyear ended October 31, 2004 compared to the year ended October 31,2003 was primarily attributable to continued competition from other operatingsystems, particularly Linux.  We believethat the inclusion of our UNIX code and derivative works in Linux has been acontributor to the decline in our UNIX revenue because users of Linux generallydo not pay for the operating system itself, but pay for services andmaintenance.  We anticipate that for theyear ending October 31, 2006 our total UNIX revenue will decline from UNIXrevenue generated in the year ended October 31, 2005 as a result of thiscontinued competition.

 

SCOsource revenue decreased by $663,000 for the yearended October 31, 2005 compared to the year ended October 31, 2004and this decrease was primarily attributable to reduced sales of IPagreements.  The decrease in SCOsourcelicensing revenue of $25,017,000 from the year ended October 31, 2003 tothe year ended October 31, 2004 was primarily attributable to minimalvendor licensing revenue in the year ended October 31, 2004 compared tosignificant vendor licensing revenue generated in the year ended October 31,2003 as a result of two large vendor licenses.

 

Sales of our UNIX products and servicesduring the years ended October 31, 2005, 2004 and 2003 were primarily topre-existing customers.  Our UNIXbusiness revenue depends significantly on our ability to market our products toexisting customers and to generate upgrades from existing customers.  Our UNIX revenue may be lower than currentlyanticipated if we are not successful with our existing customers or if we losethe support of any of our existing hardware and software vendors or our keyindustry partners withdraw their marketing and certification support or directtheir support to our competitors.  Thismay occur as a result of the decline of our UNIX business and our SCOLitigation.

 

*Products Revenue*

 
| *** ***              | *** *** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|---------------------------|--------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                      |         |     |       |       |       |     |       |       |       |     |         |
| Products  revenue         |         | $        | 30,190,000 |       | (15        | )%       | $          | 35,352,000 |       | (21      | )%           | $ | 45,028,000 |   |
| Percent of  total revenue |         | 84       | %          |       |       | 83       | %          |       |       | 57       | %            |
|                           |              |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

Our products revenue consists of software licensesfor UNIX products such as OpenServer and UnixWare, as well as sales ofUNIX-related products.  Products revenuealso includes revenue derived from OEMs, distribution partners and largeend-user accounts.  We rely heavily onour two-tier distribution channel and any disruption in our distributionchannel could have an adverse impact on future revenue.

 

28

----

 

The decrease in products revenue of $5,162,000 fromthe year ended October 31, 2004 to the year ended October 31, 2005and the decrease of $9,676,000 from the year ended October 31, 2003 to theyear ended October 31, 2004 was primarily attributable to decreasedsales of OpenServer and UnixWare products primarily resulting from continuedcompetition in the operating system market, particularly Linux.  We believe that this competition from Linuxwill continue for the year ending October 31, 2006 and future periods.

 

Our products revenue was derived primarilyfrom sales of our OpenServer and UnixWare products.  Other products revenue consists mainly ofproduct maintenance and other UNIX-related products.  Revenue for these products was as follows:

 
| *** ***                 | *** *** | **2005**  | ** ** | **Change** | ** ** | **2004**   | ** ** | **Change** | ** ** | **2003**   | *** *** |
|------------------------------|--------------|-----------|------------|------------|------------|------------|------------|------------|------------|------------|--------------|
|                         |         |      |       |       |       |       |       |       |       |       |         |
| OpenServer  revenue          |         | $         | 16,720,000 |       | (9         | )%         | $          | 18,467,000 |       | (17        | )%           | $ | 22,162,000 |   |
| Percent of  products revenue |         | 55        | %          |       |       | 52         | %          |       |       | 49         | %            |
| UnixWare  revenue            |         | 8,979,000 |       | (19        | )%         | 11,125,000 |       | (21        | )%         | 14,083,000 |         |
| Percent of  products revenue |         | 30        | %          |       |       | 32         | %          |       |       | 31         | %            |
| Other  products revenue      |         | 4,491,000 |       | (22        | )%         | 5,760,000  |       | (34        | )%         | 8,783,000  |         |
| Percent of  products revenue |         | 15        | %          |       |       | 16         | %          |       |       | 20         | %            |
|                              |              |           |            |            |            |            |            |            |            |            |              |  |  |  |

 

The decreases in revenue for OpenServer,UnixWare and other products are all primarily the result of continuedcompetition, particularly from Linux operating system providers.

 

*SCOsource Licensing Revenue*

 
| ** **                   | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** |
|------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                         |       |     |       |       |       |     |       |       |       |     |       |
| SCOsource  licensing revenue |       | $        | 166,000    |       | (80        | )%       | $          | 829,000    |       | (97      | )%         | $ | 25,846,000 |   |
| Percent of  total revenue    |       | 0        | %          |       |       | 2        | %          |       |       | 33       | %          |
|                              |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

We initiated our SCOsource business for the purposeof protecting our intellectual property rights in our UNIX source code andderivative works.  SCOsource licensingrevenue was $166,000 for the year ended October 31, 2005 and $829,000 forthe year ended October 31, 2004, down significantly from revenue of$25,846,000 generated in the year ended October 31, 2003.  The SCOsource revenue for the years ended October 31,2005 and 2004 was primarily attributable to sales of SCOsource IP agreementsand the SCOsource licensing revenue in the year ended October 31, 2003 wasprimarily attributable to fees associated with two significant vendorlicenses.  We believe and allege that ourdecrease in SCOsource revenue for the years ended October 31, 2005 and2004 was in part attributable to Novell’s claim of UNIX copyright ownership,which may have caused potential customers to delay or forego licensing until anoutcome in this legal matter has been reached.

 

We are unable to predict the amount and timing offuture SCOsource licensing revenue, and, when generated, we expect that suchrevenue will be sporadic.

 

*Services Revenue*

 
| *** ***              | *** *** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|---------------------------|--------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                      |         |     |       |       |       |     |       |       |       |     |         |
| Services  revenue         |         | $        | 5,648,000  |       | (15        | )%       | $          | 6,628,000  |       | (21      | )%           | $ | 8,380,000 |   |
| Percent of  total revenue |         | 16       | %          |       |       | 15       | %          |       |       | 11       | %            |
|                           |              |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

Services revenue consists primarily of annual andincident technical support fees, engineering services fees, professionalservices and consulting fees.  These feesare typically charged and invoiced separately from UNIX products sales.  The decrease in services revenue of $980,000,or 15%, from the year ended October 31, 2004 to the year ended October 31,2005 and the decrease of $1,752,000, or 21%, from

 

29

----

 

theyear ended October 31, 2003 to the year ended October 31, 2004 was primarilyattributable to a decrease in products revenue and decreased professionalservices revenue.

 

The majority of our support and professional servicesrevenue continues to be derived from services for UNIX-based operating systemproducts.  Our future level of servicesrevenue depends in part on our ability to generate UNIX products revenue fromnew customers as well as to renew annual support and services agreements withexisting UNIX customers.

 

*Cost of Products Revenue*

 
| *** ***                    | *** *** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|---------------------------------|--------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                            |         |     |       |       |       |     |       |       |       |     |         |
| Cost of  products revenue       |         | $        | 2,544,000  |       | (21        | )%       | $          | 3,221,000  |       | (21      | )%           | $ | 4,068,000 |   |
| Percentage  of products revenue |         | 8        | %          |       |       | 9        | %          |       |       | 9        | %            |
|                                 |              |          |            |            |            |          |            |            |            |          |              |  |  |  |  |

 

Cost of products revenue consists of manufacturingcosts, royalties to third-party vendors, technology costs and overhead costs.  Cost of products revenue decreased by$677,000, or 21%, from the year ended October 31, 2004 to the year ended October 31,2005 and decreased $847,000, or 21%, from the year ended October 31, 2003to the year ended October 31, 2004. This decrease in cost of products revenue was primarily attributable tolower products revenue, as margins did not vary significantly.

 

For the year ending October 31, 2006, we expectthe dollar amount of our cost of products revenue to be less than the yearended October 31, 2005 and, as a percentage of products revenue, to beconsistent with the percentage achieved during the year ended October 31,2005.

 

*Cost of SCOsource Licensing Revenue*

 
| ** **                          | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|-------------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                                |       |     |       |       |       |     |       |       |       |     |         |
| Cost of SCOsource licensing revenue |       | $        | 12,847,000 |       | (35        | )%       | $          | 19,743,000 |       | 108      | %            | $ | 9,500,000 |   |
|                                     |            |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

Cost of SCOsource licensing revenue includes legaland professional fees incurred in connection with our SCO Litigation, thesalaries and related personnel costs of SCOsource employees, and an allocationof corporate costs.

 

Cost of SCOsource licensing revenue decreased by$6,896,000, or 35%, from the year ended October 31, 2004 to the year endedOctober 31, 2005 and was primarily attributable to decreased legal costsincurred in connection with the SCO Litigation as a result of our EngagementAgreement with the Law Firms representing us. Cost of SCOsource licensing revenue increased by $10,243,000, or 108%,from the year ended October 31, 2003 to the year ended October 31,2004 and was primarily attributable to increased legal costs incurred inconnection with our SCO Litigation.

 

Weanticipate that the dollar amount of our cost of SCOsource licensing revenuefor the year ending October 31, 2006 will be lower than for the year endedOctober 31, 2005 as we make our final $2,000,000 payment that is due tothe Law Firms and continue to make payments for expert, consulting and otherfees.  However, futurelegal fees may include contingency payments made to the Law Firms as a resultof a settlement, judgment, or a sale of our company, which could cause cost ofSCOsource licensing revenue for the year ending October 31, 2006 to behigher than the year ended October 31, 2005.

 

*Cost of Services Revenue*

 
| ** **                      | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|---------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                            |       |     |       |       |       |     |       |       |       |     |         |
| Cost of  services revenue       |       | $        | 2,922,000  |       | (29        | )%       | $          | 4,134,000  |       | (35      | )%           | $ | 6,354,000 |   |
| Percentage  of services revenue |       | 52       | %          |       |       | 62       | %          |       |       | 76       | %            |
|                                 |            |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

30

----

 

Cost of services revenue includes the salaries andrelated personnel costs of employees delivering services revenue as well asthird-party service agreements.  Cost ofservices revenue decreased by $1,212,000, or 29%, from the year ended October 31,2004 to the year ended October 31, 2005 and decreased by $2,220,000, or35%, from the year ended October 31, 2003 to the year ended October 31,2004 and was primarily attributable to reduced employee andemployee-related costs.

 

For the year ending October 31, 2006, weexpect the dollar amount of our cost of services revenue to be less than thatincurred for the year ended October 31, 2005 and that cost of servicesrevenue as a percentage of services revenue will be consistent to thatgenerated for the year ended October 31, 2005.

 

*Sales and Marketing*

 
| ** **                   | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                         |       |     |       |       |       |     |       |       |       |     |         |
| Sales and  marketing expense |       | $        | 11,820,000 |       | (31        | )%       | $          | 17,038,000 |       | (30      | )%           | $ | 24,392,000 |   |
| Percentage  of total revenue |       | 33       | %          |       |       | 40       | %          |       |       | 31       | %            |
|                              |            |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

Sales and marketing expenses consist of the salaries,commissions and other personnel costs of employees involved in the revenuegeneration process, as well as advertising and corporate allocations.  The decrease in sales and marketing expenseof $5,218,000, or 31%, from the year ended October 31, 2004 to the yearended October 31, 2005, and the decrease of $7,354,000, or 30%, from theyear ended October 31, 2003 to the year ended October 31, 2004 wasprimarily attributable to reductions in sales and marketing employees,reduced travel expenses, less commissions and lower advertising costs.  The decrease in sales and marketing expenseas a percentage of revenue from the year ended October 31, 2004 to theyear ended October 31, 2005 was the result of costs decreasing at agreater pace than our revenue decline and the increase from the year ended October 31,2003 to the year ended October 31, 2004 was a result of lower revenue forthe year ended October 31, 2004. Our sales and marketing full-time equivalent employees decreased from114 as of October 31, 2003, to 62 as of October 31, 2004 to 55 as of October 31,2005.

 

For the year ending October 31, 2006, weanticipate that the dollar amount of sales and marketing expense will decreasefrom the year ended October 31, 2005.

 

*Research and Development*

 
| ** **                       | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|----------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                             |       |     |       |       |       |     |       |       |       |     |         |
| Research and development expense |       | $        | 8,329,000  |       | (22        | )%       | $          | 10,612,000 |       | (4       | )%           | $ | 11,012,000 |   |
| Percentage of total revenue      |       | 23       | %          |       |       | 25       | %          |       |       | 14       | %            |
|                                  |            |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

Research and development expense consists of thesalaries and benefits of software engineers, consulting expenses and corporateallocations.  Research and developmentexpense decreased by $2,283,000, or 22%, from the year ended October 31, 2004 to the year ended October 31,2005 and decreased by $400,000, or 4%, from the year ended October 31,2003 to the year ended October 31, 2004. During the years ended October 31, 2005 and 2004, our engineeringefforts were focused on the release of UnixWare 7.1.4 and on the release ofOpenServer 6; both significant releases of our two primary operating systemproducts.  These development effortsrequired us to maintain our research and development infrastructure, whichlimited our ability to cut costs in this area as significantly as we have donein other areas.  Research and developmentexpense as a percentage of revenue declined in the year ended October 31,2005 as compared to the year ended October 31, 2004 as a result of costsdecreasing at a greater pace than our revenue declined.  Research and development expense as apercentage of revenue increased in the year ended October 31, 2004 ascompared to the year ended October 31, 2003 as a result

 

31

----

 

oflower revenue in fiscal year 2004.  Ourresearch and development full-time equivalent employees decreased from 75 as ofOctober 31, 2003, to 64 as of October 31, 2004 to 49 as of October 31,2005.

 

For the year ending October 31, 2006, weanticipate that the dollar amount of research and development expense willdecrease from the year ended October 31, 2005.

 

*General and Administrative*

 
| ** **                          | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** |
|-------------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                                |       |     |       |       |       |     |       |       |       |     |       |
| General and  administrative expense |       | $        | 7,047,000  |       | (8         | )%       | $          | 7,626,000  |       | 22       | %          | $ | 6,230,000 |   |
| Percentage  of total revenue        |       | 20       | %          |       |       | 18       | %          |       |       | 8        | %          |
|                                     |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

General and administrative expense consists of thesalaries and benefits of finance, human resources, and executive management andexpenses for professional services such as legal and accounting services andcorporate allocations.  General andadministrative expense decreased by $579,000, or 8%, from the year ended October 31,2004 to the year ended October 31, 2005. This decrease was primarily attributable to lower personnel and relatedcosts offset by increased legal and accounting costs related to the restatementof our quarterly financial statements and the preparation of our recentlycompleted rescission offer.  General andadministrative expense increased by $1,396,000, or 22%, from the year ended October 31,2003 to the year ended October 31, 2004. The increase in general and administrative expense was primarilyattributable to increased legal costs as a result of corporate and regulatorylegal matters not classified as cost of SCOsource licensing revenue andincreased fees from other professional service providers.  General and administrative expense as apercent of total revenue increased during the years ended October 31, 2005and 2004 as a result of increased costs and lower revenue.  Our general and administrative full-timeequivalent employees decreased from 55 as of October 31, 2003, to 36 as ofOctober 31, 2004, to 28 as of October 31, 2005.

 

For the year ending October 31, 2006, weanticipate that the dollar amount of general and administrative expense willdecrease from the year ended October 31, 2005.

 

*Severance andExit Costs*

* *
| ** **                   | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** |
|------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                         |       |     |       |       |       |     |       |       |       |     |       |
| Severance  and exit costs    |       | $        | —     |       | n/a        |     | $          | 3,168,000  |       | 536      | %          | $ | 498,000 |   |
| Percentage  of total revenue |       | 0        | %          |       |       | 7        | %          |       |       | 1        | %          |
|                              |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

During theyear ended October 31, 2005, we did not record any charges for severanceand exit costs.  During the years ended October 31,2004 and 2003, we recorded severance and exit costs totaling$3,168,000 and $498,000, respectively. The severance and exit costs for the years ended October 31, 2004and 2003 were comprised of termination payments made to employees in connectionwith reductions in headcount, closure of certain facilities and adjustments topreviously recorded amounts as actual payments made were less than recordedaccruals.

