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**SECURITIES AND EXCHANGECOMMISSION****Washington,D.C.  20549**

**FORM 10-QSB**

 
| ý | **Quarterly Report  Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934** |
|--------|----------------------------------------------------------------------------------------------|

**For Period Ended__________________________June 30, 2001**
| o | **Transition Report  Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934** |
|---|------------------------------------------------------------------------------------------------|

**For the transition period from_____________________to**

**Commission File Number 00-23527**

**eSoft, Inc.**(Exact name of smallbusiness issuer as specified in its charter)

| **DELAWARE**                                                    |   | **84-0938960**            |
|-----------------------------------------------------------------|--------|---------------------------|
|                                                                 |   |                           |
| (State or other  jurisdiction of incorporation or organization) |   | (IRS Employer ID  Number) |
| **295 Interlocken Boulevard,  #500 Broomfield, CO 80021**       |
|                                                                 |
| (Address of Principal  Executive Offices)                       |

****
| **(303)  444-1600**(Issuer’s Telephone  Number, Including Area Code) |
|---------------------------------------------------------------------------|

(Formername, former address and former fiscal year, if changed since last report)

----

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

Transitional Small Business Disclosureformat (check one):
| YES o |   | NO  ý |
|-------|--------|------------|

The number of shares outstanding of theRegistrant's $0.01 par value common stock on July 31, 2001 was 15,748,397.

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**eSoft, Inc. and SubsidiariesTABLE OF CONTENTS**

** **

| PART I  | FINANCIAL  INFORMATION |                                                                                        |   |   |
|---------|------------------------|---------------------------------------------------------------------------------------------|--------|--------|
|    | Item  1.               | Condensed  Consolidated Financial Statements (Unaudited)                                    |   |
|    |                   |                                                                                        |   |
|    | Item  2                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |   |
|    |                   |                                                                                        |   |   |
| PART II | OTHER INFORMATION      |                                                                                        |   |   |
|    |                   |                                                                                        |   |   |
|         |                        |                                                                                             |        |        |  |  |  |  |

 

** **

**eSoft, Inc. and SubsidiariesCONSOLIDATED BALANCE SHEET(Unaudited)**

**PART I. FINANCIAL INFORMATION**

**Item 1. Condensed ConsolidatedFinancial Statements.**
| **Assets**                      |                                                                                   | June  30, 2001 |
|---------------------------------|----------------------------------------------------------------------------------------|----------------|
|                            |                                                                                   |                |   |
|                            |                                                                                   |           |   |
| **Current:**                    |                                                                                   |           |   |
|                            | Cash and cash  equivalents                                                             |           | $ | 9,520,694 |   |
|                            | Available-for-sale  securities                                                         |           | 6,264,070 |   |
|                            | Accounts receivable  trade, net of allowance of $510,396                               |           | 1,923,842 |   |
|                            | Inventories, net of  allowance of $72,560                                              |           | 630,860 |   |
|                            | Prepaid expenses and  other                                                            |           | 328,352 |   |
|                            |                                                                                   |           |  |   |
| Total current assets            |                                                                                   | 18,667,818     |   |
|                            |                                                                                   |                |   |
|                            |                                                                                   |           |   |
| **Property and equipment:**     |                                                                                   |           |   |
|                            | Computer equipment                                                                     |           | 1,632,737 |   |
|                            | Furniture and  equipment                                                               |           | 281,046 |   |
|                            | Leasehold improvements                                                                 |           | 45,358 |   |
|                            | Automobiles                                                                            |           | 70,185 |   |
|                            |                                                                                   |           |  |   |
|                            |                                                                                   | 2,029,326      |   |
| Less: accumulated  depreciation |                                                                                   | (930,147       | ) |
|                            |                                                                                   |                |   |
|                            |                                                                                   |           |   |
| Net property and  equipment     |                                                                                   | 1,099,179      |   |
|                            |                                                                                   |                |   |
|                            |                                                                                   |           |   |
| **Other assets:**               |                                                                                   |           |   |
|                            | Capitalized software  development costs, net of accumulated amortization of $1,071,516 |           | 112,659 |   |
|                            | Deferred financing  costs, net of accumulated amortization of $205,080                 |           | 109,840 |   |
|                            | Other                                                                                  |           | 74,845 |   |
|                            |                                                                                   |                |   |
|                            |                                                                                   |           |   |
| Total other assets              |                                                                                   | 297,344        |   |
|                            |                                                                                   |           |  |   |
|                            |                                                                                   |           |   |
|                            |                                                                                   | $              | 20,064,341 |   |
|                            |                                                                                   |                |   |

*The accompanying notes toconsolidated financial statements are an integral part of these statements.*

 

**eSoft, Inc. and SubsidiariesCONSOLIDATED BALANCE SHEET(Unaudited)**

** **

|                                            | June  30, 2001                                                                                          |        |
|-------------------------------------------------|---------------------------------------------------------------------------------------------------------|-------------|
|                                            |                                                                                                         |        |
| **Liabilities & Stockholders’ Equity** |                                                                                                    |        |
|                                            |                                                                                                    |        |
| **Current liabilities:**                        |                                                                                                    |        |
|                                            | Accounts payable                                                                                        | $           | 1,250,327 |   |
|                                            | Accrued expenses:                                                                                       |        |   |
|                                            | Payroll and related  expenses                                                                           | 284,167     |   |
|                                            | Other                                                                                                   | 698,522     |   |
|                                            | Deferred revenue                                                                                        | 1,066,963   |   |
|                                            | Convertible debentures                                                                                  | 1,687,546   |   |
|                                            |                                                                                                    |             |   |
| Total current  liabilities                      | 4,987,525                                                                                               |        |
|                                            |                                                                                                    |        |
| **Long-term liabilities:**                      |                                                                                                    |        |
|                                            | Convertible debentures                                                                                  | 11,521,859  |   |
|                                            |                                                                                                    |             |   |
|                                            |                                                                                                    |        |
| Total liabilities                               | 16,509,384                                                                                              |        |
|                                            |                                                                                                         |        |
|                                            |                                                                                                    |        |
| **Commitments & contingencies**             |                                                                                                    |        |
|                                            |                                                                                                    |        |
| **Stockholders’ equity:**                  |                                                                                                    |        |
|                                            | Preferred stock, $.01  par value, 5,000,000 shares authorized                                           | -           |   |
|                                            | Common stock, $.01 par  value, 100,000,000 shares authorized,  15,689,867 shares issued and outstanding | 156,898     |   |
|                                            | Additional paid-in  capital                                                                             | 41,021,608  |   |
|                                            | Notes receivable from  stockholders                                                                     | (358,860    | ) |
|                                            | Accumulated other  comprehensive loss                                                                   | (35,880     | ) |
|                                            | Accumulated deficit                                                                                     | (37,228,809 | ) |
|                                            |                                                                                                    |             |   |
|                                            |                                                                                                    |        |
| Total stockholders’  equity                | 3,554,957                                                                                               |        |
|                                            |                                                                                                         |        |
|                                            | $                                                                                                       | 20,064,341  |   |
|                                            |                                                                                                         |        |   |
|                                                 |                                                                                                         |             |  |  |  |  |  |

*The accompanying notes toconsolidated financial statements are an integral part of these statements.*

