CRITICAL PATH INC - 10-Q Quarterly Report

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

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

As of April 30, 2004, the Company had outstanding 21,388,848 shares of common stock, $0.001 par value per share.

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

Note 1 — Basis of Presentation and Summary of Significant Accounting Policies

Critical Path, Inc. was incorporated in California on February 19, 1997. Critical Path, along with its subsidiaries (collectively referred to herein as the “Company”), provides digital communications software and services that enable enterprises, government agencies, wireless carriers, and service providers to rapidly deploy scalable solutions for messaging and identity management. Built upon an open, extensible software platform, these solutions help organizations expand the range of digital communications services they provide, while helping to reduce overall costs. Critical Path’s messaging solutions - which are available both as licensed software or hosted services - provide integrated access to a broad range of communication and collaboration applications from wireless devices, Web browsers, desktop clients, and voice systems. This provides new revenue opportunities for carriers and service providers and helps enable them to attract new subscribers, drive more usage, and retain subscribers longer. For enterprises and governments, Critical Path’s solutions help to reduce burdens on helpdesks, simplify the deployment of key security infrastructure, enable easier compliance with new regulatory mandates, and reduce the cost and effort of deploying modern messaging services to distributed organizations, mobile users, deskless workers, suppliers and customers.

The unaudited condensed consolidated financial statements (“Financial Statements”) of the Company furnished herein reflect all adjustments that are, in the opinion of management, necessary to present fairly the financial position and results of operations for each interim period presented. All adjustments are normal recurring adjustments. The Financial Statements should be read in conjunction with the audited consolidated financial statements and notes thereto, together with management’s discussion and analysis of financial condition and results of operations, presented in the Company’s Annual Report on Form 10-K/A for the fiscal year ended December 31, 2003. The results of operations for the interim periods presented herein are not necessarily indicative of the results to be expected for the entire year.

Since inception, the Company has incurred aggregate consolidated net losses of approximately $2.2 billion, which includes $1.3 billion related to the impairment of long-lived assets, $445 million related to non-cash charges associated with the Company’s ten acquisitions and $172 million related to non-cash stock-based employee compensation expenses. With the Company’s history of losses, revenue generated from the sale of its products and services may not increase to a level that exceeds its operating expenses or could fluctuate significantly as a result of changes in customer demand or acceptance of future products. Accordingly, the Company’s cash flow from operations may continue to be negatively impacted.

Cash and cash equivalents totaled $37.1 million at March 31, 2004. Of the Company’s cash and cash equivalents at March 31, 2004, $2.7 million is expected to support its outstanding obligations to Silicon Valley Bank (See Note 7 - Credit Facility) and $7.6 million is located in accounts outside the United States, which may not be available to the Company’s domestic operations. Accordingly, the Company’s readily available cash resources in the United States as of March 31, 2004 were $26.8 million. At December 31, 2003, the Company’s readily available cash resources in the United States totaled $6.4 million. During 2003 and the first quarter of 2004, the Company used an average of approximately $8.8 million of cash per quarter to fund the Company’s operating activities. Historically, the Company has suffered recurring losses from operations and negative cash flow from operations. Given this factor, in combination with the Company’s financial position in the fourth quarter of 2003, the Company has recently consummated several financing transactions in order to secure sufficient funding to meet the Company’s expected cash requirements through at least December 31, 2004.

On November 18, 2003, the Company entered into a definitive agreement to issue an aggregate of $10 million in principal amount of 10% Senior Convertible Notes to General Atlantic Partners 74, L.P., GAP Coinvestment Partners II, L.P., GapStar, LLC and GAPCO GmbH & Co. K.G., (“the General Atlantic Investors”), and to convert the notes, plus $1 million in accrued interest, into approximately 7.3 million shares of the Company’s Series E Preferred Stock. In the same agreement, the Company agreed to exchange approximately $32.8 million in face value of the Company’s 5³/4% convertible subordinated notes held by a group of investors led by Cheung Kong Group and its Whampoa Limited affiliates including Campina Enterprises Limited, Cenwell Limited, Great Affluent Limited, Dragonfield Limited and Lion Cosmos Limited (“the Cheung Kong Investors”) for approximately 21.9 million shares of the Company’s Series E Preferred Stock. These notes and related interest are convertible into shares of Series E Preferred Stock at $1.50 per share only if the Company receives shareholder approval.

In November 2003, the Company announced its intention to make a rights offering to public shareholders of record to purchase up to approximately $21 million of newly issued Series E convertible preferred shares at a purchase price of $1.50 per share. Shareholders of record on the record date of April 30, 2004 will receive 0.65 subscription rights for each share of the Company’s common stock held on the record date. Each subscription right entitles the holder to purchase one share of the Company’s Series E preferred stock at the subscription price of $1.50 per share. Each share of Series E preferred stock is convertible into the number of shares of common stock obtained by dividing $1.50 plus the amount of dividends accreted to the Series E preferred stock from the date of issuance through the most recent semi-annual dividend accrual date by $1.50. The Company filed a registration statement for the Series E preferred stock to be issued pursuant to the rights offering. The Securities and Exchange Commission declared this registration statement effective on May 5, 2004. If shareholders approve, among other things, the issuance of the Series E preferred stock at a meeting to be held on June 11, 2004, the Company intends to consummate the rights offering on or around June 25, 2004.

In January 2004, the Company issued $15 million in principal amount of 10% Senior Convertible Notes to Permal U.S. Opportunities Limited, Zaxis Equity Neutral, L.P., Zaxis Institutional Partners, L.P., Zaxis Offshore Limited, Zaxis Partners, L.P. and Passport Master Fund, L.P. These notes are convertible into approximately 10 million shares of Series E Preferred Stock at $1.50 per share only if the Company receives shareholder approval at a special meeting to be held on June 11, 2004. As a result, interest expense of approximately $1.5 million will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E Preferred Stock. If the Company does not obtain shareholder approval, these notes will be convertible, at the option of each note holder, into shares of the Company’s Common Stock at $1.65 per share, provided the note holder will not be able to convert its notes into shares of Common Stock to the extent the note holder, together with its affiliates, would own 9.9% or more of the Company’s Common Stock after conversion. If these notes do not convert into Series E Preferred Stock or Common Stock, they become due and payable on the fourth anniversary of their issuance.

In March 2004, the Company issued $18.5 million in principal amount of 10% Senior Convertible Notes to investment entities affiliated with Crosslink Capital, Criterion Capital Management, Heights Capital Management and Apex Capital. These notes are convertible into approximately 12.3 million shares of Series E Preferred Stock at $1.50 per share only if the Company receives shareholder approval at a special meeting to be held on June 11, 2004. If the Company does not obtain shareholder approval, these notes will be convertible, at the option of each note holder, into shares of the Company’s Common Stock at $2.18 per share, provided the note holder will not be able to convert its notes into shares of Common Stock to the extent the note holder, together with its affiliates, would own 9.9% or more of the Company’s Common Stock after conversion. As a result, interest expense of approximately $8.4 million will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E Preferred Stock. If these notes do not convert into Series E Preferred Stock or Common Stock, they become due and payable on the fourth anniversary of their issuance.

Upon shareholder approval of the matters being presented at a special meeting on June 11, 2004, the $43.5 million in principal amount of 10% Senior Convertible Notes, plus interest, will automatically convert into approximately 29 million shares of Series E Preferred Stock at $1.50 per share. Additionally upon such approval, the $32.8 million in face value of its 5³/4% convertible subordinated notes due in April 2005 held by the Cheung Kong Investors will automatically be converted into approximately 21.9 million shares of its Series E Preferred Stock. The Series E Preferred Stock will be issued to these investors only if Critical Path receives shareholder approval and will rank senior in preference to all of the Company’s existing equity. These preferred shares will accrue dividends at an annual rate of 5³/4% of the purchase price of $1.50 per share.

In March 2004, the Company executed an amendment with a group of investors led by the Cheung Kong Investors, which would extend the maturity of the $32.8 million in face value of 5³/4% Convertible Subordinated Notes held by the Cheung Kong Investors from April 1, 2005 to April 1, 2006. The extension will only take place in the event the Company’s shareholders do not approve the exchange of the 5³/4% Convertible Subordinated Notes held by the Cheung Kong Investors for approximately 21.9 million shares of the Company’s Series E Preferred Stock. In addition, in the event the maturity date is extended to April 1, 2006, the interest rate on the 5³/4% Convertible Subordinated Notes held by the Cheung Kong Investors will increase to 7¹/2% for the period beginning April 1, 2005 and ending April 1, 2006, and the Company will be required to pay fees totaling $1.5 million.

In a separate agreement, members of the Cheung Kong Investors have granted the Company an option, which the Company may exercise in its sole discretion, to repurchase approximately 10.9 million shares of the Series E Preferred Stock held by the Cheung Kong Investors at $1.50 per share. The Company’s option expires 10 business days after the Cheung Kong Investors acquire shares of the Series E Preferred Stock after the close of the proposed rights offering of the preferred stock.

The 10% Senior Convertible Notes and related interest become due and payable on the fourth anniversary of their issuance. In addition, the notes also become due and payable upon the consummation of a qualified asset sale, a change of control or any financing or series of financings that in the aggregate raises at least $40 million. There are also certain other circumstances that cause these notes to become due and payable which have been disclosed in Note 4 - Convertible Notes.

With the Company’s history of operating losses, its primary sources of capital have come from both debt and equity financings that it has completed over the past several years. With the proceeds from the recent financing transactions discussed above, it believes that its cash, cash equivalents and available line of credit as of the date of this filing will be sufficient to maintain current and planned operations through at least December 31, 2004.

The Company is also seeking shareholder approval to increase the number of authorized shares of common stock from 125 million to 200 million and preferred stock from 5 million to 75 million.

The consolidated financial statements include the accounts of the Company, and its wholly owned and majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The equity method is used to account for investments in unconsolidated entities if the Company has the ability to exercise significant influence over financial and operating matters, but does not have the ability to control such entities. The cost method is used to account for equity investments in unconsolidated entities where the Company does not have the ability to exercise significant influence over financial and operating matters.

The Company does not currently manage its business in a manner that requires it to report financial results on a segment basis. The Company currently operates in one segment, digital communications software and services, and management uses one measure of profitability. Revenue information on a product and service basis has been disclosed in the Company’s statement of operations.

Certain amounts previously reported have been reclassified to conform to the current period presentation and such reclassifications did not have an effect on the prior periods’ net loss attributable to common shares.

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees and its related interpretations and complies with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation. Under APB No. 25, compensation expense for fixed options is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price of the option. The Company amortizes stock-based compensation using the accelerated method over the remaining vesting periods of the related options, which is generally four years. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18. The shares underlying warrants or options, which are unvested, are remeasured at each reporting date until a measurement date occurs, at which time the fair value of the warrant is fixed. The related charge is amortized over the estimated term of the relationship. In the event such remeasurement results in increases or decreases from the initial fair value, which could be substantial, these increases or decreases will be recognized immediately, if the fair value of the shares underlying the milestone has been previously recognized, or over the remaining term, if not.

