TUMBLEWEED COMMUNICATIONS CORP - 10-Q Quarterly Report

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

TUMBLEWEED COMMUNICATIONS CORP.
(Exact name of registrant as specified in its charter)

700 SAGINAW DRIVE
REDWOOD CITY, CA 94063
(Address of principal executive offices, including zip code)

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

The number of shares of common stock outstanding as of October 31, 2002 was 30,452,275.

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are subject to the "safe harbor" created by those sections. The forward-looking statements are based on our current expectations and projections about future events, including, but not limited to, implementing our business strategy; attracting and retaining customers; obtaining and expanding market acceptance of the products and services we offer; forecasts of Internet usage and the size and growth of relevant markets; rapid technological changes in our industry and relevant markets; our stock repurchase program; and competition in our market. Discussions containing such forward-looking statements may be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations." In some cases, forward-looking statements can be identified by terminology such as "may," "will," "should," "could," "predicts," "potential," "continue," "expects," "anticipates," "future," "intends," "plans," "believes," "estimates," and similar expressions. These forward-looking statements involve certain risks and uncertainties that could cause actual results, levels of activity, performance, achievements and events to differ materially from those stated or implied by such forward-looking statements. The factors that could contribute to such differences include those discussed under the caption "Risks And Uncertainties That You Should Consider Before Investing In Tumbleweed" contained herein, as well as those discussed in our Form 10-K and other filings with the Securities and Exchange Commission. These forward-looking statements are made as of the date of this Quarterly Report on Form 10-Q. Tumbleweed disclaims any obligation to update these statements or to explain the reasons why actual results may differ. The risks and uncertainties under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations—Risks and Uncertainties That You Should Consider Before Investing in Tumbleweed" contained herein, among other things, should be considered in evaluating Tumbleweed's prospects and future financial performance.

		Page
Part I
Item 1	Financial Statements	3
	Condensed Consolidated Balance Sheets as of September 30, 2002 (unaudited) and December 31, 2001	3
	Condensed Consolidated Statements of Operations for the three and nine month periods ended September 30, 2002 and September 30, 2001 (unaudited)	4
	Condensed Consolidated Statements of Cash Flows for the nine month periods ended September 30, 2002 and September 30, 2001 (unaudited)	5
	Notes to Condensed Consolidated Financial Statements (unaudited)	6
Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3	Quantitative and Qualitative Disclosures About Market Risk	33
Item 4	Controls and Procedures	34
Part II
Item 1	Legal Proceedings	35
Item 4	Submission of Matters to a Vote of Security Holders	36
Item 6	Exhibits	36
Signatures	37

Our registered trademarks include Tumbleweed®, Tumbleweed Communications®, Secure Envelope®, Secure Inbox®, Tumbleweed IME Integrated Messaging Exchange®, WorldSecure® and Worldtalk®. Additional trademarks belonging to us include Tumbleweed Secure Guardian™, Tumbleweed Secure Policy Gateway™, Tumbleweed Secure Staging Server™, Tumbleweed Staging Server™, Tumbleweed Secure Mail™, Tumbleweed Secure Redirect™, Tumbleweed Secure Public Network™, Tumbleweed SPN™, Tumbleweed Secure Archive™, Tumbleweed Secure Web™, Tumbleweed Secure CRM™, Tumbleweed Secure Messenger™, Tumbleweed Secure Statements™, Tumbleweed My Copy™, Tumbleweed L2i™, Tumbleweed IME Developer™, Tumbleweed IME Personalize™, WorldSecure/Mail™ and Tumbleweed IME Alert™.

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(in thousands)

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES
Condensed Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

The condensed consolidated financial statements included herein have been prepared by Tumbleweed Communications Corp. ("Tumbleweed" or "we") without audit, pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, we believe that that the disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with our audited financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2001, filed with the SEC on March 29, 2002.

The unaudited condensed consolidated financial statements included herein reflect all adjustments (which include normal, recurring adjustments) which are, in the opinion of management, necessary to state fairly the financial position of Tumbleweed and its subsidiaries as of September 30, 2002, and the results of operations for the three and nine months ended September 30, 2002 and 2001 and cash flows for the nine months ended September 30, 2002 and 2001. The results for the three and nine months ended September 30, 2002 and 2001 are not necessarily indicative of the results expected for the full fiscal year.

The accompanying consolidated condensed financial statements include the accounts of Tumbleweed and our subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Restructuring and related charges expensed during the nine months ended September 30, 2001 were comprised of the following (in thousands):

Employee separation	$	2,642
Facilities charges, asset impairment, and other		6,633
Stock compensation credit, net		(336	)

Total restructuring charges	$	8,939

Employee separation for approximately 100 employees included severance pay and medical and other benefits. The restructuring charges were partially offset by a non-cash credit related to previously recorded stock-based compensation on unvested options held by terminated employees. During the quarter ended March 31, 2002, we made lease settlement payments of $2.3 million on facilities no longer required primarily due to the reduction in headcount. As of September 30, 2002, we had no remaining liabilities from the January 2001 restructuring.

During the three months ended March 31, 2001, we performed an impairment assessment of the identifiable intangibles and goodwill recorded in connection with the acquisition of Interface Systems, Inc. The assessment was performed primarily due to changes in the economy, the overall decline in the industry growth rate, and our lower actual and projected operating results including that of the business acquired from Interface. Our assessment was supported by the significant sustained decline in our stock price since the valuation date of the shares issued in the Interface acquisition. As a result of the assessment, we recorded a $51.0 million impairment charge to reduce goodwill and other intangible assets to their estimated fair value. The charge was based upon the estimated discounted cash flows over the remaining useful life of the goodwill and other intangible assets using a discount rate of 15%. The assumptions supporting the cash flows, including the discount rate, were determined using our best estimates as of March 31, 2001. The remaining intangible assets were amortized in full over their remaining useful life during 2001. The impairment consisted of the following charge (in thousands):

We adopted the provisions of Statement of Financial Accounting Standards ("SFAS") 142, Goodwill and Other Intangible Assets, on January 1, 2002. In connection with SFAS 142's transitional goodwill impairment evaluation, we engaged a third-party independent valuation specialist to assess whether there was an indication that goodwill recorded in connection with our acquisition of Tumbleweed Communications KK ("TKK"), our majority-owned subsidiary in Japan, was impaired as of the date of adoption. To accomplish this, we determined the carrying value of our reporting unit by assigning our assets and liabilities, including the existing goodwill and intangible assets, to our reporting unit as of the date of adoption. As our TKK reporting unit's carrying amount exceeded its fair value, indicating that TKK's goodwill might be impaired, we performed the second step of the transitional impairment test. In the second step, we compared the implied fair value of TKK's goodwill, determined by allocating TKK's fair value to all of its assets (recognized and unrecognized) and liabilities to its carrying amount, both of which were measured as of the date of adoption. A transitional impairment loss of $974,000 was recognized as the cumulative effect of a change in accounting principle in our consolidated statement of operations.

During the six months ended June 30, 2002, TKK experienced a sustained decline in operations. As a result of this decline, as of June 30, 2002, we wrote-off $5.7 million in goodwill, which was the remainder of the goodwill balance. During the three months ended September 30, 2002 we decided to change our sales distribution model in Japan from direct sales operations to indirect sales operations. To initiate this change in Japan and based on our review of the financial position of TKK, we began the liquidation of TKK. As a result of the liquidation of TKK, during the three months ended September 30, 2002 we recorded a net operating expense of $377,000 related to the write-off of the balance sheet of TKK and our eighty percent equity position in TKK.

Basic and diluted net loss per common share are presented in conformity with SFAS 128, Earnings Per Share, for all periods presented. In accordance with SFAS 128, basic net loss per common share has been computed using the weighted average number of shares of common stock outstanding during the period, less shares subject to repurchase.

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share amounts):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2002			2001			2002			2001
Net loss	$	(3,441	)	$	(10,891	)	$	(18,235	)	$	(107,149	)
Basic and diluted:
Weighted average shares of common stock outstanding		30,682			30,310			30,725			30,094
Less: Weighted average shares subject to repurchase		—			(14	)		(2	)		(8	)
Weighted average shares used in computing basic and diluted net loss per common share		30,682			30,296			30,723			30,086

Basic and diluted net loss per share	$	(0.11	)	$	(0.36	)	$	(0.59	)	$	(3.56	)

We exclude potentially dilutive securities from our diluted net loss per share computation when their effect would be antidilutive to net loss per share amounts. The following common stock equivalents were excluded from the net loss per share computation (in thousands):

	Three Months Ended September 30,		Nine Months Ended September 30,
	2002	2001	2002	2001
Warrants and options excluded for which the exercise price was less than the average fair market value of our common stock during the period but were excluded as inclusion would decrease our net loss per share	90	1,497	318	1,103
Warrants and options excluded due to the exercise price exceeding the average fair market value of our common stock during the period	7,189	4,589	4,694	3,488
Common shares excluded resulting from common stock subject to repurchase	—	14	2	8

Total common stock equivalents excluded from diluted net loss per share	7,279	6,100	5,014	4,599

Comprehensive loss includes our net loss as well as foreign currency translation adjustments, recorded net of tax. Comprehensive loss for the three and nine months ending September 30, 2002 and 2001, respectively, is as follows (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2002			2001			2002			2001
Net loss	$	(3,441	)	$	(10,891	)	$	(18,235	)	$	(107,149	)
Other comprehensive loss—translation adjustments		(19	)		133			(46	)		(332	)

Comprehensive loss	$	(3,460	)	$	(10,758	)	$	(18,281	)	$	(107,481	)

As defined by SFAS 131, Disclosure About Segments of an Enterprise and Related Information, our chief operating decision-makers are our Chief Executive Officer ("CEO") and our Chief Operating Officer ("COO"). Our CEO and COO review financial information presented on a consolidated basis accompanied by disaggregated information about revenue by geographic region for purposes of making operating decisions and assessing financial performance. The consolidated financial information reviewed by our CEO and COO is the information presented in the accompanying consolidated statement of operations. Therefore, we operate in a single operating segment, secure messaging applications for businesses using the Internet.