**eSoft, Inc. and SubsidiariesCONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**

 
|                                                                     | For  The Three Months Ended  June 30,             |       | For  The Six Months Ended  June 30, |
|--------------------------------------------------------------------------|---------------------------------------------------|------------|-------------------------------------|
|                                                                     | 2001                                              |       | 2000                                |   |   | 2001 |   | 2000 |   |
|                                                                     |                                                   |       |
| **Revenue:**                                                             |                                              |       |                                |   |   |   |   |   |   |
|                                                                     | Product sales                                     | $          | 1,946,059                           |   | $ | 1,957,569 |   |   | $ | 3,441,673 |   | $ | 3,972,658 |   |
|                                                                     | Product development  and license fees             | 85,000     |                                | 317,000 |   |   | 117,000 |   | 1,236,000 |   |
|                                                                     | Subscriptions,  maintenance and other             | 495,180    |                                | 333,533 |   |   | 980,824 |   | 522,245 |   |
|                                                                     |                                              |            |                                |  |   |   |  |   |  |   |
| Total revenue                                                            | 2,526,239                                         |       | 2,608,102                           |   |   | 4,539,497 |   | 5,730,903 |   |
|                                                                     |                                              |       |                                |   |   |   |   |   |   |
| **Cost of revenue:**                                                     |                                              |       |                                |   |   |   |   |   |   |
|                                                                     | Product sales                                     | 1,520,303  |                                | 1,139,524 |   |   | 2,696,216 |   | 2,211,504 |   |
|                                                                     | Product development  and license fees             | -          |                                | 64,118 |   |   | - |   | 165,502 |   |
|                                                                     | Subscriptions,  maintenance and other             | 216,544    |                                | 160,190 |   |   | 387,690 |   | 269,632 |   |
|                                                                     |                                              |            |                                |  |   |   |  |   |  |   |
| Total cost of revenue                                                    | 1,736,847                                         |       | 1,363,832                           |   |   | 3,083,906 |   | 2,646,638 |   |
|                                                                     |                                                   |       |                                     |   |   |  |   |  |   |
|                                                                     |                                              |       |                                |   |   |   |   |   |   |
| **Gross profit**                                                         | 789,392                                           |       | 1,244,270                           |   |   | 1,455,591 |   | 3,084,265 |   |
|                                                                     |                                                   |       |                                     |   |   |  |   |  |   |
|                                                                     |                                              |       |                                |   |   |   |   |   |   |
| **Expenses:**                                                            |                                              |       |                                |   |   |   |   |   |   |
|                                                                     | Sales and marketing                               | 1,250,654  |                                | 2,130,093 |   |   | 2,467,345 |   | 3,685,100 |   |
|                                                                     | General and  administrative                       | 1,083,119  |                                | 1,192,179 |   |   | 2,200,204 |   | 2,591,298 |   |
|                                                                     | Research and  development                         | 800,722    |                                | 746,905 |   |   | 1,632,560 |   | 1,504,482 |   |
|                                                                     |                                              |            |                                |  |   |   |  |   |  |   |
| Total cost and  expenses                                                 | 3,134,495                                         |       | 4,069,177                           |   |   | 6,300,109 |   | 7,780,880 |   |
|                                                                     |                                                   |       |                                     |   |   |  |   |  |   |
|                                                                     |                                              |       |                                |   |   |   |   |   |   |
| Loss from operations                                                     | (2,345,103                                        | )          | (2,824,907                          | ) |   | (4,844,518 | ) | (4,696,615 | ) |
|                                                                     |                                              |       |                                |   |   |   |   |   |   |
| **Other (income) expense:**                                              |                                              |       |                                |   |   |   |   |   |   |
|                                                                     | Interest income                                   | (189,645   | )                                   | (202,636 | ) |   | (474,289 | ) | (305,643 | ) |
|                                                                     | Interest expense                                  | 430,194    |                                | 135,980 |   |   | 860,388 |   | 272,764 |   |
|                                                                     | Realized loss on sale  of assets                  | 7,871      |                                | - |   |   | 7,871 |   | - |   |
|                                                                     | Unrealized loss on  available-for-sale securities | -          |                                | - |   |   | 1,276,200 |   | - |   |
|                                                                     |                                              |            |                                |  |   |   |  |   |  |   |
| Total other (income)  expense                                            | 248,420                                           |       | (66,656                             | ) |   | 1,670,170 |   | (32,879 | ) |
|                                                                     |                                              |       |                                |   |   |   |   |   |   |
| **Net loss**                                                             | $                                                 | (2,593,523 | )                                   | $ | (2,758,251 | ) |   | $ | (6,514,688 | ) | $ | (4,663,736 | ) |
|                                                                     |                                                   |       |                                     |   |   |  |   |  |   |
|                                                                     |                                              |       |                                |   |   |   |   |   |   |
| Basic and diluted loss  per common share                                 | $                                                 | (0.17      | )                                   | $ | (0.18 | ) |   | $ | (0.42 | ) | $ | (0.31 | ) |
|                                                                     |                                                   |       |                                     |   |   |  |   |  |   |
|                                                                     |                                              |       |                                |   |   |   |   |   |   |
| Weighted-average  number of common shares outstanding, basic and diluted | 15,589,674                                        |       | 15,606,309                          |   |   | 15,578,016 |   | 15,020,743 |   |
|                                                                     |                                                   |       |                                     |   |   |  |   |  |   |

*The accompanying notes toconsolidated financial statements are an integral part of these statements.*

**eSoft, Inc. and SubsidiariesCONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY(Unaudited)**

 

|                            |                                                            |       |   | Additional  Paid-in Capital |    | Subscriptions  Receivable |       | Accumulated  Other Comprehensive Loss |   | Accumulated  Deficit |     | Total  Stockholders’ Equity |    |
|---------------------------------|-----------------------------------------------------------------|------------|--------|-----------------------------|---------|---------------------------|------------|---------------------------------------|--------|----------------------|----------|----------------------------------|---------|
| Common  Stock                   |
| Shares                          |                                                            | Amount     |
|                            |                                                                 |            |        |                             |         |                           |            |                                       |        |                      |          |                                  |         |  |
| **Balances,**December 31, 2000  |                                                            | 15,564,867 |   | $                           | 155,648 |                      | $          | 40,861,263                            |   | $                    | (234,060 | )                                | $       | (1,240,800 | ) | $ | (30,714,121 | ) | $ | 8,827,930 |   |
| ****                            |                                                                 |            |        |                             |         |                           |            |                                       |        |                      |          |                                  |         |  |  |  |  |  |  |  |  |
|                            |                                                            |       |   |                        |    |                      |       |                                  |   |                 |     |                             |    |   |
|                            | Issuance of common stock  upon exercise of warrants and options | 5,000      |   | 50                          |    | 4,950                     |       | -                                     |   | -                    |     | -                                |    | 5,000 |   |
|                            | Issuance of common stock  for cash and notes receivable         | 120,000    |   | 1,200                       |    | 124,800                   |       | (124,800                              | )      | -                    |     | -                                |    | 1,200 |   |
|                            | Stock based compensation                                        | -          |   | -                           |    | 30,595                    |       | -                                     |   | -                    |     | -                                |    | 30,595 |   |
|                            | Permanent impairment of  available- for-sale securities         | -          |   | -                           |    | -                         |       | -                                     |   | 1,240,800            |     | -                                |    | 1,240,800 |   |
|                            | Unrealized loss on  available-for-sale securities               | -          |   | -                           |    | -                         |       | -                                     |   | (35,880              | )        | -                                |    | (35,880 | ) |
|                            | Net loss for the six months  ended June 30, 2001                | -          |   | -                           |    | -                         |       | -                                     |   | -                    |     | (6,514,688                       | )       | (6,514,688 | ) |
|                                 |                                                                 |            |        |                             |         |                           |            |                                       |        |                      |          |                                  |         |  |
| **Balances**June  30, 2001 | 15,689,867                                                      |       | $      | 156,898                     |    | $                         | 41,021,608 |                                  | $      | (358,860             | )        | $                                | (35,880 | ) | $ | (37,228,809 | ) | $ | 3,554,957 |   |
| ****                            |                                                                 |            |        |                             |         |                           |            |                                       |        |                      |          |                                  |         |  |  |  |  |  |  |  |