In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods ending after December 15, 2002. The Company adopted the disclosure requirement of SFAS No. 148 on December 31, 2002.

Pro forma information regarding net loss and net loss per share is required. This information is required to be determined as if the Company had accounted for employee stock options under the fair value method of Statement of Financial Accounting Standards (“SFAS”) No. 123, as amended by SFAS No. 148.

Had compensation cost been recognized based on the fair value at the date of grant for options granted, during the first quarters of 2003 and 2004, the pro forma amounts of the Company’s net loss and net loss per share would have been as follows:

The Company calculated the fair value of each option grant on the date of grant using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following assumptions:

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (FIN 46). FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 was effective for all new variable interest entities created or acquired after January 31, 2003. In December 2003, the FASB issued FIN 46R which supercedes FIN 46. FIN 46R is applicable in financial statements of public entities that have interests in variable interest entities or potential variable interest entities commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public entities (other than small business issuers) for all other types of entities is required in financial statements for periods ending after March 15, 2004. The adoption of this standard did not have a material impact on the Company’s results of operations or financial condition.

In April 2004, the Emerging Issues Task Force issued Statement No. 03-06, or EITF 03-06, “Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share”. EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 is effective for fiscal periods beginning after March 31, 2004. The Company is still evaluating the impact of the adoption of EITF 03-06 on its results of operations and financial position.

In May 2002, the Board of Directors approved a restructuring plan to further reduce the Company’s expense levels consistent with the current business climate. In connection with the plan, a restructuring charge of $1.5 million was recognized in the second quarter of 2002. This charge was comprised of approximately $1.2 million in severance and related costs associated with the elimination of approximately 39 positions and $300,000 in facilities lease termination costs. The balance of the accrual at March 31, 2004 was approximately $0.4 million and is expected to be utilized by the end of 2004.

In January 2003, The Company announced a restructuring initiative designed to further reduce its expense levels in an effort to achieve operating profitability assuming no or moderate revenue growth. The plan includes the consolidation of some office locations and a global workforce reduction of approximately 175 positions, or approximately 30% of the workforce. The headcount reduction was partially offset by outsourcing approximately 75 positions to lower cost service providers. The Company incurred aggregate charges of approximately $8.0 million resulting from the cost reduction plan, inclusive of $7.0 million in cash and $1.0 million in non-cash expenses. Included in this plan were approximately $1.7 million in charges incurred in the fourth quarter of 2002, comprised of approximately $0.7 million in severance and related costs and $1.0 million in facilities lease termination costs. During the first quarter of 2004, this initiative was completed and at March 31, 2004, there was no remaining balance accrued.

In November 2003, the Company announced that it was restructuring certain of its facility lease obligations in an effort to reduce its long-term cash obligations. In addition, the Company identified an additional 16 positions, primarily held by management-level employees, which were to be eliminated. Costs totaling $1.9 million were recognized during the fourth quarter of 2003 associated with these initiatives, including $1.4 million in lease restructuring and termination costs and $0.5 million in severance and related headcount reduction costs. Additionally, costs totaling $1.1 million were recognized during the first quarter of 2004 associated with these initiatives, including $0.1 million in lease restructuring and termination costs and $1.0 million in severance and related headcount reduction costs. During the fourth quarter of 2003 and first quarter of 2004, cash payments totaling $1.3 million and $0.9 million, respectively, were made associated with these restructuring activities. The remaining accrual of $0.6 million associated with this restructuring is expected to be utilized by the end of the second quarter of 2004.

At December 31, 2003 and March 31, 2004, the Company was had $6.6 million of goodwill, which ceased being amortized from January 1, 2002, in accordance with SFAS No. 142.

During the three months ended March 31, 2003 and 2004, the Company recognized interest expense related to the 5³/4% convertible subordinated notes due in April 2005 of $547,000 in each respective period. As of March 31, 2004, the total balance outstanding was $38.4 million. There was approximately $1.1 million in accrued interest payable related to these notes at March 31, 2004. These 5³/4% Notes are carried at cost and had an approximate fair value at March 31, 2004 of $34.7 million.

In November 2003, the Company executed an agreement to exchange approximately $32.8 million in face value of its 5³/4% Notes, which were held by a group of investors led by Cheung Kong Investors, for approximately 21.9 million shares of Series E Preferred Stock. Upon shareholder approval at a special meeting to be held on June 11, 2004, approximately $32.8 million face value of 5³/4% Convertible Subordinated Notes held by the Cheung Kong Investors will be exchanged for approximately 21.9 million shares of Series E Preferred Stock. As a result, a charge equal to the fair value of the Series E Preferred Stock less the carrying value of the related Notes, net of unamortized issuance costs, will be recorded to arrive at net loss and net loss attributable to common shareholders as of the date of the exchange.

In March 2004, the Company executed an amendment with the Cheung Kong Investors, which would extend the maturity of the $32.8 million in face value of 5³/4% Notes held by the Cheung Kong Investors from April 1, 2005 to April 1, 2006. The extension will only take place in the event the Company’s shareholders do not approve, at the

special meeting to be held on June 11, 2004, the exchange of the 5³/4% Notes held by the Cheung Kong Investors for approximately 21.9 million shares of the Company’s Series E Preferred Stock. In addition, in the event the maturity date is extended to April 1, 2006, the interest rate on the 5³/4% Notes held by the Cheung Kong Investors will increase to 7¹/2% for the period beginning April 1, 2005 and ending April 1, 2006, and the Company will be required to pay fees totaling $1.5 million.

In November 2003, the Company issued in a private placement $10 million in 10% senior convertible notes to General Atlantic Partners 74, L.P., GAP Coinvestment Partners II, L.P., GapStar, LLC and GAPCO GmbH & Co. K.G. (referred to collectively as the General Atlantic Investors).

At issuance, the senior convertible note issued to General Atlantic Investors was deemed to have an embedded derivative, related to the acceleration of any unearned interest upon conversion prior to the first anniversary of its issue date. The fair value of this derivative, which was fixed at $750,000 at issuance, was recorded as a reduction in the carrying amount of the convertible note and will be accreted over the initial year of the four-year term. As a result, the Company recorded accretion of approximately $16,000 to interest expense during 2003.

Upon shareholder approval at a special meeting to be held on June 11, 2004, the $10 million in principal amount of senior convertible notes held by the General Atlantic Partners, plus interest, will convert into 7.3 million shares of Series E convertible preferred stock at $1.50 per share. As a result, interest expense of approximately $5.7 million will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E convertible preferred stock. Interest expense of $253,000 was recognized on the debt during the three months ended March 31, 2004 and $353,000 was payable as of March 31, 2004.

In January 2004, the Company issued $15 million in principal amount of 10% Senior Convertible Notes to Permal U.S. Opportunities Limited, Zaxis Equity Neutral, L.P., Zaxis Institutional Partners, L.P., Zaxis Offshore Limited, Zaxis Partners, L.P. and Passport Master Fund, L.P. These notes are convertible into approximately 10 million shares of Series E Preferred Stock at $1.50 per share only if the Company receives shareholder approval on June 11, 2004. As a result, interest expense of approximately $1.5 million will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E Preferred Stock. If the Company does not obtain shareholder approval, these notes will be convertible, at the option of each note holder, into shares of the Company’s Common Stock at $1.65 per share, provided the note holder will not be able to convert its notes into shares of Common Stock to the extent the note holder, together with its affiliates, would own 9.9% or more of the Company’s Common Stock after conversion. If these notes do not convert into Series E Preferred Stock or Common Stock, they become due and payable on the fourth anniversary of their issuance. Interest expense of $317,000 was recognized on the debt during the three months ended March 31, 2004 and remained payable as of March 31, 2004.

In March 2004, the Company issued $18.5 million in principal amount of 10% Senior Convertible Notes to investment entities affiliated with Crosslink Capital, Criterion Capital Management, Heights Capital Management and Apex Capital. These notes are convertible into approximately 12.3 million shares of Series E Preferred Stock at $1.50 per share only if the Company receives shareholder approval on June 11, 2004. If the Company does not obtain shareholder approval, these notes will be convertible, at the option of each note holder, into shares of the Company’s Common Stock at $2.18 per share, provided the note holder will not be able to convert its notes into shares of Common Stock to the extent the note holder, together with its affiliates, would own 9.9% or more of the Company’s Common Stock after conversion. As a result, interest expense of approximately $8.4 million will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E Preferred Stock. If these notes do not convert into Series E Preferred Stock or Common Stock, they become due and payable on the fourth anniversary of their issuance. Interest expense of $115,000 was recognized on the debt during the three months ended March 31, 2004 and remained payable as of March 31, 2004.

The 10% Senior Convertible Notes become due and payable on the consummation of a qualified asset sale, a change of control or any financing or series of financings that in the aggregate raises at least $40 million. Additionally, the notes become due and payable when declared due and payable by a holder upon the occurrence of an event of default, which include, subject to some exceptions: (1) the Company’s failure to pay any amounts due under notes when they are due and payable, (2) the Company’s default on any indebtedness with a principal amount of at least $500,000, (3) the Company’s voluntary or involuntary bankruptcy, (4) any judgment for the payment of money of more than $500,000, (5) the attachment by its lenders of any of its assets, or (6) the occurrence of any event having a material adverse effect on the Company’s business, operations, assets, properties or condition.

The 10% senior convertible notes also contain a financial covenant that requires the Company to maintain a minimum monthly average operating cash flow, over any given fiscal quarter, for its operations in the Americas of negative $3.0 million. Additionally, the Company may not incur, create or assume indebtedness or liens under the notes, with specified exceptions. Also, with some exceptions, under the notes it may not: (1) merge with another entity, (2) make any restricted payments, including dividends, distributions and the redemption any of its options or capital stock, (3) enter into any transactions with any affiliates, (4) make investments, (5) change the nature of the Company’s business, (6) permit the Company’s domestic subsidiaries to hold real or personal property in excess of specified amounts or (7) create any new subsidiaries.

If the Company breaches any representation or warranty or fails to abide by any of its covenants, including the foregoing covenants, then the 10% Senior Convertible Notes may become immediately due and payable. If these notes do not convert into Series E Preferred Stock or Common Stock, the principal and related interest will become due and payable on the fourth anniversary of their issuance.

There were no tax effects allocated to any components of other comprehensive loss during the three months ended March 31, 2003 or 2004.

As of March 31, 2003 and 2004, there were 28,776,051 and 76,244,444 potential common shares, respectively, that were excluded from the determination of diluted net loss per share, as the effect of such shares on a weighted average basis is anti-dilutive.