 

32

----

 

The detail of the activity in the accrual forseverance and exit costs for the years ended October 31, 2005, 2004 and2003, are as follows:

 
| **Year Ended October 31,  2005** | ** ** | **Balance at  November 1, 2004** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance at October 31, 2005** | *** *** |
|---------------------------------------|------------|---------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|--------------------------------------|--------------|
|                                  |       |                                  |       |          |       |            |       |            |       |                                 |         |
| Ongoing  severance and other          |       | $                                     | 401,000    |          | $          | —          |       | $               | —     |                                 | $            | (401,000 | ) | $ | — |   |
|                                       |            |                                       |            |               |            |                 |            |                 |            |                                      |              |  |  |  |  |  |

 
| **Year Ended October 31,  2004** | *** *** | **Balance at  November 1, 2003** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance at  October 31, 2004** | *** *** |
|---------------------------------------|--------------|---------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|---------------------------------------|--------------|
|                                  |         |                                  |       |          |       |            |       |            |       |                                  |         |
| One-time  severance                   |         | $                                     | —     |          | $          | 309,000         |       | $               | —     |                                  | $            | (309,000 | ) | $ | — |   |
| Ongoing  severance and other          |         | —                                |       | 2,071,000     |       | —          |       | (1,670,000      | )          | 401,000                               |         |
| Facilities                            |         | 348,000                               |       | 788,000       |       | —          |       | (1,136,000      | )          | —                                |         |
| Total                                 |         | $                                     | 348,000    |          | $          | 3,168,000       |       | $               | —     |                                  | $            | (3,115,000 | ) | $ | 401,000 |   |

 
| **Year Ended October 31,  2003** | *** *** | **Balance at  November 1, 2002** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance at  October 31, 2003** | *** *** |
|---------------------------------------|--------------|---------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|---------------------------------------|--------------|
|                                  |         |                                  |       |          |       |            |       |            |       |                                  |         |
| One-time  severance                   |         | $                                     | —     |          | $          | 198,000         |       | $               | —     |                                  | $            | (198,000 | ) | $ | — |   |
| Ongoing  severance and other          |         | 560,000                               |       | 1,388,000     |       | (273,000        | )*         | (1,675,000      | )          | —                                |         |
| Facilities                            |         | 2,117,000                             |       | —        |       | (815,000        | )*         | (954,000        | )          | 348,000                               |         |
| Total                                 |         | $                                     | 2,677,000  |          | $          | 1,586,000       |       | $               | (1,088,000 | )                                     | $            | (2,827,000 | ) | $ | 348,000 |   |

 

----

* 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 and the ongoingseverance and other adjustment of $273,000 was related to the true-up ofpreviously recorded accruals.

 

*Amortization of Intangibles*

 
| ** **                   | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                         |       |     |       |       |       |     |       |       |       |     |         |
| Amortization  of intangibles |       | $        | 2,372,000  |       | (8         | )%       | $          | 2,566,000  |       | (20      | )%           | $ | 3,190,000 |   |
| Percentage  of total revenue |       | 7        | %          |       |       | 6        | %          |       |       | 4        | %            |
|                              |            |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

During the years ended October 31, 2005, 2004 and 2003, werecorded $2,372,000, $2,566,000 and $3,190,000, respectively, for theamortization of intangible assets with finite lives.  The decrease of $194,000, or 8%, from theyear ended October 31, 2005 compared to the year ended October 31,2004 was primarily attributable to reduced amortization expense recorded oncertain assets acquired from Vultus in June 2003 that were written offduring the year ended October 31, 2004. The decrease of $624,000, or 20%, from the year ended October 31,2003 to the year ended October 31, 2004 was primarily attributable toreduced amortization expense recorded on certain assets acquired from Vultusthat were written off during the year ended October 31, 2004 and thereforewere not amortized for the last half of the year ending October 31, 2004.

 

*Loss on Disposition and Impairment of Long-livedAssets*

* *
| ** **                                               | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
|                                                     |       |     |       |       |       |     |       |       |       |     |       |
| Loss on disposition and write-down of  long-lived assets |       | $        | —     |       | (100       | )%       | $          | 2,355,000  |       | 1,336    | %          | $ | 164,000 |   |
| Percentage of total revenue                              |       | 0        | %          |       |       | 6        | %          |       |       | 0        | %          |
|                                                          |            |          |            |            |            |          |            |            |            |          |            |  |  |  |

 

33

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During the year ended October 31, 2005, we didnot have any losses on the disposition and impairment of long-livedassets.  During the years ended October 31,2004 and 2003, we recorded a write down of long-lived assets of$2,355,000 and $164,000, respectively. The loss on disposition and write-down of long-lived assets recordedduring the year ended October 31, 2004 primarily related to goodwill andintangible assets acquired in connection with our acquisition of Vultus in June 2003.  We concluded that an impairment triggeringevent occurred during the year ended October 31, 2004 as we had areduction in force that impacted our ability to move the Vultus initiativeforward on a stand-alone basis and because an anticipated partnership thatwould have solidified the Vultus revenue and cash flow opportunities did notmaterialize.  Consequently, we concludedthat no significant future cash flows related to our Vultus assets will berealized.  The loss on disposition andwrite-down of long-lived assets recorded during the year ended October 31,2003 was primarily attributable to assets written off in connection withrestructurings that occurred during that year.

 

*Write-offs of Investments*

* *
| *** ***                 | *** *** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|------------------------------|--------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                         |         |     |       |       |       |     |       |       |       |     |         |
| Write-offs  of investments   |         | $        | —     |       | n/a        |     | $          | —     |       | n/a      |         | $ | 250,000 |   |
| Percentage  of total revenue |         | 0        | %          |       |       | 0        | %          |       |       | 0        | %            |
|                              |              |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

Managementroutinely assesses our investments for impairments and adjusts the carryingamounts to estimated realizable values when impairment has occurred.  During the years ended October 31, 2005and 2004, we did not have any write-offs of investments.  During the year ended October 31, 2003,in connection with the restructuring of our investment in and relationship withVista.com, Inc. (“Vista”), we recorded a write-off of our Vista investmentand incurred a charge of $250,000.  Wehad been accounting for our investment in Vista under the equity method ofaccounting.

 

*Stock-based Compensation*

* *
| *** ***                 | *** *** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|------------------------------|--------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                         |         |     |       |       |       |     |       |       |       |     |         |
| Stock-based  compensation    |         | $        | 22,000     |       | (98        | )%       | $          | 919,000    |       | (24      | )%           | $ | 1,204,000 |   |
| Percentage  of total revenue |         | 0        | %          |       |       | 2        | %          |       |       | 2        | %            |
|                              |              |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

Stock-basedcompensation consisted of the following components for the years ended October 31,2005, 2004 and 2003:

 
| *** ***                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | *** *** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|--------------|
|                                       |       |     |       |     |       |     |         |
| Amortization  of stock-based compensation  |       | $        | 22,000     |     | $          | 325,000  |         | $ | 866,000 |   |
| Options,  warrants and shares for services |       | —   |       | 502,000  |       | 296,000  |         |
| Modifications  to options                  |       | —   |       | 92,000   |       | 42,000   |         |
| Total                                      |       | $        | 22,000     |     | $          | 919,000  |         | $ | 1,204,000 |   |
|                                            |            |          |            |          |            |          |              |  |  |  |  |

 

As of October 31, 2005, there was a $0balance in deferred compensation.  Inaccordance with SFAS No. 123R, for the year ending October 31, 2006,all stock-based compensation expense will be reclassified and presented in thevarious applicable captions in the statement of operations, as opposed to thecurrent single line item presentation.

 

34

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*Compensation to Law Firms*

 
| *** ***                 | *** *** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** | **Change** | ** ** | **2003** | *** *** |
|------------------------------|--------------|----------|------------|------------|------------|----------|------------|------------|------------|----------|--------------|
|                         |         |     |       |       |       |     |       |       |       |     |         |
| Compensation  to law firms   |         | $        | —     |       | n/a        |     | $          | —     |       | n/a      |         | $ | 8,956,000 |   |
| Percentage  of total revenue |         | 0        | %          |       |       | 0        | %          |       |       | 11       | %            |
|                              |              |          |            |            |            |          |            |            |            |          |              |  |  |  |

 

During the year ended October 31,2003, we incurred contingency fees of $8,956,000, or 11% of revenue, related toour 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 other legal fees incurred in connection with theSCO Litigation have been classified as cost of SCOsource licensing revenue.

 

*Equity in 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 our portionof the entities’ net income or net loss in our consolidated statements ofoperations.  As of October 31, 2005,the carrying value of our investments of $606,000 was related to our 30 percentownership in a Chinese company.

 

During the years ended October 31, 2005, 2004and 2003, we recorded $47,000, $111,000 and ($62,000), respectively, thatrelated to net income (losses) in these entities.  The income reported during the years ended October 31,2005 and 2004 was attributable to our portion of the net income generated bythe above-mentioned Chinese company.  Theloss reported during the year ended October 31, 2003 was primarilyattributable to losses generated from Vista.

 

*Other Income, net*

 

Other income (expense) consisted of thefollowing components for the years ended October 31, 2005, 2004 and 2003:

 
| *** ***                        | *** *** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | *** *** |
|-------------------------------------|--------------|-----------|------------|-----------|------------|-----------|--------------|
|                                |         |      |       |      |       |      |         |
| Interest  income                    |         | $         | 377,000    |      | $          | 905,000   |         | $ | 188,000 |   |
| Interest  expense                   |         | —    |       | —    |       | (3,000    | )            |
| Change in  fair value of derivative |         | —    |       | 5,924,000 |       | 2,845,000 |         |
| Other income  (expense), net        |         | 1,022,000 |       | (322,000  | )          | (203,000  | )            |
| Total other income, net             |         | $         | 1,399,000  |      | $          | 6,507,000 |         | $ | 2,827,000 |   |

 

Interest income decreased by $528,000 fromthe year ended October 31, 2004 to the year ended October 31, 2005and increased by $717,000 from the year ended October 31, 2003 to the yearended October 31, 2004.  The changesin interest income are the result of changes in our cash and available-for-salesecurities balances.

 

The income recorded on the change in fairvalue of derivative for the years ended October 31, 2004 and 2003 relatedto the decrease in fair value of this instrument and marking it to market ateach balance sheet date.  The derivativefinancial instrument was eliminated during the three months ended April 30,2004.

 

The increase in other income, net, from theyear ended October 31, 2004 to the year ended October 31, 2005 wasprimarily attributable to two items: 1) the collection of a note receivablefrom Vintela, Inc. (“Vintela”) as described in more detail in Note 12 toour financial statements, which note receivable was originally received in April 2003,but because we received the note receivable in exchange

 

35

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for the transfer of certain software to a related party and there wassubstantial doubt concerning the ability of Vintela to repay the note, no gainwas recognized until the three months ended January 31, 2005 when wereceived payment; and 2) the sale of shares we held in Troll Tech AS (“TrollTech”) as described in more detail in Note 5 to our financial statements.  The Troll Tech shares had been written off inthe year ended October 31, 2001, but because they were sold during thethree months ended April 30, 2005, we recorded income for the proceedsreceived.

 

*Provision for Income Taxes*

 

The provision for incometaxes for the years ended October 31, 2005, 2004 and 2003 was $273,000,$1,395,000 and $774,000, respectively.  The decrease inthe provision for income taxes of $1,122,000 from the year ended October 31,2004 to the year ended October 31, 2005 and the increase of $621,000 fromthe year ended October 31, 2003 to the year ended October 31, 2004was primarily attributable to an accrual for withholding taxes of approximately$710,000 made in the year ended October 31, 2004 in connection with our operationsin India.  Other than the accrualpreviously mentioned, our provision for income taxes is primarily related toearnings in foreign subsidiaries as well as from withholding taxes on revenuegenerated in certain foreign locations.

 

As of October 31,2005, we had net operating loss carry-forwards for U.S. federal and stateincome tax reporting purposes of approximately $144,980,000 that expire atvarious dates between 2019 and 2025.  Wehad net deferred tax assets, including net operating loss carry-forwards andother temporary differences between book and tax deductions, totalingapproximately $69,292,000 as of October 31, 2005.  We also had net deferred tax liabilities ofapproximately $53,000 related to taxes on foreign earnings.  A valuation allowance in the amount of $69,239,000,the difference between our deferred tax assets and liabilities, has beenrecorded as of October 31, 2005 as a result of uncertainties regarding theultimate realizability of the net deferred tax assets.

 

*ContributionsFrom (Dividends On) Redeemable 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 during the year ended October 31, 2004.**

 

With the completion of the repurchasetransaction with BayStar Capital II, L.P. (“BayStar”) duringthe year ended October 31, 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 classified as a preferred stock dividend in theamount of $15,475,000, which represented the difference in the carrying valueof the Series A-1 shares and accrued dividends less the fair value of the2,105,263 shares of common stock and the $13,000,000 in cash.  Nodividends were paid on the Series A or Series A-1 shares.

 

The following tabledetails the components of the dividends for the years ended October 31,2005, 2004 and 2003:

 
| *** ***                                                 | *** *** | **2005** | ** ** | **2004**   | ** ** | **2003**   | *** *** |
|--------------------------------------------------------------|--------------|----------|------------|------------|------------|------------|--------------|
|                                                         |         |     |       |       |       |       |         |
| Accrual of  dividends on preferred stock                     |         | $        | —     |       | $          | (2,047,000 | )            | $ | (123,000 | ) |
| Exchange of  Series A shares for Series A-1 shares |         | —   |       | (6,305,000 | )          | —     |         |
| Repurchase  of Series A-1 shares from BayStar           |         | —   |       | 15,475,000 |       | —     |         |
| Total                                                        |         | $        | —     |       | $          | 7,123,000  |         | $ | (123,000 | ) |

 

36

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**QuarterlyResults 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 inconjunction with the audited consolidated financial statements and relatednotes included elsewhere in this Form 10-K.  The operating results for any quarter are notnecessarily indicative of the operating results for any future period.

 
| *** ***                                | *** *** | **Quarter Ended**                         | ** ** |
|---------------------------------------------|--------------|-------------------------------------------|------------|
| ** **                                  | ** **   | **January 31,  2005**                | ** ** | **April 30,  2005** | ** ** | **July 31,  2005** | ** ** | **October 31,  2005** | ** ** |
| *** ***                                | *** *** | **(unaudited)**                           | ** ** |
| ** **                                  | * *     | **(In thousands, except per share data)** | * *   |
|                                        |         |                                      |       |   |   |   |   |   |   |
| Revenue                                     |         | $                                         | 8,865      |   | $ | 9,258 |   | $ | 9,353 |   | $ | 8,528 |   |
| Gross margin                                |         | 3,979                                     |       | 5,060 |   | 4,873 |   | 3,779 |   |
| Loss from  operations                       |         | (3,409                                    | )          | (2,656 | ) | (2,242 | ) | (3,592 | ) |
| Net loss  applicable to common stockholders |         | (2,961                                    | )          | (1,962 | ) | (2,372 | ) | (3,431 | ) |
| Net loss per  common share:                 |         |                                      |       |   |   |   |   |   |   |
| Basic                                       |         | $                                         | (0.17      | ) | $ | (0.11 | ) | $ | (0.13 | ) | $ | (0.19 | ) |
| Diluted                                     |         | $                                         | (0.17      | ) | $ | (0.11 | ) | $ | (0.13 | ) | $ | (0.19 | ) |
| Weighted  average basic common shares       |         | 17,751                                    |       | 17,913 |   | 17,993 |   | 18,038 |   |
| Weighted  average diluted common shares     |         | 17,751                                    |       | 17,913 |   | 17,993 |   | 18,038 |   |
|                                             |              |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 
| *** ***                                                   | *** *** | **Quarter Ended**                         | *** *** |
|----------------------------------------------------------------|--------------|-------------------------------------------|--------------|
| ** **                                                     | ** **   | **January 31,  2004**                | ** **   | **April 30,  2004** | ** ** | **July 31,  2004** | ** ** | **October 31,  2004** | *** *** |
| *** ***                                                   | *** *** | **(unaudited)**                           | *** *** |
| *** ***                                                   | *** *** | **(In thousands, except per share data)** | *** *** |
|                                                           |         |                                      |         |   |   |   |   |   |   |
| 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 |   |

 

# **Fluctuationsin Quarterly Results**

 

Factors that may affect quarterly resultsinclude:

 

•                  theinterest level of solution providers in recommending UNIX business solutions toend users as well as the changing business attitudes toward UNIX as a viableoperating system alternative to other competing systems, especially Linux;

 

•                  thecontingency fees we may pay to the Law Firms representing us in the SCOLitigation;

 

37

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•                  thelevel, magnitude and timing of SCOsource license revenue;

 

•                  theamount of legal fees and related expenses incurred in connection with the SCOLitigation;

 

•                  theintroduction, development, timing, competitive pricing and market acceptance ofour products and services and those of our competitors; and

 

•                  changesin general economic conditions that could affect capital expenditures in theUNIX market.

 

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” sections of this Form 10-K,it is possible that in some future periods our results of operations may fallbelow management’s expectations as well as the expectations of public marketanalysts and investors.  If revenue fallsbelow management’s expectations in any quarter and we are unable to reduceexpenses, our operating results will be lower than expected.

 

# **Liquidityand Capital Resources**

 

Our cash and cash equivalents balance decreased from$12,693,000 as of October 31, 2004 to $4,272,000 as of October 31,2005.  During this same time period, ourinvestment in available-for-sale securities decreased from $18,756,000 to$6,165,000.  Total cash and cashequivalents and available-for-sale securities were $10,437,000 as of October 31,2005.  As of October 31, 2005, we alsohave $5,690,000 classified as restricted cash, of which $2,875,000 is set asideto cover expert and other costs related to our SCO Litigation and $2,815,000 isset aside for royalties payable to Novell. During the year ended October 31, 2005, we expended a significantamount of cash in pursuit of our SCO Litigation.

 

We intend to use the cash and cash equivalents andavailable-for-sale securities as of October 31, 2005 to pursue our SCOLitigation and to run our UNIX business. On November 29, 2005, we completed the sale of approximately2,852,000 shares of our common stock in a private placement and raised grossproceeds of $10,005,000.  We believe thatwith the combination of our existing cash and cash equivalents andavailable-for-sale securities as of October 31, 2005 together with theproceeds from our recent financing that we will have sufficient cash resourcesto fund our current operations for at least the next 12 months.

 

Our net cash used in operating activities during theyear ended October 31, 2005 was $21,507,000 and was attributable to a netloss of $10,726,000,  changes inoperating assets and liabilities of $13,868,000, and offset, in part, bynon-cash items of $3,087,000.  Ourworking capital decreased from $15,413,000 as of October 31, 2004 to$8,669,000 as of October 31, 2005.