###### *Theaccompanying notes to consolidated financial statements are an integral part ofthese statements.*

**eSoft, Inc. and SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**

 
|                                                                         | **For the six months ended****June 30,**                                     |
|------------------------------------------------------------------------------|------------------------------------------------------------------------------|
|                                                                         | **2001**                                                                     |   | **2000** |
|                                                                         | ****                                                                         |   | **** |
| **CASH FLOW FROM OPERATING ACTIVITIES**                                      |                                                                         |   |   |   |   |
|                                                                         | Net loss from  operations                                                    | $ | (6,514,688 | ) |   | $ | (4,663,736 | ) |
|                                                                         | Adjustments to  reconcile net loss to net cash used in operating activities: |   |   |   |   |   |
|                                                                         | Depreciation and  software amortization                                      | 357,639 |   |   | 577,365 |   |
|                                                                         | Provision for losses  on accounts receivable                                 | 136,554 |   |   | 186,000 |   |
|                                                                         | Provision for obsolete  inventory                                            | 70,000 |   |   | 150,000 |   |
|                                                                         | Amortization of debt  discounts and financing costs                          | 372,889 |   |   | 221,760 |   |
|                                                                         | Stock-based  compensation                                                    | 30,595 |   |   | 38,488 |   |
|                                                                         | Loss on sale of assets                                                       | 12,340 |   |   | - |   |
|                                                                         | Unrealized loss from  available-for-sale securities                          | 1,276,200 |   |   | - |   |
|                                                                         | Changes in operating  assets and liabilities:                                |   |   |   |   |   |
|                                                                         | Accounts receivable                                                          | (656,224 | ) |   | (978,694 | ) |
|                                                                         | Other accounts  receivable                                                   | - |   |   | (537,000 | ) |
|                                                                         | Inventories                                                                  | (323,135 | ) |   | 187,191 |   |
|                                                                         | Prepaid expenses                                                             | (48,256 | ) |   | (213,937 | ) |
|                                                                         | Other assets                                                                 | 1,651 |   |   | 39,557 |   |
|                                                                         | Accounts payable                                                             | 686,441 |   |   | (87,928 | ) |
|                                                                         | Accrued expenses                                                             | (470,051 | ) |   | 108,448 |   |
|                                                                         | Deferred revenue                                                             | 303,145 |   |   | 378,628 |   |
|                                                                         |                                                                         |  |   |  |
| Net cash used in  operating activities                                       | (4,764,900                                                                   | ) |   | (4,593,858 | ) |
|                                                                         |                                                                              |   |  |
| **CASH FLOW FROM INVESTING  ACTIVITIES**                                     |                                                                         |   |   |   |   |
|                                                                         | Purchase of property  and equipment                                          | (84,100 | ) |   | (301,119 | ) |
|                                                                         | Proceeds from sale of  assets                                                | 31,025 |   |   | - |   |
|                                                                         | Purchase of  investments                                                     | (5,795,650 | ) |   | - |   |
|                                                                         |                                                                         |  |   |  |
| Net cash used in  investing activities                                       | (5,848,725                                                                   | ) |   | (301,119 | ) |
|                                                                         |                                                                              |   |  |
| **CASH FLOW FROM FINANCING  ACTIVITIES**                                     |                                                                         |   |   |   |   |
|                                                                         | Proceeds from  collection of stock subscription receivable                   | - |   |   | 30,717 |   |
|                                                                         | Proceeds from issuance  of common stock                                      | 6,200 |   |   | 13,045,030 |   |
|                                                                         |                                                                         |  |   |  |
| Net cash provided by  financing activities                                   | 6,200                                                                        |   |   | 13,075,747 |   |
|                                                                         |                                                                              |   |  |
|                                                                         |                                                                         |   |   |   |   |
| **(DECREASE) / INCREASE  IN CASH**                                      | (10,607,425                                                                  | ) |   | 8,180,770 |   |
|                                                                         |                                                                         |   |   |   |   |
| **CASH, beginning of period**                                                | 20,128,119                                                                   |   |   | 8,576,055 |   |
|                                                                         |                                                                              |   |  |
|                                                                         |                                                                         |   |   |   |   |
| **CASH, end of period**                                                      | $                                                                            | 9,520,694 |   |   | $ | 16,756,825 |   |
|                                                                         |                                                                              |   |  |
|                                                                         |                                                                         |   |   |   |   |
| **SUPPLEMENTAL DISCLOSURE OF  CASH FLOWS AND NON-CASH FINANCING ACTIVITIES** |                                                                         |   |   |   |   |
| CASH PAID DURING THE  PERIOD FOR:                                            |                                                                         |   |   |   |   |
|                                                                         | Interest                                                                     | $ | 539,533 |   |   | $ | 50,000 |   |
|                                                                         |                                                                         |  |   |  |
|                                                                              |                                                                              |  |  |  |  |  |  |  |  |

**eSoft, Inc. and Subsidiaries****SUMMARY OF ACCOUNTING POLICIES**

**Basis of Presentation**

The unaudited condensed consolidatedfinancial statements of eSoft, Inc. (the “Company”) included herein reflect alladjustments, consisting only of normal recurring adjustments which, in theopinion of management, are necessary to fairly present our consolidatedfinancial position, results of operations, and cash flows for the periodspresented.  Certain information andfootnote disclosures normally included in audited financial informationprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to the Securities and Exchange Commission's(“SEC”) rules and regulations.  The consolidatedresults of operations for the period ended June 30, 2001 are not necessarilyindicative of the results to be expected for any subsequent quarter or for theentire fiscal year.  The informationincluded in this Form 10-QSB should be read in conjunction with theconsolidated financial statements and notes thereto, together with Management’sDiscussion and Analysis of Financial Statements and notes thereto, included inthe Company’s Form 10-KSB for the year ended December 31, 2000.  Certain amounts in the prior yearconsolidated financial statements have been reclassified to conform to thecurrent year presentation.

**Available-for-Sale Securities**

Available-for-sale securities are carriedat their estimated market value, with unrealized holding gains and losses, netof tax, reported as a separate component of stockholders’ equity untilrealized.  Realized gains and losses onsecurities sold are determined based on the specific identification of thesecurities sold.  The Company reviewssecurities with unrealized losses for permanent impairment when the facts andcircumstances may indicate that the unrealized losses may be other thantemporary.