In September 2002, the Company entered into a $15.0 million one-year line of credit with Silicon Valley Bank, to be utilized for working capital and general corporate operations. The credit facility was amended on March 25, 2003 and again on July 18, 2003, as a result of non-compliance with the financial covenants of the facility. The Company regained compliance with the covenants in the credit facility upon execution of the line of credit agreement on July 18, 2003 and extended the maturity of the credit facility to January 30, 2004. In December 2003, the Company did not comply with a certain financial covenant and it subsequently received a letter from Silicon Valley Bank on December 17, 2003 waiving such covenant violation. The credit facility is collateralized by all of the Company’s personal property, including intellectual property, and borrowings under the current agreement bear a variable interest rate of Prime plus 2.0%, which has ranged from 5.25% to 6.25%, and is subject to certain covenants. Interest is paid each month with principal due at maturity. Commitment fees related to the credit facility included an initial commitment fee of 0.50%, or $75,000, and additional commitment fees of $35,000 for each amendment. The facility carries an additional fee based on unused credit of 0.45% payable at the end of each quarterly period in arrears and an early termination fee of 1.0% of the total credit facility through maturity. As of March 31, 2004, there was no balance outstanding but there were letters of credit held under the credit facility totaling $2.7 million..

On January 30, 2004, the Company executed an amendment with Silicon Valley Bank, which reduced the size of the credit line to a maximum of $5.0 million and extended the maturity date to October 31, 2004. On March 12, 2004 the Company executed an additional amendment with Silicon Valley Bank, which increased the size of the credit line to a maximum of $6.0 million and extended the maturity date to June 30, 2005. Additionally, the line of credit calls for a minimum cash balance at Silicon Valley Bank of $3.0 million. The Company does not classify this as restricted cash as it is legally unrestricted. The credit facility continues to be collateralized by all of the Company’s personal property, including intellectual property, and borrowings under the current agreement bear a variable interest rate of between Prime plus 1.5% and Prime plus 3.0%, which has historically ranged from 5.25% to 6.25%, and is subject to certain covenants. Interest is paid each month with principal due at maturity. Initial commitment fees of $20,000 and $100,000 were charged related to the January and March amendments, respectively. Additionally, the facility carries an expedite fee of $50,000, an unused facility fee of either 0.45% or 2.00%, based upon the level of cash balances held at the bank, payable at the end of each quarterly period in arrears, and an early termination fee of $50,000 if the facility is canceled prior to August 1, 2004. In connection with the March 2004 amendment to the credit facility, the Company agreed to issue warrants to purchase up to 100,000

shares of its Common Stock to Silicon Valley Bank. These warrants were fully exercisable upon grant, had an exercise price of $2.07 per share and have an expiration date of March 12, 2011. The warrants were valued using the Black-Scholes option pricing model, assuming volatility of 146%, a risk-free interest rate of 3% and a four-year term. In connection with the issuance of this warrant, the Company recorded a charge of $197,000 to interest expense during the first quarter of 2004.

In April 2004, the Company entered into an amendment to its credit facility with Silicon Valley Bank pursuant to which Silicon Valley Bank agreed to (i) waive the Company’s failure to comply with a certain financial covenant for the quarter ended March 31, 2004 and (ii) modify the Company’s financial covenant with respect to its minimum consolidated revenues. The amendment also added a covenant that the receipt of a going concern qualification in an audit report during the period commencing April 15, 2004 through the credit facility’s maturity date constitutes an event of default under the facility.

The carrying value of the Series D Preferred Stock at December 31, 2003 and March 31, 2004 was determined as follows:

In connection with the Series D Preferred Stock financing transaction, which closed in December 2001, the Series D Preferred Stock was deemed to have an embedded derivative instrument. In accordance with the provisions of SFAS No. 133, Accounting for Derivative Instruments, the Company is required to adjust the carrying value of the instrument to its fair value at each balance sheet date and recognize any change since the prior balance sheet date as a component of Interest and Other Income (Expense). At December 31, 2003 and March 31, 2004, the estimated fair value of the liquidation preference was $24.8 million and $21.7 million, respectively. During the three months ended March 31, 2003 and 2004, net charges (credits) of $6.2 million and $(3.2) million, respectively, were recorded as a result of the increase (decrease) in the fair value of the liquidation preference.

During the three months ended March 31, 2003 and 2004, the accretion on redeemable convertible preferred shares totaled $3.7 million and $3.1 million, respectively, comprised of accrued dividends of $711,000 and $1.3 million, respectively, and accretion of the beneficial conversion feature of $3.0 million and $1.8 million, respectively.

In March 2004, the Company issued 707,368 shares of restricted common stock to Mark Ferrer, the Company’s new chief executive officer, in connection with Mr. Ferrer’s employment agreement. As a result of the issuance of these shares of restricted stock, during the first quarter, the Company recorded unearned compensation of $1.5 million, which will be charged to operating expense over the vesting term of four years of the restricted stock grant. During the quarter ended March 31, 2004, the Company recorded a charge of $9,000.

The Company is a party to lawsuits in the normal course of its business. Litigation in general, and securities and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. Other than as described below, the Company is not a party to any other material legal proceedings.

Action in the Superior Court of San Diego. On December 24, 2003, the Company was named in a lawsuit filed by former shareholders of Remedy Corporation against current and former officers and directors of Peregrine Systems, Inc., Peregrine’s former accountants, some of Peregrine’s customers, including the Company, and various other unnamed defendants. The second amended complaint alleges that the Company, as Peregrine’s customer, engaged in a series of fraudulent transactions with Peregrine that were not accounted for by Peregrine in conformity with GAAP and that this substantially inflated the value of Peregrine securities issued as consideration in Remedy’s merger with Peregrine in August 2001. The complaint alleges causes of action for fraud and deceit, negligent misrepresentation, violations of California Corporations Code provisions regarding sales of securities by means of false statements or omissions, violations of California Corporations Code provisions regarding securities sales made on the basis of undisclosed, material inside information, common law conspiracy to commit fraud, and common law aiding and abetting the commission of fraud. The complaint seeks an unspecified amount of compensatory and punitive damages, along with rescission of the Peregrine securities purchased in the Remedy merger, interest and attorneys fees. The Company believes the claims are without merit and intends to defend itself vigorously. Litigation in this matter is ongoing.

Securities Class Action in Southern District of New York. Beginning on July 18, 2001, a number of securities class action complaints were filed against the Company, and certain of its former officers and directors and underwriters connected with the Company’s initial public offering of common stock in the U.S. District Court for the Southern District of New York (In re Initial Public Offering Sec. Litig.). The purported class action complaints were filed by individuals who allege that they purchased the Company’s common stock at the initial and secondary public offerings between March 29, 1999 and December 6, 2000. The complaints allege generally that the prospectus under which such securities were sold contained false and misleading statements with respect to discounts and excess commissions received by the underwriters as well as allegations of “laddering” whereby underwriters required their customers to purchase additional shares in the aftermarket in exchange for an allocation of IPO shares. The complaints seek an unspecified amount in damages on behalf of persons who purchased the Company’s stock during the specified period. Similar complaints have been filed against 55 underwriters and more than 300 other companies and other individuals. The over 1,000 complaints have been consolidated into a single action. The Company has reached an agreement in principle with the plaintiffs to resolve the cases. The proposed settlement involves no monetary payment by the Company and no admission of liability. However, it is subject to approval by the Court.

Securities and Exchange Commission Investigation. In 2001, the Securities and Exchange Commission investigated the Company and certain of its former officers, employees and directors with respect to non-specified accounting matters, financial reports, other public disclosures and trading activity in the Company’s securities. The SEC concluded its investigation of the Company in January 2002 with no imposition of fines or penalties and, without admitting or denying liability, the Company consented to a cease and desist order and an administrative order as to violation of certain non-fraud provisions of the federal securities laws. The investigation has also thus far resulted in charges being filed against five former officers and employees. The Company believes that the investigation of its former officers and employees may continue. While the Company continues to fully cooperate with any requests with respect to such investigation, it does not know the status of such investigation.

Lease Dispute. In July 2000, PeerLogic, Inc. signed a lease for office space in San Francisco, California. In December 2000, the Company acquired PeerLogic as a wholly owned subsidiary. After review, the Company determined that local zoning laws likely prohibited a business such as it or PeerLogic from occupying the leased premises, and promptly sought a zoning determination from the San Francisco Zoning Administrator to resolve the matter. The Zoning Administrator determined that the Company’s proposed use of the leased premises was not permitted, but the landlord appealed this determination and prevailed before the San Francisco Board of Appeals. In July 2002, the Company filed a Petition for Writ of Mandamus with the San Francisco Superior Court, seeking

reversal of the San Francisco Board of Appeals’ decision. In June 2003, the Court granted the Company’s petition and subsequently entered a judgment and writ remanding the matter to the San Francisco Board of Appeals and directing the Board of Appeals to make a new determination consistent with its judgment. The landlord subsequently appealed the Superior Court’s ruling.

In April 2002, the landlord filed suit in San Francisco Superior Court against the Company alleging, among other things, breach of the lease and tort claims related to the lease transaction. In its complaint, the landlord sought unspecified damages for back rent, attorneys’ fees, treble damages under certain statutes, and unspecified punitive damages. Between April 2002 and July 2003, the Company succeeded through several motions filed with the Court in having a number of the landlord’s claims dismissed and some of its requests for damages stricken, including treble damages. The landlord has chosen not to further amend its complaint. In August 2003, the Company filed its answer to the second amended complaint and a cross-complaint against the landlord, under which the Company sought compensatory damages and unspecified punitive damages for the landlord’s failure to disclose the zoning restrictions on the leased premises before the lease was signed. In early February, the Company reached an agreement in principle with the landlord to fully and finally settle this litigation in exchange for $100,000 in cash and a warrant to purchase 100,000 shares of common stock at a purchase price equal to current fair market value as of the date of settlement. A final written settlement agreement was executed by the parties on May 4, 2004. However, the cases have not yet been dismissed.

The uncertainty associated with these and other unresolved or threatened lawsuits could seriously harm the Company’s business and financial condition. In particular, the lawsuits or the lingering effects of previous lawsuits and the now completed SEC investigation could harm relationships with existing customers and the Company’s ability to obtain new customers and partners. The continued defense of lawsuits could also result in the diversion of management’s time and attention away from business operations, which could harm the Company’s business. Negative developments with respect to the settlements or the lawsuits could cause the Company’s stock price to further decline significantly. In addition, although the Company is unable to determine the amount, if any, that it may be required to pay in connection with the resolution of these lawsuits, and although the Company maintains adequate and customary insurance, the size of any such payments could seriously harm the Company’s financial condition.