 

Our net cash used in operating activities during theyear ended October 31, 2004 was $22,604,000 and was attributable to a netloss of $23,350,000, changes in operating assets and liabilities of $176,000,and offset, in part, by non-cash items of $922,000.  Our working capital decreased from$37,168,000 as of October 31, 2003 to $15,413,000 as of October 31,2004.

 

Our net cash provided by operating activities duringthe year ended October 31, 2003 was $12,087,000.  Cash provided by operations was attributableto net income of $5,427,000, non-cash items of $11,610,000 and offset, in part,by changes in operating assets and liabilities of $4,950,000.  Our long-term liabilities decreased from$1,625,000 to $508,000 during the year ended October 31, 2003.

 

Our investing activities havehistorically consisted of equipment purchases, investing in strategic partnersand the purchase and sale of available-for-sale securities.  During the year ended October 31, 2005,cash provided by investing activities was $12,255,000, which was primarily aresult of sales, net of purchases, of available-for-sale securities of$12,591,000 and the purchase of property and equipment of $336,000.

 

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During the year ended October 31,2004, cash used in investing activities was $15,443,000, which was primarily aresult of purchases, net of sales, of available-for-sale securities of$14,728,000, purchases of equipment of $506,000 and the purchase of theremaining minority interest in our Japanese subsidiary of $209,000.

 

During the year ended October 31,2003, cash used in investing activities was $5,512,000, which was primarily aresult of our purchase of available-for-sale securities of $4,095,000, equipmentpurchases of $467,000 and our investment in non-marketable securities of$950,000.

 

Our financing activities provided$959,000 during the year ended October 31, 2005 and was comprised ofproceeds of $720,000 received from the sale of common stock through our ESPPand from proceeds of $239,000 from the exercise of options to acquire shares ofour common stock.

 

Our financing activities used $13,864,000 ofcash during the year ended October 31, 2004.  The primary uses of cash were $13,000,000 forthe repurchase and retirement of shares of our Series A-1 ConvertiblePreferred Stock, $2,414,000 for the purchase of shares of our common stock onthe open market, and $211,000 paid in connection with the issuance of Series A-1shares in exchange for outstanding Series A shares.  These uses of cash were offset, in part, byproceeds generated from the exercise of options to acquire common stock of$951,000 and proceeds of $810,000 received from the sale of common stockthrough the ESPP.

 

Our financing activities provided $50,888,000of cash during the year ended October 31, 2003 and consisted primarily ofnet 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 net accountsreceivable balance decreased from $6,638,000 as of October 31, 2004 to $6,343,000as of October 31, 2005, primarily as a result of lower invoicing andrevenue generated during the three months ended October 31, 2005 ascompared to the three months ended October 31, 2004.  The majority of our accounts receivable arecurrent and our allowance for doubtful accounts was $144,000 as of October 31,2005, which represented approximately 2 percent of our gross accountsreceivable balance.  This percentage ofgross accounts receivable is consistent with our experience in prior periods,and we expect this trend to continue. Our write-offs of uncollectible accounts during the years ended October 31,2005, 2004 and 2003 were not significant.

 

OnOctober 31, 2004, we entered into the Engagement Agreement with 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 our currentlitigation with IBM.  This litigation isdescribed in more detail under Part I, Item 3 of this Form 10-K.  Our purpose in entering into this EngagementAgreement was to limit the cash expenditures needed to pursue the SCOLitigation.  The Engagement Agreementprovides for the payment of approximately $26,000,000 for all attorneys’ feesin connection with the SCO Litigation through the end of our current litigationwith IBM and the escrow of at least $5,000,000 for the payment of any expert,consulting and other expenses.  As of December 1,2005, we had paid the entire $26,000,000. Asof October 31, 2005, $2,875,000 remained in the escrow account and wasclassified as a component of restricted cash. In the event that weexhaust this remaining balance, we will continue to pay for expert, consultingand other expenses through the conclusion of our litigation with IBM.

 

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 a resultof a settlement, judgment, or a sale of our company.  The contingency fee amounts payable to theLaw Firms will be, subject to certain credits and adjustments, as follows:

 

39

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•                  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.

 

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 the year ending October 31, 2008.

 

Thefollowing table summarizes our contractual operating lease obligations and ourrequired payments to the Law Firms as of October 31, 2005:

 
| ** **                   | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1 – 3 years** | ** ** | **3 - 5 years** | ** ** | **More than  5 years** | ** ** |
|------------------------------|------------|-----------|------------|-----------------------|------------|----------------------|------------|-----------------|------------|------------------------|------------|
|                         |       |      |       |                  |       |                 |       |            |       |                   |       |
| Operating  lease obligations |       | $         | 3,774,000  |                  | $          | 1,797,000            |       | $               | 1,977,000  |                   | $          | — |   | $ | — |   |
| Payments to  Law Firms       |       | 2,000,000 |       | 2,000,000             |       | —               |       | —          |       | —                 |       |
| Total obligations            |       | $         | 5,774,000  |                  | $          | 3,797,000            |       | $               | 1,977,000  |                   | $          | — |   | $ | — |   |
|                              |            |           |            |                       |            |                      |            |                 |            |                        |            |  |  |  |  |  |  |

 

As of October 31,2005, we did not have any long-term debt obligations, purchase obligations,other long-term liabilities or material capital lease obligations.

 

Our ability to reducecosts to 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 beaccelerated if industry partners withdraw their support as a result of the SCOLitigation.  In addition, the SCOLitigation may cause industry partners, developers and hardware and softwarevendors to choose not to support or certify to our UNIX operating systemproducts.  This would lead to anaccelerated decline in our UNIX products and services revenue.  Ifour UNIX products and services revenue is less than expected, our liquiditywill be adversely impacted.

 

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 the SCO Litigation.  We may also not be able to raise capital forany number of reasons including those listed under the section “RiskFactors” under Part I, Item 1A of this Form 10-K.  If additional equity financing is available,it may not be available to us on attractive terms and may be dilutive to ourexisting stockholders.  In addition, ifour stock price declines, we may not be able to access the public equity marketson acceptable terms, if at all.  Ourability to effect acquisitions for stock would also be impaired.

 

# **RecentAccounting Pronouncements**

 

In December 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123R, “Share-Based Payment, an amendment ofFASB Statements Nos. 123 and 95,” which requires the measurement ofall employee share-based payments to employees, including grants of employeestock options, using a fair value-based method and the recording of suchexpense in the consolidated statements of operations and comprehensive loss.  The accounting provisions

 

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of SFAS No. 123Rare effective for our first fiscal year beginning after July 1, 2005,which will require us to adopt SFAS No. 123R for the three monthsending January 31, 2006.  We believethat the adoption of SFAS No. 123R will have a material impact on ourresults of operations.

 

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

 

#### **With the exception of historical facts, the statementscontained in Management’s Discussion and Analysis of Financial Condition andResults of Operations are “forward-looking statements” within the meaning ofthe Private Securities Litigation Reform Act of 1995, which reflect our currentexpectations and beliefs regarding our future results of operations,performance and achievements.  The section entitled“Business” above in Part I, Item 1 of this Form 10-K also includesforward-looking statements.  These statementsare subject to risks and uncertainties and are based upon assumptions andbeliefs that may or may not materialize. These forward-looking statements include, but are not limited to,statements concerning:**

 

•                              Our intention to continue our UNIX researchand development efforts while at the same time investing in Me Inc.;

 

•                              Our operating strategy to continue tosupport our existing users of our UNIX operating system products and protectour intellectual property rights;

 

•                              Our belief that our OpenServer andUnixWare products will continue to provide a revenue stream in the year ending October 31,2006 and 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 certain UNIXdevelopment resources on augmenting our current UNIX products and ourapplication products;

 

•                              Our intention to release various Me Inc.digital services and a development toolkit;

 

•                              Our belief that certain productenhancement will extend the lives and improve the functionality of our UNIXproducts;

 

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

 

•                              Our intention to continue to pursue theSCO Litigation and run our UNIX business;

 

•                              Our belief that our cash balance will beadequate for us to execute our business strategy as well as to continue topursue SCO Litigation and that we have sufficient cash reserves to fund ourcurrent operations for the next 12 months;

 

•                              Our expectation that maintaining ourstrategic alliances with solution providers during the year ending October 31,2006 will be critical to the success of our UNIX business and the success ofour next OpenServer product;

 

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

 

•                              Our belief that our bad debts and ourallowance for doubtful accounts receivable will remain consistent with ourprior experience;

 

41

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•                              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 the year ending October 31, 2006 will decline from UNIX revenuegenerated during the year ended October 31, 2005;

 

•                              Our belief that competition from Linuxwill continue during the year ending October 31, 2006 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 the year ending October 31,2006 that the dollar amount of our cost of products revenue will be lower thanthe dollar amount of our cost of products revenue generated during the yearended October 31, 2005;

 

•                              Our expectation for the year ending October 31,2006 that the dollar amount of our cost of SCOsource licensing revenue will belower than that generated during the year ended October 31, 2005;

 

•                              Our expectation for the year ending October 31,2006 that the dollar amount of our cost of services revenue will be less thanthe dollar amount of our cost of services revenue incurred for the year ended October 31,2005 and that cost of services revenue as a percentage of services revenue willbe consistent to that generated during the year ended October 31, 2005;

 

•                              Our expectation for the year ending October 31,2006 that the dollar amount of our sales and marketing expense will decreasefrom that generated during the year ended October 31, 2005;

 

•                              Our expectation for the year ending October 31,2006 that the dollar amount of our research and development expense will decreasefrom that generated during the year ended October 31, 2005;

 

•                              Our expectation for the year ending October 31,2006 that the dollar amount of our general and administrative expense will decreasefrom that generated during the year ended October 31, 2005;

 

•                              Our belief that our legal costs relatedto our intellectual property litigation will be less during the year ending October 31,2006 compared to the year ended October 31, 2005, exclusive of anycontingent payments; 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 our SCOLitigation, competition from other operating systems, particularly Linux, theamount and timing of SCOsource licensing revenue, our ability to enhance ourUNIX operating systems and maintain our UNIX business, and the factors setforth in the subsection entitled “Risk Factors” under Part I, item 1Aof this Form 10-K.  We also wish toadvise readers not to place any undue reliance on the forward-lookingstatements contained in this report, which reflect our beliefs and expectationsonly as of the date of this report.  Weassume no obligation to update or revise

 

42

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theseforward-looking statements to reflect new events or circumstances or anychanges in our beliefs or expectations, other than as required by law.

 

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

 

*Foreign Currency Risk. *We have foreign offices andoperations in Europe and Asia.  As aresult, a portion of our revenue is derived from sales to customers outside theUnited States.  Our international revenueis denominated in U.S. dollars, Euros and United Kingdom Pounds.  Most of the operating expenses related to ourforeign-based operations are denominated in foreign currencies and thereforeoperating results are affected by changes in the U.S. dollar exchange rate inrelation to foreign currencies such as the Euro, among others.  If the U.S. dollar further weakens comparedto the Euro, our operating expenses for foreign operations will be higher whentranslated back into U.S. dollars.  Ourrevenue can also be affected by general economic conditions in the UnitedStates, Europe and other international markets. Our results of operations may be affected in the short term byfluctuations in foreign currency exchange rates.

 

*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 cash equivalents and 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, 2005, our investmentsbalance totaled approximately $606,000 and consisted of our investment in a 30%owned Chinese company.

 

The stock market in general, and themarket for shares of technology companies in particular, has experienced pricefluctuations.  In addition, factors suchas new product introductions by our competitors or developments in the SCOLitigation may have a significant impact on the market price of our commonstock.  Furthermore, quarter-to-quarterfluctuations in our results of operations may have a significant impact on themarket price of our common stock.  Theseconditions could cause the price of our common stock to fluctuate substantiallyover short periods of time.

 

43

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**Item 8.  FinancialStatements and Supplementary Data**

 

*Index toConsolidated Financial Statements and Financial Statement Schedule*

 
| **Consolidated Financial Statements:**                                                                                           | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|
| Report of Independent Registered Public  Accounting Firm (Tanner LC)                                                             |       |
| Report of Independent Registered Public  Accounting Firm (KPMG LLP)                                                              |       |
| Consolidated Balance Sheets as of  October 31, 2005 and 2004                                                                |       |
| Consolidated Statements of Operations and  Comprehensive Income (Loss) for the years ended October 31, 2005, 2004  and 2003 |       |
| Consolidated Statements of Stockholders’  Equity for the years ended October 31, 2005, 2004 and 2003                   |       |
| Consolidated Statements of Cash Flows for  the years ended October 31, 2005, 2004 and 2003                                  |       |
| Notes to  Consolidated Financial Statements                                                                                      |       |
|                                                                                                                             |       |
| **Financial Statement Schedule:**                                                                                                | ** ** |
| Schedule II  – Valuation and Qualifying Accounts                                                                       |       |

 

44

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**Report of Independent Registered Public AccountingFirm**

 

The Board of Directors andStockholders

   The SCO Group, Inc.:

 

We have audited the consolidated balance sheetof The SCO Group, Inc. and subsidiaries as of October 31, 2005, andthe related consolidated statements of operations and comprehensive loss,stockholders’ equity and cash flows for the year then ended.  Our audit also included the financialstatement schedule as of and for the year ended October 31, 2005listed in the Index at Item 8.  Thesefinancial statements and financial statement schedule are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements and financial statement schedule based on our audit.

 

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made by management,as well as evaluating the overall financial statement presentation.  We believe that our audit provides areasonable basis for our opinion.

 

In our opinion, the financial statementsreferred to above present fairly, in all material respects, the consolidated financialposition of The SCO Group, Inc. and subsidiaries as of October 31, 2005,and the consolidated results of their operations and their cash flows for the yearthen ended in conformity with U.S. generally accepted accounting principles.  Also in our opinion, the financial statement schedule forthe related period, when considered in relation to the basic consolidatedfinancial statements taken as a whole, presents fairly, in all materialrespects, the information set forth therein.

 

 
| /s/Tanner LC           |   |
|------------------------|--------|
|                   |
| Salt Lake  City, Utah  |
| January 23,  2006 |

 

45

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**Report of Independent Registered Public AccountingFirm**

 

The Board of Directors andStockholders of

   The SCO Group, Inc.:

 

We have audited the consolidated balance sheetof The SCO Group, Inc. and subsidiaries as of October 31, 2004, andthe related consolidated statements of operations and comprehensive income(loss), stockholders’ equity and cash flows for the years ended October 31,2004 and 2003.  In connection with ouraudits of the consolidated financial statements, we have also audited thefinancial statement schedule for the related periods.  These consolidated financial statements andfinancial statement schedule are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these consolidated financial statements and financialstatement schedule based on our audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion, the consolidated financialstatements referred to above present fairly, in all material respects, thefinancial position of The SCO Group, Inc. and subsidiaries as of October 31,2004, and the results of their operations and their cash flows for the yearsended October 31, 2004 and 2003 in conformity with accounting principlesgenerally accepted in the United States of America.  Also in our opinion, the financial statement schedule forthe related periods, 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 |

 

46

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

 

**CONSOLIDATED BALANCE SHEETS**

**(in thousands, except per share data)**

 
| ** **                                                                                                    | ** ** | **October 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                    | ** ** | **2005**             | ** ** | **2004** | ** ** |
|                                                                                                          |       |                 |       |   |   |
| **ASSETS**                                                                                                    | ** ** | ** **           | ** ** | ** ** | ** ** |
|                                                                                                          |       |                 |       |   |   |
| CURRENT ASSETS:                                                                                               |       |                 |       |   |   |
| Cash and cash equivalents                                                                                     |       | $                    | 4,272      |   | $ | 12,693 |   |
| Restricted cash                                                                                               |       | 5,690                |       | 8,283 |   |
| Available-for-sale securities                                                                                 |       | 6,165                |       | 18,756 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $144 and $136, respectively                   |       | 6,343                |       | 6,638 |   |
| Other current assets                                                                                          |       | 2,454                |       | 1,870 |   |
| Total current assets                                                                                          |       | 24,924               |       | 48,240 |   |
|                                                                                                          |       |                 |       |   |   |
| PROPERTY AND EQUIPMENT:                                                                                       |       |                 |       |   |   |
| Computer and office equipment                                                                                 |       | 2,224                |       | 2,991 |   |
| Leasehold improvements                                                                                        |       | 345                  |       | 406 |   |
| Furniture and fixtures                                                                                        |       | 96                   |       | 103 |   |
|                                                                                                          |       | 2,665                |       | 3,500 |   |
| Less accumulated depreciation and  amortization                                                               |       | (2,087               | )          | (2,851 | ) |
| Net property and equipment                                                                                    |       | 578                  |       | 649 |   |
|                                                                                                          |       |                 |       |   |   |
| OTHER ASSETS:                                                                                                 |       |                 |       |   |   |
| Intangibles, net                                                                                              |       | 2,707                |       | 5,413 |   |
| Other assets                                                                                                  |       | 739                  |       | 1,098 |   |
| Total other assets                                                                                            |       | 3,446                |       | 6,511 |   |
|                                                                                                          |       |                 |       |   |   |
| Total assets                                                                                                  |       | $                    | 28,948     |   | $ | 55,400 |   |
|                                                                                                          |       |                 |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                | ** ** | ** **           | ** ** | ** ** | ** ** |
|                                                                                                          |       |                 |       |   |   |
| CURRENT LIABILITIES:                                                                                          |       |                 |       |   |   |
| Accounts payable                                                                                              |       | $                    | 2,197      |   | $ | 7,854 |   |
| Payable to Novell, Inc.                                                                                  |       | 2,815                |       | 3,283 |   |
| Accrued compensation to law firms                                                                             |       | —               |       | 7,956 |   |
| Accrued payroll and benefits                                                                                  |       | 2,656                |       | 3,369 |   |
| Accrued liabilities                                                                                           |       | 3,118                |       | 3,855 |   |
| Deferred revenue                                                                                              |       | 3,841                |       | 4,877 |   |
| Royalties payable                                                                                             |       | 406                  |       | 354 |   |
| Income taxes payable                                                                                          |       | 1,222                |       | 1,279 |   |
| Total current liabilities                                                                                     |       | 16,255               |       | 32,827 |   |
|                                                                                                          |       |                 |       |   |   |
| OTHER LONG-TERM LIABILITIES                                                                                   |       | 338                  |       | 343 |   |
|                                                                                                          |       |                 |       |   |   |
| COMMITMENTS AND CONTINGENCIES (Note 10)                                                                       |       |                 |       |   |   |
|                                                                                                          |       |                 |       |   |   |
| COMMON STOCK SUBJECT TO RESCISSION (Note 7)                                                                   |       | 1,018                |       | 528 |   |
|                                                                                                          |       |                 |       |   |   |
| STOCKHOLDERS’ EQUITY:                                                                                    |       |                 |       |   |   |
| Common stock, $0.001 par value; 45,000  shares authorized, 18,331 and 17,956 shares outstanding, respectively |       | 18                   |       | 18 |   |
| Additional paid-in capital                                                                                    |       | 246,985              |       | 246,273 |   |
| Common stock held in treasury - 290 shares                                                                    |       | (2,414               | )          | (2,414 | ) |
| Warrants outstanding                                                                                          |       | 856                  |       | 1,099 |   |
| Deferred compensation                                                                                         |       | —               |       | (22 | ) |
| Accumulated other comprehensive income                                                                        |       | 834                  |       | 964 |   |
| Accumulated deficit                                                                                           |       | (234,942             | )          | (224,216 | ) |
| Total stockholders’ equity                                                                               |       | 11,337               |       | 21,702 |   |
|                                                                                                          |       |                 |       |   |   |
| Total liabilities and stockholders’ equity                                                               |       | $                    | 28,948     |   | $ | 55,400 |   |

 

See accompanying notes to consolidated financial statements.