**Revenue Recognition**

The Company generates revenue from sales of hardwareproducts, software licenses and professional service arrangements.  TheCompany accounts for software license and related revenue under Statement ofPosition 97-2 “Software Revenue Recognition,” and related amendments,interpretations, and Technical Practice Aids issued from time to time by the American Institute of Certified Public Accountants(collectively referred to as “SOP 97-2”).

Effective January 1, 2000, the Company adopted theprovisions of SEC Staff Accounting Bulletin No. 101 (“SAB 101”), “RevenueRecognition in Financial Statements.” SAB 101, as amended, provides interpretiveguidance for publicly traded companies on the recognition, presentation, anddisclosure of revenue in the accompanying financial statements. The provisionsof SAB 101 had no material impact on the Company's revenue recognition policiesand presentation as reflected in the accompanying consolidated financialstatements.

SOP 97-2 generally requires revenueearned on software arrangements involving multiple elements to be allocated toeach element based on the relative fair values of the elements.  The fair value of an element must be basedon vendor-specific objective evidence (“VSOE”).  If VSOE does not exist for all elements of the arrangement, theCompany utilizes the residual method of accounting, whereby revenue may berecognized for delivered elements of a contract provided:  a) VSOE exists for all undelivered elements;b) none of the undelivered elements are essential to the functionality of thedelivered elements; and c) revenue is deferred equal to the fair value of allsuch undelivered elements until they are delivered.

**eSoft,Inc. and SubsidiariesSUMMARY OF ACCOUNTING POLICIES**

 

|   | The  Company generates revenue from the following elements:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|   |                            Product sales – The  Company markets, licenses and sells Internet security appliances.  Revenue from the sale of the Company's  Internet security appliance products is recognized upon delivery to the  customer, which is generally at the time the products are shipped, and when  the fee is fixed, determinable and deemed  collectible.  In general, there  are no acceptance criteria and the Company has no further obligation to the  customer.  Provision is made currently  for estimated product returns that may occur.  For sales made to distributors under terms allowing certain  rights of return and price protection on unsold product, revenue is deferred  and recognized only upon sell-through to the end user. |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|   |                            Product development  and license fees – From time to time, the Company enters into  multiple-element arrangements to develop and license the Company’s  proprietary software products.  The  Company recognizes revenue from such arrangements based upon progress to  completion.  Such arrangements may  include customer acceptance criteria, in which case revenue recognition is  deferred until customer acceptance is obtained.                                                                                                                                                                                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|   |                            Subscriptions,  maintenance and other services – The Company sells licenses for additional  software products for its Internet security products on a subscription basis,  whereby customers are granted a right to use the products for a specified  period of time.  Revenue from such  subscriptions is recognized ratably over the subscription period, commencing  upon delivery.  In addition, the  Company provides maintenance and other services under separate  agreements.  Revenue from such  agreements is deferred and recognized ratably over the service period,  generally one year.                                                                                                                                        |

The Company believes its current revenuerecognition policies and practices are consistent with the provisions of SOP97-2. Implementation guidelines for the current standards, as well as potentialnew standards, could lead to unanticipated changes in the Company’s currentrevenue recognition policies.  Suchchanges could affect the timing of the Company’s future revenue and results ofoperations.

**Net Loss Per Share**

Basic earnings or loss per share iscomputed by dividing the net earnings or loss by the weighted-average number ofshares of common stock outstanding. Diluted earnings or loss per share is determined by dividing the netearnings or loss by the sum of (1) the weighted-average number of common sharesoutstanding, (2) if not anti-dilutive, the number of shares of convertible debtas if converted upon issuance, and (3) if not anti-dilutive, the effect ofoutstanding stock options and warrants determined utilizing the treasury stockmethod.  Basic and diluted earnings pershare are the same for all periods presented.

**Use of Estimates**

The preparation of financial statementsin conformity with accounting principles generally accepted in the UnitedStates requires management to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosures of contingent assetsand liabilities at the date of the financial statements and revenues andexpenses during the reporting period. Actual results could differ from those estimates and assumptions.

**Recent Accounting Pronouncements**

In June 2001, the Financial AccountingStandards Board (the “FASB”) issued SFAS No. 141, “Business Combinations.”  SFAS No. 141 addresses financial accountingand reporting for business combinations. SFAS No. 141 is effective for all business combinations initiated afterJune 30, 2001, and for all business combinations accounted for under thepurchase method initiated before but completed after June 30, 2001.  In addition, in June 2000 the FASB issuedSFAS No. 142, “Goodwill and Other Intangible Assets.”  SFAS No. 142 addresses financial accounting and reporting foracquired goodwill and other intangible assets. SFAS No. 142 is effective for fiscal years beginning after December 15,2001, and applies to all goodwill and other intangibles recognized in thefinancial statements at that date.  Theadoption of these standards is not expected to have an impact on the Company’sfinancial position or results of operations. However, any business combinations initiated from this point forwardwill be impacted by these two standards.