Other Contractual Obligations The Company entered into other contractual obligations which total $10.8 million at March 31, 2004. These obligations are primarily associated with the maintenance of hardware and software products being utilized within engineering and hosted operations, and the management of data center operations and network infrastructure storage for the Company’s hosted operations. These obligations are expected to be completed over the next 4 years, including $8.3 million in 2004.

Indemnifications. The Company provides general indemnification provisions in its license agreements. In these agreements, the Company generally states that it will defend or settle, at its own expense, any claim against the customer by a third party asserting a patent, copyright, trademark, trade secret or proprietary right violation related to any products that the Company has licensed to the customer. The Company agrees to indemnify its customers against any loss, expense or liability, including reasonable attorney’s fees, from any damages alleged against the customer by a third party in its course of using products sold by the Company. The Company has not received any claims under this indemnification and does not know of any instances in which such a claim may be brought against the Company in the future.

Under California law, in connection with both the Company’s charter documents and indemnification agreements the Company entered into with its executive officers and directors, the Company must indemnify its current and former officers and directors to the fullest extent permitted by law. The indemnification covers any expenses and liabilities reasonably incurred in connection with the investigation, defense, settlement or appeal of legal proceedings. The Company has made payments in connection with the indemnification of officers and directors in connection with currently pending lawsuits and has reserved for estimated future amounts to be paid in connection with legal expenses and others costs of defense of pending lawsuits.

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

This report on Form 10-Q contains forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, as amended and in effect from time to time. The words “anticipates,” “expects,” “intends,” “plans,” “believes,” “seek,” and “estimate” and similar expressions are intended to identify forward-looking statements. These are statements that relate to future periods and include statements regarding our future strategic, operational and financial plans, anticipated or projected revenues, expenses and operational growth, markets and potential customers for our products and services, plans related to sales strategies and global sales efforts, the anticipated benefits of our relationships with strategic partners, growth of our competition, our ability to compete, investments in product development, the adequacy of our current facilities and our ability to obtain additional space, our litigation strategy, use of future earnings, the feature, benefits and performance of our current and future products and services, plans to reduce operating costs through continued expense reduction, anticipated effects of restructuring and retirement of debt, and our belief as to our ability to successfully emerge from the restructuring and refocusing of our operations. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Factors that might cause future results to differ materially from those projected in the forward-looking statements include, but are not limited to, difficulties of forecasting future results due to our limited operating history, failure to meet sales and revenue forecasts, evolving business strategy and the emerging nature of the market for our products and services, finalization of pending litigation and the settlement of the continuing SEC investigation against former executives and directors, turnover within and integration of senior management, board of directors members and other key personnel, difficulties in our strategic plans to exit certain products and services offerings, failure to expand our sales and marketing activities, potential difficulties associated with strategic relationships, investments and uncollected bills, general economic conditions in markets in which the Company does business, risks associated with our international operations, foreign currency fluctuations, unplanned system interruptions and capacity constraints, software defects, and failure to expand our sales and marketing activities, potential difficulties associated with strategic relationships, investments and uncollected bills, risks associated with an inability to maintain continued compliance with the Nasdaq National Market listing requirements, risks associated with our international operations, unplanned system interruptions and capacity constraints, software defects, and those discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Additional Factors That May Affect Future Operating Results” and elsewhere in this report. Readers are cautioned not to place undue reliance on these forward-looking statements. The forward-looking statements speak only as of the date hereof. We expressly disclaim any obligation to publicly release the results of any revisions to these forward-looking statements to reflect events or circumstances after the date of this filing.

All references to “Critical Path,” “we,” “our,” or the “Company” mean Critical Path, Inc. and its subsidiaries, except where it is clear from the context that such terms means only the parent company and excludes subsidiaries.

This Quarterly Report on Form 10-Q includes numerous trademarks and registered trademarks of Critical Path. Products or service names of other companies mentioned in this Quarterly Report on Form 10-Q may be trademarks or registered trademarks of their respective owners.

Web browsers, desktop clients, and voice systems. This provides new revenue opportunities for carriers and service providers and helps enable them to attract new subscribers, drive more usage, and retain subscribers longer. For enterprises and governments, Critical Path’s solutions help to reduce burdens on helpdesks, simplify the deployment of key security infrastructure, enable easier compliance with new regulatory mandates, and reduce the cost and effort of deploying modern messaging services to distributed organizations, mobile users, deskless workers, suppliers and customers.

Licenses for use of our software products. Our various messaging applications are typically licensed by telecommunications carriers, postal and government agencies, and some highly distributed enterprises for deployment in their data centers. Such licenses are usually sold as a perpetual license on a per-user basis, one for each person who might access the capabilities provided by the software. Our identity management software is typically licensed by large enterprises, government agencies, and telecommunications carriers and is deployed on site in their data centers. Our identity management software is usually sold as a perpetual license according to the number of data elements and different business systems being managed; our layered applications are usually licensed per user.

Annual support and maintenance subscriptions for our licensed software. We offer a variety of support and maintenance plans that enable customers of our licensed software to receive expedited technical support and access to new releases of our software. Most customers initially subscribe to these services when purchasing our software and then renew their subscriptions on an annual basis.

Hosted service subscriptions for access to our messaging and other digital communications applications. We offer access to email, personal information management, resource scheduling, and “newsgroup” over the Internet and wireless networks for enterprises, telecommunications operators, and, for certain services, consumers. The software powering these services runs in data centers that we jointly operate with the Hewlett-Packard Company; unlike with licensed software, customers of these services do not need to install or maintain their own copies of the software. Instead, customers pay initial setup fees and regular monthly, quarterly or annual subscriptions for the services they would like to be able to access.

Consulting, training, and professional services. We offer a range of different services designed to help our customers make more effective use of our products and services. Our licensed messaging and identity management software often require integration with customers’ existing infrastructure or customization to provide special features or capabilities. In addition, our consultants offer expertise and experience in designing and delivering new services that customers can use to supplement their own resources.

We generate most of our revenues from telecommunications operators and from large enterprises. Wireless carriers, internet service providers and fixed-line service providers purchase our products and services primarily when they are looking to offer new services to their subscribers. While they also purchase our products and services to lower their cost of operating existing services or infrastructure, their spending is often tied to the level of investment they are willing to make on new revenue-generating services.

Since our inception, we have incurred significant losses, and as of March 31, 2004, we had an accumulated deficit of approximately $2.2 billion, inclusive of a $1.3 billion charge for impairment of long-lived assets recorded in the fourth quarter of 2000. We intend to continue to invest in sales and marketing, development of our technology and solution offerings, and related enhancements. We may continue to incur operating losses. See the further discussion on our financial position in the Liquidity and Capital Resources section of Management Discussion and Analysis of Financial Condition and Results of Operations.

During 2001 we evaluated our various products, services, facilities and the business plan under which we were operating. In connection with this review, we implemented and substantially completed a strategic restructuring plan that involved reorganizing and refocusing Critical Path’s product and service offerings, a reduction in workforce and a facilities and operations consolidation. Additionally, we implemented an aggressive expense management plan to

further reduce operating costs. At the end of 2001, we had divested all of the products and services deemed to be non-core to our continued operations, reduced headcount by 44%, reduced the number of facilities by 65% and implemented other cost cutting measures, resulting in a significant reduction in overall operating expenses.

In May 2002, we approved a restructuring plan to reduce our expense levels to be consistent with the then current business climate. In connection with the plan, a restructuring charge of $1.5 million was recognized in the second quarter of 2002. This charge was comprised of approximately $1.2 million in severance and related costs associated with the elimination of approximately 39 positions and $300,000 in facilities lease termination costs.

In November 2003, we announced a restructuring of certain of our facility lease obligations in an effort to reduce our long-term cash obligations. In addition, we identified an additional 16 positions, primarily held by management-level employees, which were to be eliminated. Costs totaling $1.9 million were recognized during the fourth quarter of 2003 associated with these initiatives, including $1.4 million in lease restructuring and termination costs and $0.5 million in severance and related headcount reduction costs. During the fourth quarter of 2003, cash payments totaling $1.3 million were made associated with the facility restructuring activities and $0.4 million related to the headcount reductions.

In addition to these formal restructuring initiatives, we have sought to aggressively manage our cost structure, identifying incremental savings where possible. We intend to continue to aggressively manage our expenses in 2004, while maintaining strong service levels to our customers.

In recent months, management has focused on capital financing initiatives in order to maintain our current and planned operations. Our history of losses from operations and cash flow deficits, in combination with our cash balances, raised concerns about our short-term ability to fund operations from our existing cash at the time. Consequently, we have secured additional funds through several rounds of financing that involved the sale of senior secured notes convertible into a new series of preferred stock, subject to the approval of our shareholders at a special meeting on June 11, 2004. Owing to the financing activities we undertook in the fourth quarter of 2003 and first quarter of 2004, management believes that our cash, cash equivalents and available line of credit as of the date of this filing will be sufficient to maintain current and planned operations through at least December 31, 2004.

In view of the rapidly evolving nature of our business, organizational restructuring and limited operating history, we believe that period-to-period comparisons of revenues and operating results, including gross profit margin and operating expenses as a percentage of total net revenues, are not meaningful and should not be relied upon as indications of future performance. At March 31, 2004, we had 410 employees as compared to 418 employees at December 31, 2003, 577 employees at December 31, 2002 and 562 employees at December 31, 2001. We do not believe that our historical trends for revenues, expenses or personnel are indicative of future results.

There have been no material changes to our critical accounting policies and estimates as disclosed in our annual report on Form 10-K/A for the year ended December 31, 2003.

In view of the rapidly evolving nature of our business, prior acquisitions, organizational restructuring, and limited operating history, we believe that period-over-period comparisons of revenues and operating results, including gross profit margin and operating expenses as a percentage of total net revenues, are not meaningful and should not be relied upon as indications of future performance. At March 31, 2004, we had 410 employees as compared to 418 employees at December 31, 2003 and 438 employees at March 31, 2003. We do not believe that our historical fluctuations in revenues, expenses, or personnel are indicative of future results.

We derive most of our revenues through the sale of our messaging and identity management communications solutions. These solutions include both licensed software products and hosted messaging services. In addition, we recognize revenues from professional services and maintenance and support services. Software license revenues are derived from perpetual and term licenses for our messaging, identity management, collaborative and enterprise application integration technologies. Software license revenues are recognized when persuasive evidence of an arrangement exists, delivery of the licensed software to the customer has occurred and the collection of a fixed or determinable license fee is considered probable. Our revenue recognition policies require that revenues recognized from software arrangements be allocated to each undelivered element of the arrangement based on the fair values of the elements, such as post contract customer support, installation, training or other services. Hosted messaging revenues relate to fees for our hosted messaging and collaboration services. These fees are primarily based upon monthly contractual per unit rates for the services involved and are recognized as revenue on a ratable monthly basis over the term of the contract. Professional services revenues are derived from fees primarily related to training, installation and configuration services and revenue is recognized as services are performed. Maintenance and support revenues are derived from fees related to post-contract customer support agreements associated with software product licenses. Maintenance and support revenues are recognized ratably over the term of the agreement.