Revenue information regarding operations in the different geographic regions is as follows (in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2002		2001		2002		2001
North America	$	5,224	$	6,314	$	17,751	$	14,191
Europe		303		722		1,452		3,603
Asia		24		1,119		404		2,057

Total	$	5,551	$	8,155	$	19,607	$	19,851

Consolidated Complaint that (i) consolidated the separate actions into one action, (ii) added certain new plaintiffs, (iii) withdrew Congressional Securities, Inc. as a plaintiff, and (iv) added claims for breach of fiduciary duty and negligent misrepresentation, which are the sole remaining claims in the case. On May 20, 2002, we filed a motion to dismiss these claims, which motion has remained pending before the Court while the case has continued to proceed through the discovery phase. The accompanying financial statements do not include a reserve for any costs for damages, if any, that might result from this uncertainty. We believe this consolidated action is without merit and intend to vigorously defend against it and seek its dismissal.

Although we believe this lawsuit is without merit, no assurance can be given about its outcome, and an adverse outcome could significantly harm our business and operating results. Moreover, the costs in defending this lawsuit could harm future operating results.

In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS 142, Goodwill and Other Intangible Assets. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment.

We adopted the provisions of SFAS 142 on January 1, 2002. In connection with SFAS 142's transitional goodwill impairment evaluation, we engaged a third-party independent valuation specialist to assess whether there was an indication that goodwill recorded in connection with our acquisition of TKK was impaired as of the date of adoption. To accomplish this, we determined the carrying value of our reporting unit by assigning our assets and liabilities, including the existing goodwill and intangible assets, to our reporting unit as of the date of adoption. As our TKK reporting unit's carrying amount exceeded its fair value, indicating that TKK's goodwill might be impaired, we performed the second step of the transitional impairment test. In the second step, we compared the implied fair value of TKK's goodwill, determined by allocating TKK's fair value to all of its assets (recognized and unrecognized) and liabilities to its carrying amount, both of which were measured as of the date of adoption. A transitional impairment loss of $974,000 was recognized as the cumulative effect of a change in accounting principle in our consolidated statement of operations.

In June 2001, the FASB issued SFAS 143, Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The standard applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development, or normal use of the asset. SFAS 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. We are required to adopt the provisions of SFAS 143 as of January 1, 2003. We do not expect the adoption of SFAS 143 to have a material impact on our financial position or results of operations.

In October 2001, the FASB issued SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS 144 supersedes SFAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, it retains many of the fundamental provisions of SFAS 121. SFAS 144 also supersedes the accounting and reporting provisions of APB Opinion 30 for the disposal of a segment of a business. By broadening the presentation of discontinued operations to include more disposal transactions, SFAS 144 enhances companies' ability to provide information that helps financial statement users to assess the effects of a disposal transaction on the ongoing operations

of an entity. We adopted SFAS 144 as of January 1, 2002. The adoption of SFAS 144 did not have a material impact on our financial position or results of operations.

In June 2002, the FASB issued SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with an exit or disposal activity. SFAS 146 nullifies Emerging Issues Task Force ("EITF") Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS 146 requires that a liability be recognized for those costs only when the liability is incurred, that is, when it meets the definition of a liability in the FASB's conceptual framework. In contrast, under EITF Issue 94-3, a company recognized a liability for an exit cost when it committed to an exit plan. SFAS 146 also established fair value as the objective for initial measurement of liabilities related to exit or disposal activities. We are required to adopt the provisions of SFAS 146 as of January 1, 2003. We do not expect the adoption of SFAS 146 to have a material impact on our financial position or results of operations.

ITEM 2—MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated condensed financial statements and the accompanying notes. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and those listed under "Risks and Uncertainties That You Should Consider Before Investing In Tumbleweed".

We are a leading provider of secure messaging applications for businesses and government organizations using the Internet. Tumbleweed enables business to share sensitive information via e-mail with customers and partners, transforming e-mail from a potential source of liability and drain on resources into a tool for enhancing communication and maximizing productivity. By deploying our secure messaging solutions, businesses enhance customer service, automate traditional paper and voice-based processes, enable secure collaboration with partners, comply with government and company policies to limit liability, enhance employee productivity, and prevent network disruption.

Our suite of secure messaging products provide solutions to some of today's most pressing productivity, customer service and online security needs. By deploying some or all of our solutions, our customers can:

Every industry and organization has unique requirements that change and grow over time. Our suite of secure messaging solutions are designed to be highly flexible, extensible, and scalable. By combining our solutions, organizations can build a comprehensive, enterprise e-mail communications framework that can be mixed and matched to address both immediate and long-term secure communications and customer service needs. Our solutions are being used by some of the world's most demanding companies to provide a secure messaging framework that enhances communication and boosts productivity, while dramatically reducing the costs associated with paper- and phone-based processes.

Revenue, which consists of both product and intellectual property ("IP") revenue as well as services revenue, results from new contracts and backlog. We define backlog as deferred revenue, and contractual commitments that are not due and payable as of the balance sheet date. Product and IP revenue consists of license and transaction fees, and patent license agreement fees. support and maintenance, consulting, and training fees.

A portion of our revenue comes from our international customers or operations. Most of our international contracts are denominated in foreign currencies. We currently do not have hedging or

similar arrangements to protect us against foreign currency fluctuations. Therefore, we may be subject to currency fluctuations, which could harm our operating results in future periods.

During the three months ended September 30, 2002, we made a decision to transition from direct sales operations to indirect sales operations in Europe and Japan due to sustained declines in the operating results of those regions. In Europe, we are winding down our direct sales operations and have signed a reseller agreement with a distributor to sell our products there. In Japan, we reviewed the financial position of TKK, and given the financial position, we began the liquidation of TKK.

Our future net income and cash flow may be adversely affected by limitations on our ability to apply net operating losses for federal income tax reporting purposes against taxable income in future periods, including limitations due to ownership changes, as defined in Section 382 of the Internal Revenue Code, arising from issuance of stock.

In January 2001, our Board of Directors approved a restructuring program intended to align our cost structures with our company-wide focus on customer service, sales and research and development. The restructuring involved consolidating our facilities in the United States and closing international sales office locations in Paris, France; Chatsworth, Australia; and Stockholm, Sweden. The restructuring program also realigned our professional services organization and reduced headcount in most areas of our business. The reduction in force involved approximately 100 employees and total charges incurred as a result of the restructuring were $8.9 million during the three months ended March 31, 2001, which includes charges related to vacating leased facilities domestically and abroad. As of September 30, 2002, we had no remaining liabilities from the January 2001 restructuring.

In August 2002, our Board of Directors approved a program to repurchase up to $10.0 million of our common stock. Although we are not required to purchase any stock under the program, we may purchase shares either in the open market or in negotiated transactions as market and business conditions warrant. The timing and amount of any shares repurchased are determined by our management based on our evaluation of market conditions and other factors. The purchases are made at current market prices or in negotiated transactions off the market and are funded using our working capital. The repurchase program extends over a twelve month period and may be suspended or discontinued at any time. During the three months ended September 30, 2002 we repurchased 654,000 shares of our common stock for $726,000. In October 2002, we adopted a 10b5-1 plan, which allows us to repurchase our stock under our repurchase program during a period in which we are in possession of material non-public information, provided we previously communicated repurchase instructions to our broker at a time when we were not in possession of such material non-public information. The 10b5-1 plan does not increase the aggregate $10.0 million amount authorized for repurchase purposes.

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments in determining the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We regularly evaluate our estimates, including those related to revenue recognition, customer arrangements, collectability of accounts receivable, valuation of assets, and contingencies and litigation. When making estimates, we consider our historical experience, our knowledge of economic and market factors and various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

We believe that the following critical accounting policies represent areas where significant judgments and estimates have been used in the preparation of our consolidated financial statements.

We derive our revenue from two sources (i) product and IP revenue, which includes license and transaction fees, as well as patent license agreement fees, and (ii) services revenue, which includes support and maintenance, consulting, and training fees. As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates.

We typically offer our software products under a perpetual license. Our hosting arrangements require customers to pay a one-time license fee for the right to use our software. We enter into patent license agreements whereby licensees gain access to one or more of our patents for the duration of the patent(s) in exchange for a licensing fee. Transaction fees are based on the volume of transactions or contractual minimum volumes. Support and maintenance fees are paid, in general, for ongoing customer support during the term of the maintenance agreement, and in some instances for the right to receive future updates and upgrades of our products during the term of the maintenance agreement. For consulting engagements, we receive fees on either a monthly basis, a milestone basis, or at the completion of the engagement.

We apply the provisions of Statement of Position ("SOP") 97-2, Software Revenue Recognition, and SOP 98-9, Software Revenue Recognition with Respect to Certain Arrangements, which generally requires revenue recognized from software arrangements to be allocated to each element of the arrangement based on the relative fair values of the elements, such as software products, consulting, training, installation, or post-contract customer support. Fair values are based upon vendor specific objective evidence. If such evidence does not exist for delivered elements, we record revenue using the residual method. If such evidence does not exist for undelivered elements, all revenue from the arrangement is deferred until such time that evidence of fair value does exist, or until all elements of the arrangement are delivered, or revenue is recorded ratably if the only undelivered element is post-contract customer support. For undelivered elements such as consulting services where we can not ascertain the extent of services a customer may implement, the fair value of the consulting services is estimated to be the maximum amount to which the customer is entitled.