** **

**eSoft, Inc. and SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

| 1.     |   | Available-for-Sale  Securities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   | As of June 30, 2001,  the Company held 30,000 shares of Gateway, Inc. common stock, which were  acquired in connection with the debt financing in September 2000 (Note  3).  At March 31, 2001, management  analyzed the investment, noting the continued downturn in the capital  markets, the general economic slowdown and recent developments at Gateway,  and determined that the decline in value was other than temporary and  accordingly, a permanent impairment was recognized in the first quarter.  The unrealized loss of $1,276,200 was  determined based upon the fair market value of the securities as of March 31,  2001, which was $504,300, compared to the historical cost of the investment  of $1,780,500.  Subsequent changes in  the market price of these securities compared to the new cost basis of  $504,300 will be reflected in “other comprehensive income,” as long as the  investment continues to be held, unless any   further impairment charge is deemed necessary.                                                                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   | In addition, at June  30, 2001 the Company has invested $5,795,650 in low duration fixed income  funds.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 2.     |   | Account Receivable – Trade                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
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|   |   | The  Company had one customer that represented more than 10% of the Company’s  total revenue. This customer generated sales that represented 25% of total  revenue for the six months ending June 30, 2001 and 30% of accounts  receivable at June 30, 2001.  Accounts  receivable for international sales represented 64% of outstanding accounts  receivable at June 30, 2001.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   | The  Company, with regard to its foreign sales, does not take the risk of foreign  currency fluctuation. All sales are designated as payment in US denominated  funds at the time of sale.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.     |   | Convertible  Debentures                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   | In  September 1999, the Company issued   $2,000,000 of unsecured 5% Convertible Debentures at a 2.5% discount,  due June 10, 2002, (“Debentures”), along with stock purchase warrants  (“Warrants”) with a right to purchase an aggregate of 511,182 shares of  common stock at an exercise price of $4.4994 per share. The fair value of the  warrants of approximately $850,000 was recorded as an original issuance  discount, and is being amortized over the term of the debt as interest  expense.  The principal and accrued  interest amounts of the Debenture are convertible at any time at the  investor’s option into a fixed number of shares of eSoft common stock at  $3.9125 per share, subject to certain anti-dilution provisions and  adjustments.  The Company has the  ability, under certain circumstances, to obligate the investor to convert the  Debentures into common stock and to exercise the Warrants.  At June 30, 2001, the balance of the  unamortized original issue discount was $312,454.  The balance of the Debentures at June 30, 2001, of $1,687,546  represents the original face value of the remaining outstanding Debentures of  $2,000,000 less the balance of the unamortized discount of $312,454.                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   | In  September 2000, the Company entered into an Amendment of the Stock and  Warrant Purchase and Investor Rights Agreement dated April 26, 2000 whereby  the Company issued $12,500,000 of unsecured 7% Convertible Debentures due  September 15, 2004 (“September 2000 Debentures”) and stock purchase warrants  (“September 2000 Warrants”) with a right to purchase an aggregate of 600,000  shares of common stock, par value $.01 per share, at an exercise price of  $11.00 per share.  In connection with  the issuance of the September 2000 Debentures, the Company purchased 30,000  shares of Gateway common stock for $3 million, which reflected a premium of  approximately $1.2 million.  This  premium was recorded as an original issue discount on the September 2000  Debentures, and is being amortized over the term of the debentures as  interest expense.  The principal  amount of the September 2000 Debentures is convertible at any time at the  investor’s option into a fixed number of shares of eSoft common stock at the  then current fair market value, but not less than $11.00 or more than $19.507  per share.  The balance of the  September 2000 Debentures at June 30, 2001 of $11,521,859 represents the  original face value of the outstanding September 2000 Debentures, of  $12,500,000 less the balance of the unamortized premium of $978,141. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.     |   | Net  Loss Per Share                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   | For  the six months ended June 30, 2001, options and warrants to purchase  3,776,499 and 4,444,483 shares of common stock and debentures convertible  into 511,182 shares and 1,647,546 shares were excluded from the computation  of diluted earnings per share because their effect was anti-dilutive.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   | For  the three months ended March 31, 2001, options and warrants to purchase  3,351,556 and 3,687,293 shares of common stock and notes convertible into  511,182 shares and 1,647,546 shares were not included in the computation of  diluted earnings per share because their effect was anti-dilutive.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 5.     |   | Business  Segments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   | During  the three- and six-months ended June 30, 2001 and 2000, the Company’s  operating structure included the following operating segments:  Internet appliances, redphishtm  and corporate operations.  Our  operating segments derive substantially all revenue from the sale and licensing  of Internet security products and associated software, development and  licensing of proprietary software products, and related support, training and  consultation services.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   | Management  evaluates the performance of its operating segments separately to  individually monitor the different factors affecting financial  performance.  Segment profit or loss  includes substantially all of the segment’s costs of revenue.  However, management does not allocate  corporate expenses as it is not meaningful to do so.  Substantially all assets, liabilities and  operating expenses are managed at the corporate level.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |

 

 
|   |   | Information  about the Company’s reportable segments for the three- and six-months ended  June 30, 2001 and 2000 is as follows: |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------|

**eSoft, Inc. andSubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

** **
|         | *Three  months ended June 30, 2001* |      | *Three  months ended June 30, 2000* |
|--------------|-------------------------------------|-----------|-------------------------------------|
|         | Internet  appliances                |      | redphish                            |   | Total |   | Internet  appliances |   | redphish |   | Total |
|         |                                |      |                                |   |   |   |   |   |   |   |   |
| Revenue:     | $                                   | 1,717,999 |                                | $ | 808,240 |   | $ | 2,526,239 |   | $ | 2,291,102 |   | $ | 317,000 |   | $ | 2,608,102 |
|         |                                     |      |                                     |   |  |   |  |   |  |   |  |
|         |                                |      |                                |   |   |   |   |   |   |   |   |
| Gross profit | $                                   | 616,877   |                                | $ | 172,515 |   | $ | 789,392 |   | $ | 991,388 |   | $ | 252,882 |   | $ | 1,244,270 |
|         |                                     |      |                                     |   |  |   |  |   |  |   |  |

 
|         | *Six  months ended June 30, 2001* |      | *Six  months ended June 30, 2000* |
|--------------|-----------------------------------|-----------|-----------------------------------|
|         | Internet  appliances              |      | redphish                          |   | Total |   | Internet  appliances |   | redphish |   | Total |
|         |                              |      |                              |   |   |   |   |   |   |   |   |
| Revenue:     | $                                 | 3,295,999 |                              | $ | 1,243,240 |   | $ | 4,539,497 |   | $ | 4,495,102 |   | $ | 1,236,000 |   | $ | 5,730,903 |
|         |                                   |      |                                   |   |  |   |  |   |  |   |  |
|         |                              |      |                              |   |   |   |   |   |   |   |   |
| Gross profit | $                                 | 1,247,877 |                              | $ | 207,515 |   | $ | 1,455,591 |   | $ | 2,013,767 |   | $ | 1,070,498 |   | $ | 3,084,265 |
|         |                                   |      |                                   |   |  |   |  |   |  |   |  |

 

** **

FORWARD-LOOKING STATEMENTS

             Statementsmade in this Form 10-QSB that are not historical or current facts are“forward-looking statements” made pursuant to the safe harbor provisions ofSection 27A of the Securities Act of 1933, as amended and Section 21E of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”).  These statements often can be identified bythe use of terms such as “may,” “will,” “expect,” “believes,” “anticipate,”“estimate,” “approximate” or “continue,” or the negative thereof.  The Company intends that suchforward-looking statements be subject to the safe harbors for such statements.  The Company wishes to caution readers not toplace undue reliance on any such forward-looking statements, which speak onlyas of the date made.  Forward-lookingstatements are subject to risks, uncertainties and important factors beyond thecontrol of the Company that could cause actual results and events to differmaterially from historical results of operations and events and those presentlyanticipated or projected.  These factorsinclude adverse economic conditions, entry of new and stronger competitors,inadequate capital, unexpected costs, failure to gain product approval inforeign countries and failure to capitalize upon access to new markets.  Additional risks and uncertainties which mayaffect forward-looking statements about the Company's business and prospectsinclude the possibility that a competitor will develop a more comprehensive orless expensive solution, delays in market awareness of eSoft and its products,possible delays in eSoft’s marketing strategy, and failure of our strategicpartners to successfully implement their marketing strategies, each of whichcould have an immediate and material adverse effect by placing eSoft behind itscompetitors.  For a fuller descriptionof certain of these important factors that could cause actual results to differmaterially from those currently anticipated or projected, please see theCompany’s most recently filed Annual Report on Form 10-KSB for the fiscal yearended December 31, 2000.  The Companydisclaims any obligation subsequently to revise any forward-looking statementsto reflect events or circumstances after the date of such statement or toreflect the occurrence of anticipated or unanticipated events.

             TheCompany uses market data and industry forecasts throughout this report, whichit has obtained from internal surveys, market research, publicly availableinformation and industry publications. Industry publications generally state that the information they providehas been obtained from sources believed to be reliable, but that the accuracyand completeness of such information is not guaranteed.  Similarly, the Company believes that thesurveys and market research the Company or others have performed are reliable,but the Company has not independently verified this information.