Software License. We recognized $4.3 million in software license revenues during the first quarter of 2004 as compared to $5.0 million during the same quarter in 2003, a decrease of $795,000. We believe this decrease in software license revenues was primarily attributable to customer concern regarding our viability, which has since improved given our recent financings, as well as unfavorable worldwide macroeconomic conditions and an uncertain political climate that resulted in delayed customer information technology spending during the quarter, primarily in our Central European, Asian and domestic markets.

Hosted Messaging. We recognized $4.3 million in hosted messaging revenues during the first quarter of 2004 as compared to $5.4 million during the first quarter of 2003, a decrease of $1.0 million. This decrease in hosted messaging revenues was primarily due to the loss of customers and reduced volume.

Professional Services. We recognized $2.7 million in professional services revenues during the first quarter of 2004 as compared to $3.2 million during the same quarter in 2003, a decrease of $561,000. This decrease in professional services revenues was primarily attributable to fewer professional service projects in Europe during the quarter.

Maintenance and Support. We recognized $5.8 million in maintenance and support revenues during the first quarter of 2004 as compared to $4.4 million during the first quarter of 2003, an increase of $1.4 million. This increase in maintenance and support revenues was primarily due to the continued high-rate of existing customers renewing their maintenance and support contracts, the execution of new maintenance and support contracts in recent quarters in connection with license sales and successful renewal of maintenance services with customers whose contracts had earlier expired, particularly in Europe.

Critical Path’s international operations accounted for approximately 63% of net revenues in the first quarter of 2004 as compared to 64% in the first quarter of 2003.

Software License. Cost of net software license revenues consists primarily of product media duplication, manuals and packaging materials, personnel and facility costs and third-party royalties. The cost of net software license revenues was $911,000 during the first quarter of 2004 as compared to $1.8 million during the same quarter in 2003, a decrease of $886,000. This decrease in software license costs was primarily attributable to a higher mix of third party product costs in the first quarter of 2003.

Hosted Messaging. Cost of net hosted messaging revenues consists primarily of costs incurred in the delivery and support of messaging services, including depreciation of capital equipment used in network infrastructure, amortization of purchased technology, Internet connection charges, accretion of acquisition related retention bonuses, personnel costs incurred in operations, and other direct and allocated indirect costs. The cost of net hosted messaging revenues was $6.4 million during the first quarter of 2004 as compared to $6.3 million during the first quarter of 2003, an increase of $118,000. This increase in hosted messaging costs was primarily due to a $1.6 million increase in outsourced data center service costs as well as an increase in personnel costs of $173,000 and consulting costs of $49,000. These increases were partially offset by decreased depreciation expense included in hosted messaging costs. Depreciation expense included in hosted messaging cost of net revenues decreased $1.4 million from $2.6 million in the first quarter of 2003 to $1.2 million in the first quarter of 2004.

Professional Services. Cost of net professional services revenues consist primarily of personnel costs including custom engineering, installation and training services for both our hosted and licensed solutions, and other direct and allocated indirect costs. The cost of net professional services revenues was $3.1 million during the first quarter of 2004 as compared to $3.5 million during the same quarter in 2003, a decrease of $356,000. This decrease in professional services costs was primarily attributable to the decrease in professional services revenues over the same period.

Maintenance and Support. Cost of net maintenance and support revenues consists primarily of personnel costs related to the customer support functions for both hosted and licensed solutions, and other direct and allocated indirect costs. The cost of net maintenance and support revenues was $1.4 million during the first quarter of 2004 as compared to $1.9 million during the first quarter of 2003, a decrease of $480,000. This decrease in maintenance and support costs was primarily due to cost savings generated through our 2002 and 2003 restructuring initiatives, including the termination of employees, resulting in a reduction in related personnel expenses of $386,000 and the consolidation of facilities of $169,000, partially offset by an increase in certain outside consulting arrangements of $116,000. Depreciation expenses included in maintenance and support costs totaled $25,000 in the first quarter of 2004 as compared to $62,000 in the first quarter of 2003, a decrease of $38,000.

Operations, customer support, and professional services staff increased to 133 employees at March 31, 2004 from 129 employees at March 31, 2003.

Sales and Marketing. Sales and marketing expenses consist primarily of compensation for sales and marketing personnel, advertising, public relations, other promotional costs, and, to a lesser extent, related overhead. Sales and marketing expenses were $6.9 million during the first quarter of 2004 as compared to $9.3 million during the same quarter in 2003, a decrease of $2.4 million. This decrease in sales and marketing expenses was primarily attributable to cost savings generated through our 2002 and 2003 restructuring initiatives, including the termination of employees, from 110 at March 31, 2003 to 82 at March 31, 2004, resulting in a reduction in related personnel expenses of approximately $1.9 million, the consolidation of facilities of $180,000, and the reduction in certain marketing program costs of $47,000. This decrease was partially offset by an increase in certain outside consulting arrangements of $153,000. Depreciation expenses included in sales and marketing expenses totaled $271,000 in the first quarter of 2004 as compared to $703,000 in the first quarter of 2003, a decrease of $432,000.

Research and Development. Research and development expenses consist primarily of compensation for technical staff, payments to outside contractors, depreciation of capital equipment associated with research and development activities, and, to a lesser extent, related overhead. Research and development expenses were $5.8 million during the first quarter of 2004 as compared to $4.6 million during the first quarter of 2003, an increase of $1.2 million. This increase in research and development expenses was primarily due to increased software development expenses of $408,000 (historically these costs had been capitalized), employee additions, from 129 at March 31, 2003 to 137 at March 31, 2004, resulting in an increase in related personnel expenses of $154,000, increased localization expenses of $111,000, increased allocated facilities costs associated with employee additions of $109,000 and increased consulting expenses of $104,000. Depreciation expenses included in research and development expenses totaled $929,000 in the first quarter of 2004 as compared to $653,000 in the first quarter of 2003, an increase of $276,000.

General and Administrative. General and administrative expenses consist primarily of compensation for personnel, fees for outside professional services, occupancy costs and, to a lesser extent, related overhead. General and administrative expenses were $3.1 million during the first quarter of 2004 as compared to $3.2 million during the same quarter in 2003, a decrease of $104,000. This decrease in general and administrative expenses was primarily attributable to cost savings generated through our 2002 and 2003 restructuring initiatives, including the reduction of employees, from 70 at March 31, 2003 to 58 at March 31, 2004, resulting in a reduction in related personnel costs of $412,000, partially offset by increased bad debt expenses of $162,000, increased professional service fees (including accounting and legal services) of $189,000.

Stock-based expenses are comprised of stock-based charges related to stock options and warrants granted to employees and consultants. Stock-based expenses were approximately $46,000 during the first quarter of 2004 as compared to $59,000 during the first quarter of 2003, a decrease of $13,000. Based on the functions of the employees and consultants participating in the related option grants, $5,000 was allocated to cost of net revenues and $41,000 was allocated to operating expenses in the first quarter of 2004 and $17,000 was allocated to cost of net revenues and $42,000 was allocated to operating expenses in the first quarter of 2003.

In May 2002, the Board of Directors approved a restructuring plan to further reduce our expense levels consistent with the current business climate. In connection with the plan, a restructuring charge of $1.5 million was recognized in the second quarter of 2002. This charge was comprised of approximately $1.2 million in severance and related costs associated with the elimination of approximately 39 positions and $300,000 in facilities lease termination costs. The balance of the accrual at March 31, 2004 was approximately $0.4 million and is expected to be utilized by the end of 2004.

In January 2003, we announced a restructuring initiative designed to further reduce our expense levels in an effort to achieve operating profitability assuming no or moderate revenue growth. The plan includes the consolidation of some office locations and a global workforce reduction of approximately 175 positions, or approximately 30% of the workforce. The headcount reduction was partially offset by outsourcing approximately 75 positions to lower cost service providers. We incurred aggregate charges of approximately $8.0 million resulting from the cost reduction plan, inclusive of $7.0 million in cash and $1.0 million in non-cash expenses. Included in this plan were approximately $1.7 million in charges incurred in the fourth quarter of 2002, comprised of approximately $0.7 million in severance and related costs and $1.0 million in facilities lease termination costs. During the first quarter of 2004 this initiative was completed and at March 31, 2004, there was no remaining balance accrued.

In November 2003, we announced that we were restructuring certain facility lease obligations in an effort to reduce our long-term cash obligations. In addition, we identified an additional 16 positions, primarily held by management-level employees, which were to be eliminated. Costs totaling $1.9 million were recognized during the fourth quarter of 2003 associated with these initiatives, including $1.4 million in lease restructuring and termination costs and $0.5 million in severance and related headcount reduction costs. Additionally, costs totaling $1.1 million were recognized during the first quarter of 2004 associated with these initiatives, including $0.1 million in lease restructuring and termination costs and $1.0 million in severance and related headcount reduction costs. During the fourth quarter of 2003 and first quarter of 2004, cash payments totaling $1.3 million and $0.9 million, respectively, were made associated with these restructuring activities. The remaining accrual of $0.6 million associated with this restructuring is expected to be utilized by the end of the first quarter of 2004.

Interest and other income (expense), net consists primarily of interest earnings on cash, cash equivalents and short-term investments as well as net gains (losses) on foreign exchange transactions and changes in the fair value of the liquidation preference on the Series D preferred stock. Interest income was $150,000 during the first quarter of 2004 as compared to $116,000 during the first quarter of 2003, an increase of $34,000. This increase was due to higher cash balances available for investing. Cash balances increased during the three months ended March 31, 2004 due primarily to certain financing activities completed during the quarter and in the fourth quarter of 2003. We recognized a net gain from foreign currency transactions associated with our international operations of $362,000 during the first quarter of 2004 as compared to a net loss of $177,000 during the first quarter of 2003. Based on the current international markets, we expect that fluctuations in foreign currencies could have a significant impact on our operating results during the remainder of 2004.

In connection with the financing transaction closed in December 2001, the Series D Preferred Stock was deemed to have an embedded derivative instrument. In accordance with the provisions of SFAS No. 133, Accounting for Derivative Instruments, we are required to adjust the carrying value of the preference to its fair value at each balance sheet date and recognize any change since the prior balance sheet date as a component of other income or expense. At March 31, 2003 and 2004, the estimated fair value of the liquidation preference was $18.8 million and $21.7 million, respectively, resulting in a net charge to other expense during the first quarter of 2003 of $6.2 million and other income in the first quarter of 2004 of $3.2 million.