 

47

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

 

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

**(in thousands, except per share data)**

 
| ** **                                                                                              | ** ** | **Year Ended  October 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                    |       |                             |       |   |   |   |   |
| REVENUE:                                                                                                |       |                             |       |   |   |   |   |
| Products                                                                                                |       | $                                | 30,190     |   | $ | 35,352 |   | $ | 45,028 |   |
| SCOsource licensing                                                                                     |       | 166                              |       | 829 |   | 25,846 |   |
| Services                                                                                                |       | 5,648                            |       | 6,628 |   | 8,380 |   |
| Total revenue                                                                                           |       | 36,004                           |       | 42,809 |   | 79,254 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| COST OF REVENUE:                                                                                        |       |                             |       |   |   |   |   |
| Products                                                                                                |       | 2,544                            |       | 3,221 |   | 4,068 |   |
| SCOsource licensing                                                                                     |       | 12,847                           |       | 19,743 |   | 9,500 |   |
| Services                                                                                                |       | 2,922                            |       | 4,134 |   | 6,354 |   |
| Total cost of revenue                                                                                   |       | 18,313                           |       | 27,098 |   | 19,922 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| GROSS MARGIN                                                                                            |       | 17,691                           |       | 15,711 |   | 59,332 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| OPERATING EXPENSES:                                                                                     |       |                             |       |   |   |   |   |
| Sales and marketing (exclusive of  stock-based compensation of $14, $75, and $129, respectively)        |       | 11,820                           |       | 17,038 |   | 24,392 |   |
| Research and development (exclusive of  stock-based compensation of $8, $49, and $112, respectively)    |       | 8,329                            |       | 10,612 |   | 11,012 |   |
| General and administrative (exclusive of  stock-based compensation of $0, $795, and $963, respectively) |       | 7,047                            |       | 7,626 |   | 6,230 |   |
| Severance and exit costs                                                                                |       | —                           |       | 3,168 |   | 498 |   |
| Amortization of intangibles                                                                             |       | 2,372                            |       | 2,566 |   | 3,190 |   |
| Loss on disposition and impairment of  long-lived assets                                                |       | —                           |       | 2,355 |   | 164 |   |
| Write-off of investments                                                                                |       | —                           |       | — |   | 250 |   |
| Stock-based compensation                                                                                |       | 22                               |       | 919 |   | 1,204 |   |
| Compensation to law firms                                                                               |       | —                           |       | — |   | 8,956 |   |
| Total operating expenses                                                                                |       | 29,590                           |       | 44,284 |   | 55,896 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| INCOME (LOSS) FROM OPERATIONS                                                                           |       | (11,899                          | )          | (28,573 | ) | 3,436 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| EQUITY IN INCOME (LOSSES) OF AFFILIATES                                                                 |       | 47                               |       | 111 |   | (62 | ) |
|                                                                                                    |       |                             |       |   |   |   |   |
| OTHER INCOME (EXPENSE):                                                                                 |       |                             |       |   |   |   |   |
| Interest income                                                                                         |       | 377                              |       | 905 |   | 188 |   |
| Interest expense                                                                                        |       | —                           |       | — |   | (3 | ) |
| Change in fair value of derivative                                                                      |       | —                           |       | 5,924 |   | 2,845 |   |
| Other expense, net                                                                                      |       | 1,022                            |       | (322 | ) | (203 | ) |
| Total other income, net                                                                                 |       | 1,399                            |       | 6,507 |   | 2,827 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| INCOME (LOSS) BEFORE INCOME TAXES                                                                       |       | (10,453                          | )          | (21,955 | ) | 6,201 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| PROVISION FOR INCOME TAXES                                                                              |       | (273                             | )          | (1,395 | ) | (774 | ) |
|                                                                                                    |       |                             |       |   |   |   |   |
| NET INCOME (LOSS)                                                                                       |       | (10,726                          | )          | (23,350 | ) | 5,427 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| CONTRIBUTIONS FROM (DIVIDENDS ON)  REDEEMABLE CONVERTIBLE PREFERRED STOCK                               |       | —                           |       | 7,123 |   | (123 | ) |
|                                                                                                    |       |                             |       |   |   |   |   |
| NET INCOME AVAILABLE (LOSS APPLICABLE) TO COMMON  STOCKHOLDERS                                          |       | $                                | (10,726    | ) | $ | (16,227 | ) | $ | 5,304 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| BASIC NET INCOME (LOSS) PER COMMON SHARE                                                                |       | $                                | (0.60      | ) | $ | (1.07 | ) | $ | 0.43 |   |
| DILUTED NET INCOME (LOSS) PER COMMON SHARE                                                              |       | $                                | (0.60      | ) | $ | (1.07 | ) | $ | 0.34 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| WEIGHTED AVERAGE BASIC COMMON SHARES  OUTSTANDING                                                       |       | 17,924                           |       | 15,155 |   | 12,261 |   |
| WEIGHTED AVERAGE DILUTED COMMON SHARES  OUTSTANDING                                                     |       | 17,924                           |       | 15,155 |   | 15,679 |   |
|                                                                                                    |       |                             |       |   |   |   |   |
| OTHER COMPREHENSIVE INCOME (LOSS)                                                                       |       |                             |       |   |   |   |   |
| Net income (loss)                                                                                       |       | $                                | (10,726    | ) | $ | (23,350 | ) | $ | 5,427 |   |
| Unrealized gain (loss) on  available-for-sale securities                                                |       | 15                               |       | (67 | ) | 23 |   |
| Foreign currency translation adjustment                                                                 |       | (145                             | )          | 105 |   | 393 |   |
| COMPREHENSIVE INCOME (LOSS)                                                                             |       | $                                | (10,856    | ) | $ | (23,312 | ) | $ | 5,843 |   |

 

See accompanying notes to consolidated financial statements.

 

48

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

 

**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, 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 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** | ** ** |
| ** **                                                                                              | ** ** | ** **        | ** ** | ** **  | ** ** | ** **          | ** **  | ** **   | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** **         | ** ** | ** **   | ** ** | ** ** | ** ** |
| Amortization of stock-based  compensation                                                               |       | —            |       | —      |       | —              |        | —       |       | —       |       | —            |       | 22               |       | —             |       | —       |       | 22         |       |
| Unrealized gain  on available-for-sale securities                                                       |       | —            |       | —      |       | —              |        | —       |       | —       |       | —            |       | —           |       | 15                 |       | —       |       | 15         |       |
| Cumulative  translation adjustment                                                                      |       | —            |       | —      |       | —              |        | —       |       | —       |       | —            |       | —           |       | (145               | )          | —       |       | (145       | )          |
| Issuance of common  shares upon exercise of stock options                                               |       | 163               |       | —      |       | 239                 |        | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 239        |       |
| Issuance of  common shares under employee stock purchase program                                        |       | 212               |       | —      |       | 720                 |        | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | 720        |       |
| Expiration of a  warrant                                                                                |       | —            |       | —      |       | 243                 |        | —       |       | —       |       | (243              | )          | —           |       | —             |       | —       |       | —     |       |
| Common stock  subject to rescission                                                                     |       | —            |       | —      |       | (490                | )           | —       |       | —       |       | —            |       | —           |       | —             |       | —       |       | (490       | )          |
| Net loss                                                                                                |       | —            |       | —      |       | —              |        | —       |       | —       |       | —            |       | —           |       | —             |       | (10,726      | )          | (10,726    | )          |
| **Balance,  October 31, 2005**                                                                     | ** ** | **18,331**        | ** ** | **$**       | **18**     | ** **          | **$**       | **246,985**  | ** ** | **(290**     | **)**      | **$**             | **(2,414** | **)**            | **$**      | **856**            | ** ** | **$**        | **—** | ** ** | **$**      | **834** | ** ** | **$** | **(234,942** | **)** | **$** | **11,337** | ** ** |
|                                                                                                         |            |                   |            |             |            |                     |             |              |            |              |            |                   |            |                  |            |                    |            |              |            |            |            |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

 

49

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

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

** **
| ** **                                                                                                      | ** ** | **Year  Ended October 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                      | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| * *                                                                                                        | * *   | * *                         | * *   | * * | * * | * * | * * |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                           |       |                             |       |   |   |   |   |
| Net income (loss)                                                                                               |       | $                                | (10,726    | ) | $ | (23,350 | ) | $ | 5,427 |   |
| 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 (including  $334, $334, and $337 classified as cost of SCOsource licensing revenue) |       | 2,706                            |       | 2,900 |   | 3,527 |   |
| Stock-based compensation                                                                                        |       | 22                               |       | 919 |   | 1,204 |   |
| Depreciation and amortization                                                                                   |       | 360                              |       | 783 |   | 1,049 |   |
| Write-downs of investments                                                                                      |       | —                           |       | — |   | 250 |   |
| Issuance of a warrant (classified as cost  of SCOsource licensing revenue)                                      |       | —                           |       | — |   | 243 |   |
| Loss on disposition and write-downs of  long-lived assets                                                       |       | 46                               |       | 2,355 |   | 164 |   |
| Equity in (income) losses of affiliates                                                                         |       | (47                              | )          | (111 | ) | 62 |   |
| Change in fair value of derivative                                                                              |       | —                           |       | (5,924 | ) | (2,845 | ) |
| Changes in operating assets and  liabilities, net of effects of acquisitions:                                   |       |                             |       |   |   |   |   |
| Restricted cash                                                                                                 |       | 2,125                            |       | (5,000 | ) | — |   |
| Accounts receivable, net                                                                                        |       | 295                              |       | 2,644 |   | (837 | ) |
| Other current assets                                                                                            |       | (584                             | )          | 580 |   | 1,269 |   |
| Other assets                                                                                                    |       | 405                              |       | 84 |   | 1,501 |   |
| Accounts payable                                                                                                |       | (5,657                           | )          | 5,876 |   | (217 | ) |
| Accrued payroll and benefits                                                                                    |       | (713                             | )          | (1,383 | ) | 1,115 |   |
| Compensation to law firms                                                                                       |       | (7,956                           | )          | (2,600 | ) | 2,600 |   |
| Accrued liabilities                                                                                             |       | (737                             | )          | 101 |   | (4,091 | ) |
| Deferred revenue                                                                                                |       | (1,036                           | )          | (624 | ) | (4,555 | ) |
| Royalties payable                                                                                               |       | 52                               |       | (169 | ) | (146 | ) |
| Taxes payable                                                                                                   |       | (57                              | )          | 480 |   | 90 |   |
| Other long-term liabilities                                                                                     |       | (5                               | )          | (165 | ) | (1,679 | ) |
| Net cash provided by (used in) operating  activities                                                            |       | (21,507                          | )          | (22,604 | ) | 12,087 |   |
|                                                                                                            |       |                             |       |   |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                           |       |                             |       |   |   |   |   |
| Purchase of property and equipment                                                                              |       | (336                             | )          | (506 | ) | (467 | ) |
| Purchase of available-for-sale securities                                                                       |       | (13,624                          | )          | (59,224 | ) | (4,095 | ) |
| Proceeds from available-for-sale securities                                                                     |       | 26,215                           |       | 44,496 |   | — |   |
| Purchase of minority interest in Japanese  subsidiary                                                           |       | —                           |       | (209 | ) | — |   |
| Investment in non-marketable securities                                                                         |       | —                           |       | — |   | (950 | ) |
| Net cash provided by (used in) investing  activities                                                            |       | 12,255                           |       | (15,443 | ) | (5,512 | ) |
|                                                                                                            |       |                             |       |   |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                           |       |                             |       |   |   |   |   |
| Proceeds from sale of common stock through  employee stock purchase program                                     |       | 720                              |       | 810 |   | 236 |   |
| Proceeds from exercise of common stock  options                                                                 |       | 239                              |       | 951 |   | 2,056 |   |
| Repurchase of common stock                                                                                      |       | —                           |       | (2,414 | ) | — |   |
| Net proceeds from the issuance of warrants                                                                      |       | —                           |       | — |   | 856 |   |
| 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                                                            |       | 959                              |       | (13,864 | ) | 50,888 |   |
|                                                                                                            |       |                             |       |   |   |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                                                           |       | (8,293                           | )          | (51,911 | ) | 57,463 |   |
| EFFECT OF FOREIGN EXCHANGE RATES ON CASH                                                                        |       | (128                             | )          | 176 |   | 376 |   |
| CASH AND CASH EQUIVALENTS, beginning of  year                                                                   |       | 12,693                           |       | 64,428 |   | 6,589 |   |
| CASH AND CASH EQUIVALENTS, end of year                                                                          |       | $                                | 4,272      |   | $ | 12,693 |   | $ | 64,428 |   |

 

See accompanying notes to consolidated financial statements.

 

50

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| ** **                                                                                     | ** ** | **Year Ended October 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                     | ** ** | **2005**                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                           |       |                            |       |   |   |   |   |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:                                             |       |                            |       |   |   |   |   |
|                                                                                           |       |                            |       |   |   |   |   |
| Cash paid for income taxes                                                                     |       | $                               | 358        |   | $ | 957 |   | $ | 413 |   |
|                                                                                           |       |                            |       |   |   |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH  INVESTING AND FINANCING ACTIVITIES:                     |       |                            |       |   |   |   |   |
|                                                                                           |       |                            |       |   |   |   |   |
| Increase in common stock subject to  rescission                                                |       | $                               | 490        |   | $ | 528 |   | $ | — |   |
|                                                                                           |       |                            |       |   |   |   |   |
| 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 |   | $ | — |   |
|                                                                                           |       |                            |       |   |   |   |   |
| Deferred compensation for issuance of  common shares                                           |       | $                               | —     |   | $ | — |   | $ | 569 |   |
|                                                                                           |       |                            |       |   |   |   |   |
| 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 | ) |

 

See accompanying notes to consolidated financial statements.

 

51

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**THE SCO GROUP, INC. ANDSUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

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

 

The Company was originally incorporated asCaldera Systems, Inc. (“Caldera Systems”), a Utah corporation, on August 21,1998, and reincorporated as a Delaware corporation on March 6, 2000.  In March 2000, Caldera Systems completedan initial public offering of its common stock.

 

OnMay 7, 2001, Caldera International, Inc. (“Caldera”) was formed as aholding company to own Caldera Systems and to acquire substantially all of theassets, liabilities and operations of the server and professional servicesgroups of The Santa Cruz Operation, which changed its name to Tarantella, Inc.and was subsequently acquired by Sun Microsystems, Inc. (“Sun”).  The Santa Cruz Operation developed andmarketed server software related to networked business computing and was one ofthe leading providers of UNIX server operating systems.  In addition, these operations providedprofessional services related to implementing and maintaining UNIX systemsoftware products.  The acquisitionprovided Caldera with international offices and a distribution channel withresellers 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 business and launched the first of its SCOsource initiatives toreview and enforce its intellectual property surrounding the UNIX operatingsystem which it acquired from The Santa Cruz Operation.