**Item 2 - Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

*InstaGate, InstaGate EX, InstaGate EX2, InstaRak, SoftPak,SoftPak Director, and redphish are all service marks and/or trademarks owned byeSoft, Inc.  TEAM Internet andSiteFilter (with design) areregistered trademarks owned by eSoft, Inc.*

**Overview**

             Wedesign, develop and market secure Internet appliances that address the Internetsecurity needs of small- and medium-sized businesses and the hosting needs ofInternet Service Providers (ISPs).  Thedemand for our products is driven by thedeployment of broadband Internet connections and the growing demand for secureWebsite and email hosting services.  OurInstaGate EX2 Internet security appliance provides businesses with Internet security, firewall, virtual private network (VPN)and related offerings.  Inaddition, our InstaRak secure server appliance securely hosts web, email, anddomain name service (DNS) for multiple Internet domains.

             Ourproducts offer plug-and-play solutions that virtually eliminate traditionalcosts of hardware upgrades, box swaps and site visits with quick, hassle-freeinstallation.  In addition, we arepioneering the delivery of business and IT related applications, and securityupdates through these secure Internet appliances.  Our SoftPak applications, are available through softwaredownloads as businesses grow and new business and IT applications aredeveloped.  SoftPak applications havebeen developed by eSoft or in combination with third parties, and are mostcommonly licensed to the end user on an annual subscription basis.  This results in a recurring revenue streamfor us and our channel partners, which provides better visibility andpredictability to revenue growth.  TheSoftPak applications, as well as software updates and firewall enhancements,are distributed through our patent-pending SoftPak Director technology.  The SoftPak Director technology allows anend-user to utilize a browser-based interface to evaluate and select SoftPakapplications.  Among the SoftPakapplications are anti-virus, Web site filtering, spam filtering, reporting anda variety of communications options, with new SoftPak applications being addedcontinually.  Since SoftPak applicationscan be added without requiring new boxes, the need for hardware swaps andassociated downtime is eliminated.

             Withthe accelerating deployment of broadband communications networks, which hascreated a more immediate need for products such as firewalls, VPNs, domainhosting services and network attached storage (NAS) servers, we have continuedour focus on providing flexible, customizable, secure Internet appliances. Accordingto International Data Corporation (IDC), Firewall/VPN security appliancerevenue grew 105% from 1998 to 1999 and 152% from 1999 to 2000.  The total revenue for this sector isprojected to reach $4.0 billion by 2005.  This growth can be attributed to theconvergence of VPN and firewall technologies, the growing number of companieslinking their networks to the Internet, remote access connectivity for branchoffices and mobile users, and growing concern over network security.   IDC also estimates that in the market forfirewall appliances priced at less than $10,000, revenues will grow at anexpected compounded annual growth rate of 88% over the same period.  We recognized the need to create a firewallor VPN product that could be distinguished from the rest of the market andwould provide us with a sustainable competitive advantage.  In October 2000, the InstaGate EX Internetsecurity appliance was introduced, which is capable of providing SoftPakapplications in addition to the firewall or VPN.  In January of 2001, the InstaGate EX2 Internet security appliancewas introduced.  An enhancedhardware platform was developed for the InstaGate EX2 Internet securityappliance, which is a slim profile, highly reliable unit. The hardware platformis based on an Intel reference design motherboard and includes over a year ofcollaboration with Intel on the design and fabrication of the appliance.  In early 2001, we recognized that ISPs areseeing increased security concerns from their customers, which in turn createsthe need for secure servers designed to host web, email and DNS services formultiple Internet domains.  In July2001, we announced the introduction of the InstaRak secure server appliance,which uses the same hardware platform as the InstaGate EX2 Internet securityappliance and allows us to leverage our investments in security software andSoftPak applications.  eSoft ispioneering the delivery of secure server appliances by integrating serverfeatures with security protection, making the InstaRak appliance what webelieve to be the most secure server appliance on the market today.  This highly reliable, extensible product isdesigned to protect against hackers and individuals attempting to exploit orgain control of the operating system. The InstaRak secure server appliance is also designed to protectmultiple customers hosted on the same appliance from each other.  According to IDC, the worldwide ApplianceWeb server market was $161.9 million in 2000 and is projected to grow to $2.2billion by 2005.

             Our InstaGate EX2Internet security appliance targets small and medium enterprises (SMEs) andbranch offices that typically have between ten and 250 desktop computersconnected to a local area network, or LAN. We market this product primarily through value added resellers (VARs),ISPs and international distributors.  According to The Yankee Group, SMEs represent 98%of U.S. businesses, and account for approximately 50% of the gross nationalproduct.  The SME segmentcomprises the largest portion of installed LANs and increasingly recognizes theimportance of the Internet to grow their business and improve productivity.  Theavailability of low-cost, high-speed bandwidth, through technologies such ascable modems and digital subscriber lines, or DSL, is driving SMEs’ demand forfull-time Internet access, which in turn creates the need to effectivelyprotect corporate assets and data through the implementation of a firewall.  According to IDC, as of the year 2000, 15%of small businesses have installed firewalls, leaving 85% of the marketvirtually unprotected with respect to their corporate assets and networks.  We believe that the firewall market willincreasingly shift to small businesses because that market segment has thelargest potential.  In addition, our InstaRaksecure server appliance targets ISPs, and we market this product directly toISPs, as well as through VARs and international distributors.

             IDC projects by the year 2003 thatthe firewall appliance market will reach $1.3 billion for the United States,$836 million for Western Europe and $346 million for Asia Pacific.  In order to expand our international marketpresence, we have localized our InstaGate EX2 Internet security appliance  for the following key markets: Japanese,Traditional and Simplified Chinese, Korean, German, French and Spanish.  By localizing our product, user interface,documentation and web presence, we believe that our product offerings will provideeven more value for our partners and will continue to make Internet usage andour products simpler and easier for end users in key international markets.

             Ourredphish OEM program, targets the licensing of our InstaGate EX2 Internetsecurity appliance technology, software and hardware, along with certaincustomization or modifications from our professional engineering services, inorder to create highly specialized or customized Internet appliance offeringsfor hardware manufacturers, networking companies and broadband serviceproviders to integrate into their own offerings. Our redphish program providesa vehicle through which major hardware manufacturers can deliver customizedsecure Internet appliances and connectivity solutions to their small- and medium-sizedcustomers.  Delivered initially as asecure Internet appliance, this platform can later serve as a foundation foradditional products and services, such as enhanced e-mail, VPN, andbusiness-to-business applications, as well as any SoftPak applications providedby us.  This program allows us toleverage our research, development and product offerings, along with ourpartners’ expertise in hardware design, manufacturing and distribution. Webelieve the redphish program greatly improves our worldwide distributioncapabilities and helps to drive product requirements.  In addition, it enables us to gain time to market advantages indeveloping new software features.  Ourprogram is based on royalties or revenue sharing, which provides incentive atevery point of the distribution chain. Currently, 3Com Corporation and Hewlett Packard are involved in pursuingmarketing efforts that utilize or bundle our software or appliance.  We have currently de-emphasized this programdue to market conditions.  We willcontinue to support existing OEM relationships and will analyze any futurerelationships based on the value that they can bring to the Company.  At this time, we have seen increasinglystrong demand for our products from channel partners and end users.  Therefore, we believe that our current shiftaway from our redphish OEM program will enable us to focus resources andpersonnel on those areas of the Company that currently represent the bestopportunities for profitable growth.