Interest expense consists primarily of the interest expense and amortization of issuance costs related to our 10% Senior Convertible Notes issued in November 2003, January, 2004, and March 2004, 5³/4% Convertible Subordinated Notes issued in March 2000, interest and fees on our line of credit facility with Silicon Valley Bank, and interest on certain capital leases. During the first quarter of 2004, we incurred approximately $1.6 million in interest expense, of which $818,000 related to our 10% Senior Convertible Notes, $547,000 related to our 5³/4% Convertible Subordinated Notes. During the first quarter of 2003, we incurred approximately $769,000 in interest expense, of which $547,000 related to our 5³/4% Convertible Subordinated Notes and $89,000 related to our line of credit facility. Interest expense increased $811,000 period over period due primarily to interest on our 10% Senior Convertible Notes.

We recognized a provision for income taxes of $366,000 in the first quarter of 2004 as compared to $194,000 in the first quarter of 2003, as certain of our European operations generated income taxable in certain European jurisdictions. No current provision or benefit for U.S. federal or state income taxes has been recorded as we have incurred net operating losses for income tax purposes since our inception. No deferred provision or benefit for federal or state income taxes has been recorded as we are in a net deferred tax asset position for which a full valuation allowance has been provided due to uncertainty of realization.

In September 2002, we entered into a $15.0 million one-year line of credit with Silicon Valley Bank, to be utilized for working capital and general corporate operations. The credit facility was amended on March 25, 2003

and again on July 18, 2003, as a result of non-compliance with the financial covenants of the facility. We regained compliance with the covenants in the credit facility upon execution of the line of credit agreement on July 18, 2003 and extended the maturity of the credit facility to January 30, 2004. In December 2003 we did not comply with a certain financial covenant and it subsequently received a letter from Silicon Valley Bank on December 17, 2003 waiving such covenant violation. The credit facility is collateralized by all of our personal property, including intellectual property and borrowings under the current agreement bear a variable interest rate of Prime plus 2.0%, which has ranged from 5.25% to 6.25%, and is subject to certain covenants. Interest is paid each month with principal due at maturity. Commitment fees related to the credit facility included an initial commitment fee of 0.50%, or $75,000, and additional commitment fees of $35,000 for each amendment. The facility carries an additional fee based on unused credit of 0.45% payable at the end of each quarterly period in arrears and an early termination fee of 1.0% of the total credit facility through maturity. During the first quarter of 2003, we drew down $4.9 million against the line of credit and repaid $2.6 million during the fourth quarter of 2003 and $2.3 million during the first quarter of 2004. As of March 31, 2004, there was no balance outstanding. At March 31, 2004 there were letters of credit held under the credit facility totaling $2.7 million. All associated interest and fees are included as a component of interest expense.

On January 30, 2004, we executed an amendment with Silicon Valley Bank, which reduced the size of the credit line to a maximum of $5.0 million and extended the maturity date to October 31, 2004. On March 12, 2004 we executed an additional amendment with Silicon Valley Bank, which increased the size of the credit line to a maximum of $6.0 million and extended the maturity date to June 30, 2005. Additionally, the line of credit calls for a minimum cash balance at Silicon Valley Bank of $3.0 million. We do not classify this as restricted cash as it is legally unrestricted The credit facility continues to be collateralized by all of our personal property, including intellectual property, and borrowings under the current agreement bear a variable interest rate of between Prime plus 1.5% and Prime plus 3.0%, which has historically ranged from 5.25% to 6.25%, and is subject to covenants. Interest is paid each month with principal due at maturity. Initial commitment fees of $20,000 and $100,000 were charged related to the January and March amendments, respectively. Additionally, the facility carries an expedite fee of $50,000, an unused facility fee of either 0.45% or 2.00%, based upon the level of cash balances held at the bank, payable at the end of each quarterly period in arrears, and an early termination fee of $50,000 if the facility is canceled prior to August 1, 2004. In connection with the March 2004 amendment to the credit facility, we agreed to issue warrants to purchase up to 100,000 shares of our common stock to Silicon Valley Bank. These warrants were fully exercisable upon grant, had an exercise price of $2.07 per share and have an expiration date of March 12, 2011.

As of March 31, 2004, the total balance outstanding was $38.4 million. There was approximately $1.1 in accrued interest payable related to these notes at March 31, 2004. All related interest is included in interest expense.

In March 2004, we executed an amendment with a group of investors led by Cheung Kong Group and its Whampoa Limited affiliates including Campina Enterprises Limited, Cenwell Limited, Great Affluent Limited, Dragonfield Limited and Lion Cosmos Limited (referred to collectively as the Cheung Kong Investors) which would extend the maturity of the $32.8 million in face value of 5³/4% convertible subordinated notes held by the Cheung Kong Investors from April 1, 2005 to April 1, 2006. The extension will only take place in the event our shareholders do not approve the exchange of the 5³/4% convertible subordinated notes held by the Cheung Kong Investors for approximately 21.9 million shares of our Series E preferred stock. In addition, in the event the maturity date is extended to April 1, 2006, the interest rate on the 5³/4% convertible subordinated notes held by the Cheung Kong Investors will increase to 7¹/2% for the period beginning April 1, 2005 and ending April 1, 2006, and we will be required to pay fees totaling $1.5 million. These 5³/4% Notes are carried at cost and had an approximate fair value at March 31, 2004 of $34.7 million.

In November 2003, we issued in a private placement $10 million in 10% senior convertible notes to General Atlantic Partners 74, L.P., GAP Coinvestment Partners II, L.P., GapStar, LLC and GAPCO GmbH & Co. K.G. (referred to collectively as the General Atlantic Investors).

At issuance, the senior convertible note issued to the General Atlantic Investors was deemed to have an embedded derivative, related to the acceleration of any unearned interest upon conversion prior to the first anniversary of its issue date. The fair value of this derivative, which was fixed at $750,000 at issuance, was recorded as a reduction in the carrying amount of the senior convertible note and will accrete over the initial year of the notes’ four year term.

As part of our November 2003 private placement of 10% Senior Convertible Notes, we agreed to seek shareholder approval to amend the terms of the Series D preferred stock to, among other things, amend the Series D preferred stock liquidation preference upon a liquidation and change of control, to eliminate the participation feature, to reduce the conversion price from $4.20 to $1.50 and to reduce the amount of dividends to which the holders of Series D preferred stock are entitled. See also the 10% Senior Convertible Notes discussion below.

Upon shareholder approval, the $10 million in principal amount of senior convertible notes held by the General Atlantic Investors, plus interest, will convert into 7.3 million shares of Series E preferred stock at $1.50 per share. As a result, interest expense of approximately $5.7 million will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E preferred stock. Interest expense of $100,000 was accrued on the debt during 2003 and remained payable as of December 31, 2003.

In January 2004, we issued $15 million in principal amount of 10% senior convertible notes to Permal U.S. Opportunities Limited, Zaxis Equity Neutral, L.P., Zaxis Institutional Partners, L.P., Zaxis Offshore Limited, Zaxis Partners, L.P. and Passport Master Fund, L.P. These notes are convertible into approximately 10 million shares of Series E convertible preferred stock at $1.50 per share only if we receive shareholder approval. As a result, interest expense of approximately $1.5 million will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E preferred stock. If we do not obtain shareholder approval, these notes will be convertible, at the option of each note holder, into shares of our common stock at $1.65 per share, provided the note holder will not be able to convert its notes into shares of common stock to the extent the note holder, together with its affiliates, would own 9.9% or more of our common stock after conversion. If these notes do not convert into Series E preferred stock or common stock, they become due and payable on the fourth anniversary of their issuance.

In March 2004, we issued $18.5 million in principal amount of 10% senior convertible notes to investment entities affiliated with Crosslink Capital, Criterion Capital Management, Heights Capital Management and Apex Capital. These notes are convertible into approximately 12.3 million shares of Series E convertible preferred stock at $1.50 per share only if we receive shareholder approval. If we do not obtain shareholder approval, these notes will be convertible, at the option of each note holder, into shares of our common stock at $2.18 per share, provided the note holder will not be able to convert its notes into shares of common stock to the extent the note holder, together with its affiliates, would own 9.9% or more of our common stock after conversion. As a result, interest expense of approximately $8.4 million will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E preferred stock. If these notes do not convert into Series E preferred stock or common stock, they become due and payable on the fourth anniversary of their issuance. The terms of the 10% senior convertible notes, including their covenants and other limitations, are discussed below under the caption “Liquidity and Capital Resources - Recent Financing Transactions - Debt covenants and restrictions.”

At March 31, 2004, the carrying value of the 10% Convertible Notes was $43.5 million and accrued interest totaled $784,000.

Accretion on redeemable convertible preferred shares and valuation of liquidation preference

In connection with the financing transaction completed during December 2001, we received gross cash proceeds of approximately $30 million and retired approximately $65 million in face value of our outstanding convertible subordinated notes in exchange for shares of our Series D Cumulative Redeemable Convertible Participating Preferred Stock. The preferred stock includes an automatic redemption on November 8, 2006 and cumulative dividends at a rate of 8% per year, compounded on a semi-annual basis. At issuance, the Series D Preferred Stock was deemed to have an embedded beneficial conversion feature which was limited to the net proceeds allocable to preferred stock of approximately $42 million. The value of the beneficial conversion feature, at issuance, was initially recorded as a reduction of the carrying amount of the Series D Preferred Stock and will accrete over the term of the Series D Preferred Stock. During the first quarter of 2004, the accretion on redeemable convertible preferred shares totaled $3.1 million, comprised of $1.3 million in accrued dividends, accretion of $1.8 million, and amortization of $17,000. During the first quarter of 2003, the accretion on redeemable convertible preferred shares totaled $3.7 million, comprised of $711,000 in accrued dividends and accretion of $3.0 million.

We have operated at a loss since our inception. With our history of operating losses, our primary sources of capital have come from both debt and equity financings that we have completed over the past several years. Cash and cash equivalents totaled $37.1 million at March 31, 2004. Of our cash and cash equivalents at March 31, 2004, $2.7 million is expected to support our outstanding obligations to Silicon Valley Bank and $7.6 million is located in accounts outside the United States, which may not be available to our domestic operations. Accordingly, our readily available cash resources in the United States as of March 31, 2004 were $26.8 million. At December 31, 2003, our readily available cash resources in the United States totaled $6.4 million.

During 2003 and the first quarter of 2004, we used an average of approximately $8.8 million of cash per quarter to fund our operating activities. Faced with a cash shortfall caused by lower than budgeted revenues and higher than expected expenses in 2003, we looked to the cash held by our foreign subsidiaries. However, we determined that restrictions on cash held outside the United States, including requirements in some jurisdictions that cash held by foreign subsidiaries must be sufficient to fund the operation of such foreign subsidiary, limited our ability to access and utilize this cash for domestic operations. As a result, the actual cash available to us to fund our domestic operations is less than the actual cash balance maintained by the Company.