 

During the year ended October 31,2005, the Company used cash of $21,507,000 in its operating activities.  The majority of this cash was used to payaccounts payable, accrued compensation to law firms and liabilities related tothe Company’s intellectual property litigation. As of October 31, 2005, the Company had a total of $10,437,000 incash and cash equivalents and available-for-sale securities and an additional $5,690,000in restricted cash, of which $2,875,000 is designated to pay for experts,consultants and other expenses in the SCO Litigation (as defined herein), ifneeded, and the remaining $2,815,000 of restricted cash is for SVRx royaltiesdue to Novell, Inc. (“Novell”) .

 

On November 30,2005, the Company completed a private placement of 2,852,000 shares of itscommon stock and raised gross proceeds of $10,005,000.  Costs to date incurred to facilitate theprivate placement totaled approximately $100,000.  With the proceeds of this financing, as wellas the available cash and cash equivalents and available-for-sale securities asof October 31, 2005, the Company believes that it will have sufficientcash resources to fund its operations through at least October 31, 2006.

 

**(2) SIGNIFICANT ACCOUNTINGPOLICIES**

 

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

 

The preparation offinancial statements in conformity with U. S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenue and expenses during the reporting periods.  Actual results could differ from theseestimates.  Key estimates in theaccompanying consolidated financial statements include, among others, revenuerecognition, allowances for doubtful accounts receivable,

 

 

52

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impairment and usefullives of long-lived assets, litigation reserves, and valuation allowancesagainst deferred income tax assets.

 

**Principles of Consolidation**

 

The consolidatedfinancial statements include the accounts of the Company and its wholly ownedoperating subsidiaries after all intercompany balances and transactions havebeen 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 (UK) Ltd.            |       | United Kingdom |       | Wholly owned           |
| SCO Japan, Ltd.                   |       | Japan          |       | Wholly owned           |
| SCO Canada, Inc.             |       | Canada         |       | Wholly owned           |
| The SCO Group (Deutschland) GmbH  |       | Germany        |       | Wholly owned           |
| The SCO Group (France) Sarl       |       | France         |       | Wholly owned           |
| SCO Software (India) Private Ltd. |       | India          |       | Wholly owned           |

 

**Fair Value of FinancialInstruments**

 

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 Stockderivative and Series A Convertible Preferred Stock as of October 31,2003 were determined using a binomial pricing model (see Note 6).

 

**ForeignCurrency 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.

 

**Cashand Cash Equivalents**

 

The Company considersall investments purchased with original maturities of three or fewer months tobe cash equivalents.  Cash equivalentswere $1,528,000 and $2,633,000 as of October 31, 2005 and 2004,respectively.  Cash was $2,744,000 and$10,060,000 as of October 31, 2005 and 2004, respectively.  The Company has $100,000 of cash that isfederally insured.  All remaining amountsof cash and cash equivalents as well as restricted cash exceed federallyinsured limits.

 

53

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**Available-for-SaleSecurities**

 

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, 2005 and 2004 (in thousands):

 
| ** **               | ** ** | **October 31, 2004** | ** ** |
|--------------------------|------------|---------------------------|------------|
| ** **               | ** ** | **Cost**                  | ** ** | **Unrealized  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, 2005** | ** ** |
|--------------------------|------------|---------------------------|------------|
| ** **               | ** ** | **Cost**                  | ** ** | **Unrealized  Losses, net** | ** ** | **Fair Market  Value** | ** ** |
|                     |       |                      |       |   |   |   |   |
| U.S. Government agencies |       | $                         | 3,500      |   | $ | (35 | ) | $ | 3,465 |   |
| Auction rate notes       |       | 2,700                     |       | — |   | 2,700 |   |
| Total                    |       | $                         | 6,200      |   | $ | (35 | ) | $ | 6,165 |   |

 

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 andlosses, which are calculated based on the specific-identification method, arerecorded in operations as incurred.  Asof October 31, 2005 and 2004, available-for-sale securities at amortizedcost and fair value consisted of the following (in thousands):

 
| ** **          | ** ** | **2005**           | ** ** | **2004**       | ** ** |
|---------------------|------------|--------------------|------------|----------------|------------|
| ** **          | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
| Maturity date       |       |               |       |           |       |   |   |   |   |
| 3 – 12  months |       | $                  | 6,200      |           | $          | 6,165 |   | $ | — |   | $ | — |   |
| > 12  months     |       | —             |       | —         |       | 18,800 |   | 18,756 |   |
| Total               |       | $                  | 6,200      |           | $          | 6,165 |   | $ | 18,800 |   | $ | 18,756 |   |

 

All U.S. Governmentagencies in an unrealized loss position as of October 31, 2005 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.

 

**RestrictedCash and Payable to Novell, Inc.**

 

Pursuant to the 1995 Asset Purchase Agreement and the Company’s acquisitionof assets and operations of The Santa Cruz Operation, theCompany acts as an administrative agent in the collection of royalty paymentsfrom a limited number of pre-existing Novell customers who continue to deploySVRx technology.  Under the agencyagreement, the Company collects payments from such customers and receives 5% asan administrative fee and remits the remaining 95% to Novell on a routine basis.  The Company records the 5% administrative feeas revenue in its consolidated statements of operations.  The accompanying consolidated balance sheetsas of October 31, 2005 and 2004 reflect amounts collected related to thisagency agreement as of each balance sheet date, but not yet remitted to Novellof $2,815,000 and $3,283,000, respectively, as restricted cash and payable toNovell.

 

54

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**Allowance for Doubtful AccountsReceivable**

 

The Company offerscredit terms on the sale of the Company’s products to a significant majority ofthe Company’s customers and requires 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, 2005 and2004, the allowance for doubtful accounts was $144,000 and $136,000,respectively.

 

**Inventories**

 

Inventories consistprimarily of completed software products. Inventories are stated at the lower of cost (using the first-in,first-out method) or market value.  As ofOctober 31, 2005 and 2004, inventories amounted to $203,000 and $248,000,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.

 

**CapitalizedSoftware Costs**

 

In accordance withStatement of Financial Accounting Standards (“SFAS”) No. 86, “Accountingfor the Costs of Computer Softwareto be Sold, Leased or Otherwise Marketed,” development costs incurred in theresearch and development of new software products to be sold, leased orotherwise marketed are expensed as incurred until technological feasibility inthe form of a detailed program design. Software development costs incurred after technological feasibility wasestablished and prior to product release were not material for the years ended October 31,2005, 2004 and 2003.  The Company hascharged its software development costs to research and development expense inthe accompanying consolidated statements of operations.

 

**Impairmentof Long-Lived Assets**

 

The Company reviews itslong-lived assets for impairment when events or changes in circumstancesindicate that the carrying 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.

 

**Propertyand 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 fiveyears.  Leasehold improvements areamortized using the straight-line method over the shorter of the estimateduseful life of the improvement or the remaining term of the applicable lease.

 

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

 

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accumulated depreciationare removed from the accounts and any resulting gain or loss is recognized inthe consolidated statements of operations.

 

Depreciation andamortization expense was $360,000, $783,000 and $1,049,000 during the yearsended October 31, 2005, 2004 and 2003, respectively.

 

### **Revenue Recognition**

 

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 license revenue, primarily fromproduct sales to resellers, end users and original equipment manufacturers (“OEMs”);(ii) technical support service revenue, primarily from providing technicalsupport and consulting services to end users; and (iii) revenue from SCOsourcelicensing.

 

The Company recognizesproduct revenue upon shipment if a signed contract exists, the fee is fixed ordeterminable, collection of the resulting receivable is reasonably assured andproduct returns 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 establishedwhen such elements are sold separately. The Company recognizes revenue when the criteria for product revenuerecognition set forth above have been met. If VSOE of all undelivered elements exists, but VSOE does not exist forone or more delivered elements, then revenue is recognized using the residualmethod.  Under the residual method, thefair value of the undelivered elements is deferred and the remaining portion ofthe license fee is recognized as revenue in the period when persuasive evidenceof an arrangement is obtained assuming all other revenue recognition criteriaare met.

 

The Company recognizesproduct revenue from OEMs when the software is sold by the OEM to an end-usercustomer.  Revenue from technical supportservices and consulting services is recognized as the related services areperformed.  Revenue for maintenance isrecognized ratably over 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 SCOsourcerevenue to date has been primarily generated from agreements to utilize theCompany’s UNIX source code as well as from intellectual propertyagreements.  The Company recognizesrevenue from SCOsource agreements when a signed contract exists, the fee isfixed and determinable, collection of the receivable is probable and deliveryhas occurred.  If the payment termsextend beyond the Company’s normal payment terms, revenue is recognized as thepayments become due.

 

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**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 the years ended October 31, 2005,2004 and 2003, the Company incurred $1,133,000, $1,262,000 and $1,464,000, respectively,in royalty expense.

 

**Advertising**

 

The Company expenses thecost of advertising as incurred. Advertising expenses totaled $384,000, $350,000 and $665,000,respectively, for the years ended October 31, 2005, 2004 and 2003,respectively.

 

**Stock-basedCompensation**

 

The Company accounts forstock options issued to directors, officers and employees under AccountingPrinciples Board (“APB”) No. 25, “Accounting for Stock Issued toEmployees, and Related Interpretations.” Under APB No. 25, compensation expense is recognized if an option’sexercise price on the measurement date is below the fair market value of theCompany’s common stock.  The compensationexpense, if any, is amortized to expense over the vesting period.

 

SFAS No. 148, “Accountingfor Stock-Based Compensation,” requires pro forma information regarding net income (loss) as if the Company hadaccounted for its stock options granted under the fair value method prescribedby SFAS No. 123, “Accounting for Stock-Based Compensation.”  The fair value for the Company’s stockoptions is estimated on the date of grant using the Black-Scholesoption-pricing model.

 

Withrespect to stock options and restricted stock awards granted and employee stockpurchase plan (“ESPP”) shares purchased during the years ended October 31,2005, 2004 and 2003, the assumptions used in the Black-Scholes option-pricingmodel are as follows:

 
| ** **                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free weighted average interest rate |       | 3.9      | %          | 2.8      | %          | 2.9      | %          |
| Expected dividend yield                  |       | 0.0      | %          | 0.0      | %          | 0.0      | %          |
| Volatility                               |       | 63.4     | %          | 79.5     | %          | 126.0    | %          |
| Expected exercise life (in years)        |       | 2.7      |       | 3.0      |       | 2.7      |       |

 

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Forpurposes of the pro forma disclosure, the estimated fair value of stockoptions, restricted stock awards and ESPP shares are amortized over the vestingperiod of the award.  The following isthe pro forma disclosure and the related impact on net income (loss) to commonstockholders and the net income (loss) to common stockholders per dilutedcommon share for the years ended October 31, 2005, 2004 and 2003 (inthousands, except per share amounts):

 
| ** **                                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income available (loss applicable) to  common stockholders:                          |       |     |       |     |       |     |       |
| As reported                                                                              |       | $        | (10,726    | )        | $          | (16,227  | )          | $ | 5,304 |   |
| Stock-based compensation included in  reported net income (loss)                         |       | 22       |       | 919      |       | 1,204    |       |
| Stock-based compensation under fair value  method                                        |       | (1,880   | )          | (2,082   | )          | (1,855   | )          |
| Pro forma  net income available (loss applicable) to common stockholders                 |       | $        | (12,584    | )        | $          | (17,390  | )          | $ | 4,653 |   |
| Net income  available (loss applicable) to common stockholders per basic common share:   |       |     |       |     |       |     |       |
| As reported                                                                              |       | $        | (0.60      | )        | $          | (1.07    | )          | $ | 0.43 |   |
| Pro forma                                                                                |       | $        | (0.70      | )        | $          | (1.15    | )          | $ | 0.38 |   |
| Net income  available (loss applicable) to common stockholders per diluted common share: |       |     |       |     |       |     |       |
| As reported                                                                              |       | $        | (0.60      | )        | $          | (1.07    | )          | $ | 0.34 |   |
| Pro forma                                                                                |       | $        | (0.70      | )        | $          | (1.15    | )          | $ | 0.30 |   |

 

**IncomeTaxes**

 

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).

 

**Net Income (Loss) per CommonShare**

 

 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 number of shares issuable upon the exercise of outstandingstock options, restricted stock awards, warrants to acquire common stock andpreferred stock convertible into common shares. If dilutive, the Company computes Diluted EPS using the treasury stockmethod.

 

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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):

 
| ** **                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                           |       |     |       |     |       |     |       |
| Numerator:                                                     |       |     |       |     |       |     |       |
| Net income  available (loss applicable) to common stockholders |       | $        | (10,726    | )        | $          | (16,227  | )          | $ | 5,304 |   |
| Denominator:                                                   |       |     |       |     |       |     |       |
| Weighted  average common shares outstanding                    |       | 17,924   |       | 15,155   |       | 12,256   |       |
| Series A  Convertible Preferred Stock                     |       | —   |       | —   |       | 5        |       |
| Weighted  average basic common shares outstanding              |       | 17,924   |       | 15,155   |       | 12,261   |       |
| Stock  options                                                 |       | —   |       | —   |       | 2,833    |       |
| Restricted  stock                                              |       | —   |       | —   |       | 471      |       |
| Warrants                                                       |       | —   |       | —   |       | 114      |       |
| Weighted  average diluted common shares outstanding            |       | 17,924   |       | 15,155   |       | 15,679   |       |
| Basic EPS                                                      |       | $        | (0.60      | )        | $          | (1.07    | )          | $ | 0.43 |   |
| Diluted EPS                                                    |       | (0.60    | )          | (1.07    | )          | 0.34     |       |
|                                                           |       |     |       |     |       |     |       |
| Excluded anti-dilutive common share  equivalents               |       | 4,059    |       | 3,161    |       | 387      |       |

 

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 acquired substantially all of the assetsof 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”), theCompany’s principal stockholder as of October 31, 2004, receivedapproximately 37,000 shares.  The Companyalso assumed approximately $215,000 in accrued liabilities of Vultus.  In addition, 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.  Canopywas a stockholder and significant debt holder of Vultus.  Neither Canopy nor any of its officers ordirectors participated in the Company’s approval of this transaction.

 

The following table summarizes the componentsof the consideration paid to 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.

 

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The Company accounted for the acquisitionof Vultus 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    |   |

 

**ProForma 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** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------|------------|
|                                                           |       |                                  |       |
| Revenue                                                        |       | $                                     | 79,254     |   |
| Net income (loss) from operations                              |       | 2,133                                 |       |
| Net income available (loss) applicable to  common stockholders |       | 3,998                                 |       |
| Basic net income (loss) per common share                       |       | $                                     | 0.32       |   |
| Diluted net income (loss) per common share                     |       | $                                     | 0.25       |   |

 

Asdiscussed in more detail in Note 4, the Company recorded an asset impairmentrelated to Vultus during the year ended October 31, 2004.

 

**(4) GOODWILLAND INTANGIBLE ASSETS**

 

The following tableshows the activity related to amortized intangible assets for the years ended October 31,2005 and 2004 as well as the remaining unamortized balances as of October 31,2005 and 2004 (in thousands):

 
| ** **                     | ** ** | **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 |   |

 
| ** **                     | ** ** | **As of  October 31, 2004** | ** ** | **Year Ended  October 31, 2005** | ** ** | **As of  October 31, 2005** | ** ** |
|--------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **Net Book Value**               | ** ** | **Amortization  Expense**             | ** ** | **Additions**                    | ** ** | **Net Book Value** | ** ** |
| Amortizable intangible assets: |       |                             |       |                                  |       |                             |       |   |   |
| Distribution/reseller  channel |       | $                                | 4,636      |                                  | $          | (2,318                           | )          | $ | — |   | $ | 2,318 |   |
| Acquired  technology           |       | 673                              |       | (336                                  | )          | —                           |       | 337 |   |
| Trade name                     |       | 104                              |       | (52                                   | )          | —                           |       | 52 |   |
| Total  intangible assets       |       | $                                | 5,413      |                                  | $          | (2,706                           | )          | $ | — |   | $ | 2,707 |   |

 

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Of the $2,706,000 inamortization expense for the year ended October 31, 2005, $334,000 wasclassified as cost of SCOsource licensing revenue and the remaining $2,372,000was classified as amortization of intangible assets in operating expenses.  Of the $2,900,000 in amortization expense forthe year ended October 31, 2004, $334,000 was classified as cost ofSCOsource licensing revenue and the remaining $2,566,000 was classified asamortization of intangible assets in operating expenses.

 

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 areduction in force that impacted the Company’s ability to move the Vultusinitiative forward on a stand-alone basis and because an impending partnershipthat would have solidified the Vultus revenue and cash flow opportunities didnot materialize.  Consequently, theCompany concluded that no significant future cash flows related to its Vultusassets would be realized.  The Companyperformed an impairment analysis of its recorded goodwill related to the Vultusreporting unit 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.

 

The above intangibleassets, with a remaining carrying value of $2,707,000, are expected to be fullyamortized during the year ending October 31, 2006.

 

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, 2005 and concluded that no impairment had occurred.

 

**(5) INVESTMENTS INNON-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 joint venture inChina.  This investment is beingaccounted for using the equity method. As of October 31, 2005, the Company had a balance of $606,000 forits China investment, which is included as a component of other assets.  The Company’s other investments innon-marketable securities have been fully impaired in prior years and did nothave a carrying value as of October 31, 2005.

 

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 $47,000, $111,000 and ($62,000) for the years ended October 31,2005, 2004 and 2003, respectively.