We recognize revenue from perpetual licenses upon shipment when the following provisions are met: (i) persuasive evidence of an arrangement exists, generally based on an executed contract and non-binding purchase order; (ii) the product has been delivered, generally to a common carrier, including electronic distribution; (iii) the fee is fixed and determinable; and (iv) collection of the resulting receivable is reasonably probable. We recognize revenue from IP when (i) the patent license agreement is executed and (ii) the amounts due are billable. For contracts with extended payment terms, we recognize revenue as payments become due from the customer. Transaction revenue is recognized based on payment schedules or transaction reports from our customers. A number of our contracts include minimum transaction volume requirements. In these cases, the minimum guaranteed revenue is recognized when fees are due and payable during those months where transaction volume does not exceed the designated minimums.

Revenue from support and maintenance is recognized ratably over the period the support is provided. Consulting revenue related to installation or customization is recognized upon client acceptance or percentage of completion. Training revenue is recognized upon completion of the training.

Revenue from the reseller channel is recognized upon software shipment, the execution of a distribution agreement with the reseller, and the receipt of substantive identification of the end-user customer.

When licenses are sold together with consulting services, license fees are recognized upon delivery, provided that (i) the criteria set forth above have been met, (ii) payment of the license fees is not dependent upon the performance of the consulting and implementation services, and (iii) the services are not essential to the functionality of the software. For arrangements that do not meet the above criteria, both the product license revenues and services revenues are recognized under the percentage of completion contract method in accordance with the provisions of SOP 81-1, Accounting for Performance of Construction Type and Certain Production Type Contracts. We follow this method since reasonably dependable estimates of the revenue and costs applicable to various stages of a contract can be made.

We assess collectability based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. We do not request collateral from our customers. If we determine that collection of a fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash.

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. A considerable amount of judgment is required when we assess the realization of receivables, including assessing the probability of collection and the current credit-worthiness of each customer. We must make estimates of the collectability of our accounts receivables. We specifically analyze accounts receivable, including review of historical bad debts, customer concentrations, customer credit-worthiness, current economic trends, aging of the balance, geographic and industry mix, and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required which would result in an additional general and administrative expense in the period such determination is made.

Our determination of impairment related to certain equity investments in privately held companies is based on the latest available valuation of such investment, or, if unavailable, our assumptions related to projected operating results of the privately held company and potential effects of declines in market trends. Future events that adversely change the assumptions we use to determine valuation of investments may require us to record charges for impairment of the carrying value of our investments.

We assess the impairment of identifiable intangibles, long-lived assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important, which could trigger an impairment review, include the following:

When we determine that the carrying value of long-lived assets and goodwill may not be recoverable upon the existence of one or more of the above indicators of impairment, and such

carrying value is less than projected undiscounted cash flows attributed to the asset, we measure any impairment based on the amount by which the carrying amount of the assets exceeds the fair value of the assets.

SFAS 142 became effective on January 1, 2002 and as a result, we ceased amortizing approximately $6.7 million of goodwill. In connection with SFAS 142's transitional goodwill impairment evaluation, we engaged a third-party independent valuation specialist to assess whether there was an indication that goodwill recorded in connection with our acquisition of TKK was impaired as of the date of adoption. To accomplish this, we determined the carrying value of our reporting unit by assigning our assets and liabilities, including the existing goodwill and intangible assets, to our reporting unit as of the date of adoption. As our TKK reporting unit's carrying amount exceeded its fair value, indicating that TKK's goodwill might be impaired, we performed the second step of the transitional impairment test. In the second step, we compared the implied fair value of TKK's goodwill, determined by allocating TKK's fair value to all of its assets (recognized and unrecognized) and liabilities to its carrying amount, both of which were measured as of the date of adoption. A transitional impairment loss of $974,000 was recognized as the cumulative effect of a change in accounting principle in our consolidated statement of operations.

Revenue. Revenue consists of product and IP revenue and service revenue. Total revenue for the three months ended September 30, 2002 decreased to $5.6 million from $8.2 million for the same three months in 2001. The decrease in revenue for the three month period was due to decreases in consulting revenue and transaction revenue caused by our reduced strategic focus on consulting and transaction revenue, as well as decreases in revenue from our international regions in Europe and Asia, which decreased to $303,000 from $722,000 and to $24,000 from $1.1 million, respectively. Total revenue for the nine months ended September 30, 2002 decreased to $19.6 million from $19.9 million for the same nine months in 2001. The decrease in total revenue for the nine month period was due to decreases in revenue from our international regions in Europe and Asia, which decreased to $1.5 million from $3.6 million and to $404,000 from $2.1 million, respectively. These decreases were partially offset by an increase in maintenance revenue from growth in our installed customer base in the nine months ended September 30, 2002. Revenue from our international regions in Europe and Asia could decrease on a year-over-year basis in future quarters as we transition from direct sales operations to indirect sales operations in those regions.

Product and IP revenue for the three months ended September 30, 2002 decreased to $3.4 million from $5.0 million for the same three months in 2001. The decrease in product and IP revenue for the three month period was due to a drop in transaction revenue caused by our reduced strategic focus on transaction revenue, and a drop in license revenue from our international regions in Europe and Asia. Product and IP revenue for the nine months ended September 30, 2002 increased to $12.3 million from $12.1 million for the same nine months in 2001.

Service revenue for the three months ended September 30, 2002 decreased to $2.2 million from $3.2 million for the same three months in 2001. Service revenue for the nine months ended September 30, 2002 decreased to $7.3 million, or 29% of revenue from $7.7 million, or 37% of revenue, for the same nine months in 2001. The decrease in service revenue for the three and nine month periods was due to a decrease in consulting revenue caused by our reduced strategic focus on consulting revenue, offset in part by an increase in maintenance revenue from growth in our installed customer base.

Cost of Revenue. Cost of revenue is comprised of product and IP costs and service costs. Product license cost is primarily comprised of royalties paid to third parties for software licensed by us for inclusion in our products. Service costs are comprised primarily of personnel and overhead costs related to customer support and contract development projects. Total cost of revenue for the three months ended September 30, 2002 decreased to $1.6 million, or 29% of revenue, from $3.0 million, or 37% of revenue, for the same three months in 2001. Total cost of revenue for the nine months ended September 30, 2002 decreased to $5.6 million, or 29% of revenue, from $9.2 million, or 46% of revenue, for the same nine months in 2001. The decrease in total cost of revenue, as a percentage of revenue, for the three and nine month periods was due to a shift in our services revenue mix to higher margin support and maintenance revenue from lower margin consulting revenue. The decrease in total cost of revenue, in absolute dollars, for the three and nine month periods was primarily due to a decrease in service costs caused by a decrease in headcount. The decrease in headcount was driven by (i) our increased focus regarding the direct implementation and development of our core products, and (ii) the transition from direct sales operations to indirect sales operations in Europe and Asia. Cost of revenue from our international regions in Europe and Asia could decrease on a year-over-year basis in future quarters as we transition from direct sales operations to indirect sales operations in those regions.

Research and Development Expenses. Research and development expenses are comprised of engineering and related costs associated with the development of our applications, quality assurance

and testing. Research and development expenses for the three months ended September 30, 2002 decreased to $2.3 million from $3.6 million for the same three months in 2001. Research and development expenses for the nine months ended September 30, 2002 decreased to $7.9 million from $11.7 million for the same nine months in 2001. The decrease in research and development expenses for the three and nine month periods was primarily due to a decrease in headcount and a reduction in depreciation expense due to lower capital expenditures. The decrease in headcount is due to our decision to reduce the number of our product offerings and outsource development for non-core product offerings.

Sales and Marketing Expenses. Sales and marketing expenses are comprised of salaries, commissions, travel expenses and costs associated with marketing programs. Sales and marketing expenses for the three months ended September 30, 2002 decreased to $3.9 million from $8.5 million for the same three months in 2001. Sales and marketing expenses for the nine months ended September 30, 2002 decreased to $14.8 million from $28.0 million for the same nine months in 2001. The decrease in sales and marketing expenses for the three and nine month periods was primarily due to decreased headcount as well as lower marketing program expenses. The decrease in headcount was due to (i) a shift in our sales focus towards large accounts in target verticals which allowed us to reduce the number of direct sales representatives in North America, and (ii) the transition from direct sales operations to indirect sales operations in Europe and Asia. Sales and marketing expenses from our international regions in Europe and Asia could decrease on a year-over-year basis in future quarters as we transition from direct sales operations to indirect sales operations in those regions.

General and Administrative Expenses. General and administrative expenses consist primarily of personnel and support costs for our finance, legal, information systems, and human resources departments as well as professional fees. General and administrative expenses for the three months ended September 30, 2002 decreased to $909,000 from $2.3 million for the same three months in 2001. General and administrative expenses for the nine months ended September 30, 2002 decreased to $3.3 million from $6.5 million for the same nine months in 2001. The decrease in general and administrative expenses for the three and nine month periods was primarily due to decreased headcount, a reduction in depreciation expense due to lower capital expenditures, reduced expenses on application service providers for our enterprise software systems, and lower bad debt expense. The lower bad debt expense resulted from a decline in the receivables portfolio, increased collections efforts and more centralized operations in the United States, and improved geographic and industry mix of our customers.

Stock Compensation Expense. Stock compensation expense was recorded in connection with the amortization of deferred stock compensation recorded as a result of grants of stock options to non-employees and employees at exercise prices less than the deemed fair value on the grant date, the vesting acceleration of stock options approved for certain employees, and warrants granted to non-employees in exchange for services performed, net of a credit related to stock options granted to employees who were later terminated. The credit resulted from the reversal of accelerated stock compensation expense previously recorded for options cancelled that had not vested. Stock compensation expense for the three months ended September 30, 2002 was a credit of ($175,000) compared to $618,000 for the same three months in 2001. Stock compensation expenses for the nine months ended September 30, 2002 was a credit of ($280,000) compared to $2.6 million for the same nine months in 2001. The credit to stock compensation expense for the three and nine month periods ended September 30, 2002 was the result of the termination of certain employees whose options had not yet vested, in excess of continued amortization.