We also attempted to raise additional funds through financing transactions. However, because of the approaching maturity date of the approximately $38 million in face value of our 5³/4% Convertible Subordinated Notes due in 2005 and the uncertainty regarding our ability to remain in compliance with the covenants of the Silicon Valley Bank line of credit due to the lower than expected operating results, we found that investors were reluctant to invest cash which might be used solely to repay these debt obligations. Although we were able to raise $10 million in November 2003, due to our rate of cash usage, the amount of cash available to us and the need to dedicate a portion of the proceeds to pay down a portion of the Silicon Valley Bank line of credit, our management determined that we had sufficient cash to continue our operations only through the first quarter of 2004. As a result of this disclosure, which appeared in our registration statement on Form S-3 filed with the SEC on December 24, 2003, as well as our results of operations and our revised projections, our independent accountants updated their report as of December 22, 2003 to add a going concern qualification.

Subsequent to the updated report from our independent accountants, during the period covered by this report, we were able to raise $33.5 million from new investors as described in more detail under the heading “Recent Financing Transactions” below. In addition, we extended the maturity date of the Silicon Valley Bank line of credit to June 2005, negotiated with the holders of approximately $33 million in face value of our 5³/4% Convertible Notes to extend their maturity dates until April 2006 if they are not converted to Series E Preferred Stock. As a result, we believe that cash flow projections prepared in March 2004 support our view that we have sufficient cash and expected cash flows to fund our operations through at least December 31, 2004. The report of our independent accountants that was incorporated into our Annual Report on Form 10-K for the year ended December 31, 2003 is unqualified as to our ability to continue as a going concern.

We have recently announced that the Securities and Exchange Commission has declared effective our registration statement for a rights offering of up to 14,000,000 shares of Series E preferred stock. The consummation of the rights offering is subject to the satisfaction of conditions, one of which is the approval of the matters being submitted to a vote of our shareholders at a special meeting to be held on June 11, 2004. Provided shareholder approval, we could raise up to $21.0 million of gross proceeds, if fully subscribed, from such offering which would substantially enhance our liquidity and longer-term viability.

In January 2004, we issued $15 million in principal amount of 10% senior convertible notes to Permal U.S. Opportunities Limited, Zaxis Equity Neutral, L.P., Zaxis Institutional Partners, L.P., Zaxis Offshore Limited, Zaxis Partners, L.P. and Passport Master Fund, L.P. These notes are convertible into approximately 10 million shares of Series E preferred stock at $1.50 per share only if we receive shareholder approval at a special meeting on June 11, 2004. As a result, interest expense of approximately $1.5 million will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E preferred stock. If we do not obtain shareholder approval, these notes will be convertible, at the option of each note holder, into shares of our common stock at $1.65 per share, provided the note holder will not be able to convert its notes into shares of common stock to the extent the note holder, together with its affiliates, would own 9.9% or more of our common stock after conversion. If these notes do not convert into Series E preferred stock or common stock, they become due and payable on the fourth anniversary of their issuance.

In March 2004, we issued $18.5 million in principal amount of 10% senior convertible notes to investment entities affiliated with Crosslink Capital, Criterion Capital Management, Heights Capital Management and Apex Capital. These notes are convertible into approximately 12.3 million shares of Series E preferred stock at $1.50 per share only if we receive shareholder approval. If we do not obtain shareholder approval at a special meeting on June 11, 2004, these notes will be convertible, at the option of each note holder, into shares of our common stock at $2.18 per share, provided the note holder will not be able to convert its notes into shares of common stock to the extent the note holder, together with its affiliates, would own 9.9% or more of our common stock after conversion. As a result, interest expense of approximately $8.4 million will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E preferred stock. If these notes do not convert into Series E preferred stock or common stock, they become due and payable on the fourth anniversary of their issuance.

Upon shareholder approval of the matters being presented at a special meeting on June 11, 2004, the $43.5 million in principal amount of 10% senior convertible notes, plus interest, will automatically convert into approximately 29 million shares of Series E preferred stock at $1.50 per share. Additionally upon such approval, the $32.8 million in face value of its 5³/4% convertible subordinated notes due in April 2005 held by the Cheung Kong Investors will automatically be converted into approximately 21.9 million shares of Series E preferred stock. The Series E preferred stock will be issued to these investors only if Critical Path receives shareholder approval and will rank senior in preference to all of our existing equity. These preferred shares will accrue dividends at an annual rate of 5³/4% of the purchase price of $1.50 per share.

In March 2004, we executed an amendment with a group of investors led by the Cheung Kong Investors which would extend the maturity of the $32.8 million in face value of 5³/4% convertible subordinated notes held by the Cheung Kong Investors from April 1, 2005 to April 1, 2006. The extension will only take place in the event our shareholders do not approve the exchange of the 5³/4% convertible subordinated notes held by the Cheung Kong Investors for approximately 21.9 million shares of our Series E preferred stock. In addition, in the event the maturity date is extended to April 1, 2006, the interest rate on the 5³/4% convertible subordinated notes held by the Cheung Kong Investors will increase to 7¹/2% for the period beginning April 1, 2005 and ending April 1, 2006, and we will be required to pay fees totaling $1.5 million.

In a separate agreement, members of the Cheung Kong Investors have granted us an option, which we may exercise in our sole discretion, to repurchase approximately 10.9 million shares of the Series E preferred stock held by the Cheung Kong Investors at $1.50 per share. Our option expires 10 business days after the Cheung Kong Investors acquire shares of the Series E preferred stock after the close of the proposed rights offering of the preferred stock.

On January 30, 2004, we executed an amendment with Silicon Valley Bank, which reduced the size of the credit line to a maximum of $5.0 million and extended the maturity date to October 31, 2004. On March 12, 2004 we executed an additional amendment with Silicon Valley Bank, which increased the size of the credit line to a maximum of $6.0 million and extended the maturity date to June 30, 2005. Additionally, the line of credit calls for a minimum cash balance at Silicon Valley Bank of $3.0 million. The Company does not classify this as restricted cash as it is legally unrestricted. The credit facility continues to be collateralized by all of our personal property, including intellectual property and borrowings under the current agreement bear a variable interest rate of between Prime plus 1.5% and Prime plus 3.0%, which has historically ranged from 5.25% to 6.25%, and is subject to certain covenants. Interest is paid each month with principal due at maturity. Initial commitment fees of $20,000 and $100,000 were charged related to the January and March amendments, respectively. Additionally, the facility carries an expedite fee of $50,000, an unused facility fee of either 0.45% or 2.00%, based upon the level of cash balances held at the bank, payable at the end of each quarterly period in arrears, and an early termination fee of $50,000 if the facility is canceled prior to August 1, 2004. In connection with the March amendment to the credit facility, we agreed to issue warrants to purchase up to 100,000 shares of our common stock to Silicon Valley Bank. These warrants were fully exercisable upon grant, had an exercise price of $2.07 per share and have an expiration date of March 12, 2011.

In April 2004, we entered into the Fourth Amendment to Amended and Restated Loan and Security Agreement with Silicon Valley Bank (the April 2004 Amendment). As part of the April 2004 Amendment, Silicon Valley Bank (i) waived our failure to comply with the financial covenant for the quarter ended March 31, 2004, (ii) modified the minimum consolidated revenue covenant, and (iii) added a covenant that our receipt of a going concern qualification in an audit report commencing from the date of the April 2004 Amendment through the credit facility’s maturity date constitutes an event of default.

The 10% senior convertible notes become due and payable upon the consummation of a qualified asset sale, a change of control or any financing or series of financings that in the aggregate raises at least $40 million.

Additionally, the notes become due and payable when declared due and payable by a holder upon the occurrence of an event of default, which include, subject to some exceptions: (1) our failure to pay any amounts due under notes when they are due and payable, (2) our default on any indebtedness with a principal amount of at least $500,000, (3) our voluntary or involuntary bankruptcy, (4) any judgment for the payment of money of more than $500,000, (5) the attachment by our lenders of any of our assets, or (6) the occurrence of any event having a material adverse effect on our business, operations, assets, properties or condition.

The 10% senior convertible notes also contain a financial covenant that requires us to maintain a minimum monthly average operating cash flow, over any given fiscal quarter, for our operations in the Americas of negative $3.0 million. Additionally, we may not incur, create or assume indebtedness or liens under the notes, with specified exceptions. Also, with some exceptions, under the notes we may not: (1) merge with another entity, (2) make any restricted payments, including dividends, distributions and the redemption any of our options or capital stock, (3) enter into any transactions with any affiliates, (4) make investments, (5) change the nature of our business, (6) permit our domestic subsidiaries to hold real or personal property in excess of specified amounts or (7) create any new subsidiaries.

If we breach any representation or warranty or fail to abide by any of our covenants, including the foregoing covenants, then the 10% senior convertible notes may become immediately due and payable. If these notes do not convert into Series E preferred stock or common stock, the principal and related interest will become due and payable on the fourth anniversary of their issuance.

The Silicon Valley Bank credit facility contains provisions for the acceleration of payment of the indebtedness in the event of a default which include, subject to some exceptions: (1) breach of representation or warranty, (2) failure to pay any amounts due under the credit facility when due and payable, (3) exceeding the credit limit, (4) breach of financial covenants or other covenants, (5) attachment by our lenders of any of our assets, (6) default on any permitted indebtedness, (7) any breach which results in a material adverse change to our business, operations, assets, properties or condition, (8) dissolution or voluntary or involuntary bankruptcy, (9) revocation of a guaranty or pledge, (10) payment by the Company of subordinated indebtedness, (11) change in beneficial ownership, (12) fraud or (13) any material adverse change to our business, operations, assets, properties or condition.

The holders of the 5³/4% convertible subordinated notes may convert the notes into shares of our common stock at any time before their maturity or the business day before their redemption or repurchase by us. The conversion rate is 9.8546 shares per $1,000 principal amount of notes subject to adjustment in specified circumstances. This rate is equivalent to a conversion price of approximately $405.92 per share. In the event of a change of control, the holders of the 5³/4% convertible subordinated notes have the option of requiring us to repurchase any notes held at a price of 100% of the principal amount of the notes plus accrued interest to the date of repurchase.

In March 2004, we executed an amendment with a group of investors led by the Cheung Kong Investors which would extend the maturity of the $32.8 million in face value of 5³/4% convertible subordinated notes held by the Cheung Kong Investors from April 1, 2005 to April 1, 2006. The extension will only take place in the event our shareholders do not approve the exchange of the 5³/4% convertible subordinated notes held by the Cheung Kong Investors for approximately 21.9 million shares of our Series E preferred stock. In addition, in the event the maturity date is extended to April 1, 2006, the interest rate on the 5³/4% convertible subordinated notes held by the Cheung Kong Investors will increase to 7¹/2%, for the period beginning April 1, 2005 and ending April 1, 2006, and we will be required to pay fees totaling $1.5 million.