**Liquidity and Capital Resources**

             The Company's cash on hand at June30, 2001 was $9,521,000, a decrease of $10,607,000 from year end, primarily dueto our continued operating losses and additional investments made in fixedincome funds.  The Company’s workingcapital at June 30, 2001 was $13,680,000, a decrease of $6,269,000 fromDecember 31, 2000.  Managementanticipates continuing losses in support of its growth initiatives and, thusexpects continued negative cash flow in 2001. The Company has increased efforts to reduce its accounts receivablebalance through more stringent collection efforts of the current customer basein an attempt to reduce the days sales outstanding and is encouraged by therecent results.  The Company hasanalyzed its accounts receivable and adjusted its allowance for doubtfulaccounts and sales returns to $510,000 at June 30, 2001.  We anticipate that we will continue togenerate losses in support of our growth initiatives, and coincidentally,expect negative cash flow from operations for the year.  However, we are continuing to improve ourcash management efforts and to reduce operating costs where possible.  Additional cash will be used in 2002 if theshort-term convertible debentures are not converted into stock by June 10,2002.  If the debentures are converted,it will eliminate the need for the cash set aside for this purpose.  We believe that our current cash positionand investments, together with the anticipated cash generated from operationswill be sufficient to meet our working capital, debt service, and capitalexpenditure requirements  for at leastthe next twelve months and the foreseeable future.  Because we expect to incur a net loss for the year 2001, our cashand investments are expected to decrease as necessary to fund such losses.

**Cash Flow**

             Netcash used in operating activities for the six months ending June 30, 2001 was$4,765,000 compared with $4,594,000 for the six months ending June 30, 2000, anincrease of $171,000.  The Company’s net loss at June 30, 2001 was$6,515,000, an increase of $1,851,000 compared with June 30, 2000.  The increase in the loss is due primarily tothe recognition of a $1,276,000 unrealized non-cash loss relating to theother-than-temporary impairment of equity securities of Gateway acquired inSeptember 2000 in connection with our debenture financing.  Other factors include lower gross marginsassociated with sales of new products, sales of hardware to OEMs, and lowerlevels of high margin licensing and development fees.

             Netcash used in investing activities for the six months ending June 30, 2001 was$5,849,000, compared with $301,000 used in investing activities for the sixmonths ending June 30, 2000.  Theincrease in cash used of $5,548,000 for the 2001 period compared to the 2000period was due to investments of $5,796,000 made in fixed income funds.

             Netcash provided by financing activities for the six months ending June 30, 2001was $6,000 compared with $13,076,000 for the six months ending June 30,2000.  The decrease of $13,070,000 forthe 2001 period compared to the 2000 period was primarily due to $12,500,000for the proceeds from the equity investment by Gateway in April 2000.

**Results Of Operations For Three Months Ended June 30, 2001Compared To The Three Months Ended June 30, 2000**

             Inthe second quarter of 2001, revenues totaled $2,526,000 versus revenue of$2,608,000 for the second quarter of 2000, a decrease of $82,000 or 3%.  Product revenue for the second quarter of2001 was $1,946,000, a decrease of $12,000, or 1%, from $1,958,000 in thesecond quarter of 2000.  The decrease isrelated to the lower price points associated with our recently introducedInstaGate EX2 Internet security appliance. International sales accounted for 54% of product revenue in the secondquarter of 2001 compared to 25% for the same period of 2000.  Revenue from software development andlicense fees totaled $85,000 in the second quarter of 2001 versus revenue of$317,000 for the same period of 2000, a decrease of $232,000 or 73%.  This decrease represents the timing of softwaredevelopment contracts from 1999, which are recognized based on progress tocompletion.  In the second quarter of2000, we were working on projects in connection with agreements with Intel,Inc., Gateway Companies, Inc. and 3Com Corporation.  In 2001, this revenue represents license fees from Gateway.  The revenue from subscriptions, maintenanceand other services totaled $495,000 in the second quarter of 2001 compared to$334,000 for the same period of 2000, an increase of $161,000 or 48%.  Over the past year, the Company has focusedon building a recurring revenue stream through the sales of SoftPakapplications.  With the October 2000implementation of the patent pending SoftPak Director technology, which enablesus to seamlessly download SoftPak applications to the end user, we have beenable to increase the number of InstaGate customers who purchase SoftPakapplications.  The Company alsointroduced four additional SoftPak applications in the second quarter of 2001.

             Grossprofit margin in the current quarter was $789,000, which is 31% of revenue forthe three months ended June 30, 2001, compared to $1,244,000, which is 48% ofrevenue for the three months ended June 30, 2000.  Gross margin on product was 22% and 42% for the three monthsending June 30, 2001 and 2000, respectively. The decrease is attributed tobelow average margins on product sales to a specific OEM partner, whichgenerated significant sales in 2001.  Inaddition, new products were launched in late 2000 and early 2001 with morecompetitive pricing, resulting in lower margins.** **Gross profit marginon product development and license fees was 100% and 80% for the secondquarters of 2001 and 2000, respectively. The increase is due to all of the activity in 2001 resulting fromlicensing arrangements that have no costs associated with them, while in 2000the activity resulted from software development and licensing.  Gross profit margin on subscriptions,maintenance and other was 56% and 52% in the second quarters of 2001 and 2000,respectively.  This increase relates toadditional maintenance agreements being in place in 2001, which have moreattractive margins than various other SoftPak applications.

             Operatingexpenses decreased $935,000, or 23%, from $4,069,000 for the quarter ending June30, 2000 to $3,134,000 for the quarter ending June 30, 2001.  Sales and marketing expenses decreased$879,000, or 41%, from $2,130,000 in the second quarter of 2000 to $1,251,000in the same period of 2001.  Thedecrease is associated with the discontinuation of SmartDSL at the end of 2000and the related reduction in the sales force and marketing efforts.  In addition, headcount decreased due to theclosing of the Atlanta office in late 2000. Furthermore, travel related expenses have decreased with the eliminationof outside sales representatives and cost control measures put in place.  General and administrative expensesdecreased $109,000, or 9%, from $1,192,000 in the second quarter of 2000compared to $1,083,000 for the same period of 2001.  This can be attributed to careful management of outside servicessuch as printing fees, audit fees, legal expenses, and closely managingaccounts receivable to reduce bad debt expense.  Research and development expenses increased $54,000 from $747,000for the quarter ending June 30, 2000 to $801,000 for the same period of2001.  This can be attributed toservices outsourced for translation of the product into German, Spanish,French, Chinese, Korean, and Japanese. The Company will continue to closely monitor operating expenses inconjunction with targeting near term positive EBITDA.

             Interestexpense increased $294,000 in the three months ended June 30, 2001 from$136,000 in the second quarter of 2000 to $430,000 for the same period of2001.  The interest is due to theinterest and discount amortization on the convertible debentures issued inSeptember 2000 and amortization of associated deferred offering costs.  Interest income decreased $13,000 in thequarter as a result of lower average cash balances.

             Netloss was $2,594,000 for the three months ended June 30, 2001, compared to$2,758,000 for the same period in 2000, a decrease in the loss of $164,000 overthe same period. The decrease in the loss is due primarily to the decreases inour operating expenses, offset by lower gross margins on revenue and interestexpense.  The remaining net losses areassociated with the selling, general and administrative expense necessary tosupport our current business strategy. Losses are anticipated to continue through the current fiscal year dueto expenditures in support of continued growth and market penetration.