Amortization of Goodwill and Intangible Assets. Goodwill and other intangible assets resulted from the purchase of Interface and, to a lesser extent, our increase in ownership of TKK from 50% to 80% during 2000. In July 2001, the FASB issued SFAS 142. SFAS 142 requires that goodwill and

intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. We adopted the provisions of SFAS 142 effective January 1, 2002. Prior to our adoption of SFAS 142, goodwill and intangible assets were amortized over their respective lives, generally one to five years. Amortization of goodwill and intangible assets for the three months and nine months ended September 30, 2002 decreased to $0 and $0, respectively, from $1.5 million and $11.1 million, respectively, for the same three and nine month periods, respectively, in 2001 as a result of the adoption of SFAS 142 and the intangible assets becoming fully amortized in September 2001.

Impairment and Restructuring Expenses. In January 2001, our Board of Directors approved a restructuring program intended to align our cost structures with our company-wide focus on customer service, sales and research and development. The restructuring involved consolidating our facilities in the United States and closing international sales office locations in Paris, France; Chatsworth, Australia; and Stockholm, Sweden. The restructuring program also realigned our professional services organization and reduced headcount in most areas of our business. The reduction in force involved approximately 100 employees and total charges incurred as a result of the restructuring were $8.9 million during the nine months ended September 30, 2001, which includes charges related to vacating leased facilities domestically and abroad. As of September 30, 2002, we had no remaining liabilities from the January 2001 restructuring.

During the three months ended March 31, 2001, we performed an impairment assessment of the identifiable intangibles and goodwill recorded in connection with the acquisition of Interface. The assessment was performed primarily due to changes in the economy, the overall decline in the industry growth rate, and our lower actual and projected operating results including that of the business acquired from Interface. Our assessment was supported by the significant sustained decline in our stock price since the valuation date of the shares issued in the Interface acquisition. As a result of the assessment, we recorded a $51.0 million impairment charge to reduce goodwill and other intangible assets to their estimated fair value. The charge was based upon the estimated discounted cash flows over the remaining useful life of the goodwill and other intangible assets using a discount rate of 15%. The assumptions supporting the cash flows, including the discount rate, were determined using our best estimates as of March 31, 2001. The remaining intangible assets were amortized in full over their remaining useful life during 2001.

In connection with SFAS 142's transitional goodwill impairment evaluation, we engaged a third-party independent valuation specialist to assess whether there was an indication that goodwill recorded in connection with our acquisition of TKK was impaired as of the date of adoption. To accomplish this, we determined the carrying value of our reporting unit by assigning our assets and liabilities, including the existing goodwill and intangible assets, to our reporting unit as of the date of adoption. As our TKK reporting unit's carrying amount exceeded its fair value, indicating that TKK's goodwill might be impaired, we performed the second step of the transitional impairment test. In the second step, we compared the implied fair value of TKK's goodwill, determined by allocating TKK's fair value to all of its assets (recognized and unrecognized) and liabilities to its carrying amount, both of which were measured as of the date of adoption. A transitional impairment loss of $974,000 was recognized as the cumulative effect of a change in accounting principle in our consolidated statement of operations.

During the three months ended June 30, 2002 we recorded an impairment charge of $88,000 to write-off our investment balance related to a non-public company that we made an investment in during 2000. During the three months ended September 30, 2002 we recorded an impairment charge of $455,000 to write-off our investment balance related to another non-public company that we made an investment in during 2000.

Other Income, Net. Other income, net, is primarily comprised of interest income earned on investment securities as well as the loss on the sale of short-term investments in the three months ended September 30, 2002. Other income, net, for the three months ended September 30, 2002 decreased to $25,000 from $439,000 for the same three months in 2001. Other income, net, for the nine months ended September 30, 2002 decreased to $760,000 from $2.1 million for the same nine months in 2001. The decrease in other income, net, for the three and nine month periods is due to the decline in interest rates and a reduction in our cash balances relative to the year-earlier period as well as a $207,000 loss on the sale of short-term investments in the three months ended September 30, 2002.

Since inception, we have financed our operations primarily through the issuance of equity securities. On September 30, 2002, we had approximately $30.8 million in cash and cash equivalents, including restricted cash deposits of $729,000 related to our facilities in Redwood City, California and New York, New York.

Net cash used in operating activities for the nine months ended September 30, 2002 decreased to $12.6 million from $29.6 million for the same nine months in 2001. Cash used in operating activities was primarily the result of our net operating loss and adjustments to reconcile net loss to net cash used in operating activities, including a $5.7 million goodwill impairment charge recorded in the three months ended June 30, 2002, a reduction in accounts payable and accrued liabilities of $4.2 million, and lease settlement payments of $2.3 million in the three months ended March 31, 2002 to pay off a restructuring expense recorded in 2001 on facilities no longer required.

Net cash provided by investing activities for the nine months ended September 30, 2002 was $366,000. Net cash used in investing activities was $2.9 million for the same nine months in 2001. Net cash provided by investing activities for the nine months ended September 30, 2002 consists of proceeds of $555,000 from the sale of short-term investments in the three months ended September 30, 2002, offset by purchases of property and equipment. Net cash used in investing activities for the nine months ended September 30, 2001 was comprised of purchases of property and equipment.

Net cash used in financing activities for the nine months ended September 30, 2002 was $600,000. Net cash provided by financing activities was $165,000 for the same nine months in 2001. Net cash used in financing activities for the nine months ended September 30, 2002 was comprised of 654,000 shares of our common stock that we repurchased for $726,000 in the three months ended September 30, 2002 and repayments of borrowings, offset by proceeds from the issuance of equity securities under our stock option and employee stock purchase plans. Net cash provided by financing activities for the nine months ended September 30, 2001 was primarily the result of proceeds from the issuance of equity securities under our stock option and employee stock purchase plans, reduced by payments of borrowings.

As of September 30, 2002, our principal commitments consisted of obligations related to outstanding operating and capital leases and unconditional purchase obligations. Our equipment leases require payment of rental fees to third party leasing providers. In most cases, we have no obligations to purchase the equipment at the end of the lease term. We do not anticipate a substantial increase in capital expenditures in the immediate future. We also do not anticipate an increase in operating lease obligations.

Our capital requirements depend on numerous factors, including revenue generated from operations and market acceptance of our products and services, the resources devoted to the development of our products and services and the resources devoted to sales and marketing. We have decreased our spending on capital expenditures in recent quarters and do not anticipate increases in capital expenditures in the immediate future. We believe that our existing capital resources should enable us to maintain our current and planned operations for at least the next 12 months; however, we may need to raise funds prior to that time.

We will continue to consider future financing alternatives, which may include the incurrence of indebtedness, additional public or private equity offerings or an equity investment by a strategic partner; however, we have no present commitments or arrangements assuring us of any future equity or debt financing. Additionally, equity or debt financing may not be available to us on favorable terms, if at all.

Future cash payments for contractual obligations and commercial commitments as of September 30, 2002, are as follows (in thousands):

RISKS AND UNCERTAINTIES THAT YOU SHOULD CONSIDER BEFORE INVESTING IN TUMBLEWEED.

Our prospects must be considered in light of the risks, expenses, delays and difficulties frequently encountered by companies companies engaged in new and rapidly evolving technology markets like ours. We incurred net losses of $114.2 million, $69.8 million, and $24.2 million in the years ended December 31, 2001, 2000, and 1999, respectively. As of September 30, 2002, we had incurred cumulative net losses of $267.5 million.

Our success may depend in large part upon increased adoption and utilization of our products and technology, as well as our ability to effectively maintain existing relationships and develop new

relationships with customers and strategic partners. If we do not succeed, we may not achieve or maintain profitability on a timely basis or at all. In particular, we intend to expend significant financial and management resources on product development, sales and marketing, strategic relationships, technology and operating infrastructure. As a result, we may incur additional losses and continued negative cash flow from operations for the foreseeable future.

As a result of the emerging nature of the markets in which we compete, we may not be able to accurately forecast our revenue or expenses. Our revenue has fluctuated and our quarterly operating results will continue to fluctuate based on the timing of the execution and termination of customer agreements in a given quarter. Our ability to receive revenue from services is subject to multiple risks, including the risk that we may not be able to meet increasing customer demand because of a lack of adequately trained personnel, and the risk that customers may not timely accept the services provided and delay payment for such services. In addition, we have experienced, and expect to continue to experience, fluctuations in revenue and operating results from quarter to quarter for other reasons, including, but not limited to:

As a result of these factors, we believe that quarter-to-quarter comparisons of our revenue and operating results are not necessarily meaningful, and that these comparisons may not be accurate indicators of future performance. Because our staffing and operating expenses are based on anticipated revenue levels, and because a high percentage of our costs are fixed, small variations in the timing of the recognition of specific revenue could cause significant variations in operating results from quarter to quarter. In addition, many of our customers delay purchases of our products until the end of each quarter. If we are unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall, any significant revenue shortfall would likely have an immediate negative effect on our operating results. Moreover, we believe the difficulties outlined above with respect to financial forecasts also apply to securities analysts that may publish estimates of our financial results. Our operating results in one or more future quarters may fail to meet the expectations of securities analysts or investors due to any of a wide variety of factors, including fluctuations in financial ratios or other metrics used to measure our performance. If this occurs, we would expect to experience an immediate and significant decline in the trading price of our stock.