 

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**Sale of Troll Tech Shares**

 

In December 1999, the Company and Canopy, a former holder of theCompany’s common stock, entered into an agreement with Troll Tech AS (“TrollTech”) and its stockholders.  Pursuant tothe agreement, the Company acquired shares of Troll Tech in exchange for sharesof the Company, and Canopy acquired shares of Troll Tech in exchange for$1,000,000.  The Company recorded itsinvestment in Troll Tech’s common stock at $400,000, based on the cash priceper share paid by Canopy.  The Companydetermined that the cash price per share paid by Canopy was the most reliableevidence of the value of Troll Tech’s common stock.  During the year ended October 31, 2001,management determined that the carrying value of the investment in Troll Techof $400,000 would most likely not be recoverable, and the investment waswritten down to $0.

 

During the three months ended April 30, 2005, the Company receivednotice from Troll Tech that a third-party investor was interested in acquiringthe Company’s shares of Troll Tech.  On March 14,2005, the Company received proceeds of $779,100 for the Troll Tech shares.  The Company accounted for the sale andproceeds of the Troll Tech shares in the three months ended April 30, 2005when it received the proceeds from the shares. All amounts related to the book value of the shares had been written offduring the year ended October 31, 2001, and the Company recorded theproceeds received as a component of other income in its statement of operationsand comprehensive loss for the year ended October 31, 2005.

 

**Investment Impairments andWrite-offs**

 

Management routinely assesses the Company’s investments for impairmentand adjusts the carrying amounts to estimated realizable values when impairmenthas occurred.  During the year ended October 31,2003, management determined that the carrying value of certain of itsinvestments would most likely not be recoverable and incurred a write-off of$250,000.  The necessary write-offs weredue to declines in general economic conditions and the impact of such declinesin the operations of these companies as well as a decline in overall marketvaluations.  The Company did not recordany write-offs during the years ended October 31, 2005 and 2004.

 

**(6) REDEEMABLE CONVERTIBLEPREFERRED 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 Companydetermined the initial fair value of the derivative was $18,069,000.  As of October 31, 2003, the fair valueof the derivative was $15,224,000 and the decrease in fair value of $2,845,000was recorded as a gain as a change in fair value of derivative in other incomein the statement of operations 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

 

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“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 change in fair value of derivative in otherincome in the statement of operations.

 

As of February 5,2004, the Company determined the fair value of the Series A-1 was$45,276,000.  The Company incurred$211,000 in offering costs in connection with the issuance of the Series A-1in the exchange for Series A, resulting in a net fair value of$45,065,000.  The difference of$6,305,000 in the fair value of the Series A-1 and the combined carryingvalue of the Series A and the related derivative was recorded as anon-cash dividend in the statements of operations for the three months ended April 30,2004.

 

**Conversion of Series A-1 Shares and Transferof Series A-1 Shares to BayStar**

 

On May 5, 2004, the Company received anotice from Royal Bank of Canada (“RBC”), one of the holders of the Series A-1shares that RBC had elected to convert 10,000 Series A-1 shares into atotal of 740,740 shares of the Company’s common stock.  The converted Series A-1 shares werepurchased at a price of $1,000 per share and were converted into shares ofcommon 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.

 

**Agreement to 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 repurchase with BayStar closed on that date.  The fair value of the cash and common sharesdelivered to BayStar was less than the carrying value of the remaining value ofthe Series A-1 shares and the Company recorded a capital contribution as adividend for this difference as outlined in the following 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.

 

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**(7) COMMON STOCK SUBJECT TORESCISSION**

 

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 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 payfines or impose other sanctions.  TheCompany has determined to make a rescission offer to certain Plan participants.

 

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 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 $1,018,000 in the aggregate,excluding interest and other possible fees.

 

Subsequent to October 31,2005, the Company completed a rescission offer to eligible plan participants(see Note 16).

 

**(8) STOCKHOLDERS’EQUITY**

 

**Stock Options**

 

During the year ended October 31,1998, the Company adopted the 1998 Stock Option Plan (the “1998 Plan”) thatprovided for the granting of nonqualified stock options to purchase shares ofcommon stock.  On December 1, 1999,the Company’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.

 

On May 16, 2003, the Company’s stockholdersapproved the 2002 Omnibus Stock Incentive Plan (the “2002 Plan”) upon therecommendation of the board of directors. The 2002 Plan permits the award of stock options, stock appreciationrights, restricted stock, phantom stock rights, and stock bonuses.  Stock options may have an exercise priceequal to, less than, or greater than the fair market value of the common stockon the date of grant, except that the exercise price of incentive stock optionsmust be equal to or greater than the fair market value of the common stock asof the date of grant.

 

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On April 20, 2004, the Company’s stockholdersapproved the 2004 Omnibus Stock Incentive Plan (the “2004 Plan”) upon therecommendation of the board of directors. The 2004 Plan allows for the award of up to 1,500,000 shares of theCompany’s common stock and permits the award of stock options, stockappreciation rights, restricted stock, phantom stock rights, and stock bonuses.The 2004 Plan incorporates an evergreen formula pursuant to which on each November 1,the aggregate number of shares reserved for issuance under the 2004 Plan willincrease by a number of shares equal to three percent of the outstanding shareson the day preceding (October 31).  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 subject to each option, and the exercisability of theoptions.  Stock options may have anexercise price equal to, less than, or greater than the fair market value ofthe common stock on the date of grant, except that the exercise price ofincentive stock options must be equal to or greater than the fair market valueof the common stock as of the date of grant. Shares issued pursuant to the 2004 Plan may be authorized and unissuedshares, treasury shares or shares acquired by the Company for purposes of the2004 Plan.

 

Under the terms of the 1998, 1999, 2002 and 2004Plans, options generally expire 10 years from the date of grant or within 90days of termination.  Options grantedunder these plans generally vest at 25 percent after the completion of one yearof service and then 1/36 per month for the remaining three years and would befully vested at the end of four years.

 

The board may suspend, revise, terminate or amendany of the option plans at any time; provided, however, that stockholderapproval must be obtained if and to the extent that the board deems itappropriate to satisfy Section 162(m) of the Code, Section 422 of theCode or the rules of any stock exchange on which the common stock islisted.  No action under the option plansmay, without the consent of the participant, reduce the participant’s rightsunder any outstanding award.

 

As of October 31, 2005, 238,000 shares wereavailable for issuance under the 1999 Plan, 561,000 shares were available forissuance under the 2002 Plan, and 738,000 shares were available for issuanceunder the 2004 Plan.  A summary of stockoption activity under the 1998, 1999, 2002 and 2004 Plans for the years ended October 31, 2005, 2004 and2003 is as follows (in thousands, except per share amounts):

 
| ** **                     | ** ** | ** **  | ** ** | **Weighted Average** | ** ** |
|--------------------------------|------------|-------------|------------|----------------------|------------|
| ** **                     | ** ** | **Options** | ** ** | **Exercise Price**   | ** ** |
|                           |       |        |       |                 |       |
| 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                 |       |
| Granted                        |       | 1,118       |       | 4.40                 |       |
| Exercised                      |       | (162        | )          | 1.48                 |       |
| Cancelled                      |       | (293        | )          | 6.63                 |       |
| Balance, October 31, 2005 |       | 3,824       |       | $                    | 4.17       |   |

 

The weighted average fair value of options granted for the years ended October 31,2005, 2004 and 2003 was $4.40, $7.31 and $5.56, respectively.

 

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During the years ended October 31, 2005, 2004 and 2003, 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 31,2005 is as follows (in thousands, except per share amounts):

 
| ** **           | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|----------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **           | ** ** | ** **              | ** ** | **Weighted**            | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **           | ** ** | ** **              | ** ** | **Average**             | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **           | ** ** | **Options**             | ** ** | **Contractual**         | ** ** | **Exercise** | ** ** | **Options** | ** ** | **Exercise** | ** ** |
| **Exercise Prices**  | ** ** | **Outstanding**         | ** ** | **Life**                | ** ** | **Price** | ** ** | **Exercisable** | ** ** | **Price** | ** ** |
|                 |       |                    |       |                    |       |   |   |   |   |   |   |
| $ 0.76 - $2.00  |       | 1,254                   |       | 6.54 years              |       | $ | 0.91 |   | 988 |   | $ | 0.93 |   |
| $ 2.07 - $4.25  |       | 1,280                   |       | 8.46                    |       | 3.31 |   | 451 |   | 2.45 |   |
| $ 4.50 - $7.18  |       | 939                     |       | 8.74                    |       | 5.44 |   | 216 |   | 5.89 |   |
| $ 8.71 - $28.00 |       | 351                     |       | 7.27                    |       | 15.50 |   | 217 |   | 16.13 |   |
|                 |       | 3,824                   |       | 7.79 years              |       | $ | 4.17 |   | 1,872 |   | $ | 3.63 |   |

 

**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.  Effective for the purchase period beginning December 1,2005, the look-back period for the plan was reduced from 24 months to 6months.  The board may at any time amendor modify the plan.  The plan willterminate no later than the last business day in April 2010.

 

During the year ended October 31,2005, approximately 213,000 shares were purchased at prices ranging from $3.38to $3.52 per share.  During the yearended October 31, 2004, 691,000 shares were purchased at prices rangingfrom $0.66 to $5.21 per share and during the year ended October 31, 2003,345,000 shares were purchased at prices ranging from $0.66 to $1.38 per share.

 

**Stock-based Compensation**

 

Stock-based compensationwas $22,000, $919,000 and $1,204,000 during the years ended October 2005,2004 and 2003, respectively.  Thefollowing table summarizes the components of stock-based compensation (inthousands):

 
| ** **                                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |     |       |
| Amortization of stock-based compensation  |       | $        | 22         |     | $          | 325      |       | $ | 866 |   |
| Options, warrants and shares for services |       | —   |       | 502      |       | 296      |       |
| Option modifications                      |       | —   |       | 92       |       | 42       |       |
| Total                                     |       | $        | 22         |     | $          | 919      |       | $ | 1,204 |   |

 

**RestrictedStock Awards**

 

During the years ended October 31,2005 and 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

 

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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 in the form ofrestricted stock awards.  The Companyissued 27,500 shares of common stock with a fair value of $36,000 that wasexpensed as a component of options, warrants and shares for services in theabove table.  Finally, the Companygranted 150,000 shares of restricted common stock to members of the Company’sboard of directors with a fair value of $195,000 and was recorded as acomponent of deferred compensation.  Therestricted common stock issued to the board of directors was in lieu of cashcompensation for their services to the Company during the year ended October 31,2003 and the restrictions lapsed on October 31, 2003.

 

**Warrants**

 

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 31,2005, 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 recorded the fair value of thewarrant 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.  During the year endedOctober 31, 2005, the warrant expired unexercised and the Company removedthe value of $243,000 of the warrant from warrants outstanding and recordedthis amount as a component of additional paid-in capital.

 

**Repurchaseof 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, the Company purchased approximately 290,000shares of its common stock at a total cost of approximately $2,414,000.  The Company did not purchase any shares ofits common stock during the year ended October 31, 2005.

 

**StockholderRights 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

 

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market or through private transactions and to prevent an acquirer fromgaining control of the Company without offering a fair price to all of theCompany’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 isimmaterial as of October 31, 2005.

 

**Change in Control Agreements**

 

On December 10,2004, the Companyentered into Change in Control Agreements with the following officers: Darl C.McBride;Bert B. Young; Christopher Sontag;Jeff F. Hunsaker; and Ryan E. Tibbitts (each, an “Officer”).  In addition, on January 23, 2006, theCompany entered into Change in Control Agreements with two additional officers:Tim Negris and Sandy Gupta.

 

Pursuant to the terms ofeach Agreement, the Officer agrees that he or she will not voluntarily leavethe employ of the Company in the event any individual, corporation,partnership, company or other entity takes certain steps to effect a Change inControl (as defined in the Agreement) of the Company, until the attempt toeffect a Change in 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 be solely responsible for any taxes that arise orbecome due pursuant to the acceleration of vesting that occurs pursuant to theAgreement.  The adoption of thisprovision represented a modification to the underlying stock option award foreach Officer.  In accordance with FASBInterpretation No. 44, “Accounting for Certain Transactions InvolvingStock Compensation,” the Company has calculated the intrinsic value of theawards on the modification date which was approximately $2,012,000.  No expense was recognized during the yearended October 31, 2005 and no expense will be recognized until such timethat a Change in Control becomes probable.

 

On October 20,2005, the Company’s Board of Directors approved to allow for 12 months ofvesting on stock option awards for employees who are non-executives in theevent of a Change in Control.  Theadoption of this provision represents a modification to the underlying stockoption award and the Company has calculated the intrinsic value of the awardson the modification date, which value was approximately $70,000.  No expense was recognized during the year endedOctober 31, 2005 and no expense will be recognized until such time that aChange in Control becomes probable.

 

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**(9) INCOME TAXES**

 

The net income (loss)before income taxes consisted of the following components for the years ended October 31,2005, 2004 and 2003 (in thousands):

 
| ** **               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
|                     |       |     |       |     |       |     |       |
| Domestic U.S. operations |       | $        | (10,333    | )        | $          | (21,875  | )          | $ | 8,546 |   |
| Foreign operations       |       | (120     | )          | (80      | )          | (2,345   | )          |
| Total                    |       | $        | (10,453    | )        | $          | (21,955  | )          | $ | 6,201 |   |

 

The components of theprovision for income taxes for the years ended October 31, 2005, 2004 and2003 are as follows (in thousands):

 
| ** **                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                          |       |     |       |     |       |     |       |
| U.S. state                        |       | $        | —     |     | $          | 27       |       | $ | 16 |   |
| Non – U.S.                   |       | 273      |       | 1,368    |       | 758      |       |
|                              |       | 273      |       | 1,395    |       | 774      |       |
| Deferred:                         |       |     |       |     |       |     |       |
| U.S. federal                      |       | (2,250   | )          | (13,248  | )          | 1,114    |       |
| U.S. state                        |       | (334     | )          | (499     | )          | 42       |       |
| Change in  valuation allowance    |       | 2,584    |       | 13,747   |       | (1,156   | )          |
| Total  provision for income taxes |       | $        | 273        |     | $          | 1,395    |       | $ | 774 |   |

 

Deferred income taxassets and liabilities are determined based on the differences between thefinancial reporting 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 31,2005 and 2004 are as follows (in thousands):

 
| ** **                                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred income tax assets:                                   |       |     |       |     |       |
| Net  operating loss carry-forwards                            |       | $        | 55,917     |     | $          | 45,580 |   |
| Intangible  assets                                            |       | 6,486    |       | 7,299    |       |
| Tax basis in  excess of book basis related to acquired assets |       | 4,118    |       | 4,491    |       |
| Reserves and  accrued expenses                                |       | 1,502    |       | 4,862    |       |
| Book  depreciation in excess of tax                           |       | 373      |       | 425      |       |
| Deferred  revenue                                             |       | 284      |       | 270      |       |
| Basis  difference in investments                              |       | 138      |       | 151      |       |
| Capital loss  carry-forward                                   |       | 474      |       | 4,009    |       |
| Total deferred income tax assets                              |       | 69,292   |       | 67,087   |       |
| Deferred tax  liabilities:                                    |       |     |       |     |       |
| Tax on  foreign earnings                                      |       | (53      | )          | (432     | )          |
| Total deferred income tax liabilities                         |       | (53      | )          | (432     | )          |
| Valuation  allowance                                          |       | (69,239  | )          | (66,655  | )          |
| 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, if any, and other futureevents, the effects of which cannot be determined.  The Company has established a full valuationallowance against its net deferred income tax assets.  Management believes that as of October 31,2005, based on a number of

 

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factors, the availableobjective evidence creates sufficient uncertainty regarding the ultimaterealizability of these deferred income tax assets, that it is more likely thannot that those assets will not be realized. As of October 31, 2005, the Company has used the enacted federalstatutory rate of 35% because the benefit of the deferred income tax assets, ifutilized, will likely be realized at 35%.

 

As of October 31,2005, the Company had net operating loss carry-forwards for federal income taxreporting purposes totaling approximately $144,980,000 that expire between 2019and 2025.  Approximately $19,371,000 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 additional paid-in capital.

 

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:

 
| ** **                                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |     |       |
| Provision (benefit) at statutory rate     |       | (35.0    | )%         | (34.0    | )%         | 34.0     | %          |
| Other permanent book to tax differences   |       | 0.2      | %          | 1.9      | %          | 0.2      | %          |
| State income taxes, net of federal effect |       | 0.0      | %          | 0.0      | %          | 0.3      | %          |
| Foreign income taxes                      |       | 2.6      | %          | 6.4      | %          | 12.3     | %          |
| Change in fair value of derivative        |       | 0.0      | %          | (9.1     | )%         | (15.6    | )%         |
| Change in valuation allowance             |       | 34.8     | %          | 41.2     | %          | (18.7    | )%         |
| Total  provision for income taxes         |       | 2.6      | %          | 6.4      | %          | 12.5     | %          |

 

**(10) COMMITMENTS AND CONTINGENCIES**

 

**Litigation**

 

*IBM Corporation*

 

On or about March 6, 2003, the Companyfiled a civil complaint against IBM in the United States District Court for theDistrict of Utah, under the title The SCO Group, Inc. v. InternationalBusiness Machines Corporation, Civil No. 2:03CV0294.  In this action the Company claims, amongother things, that IBM breached its UNIX source code licenses (both the IBM andSequent Computer Systems, Inc. “Sequent” licenses) by disclosingrestricted information concerning the UNIX source code and derivative works andrelated information in connection with its efforts to promote the Linuxoperating system.  The Company’scomplaint includes, among other things, claims for breach of contract, unfaircompetition, tortious interference and copyright infringement.  As a result of IBM’s actions, the Company isrequesting damages in an amount to be proven at trial and seeking injunctiverelief.