**Resultsof Operations For Six Months Ended June 30, 2001 Compared To The Six MonthsEnded June 30, 2000**

             Revenuesfor the first six months in 2001 totaled $4,539,000 versus revenue of$5,731,000 for the same period in 2000, a decrease of $1,192,000, or 21%.  Product revenue for the six months endedJune 30, 2001 was $3,442,000, a decrease of $531,000, or 13%, from $3,973,000 forthe first six months in 2000.  The decreaseis mainly attributed to lower price points associated with our recentlyintroduced InstaGate EX2 Internet security appliance.  International sales accounted for 52% of product revenue in 2001compared to 25% for the same period of 2000. Revenue from software development and license fees totaled $117,000 forthe six months ended June 2001 versus revenue of $1,236,000 for the same periodin 2000, a decrease of $1,119,000, or 91%. This decrease represents the timing of software development contracts from1999, which are recognized based on the percentage of completion method.  In the first quarter of 2000, we wereworking on a significant project in connection with an agreement with Intel,Inc.  In 2001, this revenue representslicense fees from Gateway.  The revenuefrom subscriptions, maintenance and other services totaled $981,000 for the sixmonths ended June 2001 compared to $522,000 for the same period in 2000, anincrease of $459,000 or 88%.  Over thepast year, the Company has focused on building a recurring revenue streamthrough the sales of SoftPak applications. With the October 2000 implementation of the patent pending SoftPakDirector technology, which enables us to seamlessly download SoftPak applicationsto the end user, we have been able to increase the number of InstaGatecustomers who purchase SoftPak applications. The Company also introduced four additional SoftPak applications in thesecond quarter of 2001.

             Grossprofit margin for the six months ended June 30, 2000 was $1,456,000, which is32% of revenue, compared to $3,084,000, which is 54% of revenue for the sixmonths ended June 30, 2000.  Grossmargin on product was 22% and 44% for the six months ended June 30, 2001 and2000, respectively. The decrease is attributed to below average margins onproduct sales to a specific OEM partner, which generated significant sales in2001.  In addition, new products werelaunched in late 2000 and early 2001 with more competitive pricing, resultingin lower margins.  Gross profit marginon product development and license fees was 100% and 87% for the six monthsended June 2001 and 2000, respectively. The increase is due to all of the activity in 2001 resulting fromlicensing arrangements that have no costs associated with them, while in 2000the activity resulted from software development and licensing.  Gross profit margin on subscription,maintenance and other was 60% and 48% for the first six months of 2001 and2000, respectively.  This increaserelates to additional maintenance agreements being in place in 2001, which havemore attractive margins than various other SoftPak applications.

             Operatingexpenses decreased $1,481,000 or 19% from $7,781,000 for the first six monthsin 2000 to $6,300,000 for the same six months in the 2001 period. Sales andmarketing expenses decreased $1,218,000 from $3,685,000 in 2000 to $2,467,000in 2001.  The decrease is associatedwith the discontinuation of SmartDSL at the end of 2000 and the relatedreduction in the sales force and marketing efforts.  In addition, headcount decreased in relation to the closing ofthe Atlanta office in late 2000. Furthermore, travel related expenses have decreased with the eliminationof outside sales representatives and cost control measures put in place.  General and administrative expense decreased$391,000 from $2,591,000 in the 2000 period compared to total expenses of$2,200,000 in 2001.  This decrease canbe attributed to careful management of outside services such as printing fees,audit fees, legal expenses.  Inaddition, we have closely managed accounts receivable in order to reduce baddebt expense.  Furthermore, in 2000 wealso experienced greater filing fees due to initial listing fees for thenational Nasdaq market.  Softwareamortization of $431,000 and $75,000 is included in general and administrativeexpense for the six months ending June 30, 2000 and 2001, respectively.  Research and development expenses increased$129,000 from $1,504,000 for the six months ended June 2000 to $1,633,000 forthe same period in 2001.  This increasewas related to translation of the product into German, Spanish, French,Chinese, Korean, and Japanese.  TheCompany will continue to closely monitor operating expenses in conjunction withtargeting near term positive EBITDA.

             Interestexpense increased $587,000 for the six months ended June 30, 2001 from $273,000in 2000 to $860,000 in 2001.  Theadditional interest is due to the interest and discount amortization on theconvertible subordinated debentures issued in September 2000 and amortizationof associated deferred offering costs. Interest income increased $168,000 for the six month ended June 2001 inrelation to additional cash on hand in the first quarter of 2001 related to theconvertible debentures issued to Gateway in September 2000, offset bydecreasing cash balances as we use cash to fund our operating losses.

             Netloss from operations was $6,515,000 for the six months ended June 30, 2001,compared to a $4,664,000 loss for the same period in 2000, an increase in theloss of $1,851,000 over the same period. The increase in the loss is primarily due to the unrealized lossrecorded for the “other than temporary” impairment of equity securities as wellas lower gross margins, offset by decreased operating expenses.  The remaining net losses are associated withthe selling, general and administrative expenses necessary to support itscurrent business strategy.  Losses areanticipated to continue through the current fiscal year due to expenditures insupport of continued growth and market penetration.

**Income Taxes**

             AtJune 30, 2001, a valuation allowance of 100% of the deferred tax asset has beenrecorded, as management of the Company is not able to determine that it is morelikely than not that its deferred tax assets will be realized.  In addition, the Company’s operating losscarryforwards may be limited under Section 382 of the Internal Revenue Code.

**Other Matters**

             TheCompany has reviewed all other recently issued, but not yet adopted, accountingstandards in order to determine their effects, if any, on the results ofoperations or financial position of the Company.  Based on that review, the Company believes that none of thesepronouncements will have a significant effect on current or future earnings oroperations.
PARTII - OTHER INFORMATION
 Item  1.Legal  Proceedings     The  Company is not currently involved in any material legal proceedings.  From time to time, the Company may become  involved in or subject to various litigation and legal proceedings incidental  to the normal conduct of its business.    Item  4.Submission  of Matters to a Vote of Security Holders     The  Annual Meeting of Stockholders was held on May 10, 2001 and the matters upon  which the stockholders voted include:  1.Proposal  to elect Richard Rice as a director of the Company.  The number of votes cast For totaled 12,857,947, and the number  of votes cast Against/Abstained totaled 164,330.  2.Proposal  to approve the Company’s 2000 Employee Stock Purchase Plan.  The number of votes cast For totaled 5,473,890,  and the number of votes cast Against/Abstained totaled 252,153.  3.Proposal  to ratify the selection of Arthur Andersen, LLP as the Company’s independent  auditors for the fiscal year ended December 31, 2001.  The number of votes cast For totaled 12,925,158,  and the number of votes cast Against/Abstained totaled 96,919.
SIGNATURES

In accordance with the requirements ofthe Exchange Act, the Registrant caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
Date:  August 13, 2001eSoft,  Inc.        /s/  Jeffrey Finn    Jeffrey  Finn  President  and Chief Executive Officer  *(Principal  Executive Officer)*      Date:  August 13, 2001 /s/  Amy Beth Hansman    Amy  Beth Hansman  Vice  President of Finance  *(Principal  Financial Officer)*