Economic conditions could adversely affect our revenue growth and ability to forecast revenue.

The revenue growth and profitability of our business depends on the overall demand for our products, our intellectual property, and our services, particularly within the industries in which we offer specific versions of our products. Because our sales are primarily to customers in the financial services, health care, and government industries, our business depends on the overall economic conditions and

the economic and business conditions within these industries. The progressive weakening of the global economy, the weakening of the information technology industry, and the weakening of the business conditions within the above industries has caused a decrease in our license revenues. A softening of demand for computer software caused by a continued weakening of the economy, domestically or internationally, may result in a continued decrease in revenues.

In addition, the financial, political, economic and other uncertainties following the terrorist attacks upon the United States have led to a further weakening of the global economy, and have created an uncertain economic environment. We cannot predict the impact of these events, any subsequent terrorist acts or of any related military action, on our customers or business. Subsequent terrorist acts and/or the threat of future outbreak or continued escalation of hostilities involving the United States or other countries could adversely affect spending on information technology and on our software license revenue, as well as have an adverse effect on our business, financial condition or results of operations.

As of September 30, 2002, we had cash and cash equivalents of $30.8 million and incurred cumulative net losses of $267.5 million. Our current cash reserves, especially in light of our $10.0 million stock repurchase program authorized in August of 2002, may be insufficient in the face of either lower than expected revenues or extraordinary or unexpected cash expenses. As a result, we may be required to raise funds through public or private financings, strategic relationships, or other arrangements. Funding, if needed, however, may not be available on acceptable terms or at all. If adequate funds are not available, we may be required to curtail significantly or defer one or more of our operating goals or programs, or take other steps that could harm our business.

A limited number of customers account for a high percentage of our revenue, and the failure to maintain or expand these relationships could harm our business.

The loss of one or more of our major customers, the failure to attract new customers on a timely basis or a reduction in usage and revenue associated with the existing or proposed customers would harm our business and prospects. For the three months ended September 30, 2002 and 2001, five customers comprised approximately 30% and 21%, respectively, of our revenue. For the three and nine month periods ended September 30, 2002, and 2001, respectively, no single customer comprised 10% or more of our revenue.

Failure to obtain needed financing could affect our ability to maintain current operations and pursue future growth, and the terms of any financing we obtain may impair the rights of our existing stockholders.

In the future, we may be required to seek additional financing to fund our operations. Factors such as the commercial success of our existing products and services, the timing and success of any new products and services, the progress of our research and development efforts, our results of operations, the status of competitive products and services, and the timing and success of potential strategic alliances or potential opportunities to acquire or sell technologies or assets may require us to seek additional funding sooner than we expect. In the event that we require additional cash, we may not be able to secure additional financing on terms that are acceptable to us, especially in light of the uncertainty in the current market environment, and we may not be successful in implementing or negotiating such other arrangements to improve our cash position. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced and the securities we issue might have rights, preferences and privileges senior to those of our current stockholders. If adequate funds were not available on acceptable terms, our ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion,

take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures could be significantly limited.

We assume a certain level of credit risk with our customers in order to do business. Conditions affecting any of our customers could cause them to become unable or unwilling to pay us in a timely manner, or at all, for products or services we have already provided them. For example, if the current economic conditions continue to decline or if new or unanticipated government regulations are enacted which affect our customers, they may be unable to pay their bills. In the past, we have experienced significant collection delays from certain customers, and we cannot predict whether we will continue to experience similar or more severe delays in the future. In particular, some of our customers are suffering from the general weakness in the economy and among technology companies in particular. Although we have established reserves that we believe are sufficient to cover losses due to delays in or inability to pay and while we take a consistently conservative position on the collectability of revenue with respect to particular customers, our reserves may not be sufficient to cover our losses. If losses due to delays or inability to pay are greater than our reserves, we would be required to recognize an additional expense for the write-off and to increase our reserves, which could adversely affect our operating results.

If we do not secure key relationships with enterprise customers, our access to broader markets will be limited.

Our enterprise customers, which use or intend to use our products to intelligently manage the incoming and outgoing online communications of their enterprises, are a significant source of our revenue. A key aspect of our strategy is to access target markets prior to adoption of alternative solutions by the larger participants in these markets. The failure to secure key relationships with new enterprise customers in targeted markets could limit or effectively preclude our entry into these target markets, which would harm our business and prospects.

Customers in a preliminary phase of implementing our product may not proceed on a timely basis or at all.

Some of our customers are currently in a pre-production or pre-launch stage of implementing our products and may encounter delays or other problems in introducing them. A customer's decision not to do so or a delay in implementation could result in a delay or loss in related revenue or otherwise harm our businesses and prospects. We cannot predict when any customer that is currently in a pilot or preliminary phase will implement broader use of our services.

The markets for secure messaging applications generally, and for our products specifically, are new and may not develop.

The market for our products and services is new and evolving rapidly. If the market for our products and services fails to develop and grow, or if our products and services do not gain broad market acceptance, our business and prospects will be harmed. In particular, our success will depend upon the adoption and use by current and potential customers and their end-users of secure messaging applications. Our success will also depend upon acceptance of our technology as the standard for providing these services. The adoption and use of our products and services will involve changes in the manner in which businesses have traditionally exchanged information. In some cases, our customers have little experience with products, services and technology like those offered by us. Our ability to influence usage of our products and services by customers and end-users is limited. For example, the usage of Secure Messenger by the end-users of our service provider customers has been limited to date. We have spent, and intend to continue to spend, considerable resources educating potential customers and their end-users about the value of our products and services. It is difficult to assess, or to predict with any assurance, the present and future size of the potential market for our products and services, or our growth rate, if any. Moreover, we cannot predict whether our products and services will achieve any market acceptance. Our ability to achieve our goals also depends upon rapid market acceptance of future enhancements of our products and our ability to identify new markets as they emerge. Any enhancement that is not favorably received by customers and end-users may not be profitable and, furthermore, could damage our reputation or brand name. Any failure to identify and address new market opportunities could harm our business and prospects.

We may not find broad acceptance of the Tumbleweed Secure Guardian suite of products.

In October of 2001 we re-launched our existing product line under the Tumbleweed Secure Guardian suite of products including Tumbleweed Secure Mail (formerly Tumbleweed MMS) and Tumbleweed Secure Messenger, Tumbleweed Secure Statements (formerly IME and IME Statements) and Tumbleweed Secure Redirect (formerly MMS Secure Redirect). If we do not obtain anticipated acceptance and understanding of these re-branded product offerings, our ability to grow our sales may suffer. In addition, if we do not achieve the anticipated growth of the new marketing or even suffer sales decreases as a result of misperceptions of our products, we may be forced to expend additional resources in new or different marketing directions.

The markets we address are highly competitive and rapidly changing, and we may not be able to compete successfully.

We may not be able to compete successfully against current and future competitors, and the multiple competitive pressures we face could harm our business and prospects. The markets in which we compete are intensely competitive and rapidly changing.

Our principal competition for our Tumbleweed Secure Guardian protection solutions are companies that offer various Internet content security, web security, messaging policy management, and enterprise relationship management products. Companies that sell products that compete with some of the features within our products include Kana Communications, Inc, Clearswift Technologies, Symantec Corp. and Trend Micro Incorporated.

Our principal competition in the secure document delivery and statement presentment market area comes from other online communication or information security service providers, some of which have services or products that are intended to compete directly with our products or that could be used as alternatives to our products. Examples of some of these providers are Automatic Data Processing, Inc.; DST Systems, Inc.; PostX Corporation; and Sigaba Corporation. Our solutions can be an alternative to traditional mail and courier delivery services such as those offered by Federal Express Corporation, UPS, or the U.S. Postal Service, and to general purpose e-mail applications and services. In addition, companies with which we do not presently directly compete may become competitors in the future, either through the expansion of our products or through their product development in the area of secure online communication services. These companies include International Business Machines Corporation/Lotus Development Corporation, and Microsoft Corporation.

The principal competitive factors in our industry include price, product functionality, product integration, platform coverage and ability to scale, worldwide sales infrastructure and global technical support. Some of our competitors have greater financial, technical, sales, marketing and other resources than we do, as well as greater name recognition and a larger installed customer base. Additionally, some of these competitors have research and development capabilities that may allow them to develop new or improved products that may compete with product lines we market and distribute. We expect that the market for secure messaging applications will become more consolidated with larger companies being better positioned to compete in such an environment in the long term. As this market continues to develop, a number of companies with greater resources than ours could attempt to increase their presence in this market by acquiring or forming strategic alliances with our competitors or business partners. Our success will depend on our ability to adapt to these competing forces, to develop more advanced products more rapidly and less expensively than our competitors, and to educate potential customers as to the benefits of licensing our products rather than developing their own products. Competitors could introduce products with superior features, scalability and functionality at lower prices than our products and could also bundle existing or new products with other more established products in order to compete with us. In addition, because there are relatively low barriers to entry for the software market, we expect additional competition from other established and emerging companies. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any of which could harm our business.

Our recent product releases may not be accepted and our development efforts may be hindered by a variety of factors.

In October 2001 we released the newest versions of our existing product lines (Secure Mail 5.0 and Secure Messenger 5.0) under the Secure Guardian Framework. These releases may not be scalable, may contain unexpected bugs or problems, may not meet customers' requirements or expectations and may not be accepted as providing added value to our existing customers. In addition, the installation of integrated or complementary software products at customer sites may result in difficulties associated

with customer-specific installation processes and may result in new issues arising with respect to our new software releases.

Restructuring of operations and other cost reducing measures we have implemented may not achieve the results we intend and even may harm our business.