 

On or about March 6, 2003, the Company notifiedIBM that they were not in compliance with the Company's UNIX source codelicense agreement and on or about June 13, 2003, the Company delivered toIBM a notice of termination of IBM’s UNIX source code license agreement, whichunderlies IBM’s AIX software.  On orabout August 11, 2003, the Company sent a similar notice terminating theSequent source code license.  IBMdisputes the Company’s right to terminate those licenses.  In the event the Company’s termination ofthose licenses is valid, the Company believes IBM is exposed to substantialdamages and injunctive relief based on its continued use and distribution ofthe AIX operating system.  On June 9,2003, Novell sent the Company a notice purporting to waive the Company’s claimsagainst

 

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IBM regarding its license breaches. The Company does believe that Novell had the right to take any suchaction relative to the Company's UNIX source code rights.

 

On February 27, 2004, the Company fileda second amended complaint which alleges nine causes of action that are similarto those set forth above, adds a new claim for copyright infringement andremoves the claim for misappropriation of trade secrets.  IBM filed an answer and fourteen counterclaims.  Among other things, IBM has asserted that theCompany does not have the right to terminate IBM’s UNIX license and IBM hasclaimed that the Company has breached the GNU General Public License and hasinfringed certain patents held by IBM. IBM’s counterclaims include claims for breach of contract, violation ofthe Lanham Act, unfair competition, intentional interference with prospectiveeconomic relations, unfair and deceptive trade practices, promissory estoppel,patent infringement and a declaratory judgment claim for non-infringement ofcopyrights.  On October 6, 2005, IBMvoluntarily dismissed with prejudice its claims for patent infringement.

 

On February 9, 2005, the Court denied threemotions for partial summary judgment that IBM had filed on the Company’scontract claims, on IBM’s eighth counterclaim for copyright infringement, andon IBM’s tenth counterclaim for a declaration of non-infringement of theCompany's copyrights.  The Court deniedeach of those motions without prejudice to IBM’s renewing or refiling themotions after discovery is complete.  TheCourt also denied the Company’s motion to stay or dismiss IBM’s tenthcounterclaim.  The Court ordered that nofurther dispositive motions could be filed until the close of discovery.

 

On July 1, 2005, the Court issued a revised SchedulingOrder establishing, among other things, discovery and motion deadlines over thenext 18 months with a five-week jury trial to commence on February 26,2007.

 

Pursuant to the Court’s July 1, 2005 SchedulingOrder, the Company filed its Interim Disclosure of Material Misused by IBM on October 28,2005.  The Company’s report includes amatrix that identifies 217 separate technology disclosures that it contends IBMimproperly made to enhance Linux in violation of one or more contractualprohibitions governing IBM’s use of the Company’s proprietary material.  The Company continued to review relevantmaterials, including evidence IBM has produced in discovery, and filed anupdated report on December 22, 2005 detailing IBM’s misuse of the Company’sproprietary material.  The Company’s December 22,2005 report includes 293 total disclosures which the Company claims violate itscontractual rights and copyrights.  Thesereports and the disclosures identified are the result of analysis fromexperienced outside technical consultants. Discovery is ongoing in the case as the parties prepare for trial.

 

*Novell, Inc.*

 

On January 20, 2004, the Company filed suit inUtah state court against Novell, Inc. for slander of title seeking relieffor its alleged bad faith effort to interfere with the Company's ownership ofcopyrights related to the Company’s UNIX source code and derivative works and theCompany's UnixWare product.  The case 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 the Companybelieves Novell has wrongfully registered, prevent Novell from representing anyownership interest in those copyrights and require Novell to retract orwithdraw all representations it has made regarding its purported ownership of thosecopyrights and UNIX itself.

 

*Novellhas filed two motions to dismiss claiming, among other things, that Novell’sfalse statements were not uttered with malice and are privileged under thelaw.  The Court denied both of Novell’smotions to dismiss.  On July 29,2005, Novell filed its Answer and Counterclaims against the Company, assertingcounterclaims for the Company’s alleged breaches of the Asset PurchaseAgreement*

 

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*between Novell and our predecessor-in-interest,The Santa Cruz Operation, Inc., for slander of title, restitution/unjustenrichment, and accounting, and for declaratory relief regarding Novell’salleged rights under the Asset Purchase Agreement.  On December 6, 2005, a scheduling orderwas entered by the Court setting a schedule of discovery and motionsleading up to a trial in June 2007. On or about December 30, 2005, the Company filed a motion for leaveto amend its complaint to assert additional claims against Novell includingcopyright infringement, unfair competition and a breach of Novell’s limitedlicense to use the Company’s UNIX code.  Novellhas consented to the Company's filing of these additional claims.  Discovery is commencing in the case.*

* *

*DaimlerChryslerCorporation*

* *

On or about March 3, 2004, the Company broughtsuit against DaimlerChrysler Corporation for its alleged violations of its UNIXlicense agreement with the Company.  Thelawsuit alleges that DaimlerChrysler breached its UNIX software agreement byfailing to provide an adequate or timely certification of its compliance withthat agreement as the Company requested. The lawsuit, filed in Oakland CountyCircuit Court in the State of Michigan, requests the court to declare thatDaimlerChrysler 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 UNIX softwareagreement and award the Company 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.

 

In response to DaimlerChrysler’s motion to dismiss,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 and basedon a stipulation of the parties, the Court signed an order of dismissal withoutprejudice.  The Appellate Court hasdismissed our appeal of the July 21, 2004 ruling finding that the orderwas not a final, appealable order.

 

*AutoZone, Inc.*

 

On or about March 2, 2004, the Company broughtsuit against AutoZone, Inc. for its alleged violations of the Company’sUNIX copyrights through its use of Linux.  The lawsuit alleges copyright infringement byAutoZone by, among other things, running versions of the Linux operating 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 requestsdamages as a result of AutoZone’s infringement in an amount to be proven attrial.  In response to AutoZone’s motionto transfer the case to Tennessee or stay the case, the Federal Court in Nevadagranted AutoZone’s motion to stay the case, with 90-day status reports to the Court,and denied without prejudice AutoZone’s motion to transfer the case toTennessee.  The Court allowed the partiesto take limited expedited discovery relating to the issue of preliminaryinjunctive relief which discovery was concluded in May 2005.

 

The Company has concluded the initial discoveryallowed by the Court and filed its report with the Court on May 27,2005.  Contrary to AutoZone’s ownstatements to the Court, the Company found through discovery, includingdepositions and other admissions of AutoZone, many instances of copying ofprograms containing the Company’s OpenServer code.  AutoZone has represented that it has nowremoved all of the Company’s code and proprietary information it copied or usedin its migration to Red Hat Linux.  BecauseAutoZone represents it has removed or otherwise is not using the Company’s codeand proprietary information, the Company currently does not intend to move fora preliminary injunction.  AutoZone doesnot admit that it violated the Company’s rights or caused us damage in that

 

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migrationprocess, which are still points of dispute between the parties.  Given the stay issued by the Court in thecase, the Company reserves the right to pursue infringement and damages in thefuture based on these issues and other issues stayed by the Court.

 

*IPO Class Action Matter*

 

The Company is an issuer defendant in a series ofclass action lawsuits involving over 300 issuers that have been consolidatedunder In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS).  The consolidated complaint alleges, amongother things, certain improprieties regarding the underwriters’ conduct during theCompany’s initial public offering and the failure to disclose such conduct inthe registration statement in violation of the Securities Act of 1933, asamended.

 

The plaintiffs, the issuers and the insurancecompanies have negotiated an agreement to settle the dispute between theplaintiffs and the issuers.  All parties,including the plaintiffs, issuers and insurance companies, have executed thissettlement agreement and the settlement agreement has been submitted to the Courtfor approval.  If the settlementagreement is approved by the Court, and if no cross-claims, counterclaims orthird-party claims are later asserted, this action will be dismissed withrespect to the Company and our directors.

 

The Company has notified its underwriters andinsurance companies of the existence of the claims.  Management believes, after consultation withlegal counsel, that the ultimate outcome of this matter will not have amaterial adverse effect on the Company’s results of operations or financialposition and will not exceed the $200,000 self-insured retention already paidor accrued by the Company.

 

*Red Hat, Inc.*

 

On August 4, 2003, Red Hat, Inc. filed acomplaint against the Company.  Theaction is pending in the United States District Court for the District ofDelaware under the case caption Red Hat, Inc. v. The SCO Group, Inc.,Civil No. 03-772.  Red Hat assertsthat the Linux operating system does not infringe on the Company’s UNIXintellectual property rights and seeks a declaratory judgment fornon-infringement of copyrights and no misappropriation of trade secrets.  In addition, Red Hat claims the Company hasengaged in false advertising in violation of the Lanham Act, deceptive tradepractices, unfair competition, tortious interference with prospective businessopportunities, trade libel and disparagement.  On April 6, 2004, the Court denied theCompany’s motion to dismiss this case; however, the Court stayed the case andrequested status reports every 90 days regarding the case against IBM.  Red Hat filed a motion for reconsideration,which the Court denied on March 31, 2005.  The Company intends to vigorously defend thisaction.  In the event the stay is liftedand Red Hat is allowed to pursue its claims, the Company will likely assertcounterclaims against Red Hat.

 

*Other Matters*

 

In April 2003, the Company’s former Indiandistributor filed a claim in India, requesting summary judgment for payment of$1,428,000, and an order that the Company trade in India only through thedistributor and/or give a security deposit until the claim is paid.  The distributor claims that the Company isresponsible to repurchase certain software products and to reimburse thedistributor for certain other operating costs. Management does not believe that the Company is responsible to reimbursethe distributor for any operating costs and also believes that the returnrights related to any remaining inventory have lapsed.  The distributor additionally requested thatthe Indian courts grant interim relief in the form of attachment of localassets.  These requests for interimrelief have failed in the court, and discovery has commenced and hearings onthe main claims have been held and are ongoing. The Company intends to vigorously defend this action.

 

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Pursuit and defense of the above-mentioned matters will be costly, andmanagement expects the costs for legal fees and related expenses will besubstantial.

 

The ultimate outcome or potential negative effect on the Company’sresults of operations or financial position of the Red Hat, Inc., IPO Class Action,or Indian Distributor matters is neither probable nor estimable.

 

The Company is a party to certain other legal proceedings arising inthe ordinary course of business. Management believes, after consultation with legal counsel, that theultimate outcome of these legal proceedings will not have a material adverseeffect on the Company’s results of operations or financial position.

 

**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 through theyear ending October 31, 2008.  Future minimum lease payments undernon-cancelable operating leases as of October 31, 2005 were as follows (inthousands):

 
| ** **                   | ** ** | **Operating** | ** ** |
|------------------------------|------------|---------------|------------|
| ** **                   | ** ** | **Leases**    | ** ** |
| Year ending October 31, |       |          |       |
| 2006                         |       | $             | 1,797      |   |
| 2007                         |       | 1,665         |       |
| 2008                         |       | 312           |       |
| 2009                         |       | —        |       |
| 2010                         |       | —        |       |
| Total minimum payments       |       | $             | 3,774      |   |

 

Total rent expense forall of the Company’s operating leases was $1,698,000, $3,097,000 and $3,170,000for the years ended October 31, 2005, 2004 and 2003, respectively.

 

**Arrangement with 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 attorney fees in connection with theSCO Litigation through the end of the current litigation between the Companyand IBM and the escrow of at least $5,000,000 for the payment of any expert,consulting and other expenses.  As of December 1,2005, the Company had paid all of the $26,000,000.  As of October 31, 2005, $2,875,000remained in the escrow account and is classified as a component of restrictedcash.

 

Inaddition, the Company must also pay one or more contingency fees upon anyamount the Company or its stockholders may receive as a result of a settlement,judgment or a sale of the Company.  Thecontingency fee amounts payable to the Law Firms will be, subject to certaincredits and adjustments, as follows:

 

 

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•                  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, 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.

 

**Grants of Unregistered StockOptions; Potential Interest and Penalties Related to Rescission**

 

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 mayrequire the Company to pay fines or impose other sanctions.

 

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.  Because the options in question have not beenexercised, no amounts are recorded in permanent equity.

 

The Company currentlydoes not intend to make a rescission offer to participants who are holding suchoptions.  Since any loss is consideredreasonably possible but not estimable, the Company has not recorded a liabilityfor this contingency.

 

The Company may also berequired to pay interest and penalties up to statutory limits in connectionwith Plan participants making rescission claims.  The Company believes that it is reasonablypossible that it may be required to pay interest and penalties, but it is notable to estimate an amount.

 

**(11) RESTRUCTURINGS**

 

Since the year ended October 31,2001, the Company has undertaken significant restructuring activities to reduceits ongoing cost of operations.  Allrestructurings that occurred prior to the year ended October 31, 2003 wereaccounted for in accordance with Emerging Issues Task Force (“EITF”) No. 94-3,“Liability Recognition for Certain Employee Termination Benefits and OtherCosts to Exit an Activity.”  Forrestructuring activities initiated beginning with the year ended October 31,2003, the Company has accounted for one-time termination benefits, contract terminationcosts and other associated costs in accordance with SFAS No. 146, “Accountingfor Costs Associated with Exit or Disposal Activities.”  Other severance benefits under ongoingseverance plans have 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.”

 

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 andclosing certain international offices. The total cost associated with this activity was $2,486,000.

 

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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):

 
| **Year Ended  October 31, 2005** | ** ** | **Balance at  November 1, 2004** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance at  October 31, 2005** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|---------------------------------------|------------|
|                                  |       |                                  |       |          |       |            |       |            |       |                                  |       |
| Ongoing  severance and other          |       | $                                     | 401        |          | $          | —          |       | $               | —     |                                  | $          | (401 | ) | $ | — |   |
|                                       |            |                                       |            |               |            |                 |            |                 |            |                                       |            |  |  |  |  |  |

 
| **Year Ended  October 31, 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 |   |

 
| **Year Ended  October 31, 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 and the adjustment for the$273,000 for ongoing severance was for the true-up of previously recordedaccruals.

 

**(12) RELATED PARTY TRANSACTIONS**

 

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, and at that timewe were no longer a related party to Canopy.

 

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,

 

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C7 issued, and Vintelaassumed, a $500,000 non-recourse promissory note payable to the Company,secured by the Assigned Software.  Thisnote was originally due on April 30, 2005 with interest payable at a rateof one percent above the prime rate as reported in the Wall Street Journal.

 

In late November 2004,the Company entered into discussions with Vintela with respect to thecancellation of the Marketing Agreement and repayment of the Note.  It was later agreed that once Vintela hadreceived funding from an outside third party, the Company would forego anyinterest charges on the promissory note in return for an immediate payment ofthe $500,000.  On December 9, 2004,the Company received the $500,000 payment from Vintela and forgave theoutstanding interest charges associated with the promissory note.

 

At the time thepromissory note was executed, the Company had no recorded basis in the AssignedSoftware.  Because the transfer of theAssigned Software was to a related party in exchange for a promissory note andthere was substantial doubt concerning the ability of C7 to repay the debt asthey were not profitable and being funded by Canopy, no gain was recognized bythe Company until payment was received on December 9, 2004.  The Company recorded the $500,000 received asa component of other income in its statement of operations and comprehensiveloss for the year ended October 31, 2005.

 

Kevin McBride is alicensed attorney working on the SCO Litigation as part of the EngagementAgreement and is also the brother of the Company’s Chief Executive Officer,Darl McBride.  During the year ended October 31,2005, Kevin McBride’s legal fees were paid by Boies, Schiller &Flexner.  Prior to October 31, 2004,Kevin McBride’s costs for both legal fees and reimbursable expenses were paidby Boies, Schiller & Flexner in connection with the initial engagementagreement.

 

As part of theEngagement Agreement entered into on October 31, 2004, the Company startedpaying directly to Kevin McBride reimbursable expenses associated with the SCOLitigation, which primarily included document management, outsourced technical andlitigation assistance, and travel expenses. During the year ended October 31, 2005, the Company incurred costsof approximately $323,000 for the above-mentioned expenses for Kevin McBride.

 

**(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 the plan.  During the years ended October 31, 2005,2004 and 2003, the Company contributed $208,000, $217,000 and $206,000,respectively, to the plan for matching contributions.

 

**(14) CONCENTRATION OF RISK**

 

Asof October 31, 2005 and 2004, the Company had no customers who made upmore than 10% of the ending accounts receivable balance.

 

Duringthe years ended October 31, 2005 and 2004, the Company did not have anysingle customers that accounted for more than 10% of total revenue.

 

Duringthe year ended October 31, 2003, two significant customers, Microsoft andSun, accounted for approximately 21% and 12% of the Company’s revenue.