In January 2001, we announced a restructuring of our business, which included a reduction in force and the closure of three international locations. Since that time we have engaged in other ongoing measures to reduce expenses and establish an enterprise that is appropriate for our expected revenue levels including making a decision during the three months ended September 30, 2002, to change our sales distribution model from direct sales operations to indirect sales operations in Europe and Japan. The planning and implementation of these efforts have placed, and may continue to place, a significant strain on our managerial, operational, financial and other resources. Additionally, the actions undertaken to restructure the business may negatively affect our revenue stream, customer satisfaction, employee turnover, recruiting and retention of important employees. If we experience difficulties in carrying out the restructuring, our expenses could increase more quickly than we expect. If we find that the actions taken to date did not sufficiently decrease our expenses, we may find it necessary to implement further streamlining of our expenses, to perform additional reductions in our headcount or to undertake additional restructurings of our business.

We restructured our business in 2001, which has placed, and continues to place, a significant strain on managerial, informational, administrative and operational resources. Our current systems, procedures and controls may not be adequate to achieve the rapid execution necessary to effectively operate within the market for our products and services. We need to continue to enhance and improve our managerial capacity, and improve or replace our existing operational, customer service and financial systems, procedures and controls. Any failure to properly manage these systems and procedural transitions could impair our ability to attract and service customers, and could cause us to incur higher operating costs and delays in the execution of our business plan. Despite our restructuring, we expect that we may need to expand elements of our employee base on a selective basis. Our management may not be able to hire, train, retain, motivate and manage required personnel. In addition, our management may not be able to successfully identify, manage and exploit existing and potential market opportunities. If we cannot manage growth effectively, our business and operating results could suffer. Finally, we may have operational, customer service and financial systems that are not appropriate for our current estimated size. Moving to more appropriate office systems may also place a strain on our current systems and require financial expenditures to end the commitments on other systems.

We have a lengthy sales and implementation cycle which could harm our business.

If we are unable to license our services to new customers on a timely basis or if our existing and proposed customers and their end-users suffer delays in the implementation and adoption of our services, our revenue may be limited and business and prospects may be harmed. Our customers must evaluate our technology and integrate our products and services into the products and services they provide. In addition, our customers may need to adopt a comprehensive sales, marketing and training program in order to effectively implement some of our products. Finally, we must coordinate with our customers using our product for third-party communications in order to assist end-users in the adoption of our products. For these and other reasons, the cycle associated with establishing licenses and implementing our products can be lengthy. This cycle is also subject to a number of significant delays over which we have little or no control. Forecasts about license revenue may be inaccurate as a result

of any or all of these factors, and inaccurate forecasts may cause our business, or market valuation, to suffer.

A failure to protect our intellectual property may significantly harm our business.

We currently rely on a combination of patents, trade secrets, copyrights, trademarks and licenses, together with non-disclosure and confidentiality agreements to establish and protect our proprietary rights in our products. We hold certain patent rights with respect to some of our products. We have filed, and expect in the future to file, additional patent applications. Our existing patents or trademarks, as well as any future patents or trademarks obtained by us, may be challenged, invalidated or circumvented, or our competitors may independently develop or patent technologies that are substantially equivalent or superior to our technology. Further patent or trademark protection may not be obtained, in the United States or elsewhere, for our existing or new products, applications or services. In addition, further protection, if obtained, may not be effective. In some countries, meaningful patent or trademark protection is not available.

Third parties could assert infringement claims against us in the future, and the cost of responding to such assertions, regardless of their validity, could be significant. We may increasingly be subject to claims of intellectual property infringement as the number of our competitors grows and the functionality of their products and services increasingly overlap with ours. We aggressively seek to enforce our patent and other intellectual property rights. The enforcement process may be costly and require significant management attention. In addition, our enforcement of our patent and other intellectual property rights may increase the risk of adverse claims, with or without merit, which could be time consuming to defend, result in costly litigation, divert management's attention and resources, limit use of our services or require us to enter into royalty or license agreements. In addition, such claims may be found to be valid and could result in awards against us, which could harm our business.

We also rely, to some extent, on unpatented trade secrets and other unpatented proprietary information. Our policy is to have employees sign confidentiality agreements, to have selected parties sign non-competition agreements and to have third parties sign non-disclosure agreements. Although we take precautionary measures to maintain our unpatented proprietary information, others may acquire equivalent information or otherwise gain access to or disclose our proprietary information and we may be unable to meaningfully protect our rights to our proprietary information.

If we do not provide adequate support services to our customers to implement our products, our business may suffer.

Our professional services organization assists our customers in implementing our products through software installation, integration with existing customer systems, contract engineering, consulting and training. If the professional services organization does not adequately assess customer requirements or address technical problems, customers may seek to discontinue their relationships with us due to dissatisfaction with the product or our customer support. Furthermore, these customers may realize lower usage than they could have otherwise achieved because they did not fully capitalize on the product in ways that could have been addressed by our professional services organization. Our products must be integrated with existing hardware and complex software products of our customers or other third parties, and our customers may not have significant experience with the implementation of products similar to our own. In addition, profitably providing contract engineering and integration services is an increasingly important aspect of our strategy to strengthen customer loyalty to our product and company. Therefore, our business and future prospects significantly depend on the strength of our professional services organization and our ability to leverage this organization by augmenting our reach through trained and qualified systems integrators. If our professional services organization does not adequately meet these multiple challenges, our business and prospects could suffer.

Product performance problems, system failures, and internet problems could severely damage our business.

The ability of our customers to use Tumbleweed-based services depends on stable product performance, and the efficient and uninterrupted operation of the computer and communications hardware as well as the software and Internet network systems that they maintain. Although our ability to manage the effects of system failures which occur in computer hardware, software and network systems is limited, the occurrences of these failures could harm our reputation, business and prospects. The Internet has experienced a variety of outages and other delays as a result of damage to portions of our infrastructure, and the Internet could face similar outages and delays in the future. In addition, an increasing number of our customers require us to provide computer and communications hardware, software and Internet networking systems to them as an outsourced data center service. All data centers, whether hosted by us, our customers or by an independent third party to which it outsources this function, are vulnerable to damage or interruption from fire, flood, earthquake, power loss, telecommunications failure or other similar events.

If our software contains errors, we may lose customers or experience reduced market acceptance of our products.

Our software products are inherently complex and may contain defects and errors that are detected only when the products are in use. In addition, some of our customers require or may require enhanced customization of our software for their specific needs, and these modifications may increase the likelihood of undetected defects or errors. Further, we often render implementation, consulting and other technical services, the performance of which typically involves working with sophisticated software, computing and networking systems, and we could fail to meet customer expectations as a result of any defects or errors. As a result, we may lose customers, customers may fail to implement our products more broadly within their organization and we may experience reduced market acceptance of our products. Some of our products are designed to facilitate the secure transmission of sensitive business information to specified parties outside the business over the Internet. As a result, the reputation of our software products for providing good security is vital to their acceptance by customers. Our products may be vulnerable to break-ins, theft or other improper activity that could jeopardize the security of information for which we are responsible. Problems caused by product defects, failure to meet project milestones for services or security breaches could result in loss of or delay in revenue, loss of market share, failure to achieve market acceptance, diversion of research and development resources, harm to our reputation, or increased insurance, service and warranty costs. To address these problems, we may need to expend significant capital resources that may not have been budgeted.

We may be unable to recruit, retain and motivate qualified personnel, which could harm our business, including product development.

We must continue to identify, recruit, hire, train, retain and motivate highly skilled technical, managerial, sales, marketing and customer service personnel. Competition for these personnel is intense, and we may not be able to successfully recruit, assimilate or retain sufficiently qualified personnel. In particular, we may encounter difficulties in recruiting a sufficient number of qualified software developers and sales personnel, and we may not be able to retain these employees. The failure to recruit and retain necessary technical, managerial, sales, merchandising, marketing and customer service personnel could harm our business and our ability to obtain new customers and develop new products. Although we have used and continue to use stock options as a retention tool, many of our employees hold stock options that are "underwater" (i.e., the market price of our stock is below their option exercise price), and these options may be ineffective as a retention tool. Our employee turnover may increase if outstanding stock options continue to remain underwater and we do not adjust the

option exercise prices. Any adjustment of stock option exercise prices may result in dilution to our stockholders and depress our stock price.

If we lose the services of executive officers or other key employees, our ability to develop our business and secure customer relationships will suffer.

We are substantially dependent on the continued services and performance of our executive officers and other key personnel. The loss of the services of any of our executive officers or other key employees could significantly delay or prevent the achievement of our development and strategic objectives. We do not have long-term employment agreements with any of our key personnel. The loss of services of any of our executive officers or other key personnel could significantly harm our business and prospects.

Our efforts to establish, maintain and strengthen our brands will require significant expenditures and may not be successful.

If the marketplace does not associate our brands with high quality Internet communication services, it may be more difficult for us to attract new customers or introduce future products and services. The market for our services is new. Therefore, our failure to establish brand recognition at this stage could harm our ability to compete in the future with other companies that successfully establish a brand name for their services. We must succeed in our marketing efforts, provide high quality services and increase our user base in order to build our brand awareness and differentiate our products from those of our competitors. These efforts have required significant expenditures to date. Moreover, we believe that these efforts will require substantial commitments of resources in the future as our brands become increasingly important to our overall strategy and as the market for our services grows.

Because our products utilize the Internet, if use of the Internet does not increase, or the architecture of the Internet is altered, the level of use of our products will suffer.

If the Internet and other products and services necessary for the utilization of our products are not sufficiently developed, fewer customers and end-users will use our products and our business will be harmed. In particular, the success of our products and services will depend on the development and maintenance of adequate Internet infrastructure, such as a reliable network backbone with the necessary speed, data capacity and other features demanded by users. Moreover, our success will also depend on the timely development of complementary products or services such as high-speed Internet connections for providing reliable access and services and this may not occur. Moreover, changes in the architecture of the Internet may limit the success of our products. Because the online exchange of information is new and evolving, the Internet may not prove to be a viable platform for secure messaging applications in the long term. The Internet has experienced, and is expected to continue to experience, significant growth in the numbers of users and amount of traffic. As the Internet continues to experience increased numbers of users and frequency of use, or if its users require increasingly more resources, the Internet infrastructure may not be able to support the demands placed on it. As a result, the performance or reliability of the Internet may be harmed. This in turn could decrease the level of Internet usage and also the level of utilization of our products and services.

Government regulation relating to the Internet may increase costs of doing business or require changes in our business model.

We are subject to regulations applicable to businesses generally and laws or regulations directly applicable to companies utilizing the Internet. Although at present there are relatively few specific laws and regulations directly applicable to the Internet, it is possible that a number of laws and regulations may be adopted with respect to the Internet. These laws could cover issues like user privacy, pricing,

content, intellectual property, distribution, taxation, antitrust, legal liability and characteristics and quality of products and services. The adoption of any additional laws or regulations could decrease the demand for our products and services and increase our cost of doing business or otherwise harm our business or prospects. Delays in the enactment of expected regulations may result in delayed software purchasing by our customers who are subject to such regulations, which in turn may harm our business.

Moreover, the applicability to the Internet of existing laws in various jurisdictions governing issues like property ownership, sales and other taxes, libel and personal privacy is uncertain and may take years to resolve. For example, tax authorities in a number of states are currently reviewing the appropriate tax treatment of companies engaged in online commerce. New state tax regulations may subject us to additional state sales and income taxes. Any new legislation or regulation, the application of laws and regulations from jurisdictions whose laws do not currently apply to our business, or the application of existing laws and regulations to the Internet and commercial online services could harm our ability to conduct business and harm operating results.

Our products are subject to export controls, and we may be unable to obtain necessary export approvals.

Exports of software products utilizing encryption technology are generally restricted by the U.S. and various foreign governments. All cryptographic products require export licenses from certain U.S. government agencies. We have obtained approval to export products using up to 128-bit symmetric encryption and 1024-bit public key encryption, including the products formerly named IME Server, IME Desktop, IME Receive Applet, IME Remote API using OmniORB with SSL, MMS WorldWide/56 and MMS Strong WorldWide/128. We are not exporting other products and services that are subject to export control under U.S. law. However, the list of products and countries for which export approval is required, and the related regulatory policies, could be revised, and we may not be able to obtain necessary approval for the export of future products. The inability to obtain required approvals under these regulations could limit our ability to make international sales. Furthermore, competitors may also seek to obtain approvals to export products that could increase the amount of competition we face. Additionally, countries outside of the U.S. could impose regulatory restrictions impairing our ability to import our products into those countries.

Costs of communicating via the Internet could increase if access fees are imposed.

Certain local telephone carriers have asserted that the increasing popularity and use of the Internet has burdened the existing telecommunications infrastructure, and that many areas with high Internet use have begun to experience interruptions in telephone service. These carriers have petitioned the Federal Communications Commission to impose access fees on Internet service providers and online service providers. If these access fees are imposed, the costs of communicating on the Internet could increase substantially, potentially slowing the increasing use of the Internet. This could in turn decrease demand for our services or increase the costs of doing business.

As a provider of Internet communication products and services, we face potential liability for defamation, negligence, copyright, patent or trademark infringement and other claims based on the nature and content of the materials transmitted online. Any imposition of liability, particularly liability that is not covered by insurance or is in excess of insurance coverage, could be costly and could require us to implement measures to reduce exposure to this liability. This may require us to expend substantial resources or to discontinue selected service or product offerings.

We do not and cannot screen all of the content generated by users of our product but may be exposed to liability with respect to this content. Furthermore, certain foreign governments, such as

Germany, have enforced laws and regulations related to content distributed over the Internet that are more strict than those currently in place in the U.S. Other countries, such as China, regulate or prohibit the transport of telephonic data in their territories. Failure to comply with regulations in a particular jurisdiction could result in fines or criminal penalties or the termination of service in one or more jurisdictions. Moreover, the increased attention focused on liability issues as a result of lawsuits and legislative proposals could impact the growth of Internet use. Liability insurance may not cover claims of these types, or may not be adequate to indemnify against all liability that may be imposed.

Interface Systems, Inc., a Tumbleweed subsidiary, is a defendant in a purported securities lawsuit.

On July 7, 2000, three complaints were filed by David H. Zimmer, Congressional Securities, Inc. and other plaintiffs against Interface Systems, Inc. (a company Tumbleweed acquired in 2000) and various additional defendants, including Interface's prior president and chief executive officer, Robert A. Nero, and Fiserv Correspondent Services, Inc., in the United States District Court for the Southern District of New York. The three complaints contained substantially similar allegations of false and misleading representations by various defendants allegedly designed to inflate Interface's stock price. The complaints sought relief under the federal securities laws on behalf of purported classes of persons who purchased, held, or sold shares of Interface stock, and under various other causes of action. On July 27, 2001, the Court granted our motion to transfer the lawsuits to the United States District Court for the Eastern District of Michigan, which, on April 19, 2002, dismissed with prejudice plaintiffs' class allegations and federal securities law claims that purportedly arose under Section 10(b) of the Securities Exchange Act of 1934. Also on April 19, 2002, plaintiffs filed a Second Amended Consolidated Complaint that (i) consolidated the separate actions into one action, (ii) added certain new plaintiffs, (iii) withdrew Congressional Securities, Inc. as a plaintiff, and (iv) added claims for breach of fiduciary duty and negligent misrepresentation, which are the sole remaining claims in the case. On May 20, 2002, we filed a motion to dismiss these claims, which motion has remained pending before the Court while the case has continued to proceed through the discovery phase. The accompanying financial statements do not include a reserve for any costs for damages, if any, that might result from this uncertainty. We believe this consolidated action is without merit and intend to vigorously defend against it and seek its dismissal.

Internet and technology related stock prices are especially volatile and this volatility may depress our stock price.

The stock market has experienced significant price and volume fluctuations and the market prices of securities of technology companies, particularly Internet-related companies, have been highly volatile. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted against companies. The institution of this type of litigation against us could result in substantial costs and a diversion of our management's attention and resources, which could harm our business and prospects.

Our certificate of incorporation and bylaws contain provisions that could discourage or prevent an acquisition of Tumbleweed, which could depress our stock price.

Our certificate of incorporation and bylaws may inhibit changes of control that are not approved by our Board of Directors. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. In particular, our certificate of incorporation provides for a classified Board of Directors and prohibits stockholder action by written consent. These provisions require advance notice for nomination of directors and stockholders' proposals. In addition, as a

Delaware corporation, we are subject to Section 203 of the Delaware General Corporation Law. In general, this law prevents a person who becomes the owner of 15% or more of the corporation's outstanding voting stock from engaging in specified business combinations for three years unless specified conditions are satisfied. In addition, our certificate of incorporation allows our Board of Directors to issue preferred stock without further stockholder approval. This could have the effect of delaying, deferring or preventing a change in control. The issuance of preferred stock also could effectively limit the voting power of the holders of Tumbleweed common stock. The provisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, may discourage or prevent an acquisition or disposition of our business.

We may not be able to maintain our listing on The Nasdaq National Market, and if we fail to do so, the price and liquidity of our common stock may decline.

The Nasdaq Stock Market has quantitative maintenance criteria for the continued listing of common stock on the Nasdaq National Market. The requirements include maintaining a minimum bid price per share of $1. As of November 14, 2002, we were in compliance with all Nasdaq National Market listing requirements. However, there have been recent periods when the closing bid price per share for our common stock has dropped below $1. Although our bid price has generally been above $1 per share, if the bid price of our common stock price slips below $1 per share for more than 30 trading days, we may be required to effect a reverse stock split or become subject to a delisting action of our common stock on The Nasdaq National Market. We may nonetheless be unable to comply with the quantitative maintenance criteria or any of the Nasdaq National Market's listing requirements and other rules in the future. If we fail to maintain continued listing on the Nasdaq National Market and must move to a market with less liquidity, our financial condition could be harmed and our stock price may decline. If we were to be delisted, it could have a material adverse effect on the market price of, and the liquidity of the trading market for, our common stock.

We currently do not use financial instruments to hedge international operating expenses denominated in the respective local currency. As a result, our financial results could be affected by changes in foreign currency exchange rates or weak economic conditions in foreign markets. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.

We do not use derivative financial instruments for speculative trading purposes, nor do we hedge our foreign currency exposure in a manner that entirely offsets the effects of changes in foreign exchange rates. We regularly review our hedging program and may as part of this review determine at any time to change our hedging program.

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the fair value of the investment to fluctuate. For example, if we hold a security that was issued with a fixed rate equal to the then-prevailing interest rate and the prevailing interest rate later rises, the fair value of our investment will decline. To minimize this risk, we maintain our portfolio of cash equivalents in commercial paper and money market funds. In general, our investments are not subject to market risk because the interest paid on these funds fluctuates with the prevailing interest rate. As of September 30, 2002, none of our cash equivalents were subject to market risk.

Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to Tumbleweed (including our consolidated subsidiaries) required to be included in our reports filed or submitted under the Exchange Act.

Subsequent to September 30, 2002, we implemented a new financial accounting system. The new financial accounting system has been designed to maintain our existing internal controls. The implementation of the new financial accounting system has no impact on our financial statements as of September 30, 2002.

In addition to the matters discussed below, in the normal course of business, we are at times subject to pending and threatened legal actions and proceedings. Management believes that the outcomes of such actions or proceedings will not have a material adverse effect on our financial position or results of operations.