 

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**(15) SEGMENT INFORMATION ANDGEOGRAPHIC 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.  Segment disclosures for the Company are asfollows (in thousands):

 
| ** **                     | ** ** | **Year Ended October 31,  2005** | ** ** |
|--------------------------------|------------|---------------------------------------|------------|
| ** **                     | ** ** | **UNIX**                              | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                           |       |                                  |       |   |   |   |   |   |   |   |
| Revenue                        |       | $                                     | 35,838     |   | $ | 166 |   | $ | 36,004 |   |
| Cost of revenue                |       | 5,466                                 |       | 12,847 |   | 18,313 |   |
| Gross margin  (deficit)        |       | 30,372                                |       | (12,681 | ) | 17,691 |   |
| Sales and marketing            |       | 11,666                                |       | 154 |   | 11,820 |   |
| Research and development       |       | 7,940                                 |       | 389 |   | 8,329 |   |
| General and administrative     |       | 6,604                                 |       | 443 |   | 7,047 |   |
| Other                          |       | 2,394                                 |       | — |   | 2,394 |   |
| Total  operating expenses      |       | 28,604                                |       | 986 |   | 29,590 |   |
|                           |       |                                  |       |   |   |   |   |
| Income  (loss) from operations |       | $                                     | 1,768      |   | $ | (13,667 | ) | $ | (11,899 | ) |

 
| ** **                 | ** ** | **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 | ) |

 
| ** **                     | ** ** | **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 |   |

 

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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, 2005 and 2004 (in thousands):

 
| ** **                              | ** ** | **October 31,  2005** | ** ** | **October 31,  2004** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Intangible assets and goodwill:         |       |                       |       |                       |       |
| UNIX  (reseller channel and trade name) |       | $                          | 2,370      |                       | $          | 4,740 |   |
| SCOsource  (UNIX technology)            |       | 337                        |       | 673                        |       |
| Total  intangible assets                |       | $                          | 2,707      |                       | $          | 5,413 |   |

 

**Geographic Regions**

 

The Company’s twogeographic regions consist of the Americas and International.  The International division consists of EMEA(Europe, the Middle East and Africa) and Asia.  Any financial amounts not directlyattributable to either the Americas or International geographic region areincluded in the corporate column.  Thefollowing tables present the Company’s results of operations by geographicregion (in thousands):

 
| ** **                 | ** ** | **Year Ended October 31,  2005** | ** ** |
|----------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **Americas**                          | ** ** | **International** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                       |       |                                  |       |   |   |   |   |   |   |
| Revenue                    |       | $                                     | 18,634     |   | $ | 17,370 |   | $ | — |   | $ | 36,004 |   |
| Cost of revenue            |       | 15,955                                |       | 2,358 |   | — |   | 18,313 |   |
| Gross margin               |       | 2,679                                 |       | 15,012 |   | — |   | 17,691 |   |
| Sales and marketing        |       | 4,505                                 |       | 7,315 |   | — |   | 11,820 |   |
| Research and development   |       | 4,331                                 |       | 3,998 |   | — |   | 8,329 |   |
| General and administrative |       | 3,664                                 |       | 3,383 |   | — |   | 7,047 |   |
| Other                      |       | —                                |       | — |   | 2,394 |   | 2,394 |   |
| Total  operating expenses  |       | 12,500                                |       | 14,696 |   | 2,394 |   | 29,590 |   |
|                       |       |                                  |       |   |   |   |   |   |   |
| Loss from  operations      |       | $                                     | (9,821     | ) | $ | 316 |   | $ | (2,394 | ) | $ | (11,899 | ) |

 
| ** **                 | ** ** | **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 | ) |

 

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| ** **                     | ** ** | **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 |   |

 

Long-lived assets, whichinclude property and equipment and intangible assets, by geographic regionconsist of the following as of October 31, 2005 and October 31, 2004(in thousands):

 
| ** **               | ** ** | **October 31,  2005** | ** ** | **October 31,  2004** | ** ** |
|--------------------------|------------|----------------------------|------------|----------------------------|------------|
| Long-lived assets:       |       |                       |       |                       |       |
| Americas                 |       | $                          | 3,231      |                       | $          | 5,953 |   |
| International            |       | 54                         |       | 109                        |       |
| Total  long-lived assets |       | $                          | 3,285      |                       | $          | 6,062 |   |

 

**(16) SUBSEQUENT EVENTS**

 

**Equity Financing**

 

On November 29,2005, the Company entered into a Common Stock Purchase Agreement (“PurchaseAgreement”) with several institutional investors and one member of the Company’sboard of directors.  The Company sold tothe investors 2,852,000 shares of the Company’s common stock for gross proceedsof approximately $10,005,000.  The coststo date to facilitate the private placement of the common stock are approximately$100,000.  The shares issued to theinstitutional investors were at $3.50 per share and the shares issued to theboard member were at $3.92 per share. Pursuant to the Purchase Agreement, the Company agreed to use its bestefforts to file a registration statement with the Securities and ExchangeCommission

 

**Completion of Rescission Offer**

 

In December 2005, theCompany offered to rescind a total of 337,289 shares of common stock issuedunder its ESPP to current and former employees while they resided in any ofCalifornia, Connecticut, Illinois, New Jersey, Utah, Texas or Washington.  These shares represented all of the ESPPshares the Company issued to residents of these states for which a purchasercould claim a rescission right.  Therescission offer was intended to address the Company’s rescission liabilityrelating to its federal and state securities laws compliance issues by allowingthe holders of the shares covered by the rescission offer to rescind theunderlying securities transactions and sell those securities back to theCompany or recover damages, as the case may be.

 

Therescission offer concluded on January 20, 2006.  As of that date, 14 offerees had accepted theCompany’s offer to rescind the purchase of approximately 7,300 shares.  The Company plans to make aggregate paymentsto such offerees of approximately $41,500, which includes approximately $9,700in applicable statutory interest and damages. As a result of the rescission offer, the Company believes it has

 

80

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extinguishedits state rescission liability and mitigated its federal rescission liabilityto anyone to whom the rescission offer was made for noncompliance with theregistration or qualification requirements of federal and state securities lawsas they relate to the shares issued under the ESPP.

 

81

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**THE SCO GROUP, INC.**

**AND SUBSIDIARIES**

 

**SCHEDULE II – VALUATION AND QUALIFYING ACCOUNTS**

 

**(in thousands)**

 
| **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,  2005    |       | $                                    | 136        |                                | $          | 18             |       | $                             | (10          | )(a) | $ | 144 |   |
| Year ended October 31,  2004    |       | 230                                  |       | 11                                  |       | (105           | )(a)       | 136                           |         |
| Year ended October 31,  2003    |       | 348                                  |       | 296                                 |       | (414           | )(a)       | 230                           |         |
| **Inventory reserves:**              |       |                                 |       |                                |       |           |       |                          |         |
| Year ended October 31,  2005    |       | 56                                   |       | 39                                  |       | (24            | )(b)       | 71                            |         |
| Year ended October 31,  2004    |       | 19                                   |       | 59                                  |       | (22            | )(b)       | 56                            |         |
| Year ended October 31,  2003    |       | 115                                  |       | —                              |       | (96            | )(b)       | 19                            |         |
| **Allowance for sales returns:**     |       |                                 |       |                                |       |           |       |                          |         |
| Year ended October 31,  2005    |       | 258                                  |       | 967                                 |       | (638           | )(c)       | 587                           |         |
| Year ended October 31,  2004    |       | 819                                  |       | 489                                 |       | (1,050         | )(c)       | 258                           |         |
| Year ended October 31,  2003    |       | 1,055                                |       | 1,958                               |       | (2,194         | )(c)       | 819                           |         |
|                                      |            |                                      |            |                                     |            |                |            |                               |              |  |  |  |  |

 

----

(a)          Representswrite-offs of uncollectible accounts receivable

 

(b)         Representsinventory destroyed or scrapped

 

(c)          Representsproduct returns

 

82

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

 

None.

 

**Item 9A.  Controls andProcedures**

 

*Evaluation of disclosure controlsand procedures.*  Under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, we evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934 (the “Exchange Act”)).  Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that, as of the end ofthe period covered by this report, our disclosure controls and procedures wereeffective.

 

*Changes in internal control overfinancial reporting.*  During the most recent fiscal quarter coveredby this report, there has been no change in our internal control over financialreporting (as defined in Rule 13a-15(f) under the Exchange Act) thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

**Item9B.  Other Information**

 

None.

 

**PART III**

 

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

 

Information with respectto this item is set forth under “Executive Officers and Directors” appearing inthe definitive proxy statement to be delivered to stockholders in connectionwith the 2006 Annual Meeting of Stockholders (the “Proxy Statement”).  Such information is incorporated herein byreference.

 

We have adopted a code ofethics that applies to all employees, including employees of our subsidiaries,as well as each member of our Board of Directors.  The code of ethics is available at ourwebsite at www.sco.com.

 

We intend to satisfy anydisclosure requirement under Item 5.05 of Form 8-K regarding an amendmentto, or waiver from, a provision of this code of ethics by posting suchinformation on our website, at the address specified above.

 

**Item11.  Executive Compensation**

 

Information with respect to this item is setforth under “Historical Compensation of the Company” in the ProxyStatement.  Such information isincorporated herein by reference.

 

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

 

Information with respectto this item is set forth under “Security Ownership of Certain BeneficialOwners and Management” in the Proxy Statement. Such information is incorporated herein by reference.

 

Information regardingour equity compensation plans, including both stockholder approved plans andnon-stockholder approved plans, is set forth in the section entitled “EquityCompensation Plan Information’ in the Proxy Statement, which information isincorporated herein by reference.

 

83

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**Item 13. Certain Relationships and Related Transactions**

 

Information with respect to this item is setforth under “Certain Relationships and Related Transactions” in the ProxyStatement.  Such information isincorporated herein by reference.

 

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

 

Informationwith respect to this item is set forth under “Principal Accountant Fees andServices” in the Proxy Statement.  Suchinformation is incorporated herein by reference.

 

**PART IV.**

 

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

 

(a)                                  The following documents are filed as partof this report:

 

(1)                                  Consolidated Financial Statements:  See Index to Consolidated FinancialStatements at Item 8 on page 45 of this report.

 

(2)                                  Financial Statement Schedule:  See Index to Consolidated FinancialStatements at Item 8 on page 45 of this report.

 

(3)                                  Exhibits are incorporated herein byreference or are 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                                                                                                                                                                                                                                                                                                                             |

 

84

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|   |   | 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. (incorporated by reference to Exhibit 10.2 to  the Registrant’s Annual Report on Form 10-K for the fiscal year ended October 31,  2004 (File No. 000-29911).                                                                                                       |
| 10.3*  |   | Form Notice of  Grant of Stock Options for 1998 Stock Option Plan. (incorporated by reference  to Exhibit 10.3 to the Registrant’s Annual Report on Form 10-K for  the fiscal year ended October 31, 2004 (File No. 000-29911).                                                                                |
| 10.4*  |   | 1999 Omnibus Stock  Incentive Plan, as amended (incorporated by reference 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. (incorporated by reference to Exhibit 10.5  to the Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2004 (File No. 000-29911).                                                                                            |
| 10.6*  |   | Amendment No. 6  to 1999 Omnibus Stock Incentive Plan. (incorporated by reference to Exhibit 10.6  to the Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2004 (File No. 000-29911).                                                                                            |
| 10.7*  |   | Form Notice of  Grant of Stock Options for 1999 Omnibus Stock Incentive Plan. (incorporated  by reference to Exhibit 10.7 to the Registrant’s Annual Report on Form 10-K  for the fiscal year ended October 31, 2004 (File No. 000-29911).                                                                     |
| 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. (incorporated by reference to Exhibit 10.9  to the Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2004 (File No. 000-29911).                                                                                            |
| 10.10* |   | Amendment No. 3  to 2000 Employee Stock Purchase Plan. (incorporated by reference to Exhibit 10.10  to the Registrant’s Annual Report on Form 10-K for the fiscal year ended  October 31, 2004 (File No. 000-29911).                                                                                           |
| 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* |   | Amendment No. 5  to 2000 Employee Stock Purchase Plan                                                                                                                                                                                                                                                                                   |
| 10.13* |   | 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)).                                                                                                                 |
| 10.14* |   | Form Notice of  Grant of Stock Options for 2002 Omnibus Stock Incentive Plan. (incorporated  by reference to Exhibit 99.3 to the Registrant’s Current Report on Form 8-K  filed on January 27, 2006 (File No. 000-29911).                                                                                      |
| 10.15  |   | 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)). |

 

85

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| 10.16  |   | 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)).        |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.17  |   | 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)).                       |
| 10.18  |   | 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)).  |
| 10.19  |   | 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)).  |
| 10.20  |   | 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)). |
| 10.21  |   | 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)).        |
| 10.22  |   | 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 for the fiscal year ended October 31,  2003 (File No. 000-29911)).         |
| 10.23  |   | 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)).      |
| 10.24  |   | 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)).                         |
| 10.25  |   | 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)).         |
| 10.26* |   | 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)).                                                                 |
| 10.27  |   | 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)).                              |

 

86

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| 10.28  |   | 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)).                                          |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.29  |   | 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)). |
| 10.30  |   | 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)).                                                                                |
| 10.31  |   | 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)).                                                                        |
| 10.32  |   | 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)).                                                                                       |
| 10.33  |   | 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)).                                           |
| 10.34* |   | 2004 Omnibus Stock  Incentive Plan. (incorporated by reference to Exhibit 10.34 to the  Registrant’s Annual Report on Form 10-K for the fiscal year ended October 31,  2004 (File No. 000-29911).                                                                                                                           |
| 10.35* |   | Form Notice of  Grant of Stock Options for 2004 Omnibus Stock Incentive Plan. (incorporated  by reference to Exhibit 99.1 to SCO’s Current Report on Form 8-K  filed on July 15, 2005 (File No. 000-29911)).                                                                                                           |
| 10.36* |   | Form of Executive  Officer Stock Option Agreement (incorporated by reference to Exhibit 10.3  to the Registrant’s Quarterly Report on Form 10-Q for the fiscal quarter  ended January 31, 2005 (File No. 000-29911)).                                                                                                  |
| 10.37* |   | The SCO Group Employee  Incentive Bonus Program for Fiscal Year 2006 (incorporated by reference to Exhibit 99.2  to the Registrant’s Current Report on Form 8-K filed on January 27,  2006 (File No. 000-29911)).                                                                                                           |
| 10.38* |   | Form of Change in  Control Agreement (incorporated by reference to Exhibit 99.1 to the  Registrant’s Current Report on Form 8-K filed on December 16, 2004  (File No. 000-29911)).                                                                                                                                     |
| 10.39* |   | Form of  Indemnification Agreement for directors and officers (incorporated by  reference to Exhibit 10.36 to Post-Effective Amendment No. 1 to Form S-3  on Form S-1 filed on May 18, 2005 (File No. 333-116732)).                                                                                               |
| 10.40  |   | Common Stock Purchase  Agreement dated as of November 29, 2005 among the Registrant and the  persons listed therein as Purchasers (incorporated by reference to Exhibit 10.43  to Form S-1 filed on December 22, 2005 (File No. 333-130609)).                                                                               |
| 10.41* |   | America Sales  Compensation Plan for Fiscal Year 2006 (incorporated by reference to Exhibit 99.1  to the Registrant’s Current Report on Form 8-K filed on January 27,  2006 (File No. 000-29911)).                                                                                                                          |
| 10.42* |   | Summary Sheet of  Compensation of Named Executive Officers.                                                                                                                                                                                                                                                                                          |
| 10.43* |   | Summary Sheet of  Compensation of Directors (incorporated by reference to Exhibit 99.2 to the  Registrant's Current Report on Form 8-K filed on July 5, 2005 (File No.  000-29911)).                                                                                                                                                                 |

 

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| 21.1 |   | Subsidiaries of the  Registrant.                                                                                                                                                                                               |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 23.1 |   | Consent of Tanner LC,  Independent Registered Public Accounting Firm.                                                                                                                                                          |
| 23.2 |   | 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.                 |

 

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* These items identify a management contract or compensatory plan.

 

88

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**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 January 27, 2006.

 
|   | 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 |     | January 27, 2006 |
|   Darl C. McBride                       |       | Officer and Director |                       |     |
|                                              |       |                 |                       |     |
| **Principal  Financial and  Accounting Officer:** |       |                 |                       |     |
|                                              |       |                 |                       |     |
|   /s/ Bert B. Young                     |       |                 | Chief Financial Officer    |     | January 27, 2006 |
|   Bert B. Young                         |       |                 |                       |     |
|                                              |       |                 |                       |     |
| **Directors:**                                    |       |                 |                       |     |
|                                              |       |                 |                       |     |
|   /s/ Ralph J. Yarro III                |       |                 | Chairman of the Board      |     | January 27, 2006 |
|   Ralph J. Yarro III                    |       |                 |                       |     |
|                                              |       |                 |                       |     |
|   /s/ Darcy G. Mott                     |       |                 | Director                   |     | January 27, 2006 |
|   Darcy G. Mott                         |       |                 |                       |     |
|                                              |       |                 |                       |     |
|   /s/ Edward E. Iacobucci               |       |                 | Director                   |     | January 27, 2006 |
|   Edward E. Iacobucci                   |       |                 |                       |     |
|                                              |       |                 |                       |     |
|   /s/ R. Duff Thompson                  |       |                 | Director                   |     | January 27, 2006 |
|   R. Duff Thompson                      |       |                 |                       |     |
|                                              |       |                 |                       |     |
|   /s/ J. Kent Millington                |       |                 | Director                   |     | January 27, 2006 |
|   J. Kent Millington                    |       |                 |                       |     |
|                                              |       |                 |                       |     |
|   /s/ Daniel W. Campbell                |       |                 | Director                   |     | January 27, 2006 |
|   Daniel W. Campbell                    |       |                 |                       |     |
|                                              |       |                 |                       |     |
|   /s/ Omar T. Leeman                    |       |                 | Director                   |     | January 27, 2006 |
|   Omar T. Leeman                        |       |                 |                       |     |

 

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