In September 2002, we received a letter from Entrust, Inc. ("Entrust") indicating that we may be interested in licensing the technology covered by U.S. Patent No. 6,393,568 ("Encryption and Decryption System and Method with Content Analysis Provision") (the "'568 Patent") issued to Entrust. We believe that we do not infringe the '568 patent and in October 2002 we sent a letter to Entrust indicating that Entrust may be interested in licensing the technology covered by four patents issued to Tumbleweed, namely, U.S. Patent Nos. 6,061,448 ("Method & System For Dynamic Server Document Encryption"), 6,119,137 ("Distributed Dynamic Document Conversion Server"), 6,151,675 ("Method & Apparatus For Effecting Secure Document Format Conversion"), and 6,470,086 ("Method & Apparatus For Effecting Secure Document Format Conversion"). If we were to conclude based on additional information that some element of our processes are or might be covered by the '568 patent, we might seek to negotiate and obtain a license from Entrust. If we were unwilling or unable to obtain a license from Entrust, we would remain subject to potential liability for patent infringement. Although we will contest any lawsuit by Entrust vigorously, we cannot make assurances that we will prevail if Entrust were to sue us for infringement of the '568 Patent. If any portions of our products were found to be infringing the '568 patent, then we would likely be unable to continue to offer those portions of our products found to be infringing. We could also then be required to pay damages for past infringing use, possibly attorneys' fees, and possibly treble damages. This could have a material adverse effect on our business prospects, financial condition, results of operations, and cash flows.

In May 2002 we sued PayPal, Inc. alleging infringement of our U.S. Patent No. 5,790,790 and our U.S. Patent No. 6,192,407. In May 2002 PayPal filed an answer and counterclaims denying our allegations and seeking declarations from the court that our patents are not infringed and are invalid. In September 2002 we filed a First Amended Complaint that added eBay, Inc. as a defendant. Both PayPal and eBay filed an answer and counterclaims to the First Amended Complaint denying our allegations and seeking declarations from the court that our patents are not infringed and are invalid. The litigation is proceeding and is currently in the claim construction phase.

In September 2002 we sued Yahoo!, Inc. alleging infringement of our U.S. Patent No. 5,790,790 and our U.S. Patent No. 6,192,407. This litigation is in its preliminary phases.

In October 2002 we sued E*Trade, Inc. alleging infringement of our U.S. Patent No. 6,192,407. This litigation is in its preliminary phases.

On May 30, 2002, we held our Annual Meeting of Stockholders. The stockholders voted on the following matters:

1) Election of directors: Christopher Greendale, David Marquardt and Standish O'Grady were elected as Class III directors for a term expiring in 2005. Votes were counted as follows:

	For	Broker Withheld
Christopher Greendale	20,157,498	106,655
David Marquardt	20,157,264	106,889
Standish O'Grady	19,954,009	310,655

2) Ratification of the selection of KPMG LLP as our independent auditors for the fiscal year ending December 31, 2002. The selection of KPMG LLP was ratified by a vote of 22,843,550 for and 234,540 votes against, with 26,753 votes withheld or abstaining and no shares non-voting.

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, hereunto duly authorized:

CERTIFICATION
Pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Jeffrey C. Smith, Chairman and Chief Executive Officer of Tumbleweed Communications Corp. (the "Company"), certify that:

1. I have reviewed this quarterly report on Form 10-Q of Tumbleweed Communications Corp.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):

6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

CERTIFICATION
Pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Gregory M. Capitolo, Senior Vice President—Finance and Chief Financial Officer of Tumbleweed Communications Corp. (the "Company"), certify that:

1. I have reviewed this quarterly report on Form 10-Q of Tumbleweed Communications Corp.;

			September 30, 2002			December 31, 2001
			(unaudited)
Assets
Current Assets:
	Cash and cash equivalents		$	30,828		$	43,750
	Accounts receivable, net			4,530			6,795
	Prepaid expenses and other current assets			1,122			2,022

		Total current assets		36,480			52,567
Property and equipment, net				2,342			4,935
Goodwill, net				—			6,687
Other assets				772			1,121

		Total assets	$	39,594		$	65,310

Liabilities and Stockholders' Equity
Current liabilities:
	Accounts payable		$	1,988		$	2,738
	Current installments of long-term debt			166			379
	Accrued liabilities			4,577			8,067
	Accrued restructuring			—			2,335
	Deferred revenue			7,055			6,330

		Total current liabilities		13,786			19,849
	Long-term debt, excluding current installments			118			194
	Deferred revenue			1,219			1,568
	Other long-term liabilities			—			248

		Total liabilities		15,123			21,859
Minority interest				—			356
Stockholders' equity:
	Common stock			31			31
	Additional paid-in capital			293,387			294,727
	Treasury stock			(726	)		—
	Deferred compensation expense			(111	)		(1,834	)
	Accumulated other comprehensive loss			(631	)		(585	)
	Accumulated deficit			(267,479	)		(249,244	)

		Total stockholders' equity		24,471			43,095
		Total liabilities and stockholders' equity	$	39,594		$	65,310

			Three Months Ended September 30,						Nine Months Ended September 30,
			2002			2001			2002			2001
Revenue
	Product and intellectual property revenue		$	3,384		$	4,958		$	12,295		$	12,117
	Service revenue			2,167			3,197			7,312			7,734

		Total revenue		5,551			8,155			19,607			19,851
Cost of revenue(1)				1,596			3,013			5,630			9,150

Gross profit				3,955			5,142			13,977			10,701
Operating expenses:
	Research and development(2)			2,286			3,615			7,902			11,738
	Sales and marketing(3)			3,944			8,472			14,802			27,984
	General and administrative(4)			909			2,286			3,310			6,537
	Stock-based compensation			(175	)		618			(280	)		2,607
	Amortization of goodwill and intangible assets			—			1,485			—			11,069
	Impairment of goodwill and intangible assets			—			—			5,713			50,983
	Restructuring expenses(5)			—			—			—			8,939

		Total operating expenses		6,964			16,476			31,447			119,857

		Operating loss		(3,009	)		(11,334	)		(17,470	)		(109,156	)
Other income, net				25			439			760			2,064
Impairment of investments				(455	)		—			(543	)		—

Net loss before provision for taxes				(3,439	)		(10,895	)		(17,253	)		(107,092	)
	Provision for (benefit from) taxes			2			(4	)		8			57

	Net loss before cumulative effect of change in accounting principle			(3,441	)		(10,891	)		(17,261	)		(107,149	)
	Cumulative effect of change in accounting principle			—			—			(974	)		—

	Net loss		$	(3,441	)	$	(10,891	)	$	(18,235	)	$	(107,149	)

Net loss per share—basic and diluted			$	(0.11	)	$	(0.36	)	$	(0.59	)	$	(3.56	)

Weighted average shares—basic and diluted				30,682			30,296			30,723			30,086

Pro forma amounts assuming change in accounting principle is applied retroactively:
	Net loss			(3,441	)		(9,751	)		(17,261	)		(98,602	)
	Net loss per share—basic and diluted		$	(0.11	)	$	(0.32	)	$	(0.56	)	$	(3.28	)

				Nine months ended September 30,
				2002			2001
Cash flows from operating activities:
	Net loss			$	(18,235	)	$	(107,149	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Stock-based compensation			(280	)		2,607
		Depreciation and amortization			2,491			14,150
		Bad debt expense			532			1,670
		Minority interest			(356	)		(173	)
		Impairment of goodwill and intangible assets			5,713			50,983
		Loss on sale of short-term investments			291			—
		Impairment of investments			543			—
		Cumulative effect of change in accounting principle			974			—
		Loss on disposal of property and equipment			253			3,694
		Other non-cash items			(762	)		—
	Changes in operating assets and liabilities:
		Accounts receivable			1,733			793
		Prepaid expenses and other assets			706			686
		Accounts payable and accrued liabilities			(4,240	)		(7,227	)
		Accrued restructuring			(2,335	)		5,491
		Deferred revenue			376			4,873

			Net cash used in operating activities		(12,642	)		(29,602	)
Cash flows from investing activities:
	Purchase of property and equipment				(189	)		(2,875	)
	Sale of short-term investments				555			—

			Net cash provided by (used in) investing activities		366			(2,875	)
Cash flows from financing activities:
	Repayments of borrowings				(537	)		(522	)
	Repurchases of common stock				(726	)		—
	Proceeds from issuance of common stock				663			687

			Net cash provided by (used in) financing activities		(600	)		165
Effect of exchange rate fluctuation					(46	)		(332	)

Net decrease in cash and cash equivalents					(12,922	)		(32,644	)
Cash and cash equivalents, beginning of period					43,750			75,497

Cash and cash equivalents, end of period				$	30,828		$	42,853

Supplemental disclosures of cash flow information:
	Cash paid during the period for interest			$	14		$	108

Goodwill	$	49,210
Developed and core technology		1,127
Acquired workforce		646

Total impairment	$	50,983

	TUMBLEWEED COMMUNICATIONS CORP.
Date: November 14, 2002	By:	/s/ JEFFREY C. SMITH Jeffrey C. Smith Chairman of the Board and Chief Executive Officer (Principal Executive Officer)
Date: November 14, 2002	By:	/s/ GREGORY M. CAPITOLO Gregory M. Capitolo Senior Vice President-Finance and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

	2002		2003		2004		2005		2006		After 2006		Total
Operating leases	$	619	$	2,071	$	1,750	$	128	$	—	$	—	$	4,568
Unconditional purchase obligations		343		1,008		86		—		—		—		1,437
Capital leases		22		89		94		—		—		—		205
Debt		81		—		—		—		—		—		81

Total	$	1,065	$	3,168	$	1,930	$	128	$	—	$	—	$	6,291