Subject to certain exceptions for, among others, indebtedness for accounts payable incurred in the ordinary course of business or indebtedness to acquire any equipment or similar property, holders of: (1) a majority of the 10% senior convertible notes issued in November, (2) a majority of the 10% senior convertible notes issued in January and (3) a majority of the 10% senior convertible notes issued in March, must consent to our incurrence of any additional indebtedness. Under the terms of our line of credit with Silicon Valley Bank, we are not permitted to incur additional indebtedness without the approval, by Silicon Valley Bank in its sole discretion, that the terms of the debt are adequately subordinated to the obligations due under the Silicon Valley Bank credit facility. In addition, we must seek the consent of the holders of a majority of our Series D preferred stock in order to incur any additional indebtedness.

Operating Activities. Cash and cash equivalents increased by $18.1 million during the first quarter of 2004, from $19.0 million at December 31, 2003 to $37.1 million at March 31, 2004, and decreased by $2.1 million during the first quarter of 2003, from $33.5 million at December 31, 2002 to $31.4 million at March 31, 2003. We used cash to fund operating activities of $9.3 million during the first quarter of 2004 and $15.0 million during the first quarter of 2003. This use of cash was primarily due to our net losses during those quarters, adjusted for non-cash charges, as operating costs, primarily employee and employee related costs, exceeded the related revenues from the sale of our software products and services. Additionally, we made cash payments related to our 2002 and 2003 strategic restructuring initiatives of $907,000 during the first quarter of 2004 and $3.6 million during the first quarter of 2003. These cash outflows for operating activities were partially offset by improved accounts receivable collections of $3.1 million during the first quarter of 2003 and partially offset by the increase of our accrued liabilities and deferred revenue during the first quarter of 2004. A more detailed discussion of our operating results can be found in the Results of Operations section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

We may face restrictions on our ability to use cash held outside of the United States for purposes other than the operation of each of our respective foreign subsidiaries that hold that cash. For example, our ability to use cash held in our German subsidiary for any reason other than the operation of this subsidiary may result in certain tax liabilities and may be subject to local laws that could prevent the transfer of cash from Germany to any other foreign or domestic account.

We are exposed to foreign currency exchange rate risk inherent in our sales commitments, anticipated sales, contracts with vendors, and working capital, as a significant portion or our worldwide operations have a functional currency other than the United States dollar. The impact of future exchange rate fluctuations cannot be predicted adequately. To date, we have not sought to hedge the risks associated with fluctuations in exchange rates.

Revenue generated from the sale of our products and services may not increase to a level that exceeds our expenses or could fluctuate significantly as a result of changes in customer demand or acceptance of future products. Although we expect to continue to review our operating expenses, if we are not successful in achieving a cost reduction or generating sufficient revenues, our cash flow from operations will continue to be negatively impacted.

Our primary source of operating cash flow is the collection of accounts receivable from our customers and the timing of payments to our vendors and service providers. We measure the effectiveness of our collections efforts by an analysis of the average number of days our accounts receivable are outstanding. At March 31, 2004, our days sales outstanding were 88 days, down from 99 days at March 31 2003. Collections of accounts receivable and related days outstanding will fluctuate in future periods due to the timing, amount of our future revenues, payment terms on customer contracts and the effectiveness of our collection efforts.

A number of non-cash items have been charged to expense and increased our net losses during the first quarters of 2004 and 2003. These items include depreciation and amortization of property and equipment and intangible assets, amortization of unearned stock-based compensation and other stock-based compensation charges and provisions for doubtful accounts. To the extent these non-cash items increase or decrease in amount and increase or decrease our future operating results, there will be no corresponding impact on our cash flows.

Our operating cash flows will be impacted in the future based on the timing of payments to our vendors for accounts payable. We endeavor to pay our vendors and service providers in accordance with the invoice terms and conditions. The timing of cash payments in future periods may be impacted by the nature of accounts payable arrangements.

Investing Activities. We used cash in investing activities of $1.1 million during the first quarter of 2004 and received cash from investing activities of $8.0 million during the first quarter of 2003. Cash used in investing activities related to the purchase of property and equipment, primarily for the acquisition of additional network infrastructure equipment, strategic investments in private entities and short-term investments in high-grade, low risk instruments. Cash proceeds are comprised of the sale of investments and marketable securities and the release of restricted cash and funds held in escrow.

Investments in property and equipment totaled $1.1 million during the first quarter of 2004 and $4.3 million during the first quarter of 2003. These cash outflows for investing activities were partially offset by $9.6 million received from the sale of marketable securities and unrestricting $2.7 million in previously restricted cash during the first quarter of 2003.

Financing Activities. We received net cash from financing activities of $31.1 million during the first quarter of 2004 and $4.6 million during the first quarter of 2003. During the first quarter of 2004, we raised cash of $15.0 million through the issuance of 10% Senior Convertible Notes to Permal U.S. Opportunities Limited, Zaxis Equity Neutral, L.P., Zaxis Institutional Partners, L.P., Zaxis Offshore Limited, Zaxis Partners, L.P. and Passport Master Fund, L.P and $18.5 million through the issuance of 10% Senior Convertible Notes to investment entities affiliated with Crosslink Capital, Criterion Capital Management, Heights Capital Management and Apex Capital. Additionally, we raised $163,000 from the issuance of common stock during the first quarter of 2004. These cash

inflows from financing activities were partially offset by payments of $2.3 million to payoff our line of credit facility and $287,000 to payoff capital lease obligations. During the first quarter of 2003, we borrowed $4.9 million in cash against our line of credit facility with Silicon Valley Bank. This cash inflow from financing activities was partially offset by principal payments of $307,000 on note and capital lease obligations.

We receive cash from the exercise of stock options and the sale of stock under our employee stock purchase plan. While we expect to continue to receive these proceeds in future periods, the timing and amount of such proceeds is difficult to predict and is contingent on a number of factors including the price of our common stock, the number of employees participating in the stock option plans and our employee stock purchase plan and general market conditions.

We have no present understandings, commitments or agreements for any material acquisitions of, or investments in, other complementary businesses, products or technologies. We continually evaluate potential acquisitions of, or investments in, other businesses, products and technologies, and may in the future utilize our cash resources or may require additional equity or debt financing to accomplish any acquisitions or investments. These alternatives could increase liquidity through the infusion of investment capital by third- party investors or decrease our liquidity as a result of Critical Path seeking to fund expansion into these markets. Such expansions might also cause an increase in capital expenditures and operating expenses.

The table below sets forth our significant obligations and commitments as of March 31, 2004.

Since December 31, 2003, we have issued an additional $33.5 million in principal amount of 10% senior notes. These notes are convertible into shares of Series E preferred stock, if we receive shareholder approval, and otherwise are convertible into shares of common stock, if we do not, at the option of the holder. A discussion of the terms of the convertible notes is provided above under the caption “Liquidity and Capital Resources - Recent Financing Transactions.” If the holders of the convertible notes convert the notes or a portion of the notes to shares of our equity stock, then the contractual obligation would be correspondingly reduced. In the event that these notes are not converted into shares of our equity stock, $21 million in principal and interest will be due and payable in January 2008 and $25.9 million in principal and interest will be due and payable in March 2008.

In March 2004, we executed an agreement that extends the maturity of $32.8 million in face value of the 5³/4% convertible subordinated notes due in April 2005 to April 2006, if our shareholders do not approve the conversion of these notes into new Series E preferred stock. In the event the maturity is extended, $32.8 million currently due in April 2005 will be extended to April 2006. In addition, under the agreement we would be required to increase the

interest rate for the extended one-year period to 7.5% and pay a fee for such extension of $1.5 million. Under the amended agreement for the $32.8 million in notes, $100,000 in fees would be due in 2004, $2.6 million in fees and interest would be due in 2005 and $34 million in principal and interest would be due in 2006.

In April 2004, the Emerging Issues Task Force issued Statement No. 03-06, or EITF 03-06, “Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share”. EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 is effective for fiscal periods beginning after March 31, 2004. We are currently evaluating the impact of the adoption of EITF 03-06 on our results of operations and financial position.

In April 2004, the Company entered into a Separation Agreement and Mutual Release with William McGlashan (the Executive) the Company’s former Chief Executive Officer. The Company expects to record a charge related to the agreement during the three month period ending June 30, 2004. The Company and the Executive have mutually agreed to treat the termination of employment as eligible for payment of certain of the separation benefits provided under the Employment Agreement with additional provisions as set forth below. (i) the Executive will forfeit his eligibility to receive a loan from the Company, (ii) the Executive will continue to serve as a nonemployee Chairman of the Board of Directors, (iii) the Change of Control Severance Agreement between the Company and the Executive is amended to provide that its applicability shall be extended and that any payout to the Executive first be reduced by $405,000, (iv) the Executives outstanding stock options shall cease vesting but remain exercisable for a period of three years, (v) the Executive outstanding stock loan shall be retired and the Loan Agreement between the Company and the Executive be terminated.

We have a history of losses, expect continuing losses and may never achieve profitability.

We have not achieved profitability in any period and may continue to incur net losses in accordance with generally accepted accounting principles for the foreseeable future. In addition, we intend to continue to spend resources on maintaining and strengthening our business, and this may, in the near term, cause our operating expenses to increase and our operating results to decline.

In past quarters, we have spent heavily on technology and infrastructure development. We may continue to spend substantial financial and other resources to further develop and introduce new messaging and identity management solutions, and to improve our sales and marketing organizations, strategic relationships and operating infrastructure. We expect that our cost of revenues, sales and marketing expenses, general and administrative

expenses, operations, research and customer support expenses and depreciation and amortization expenses could continue to increase in absolute dollars and may increase as a percent of revenues. In addition, in future periods we may incur significant non-cash charges related to stock-based compensation. If revenues do not correspondingly increase, our operating results could decline. If we continue to incur net losses in future periods, we may not be able to retain employees, or fund investments in capital equipment, sales and marketing programs, and research and development to successfully compete against our competitors. We also may never obtain sufficient revenues to exceed our cost structure and achieve profitability. If we do achieve profitability, we may not be able to sustain or increase profitability in the future. This may also, in turn, cause the price of our common stock to demonstrate volatility and/or continue to decline.

We may need to raise additional capital and may need to initiate other operational strategies to continue our operations.

In the future, we may be required to raise additional funds, particularly if we are unable to generate positive cash flow as a result of our operations. Such financing may not be available in sufficient amounts or on terms acceptable to us. Additionally, we face a number of challenges in operating our business, including our ability to overcome viability concerns of our prospective customers given our recent capital needs, the amount of resources necessary to maintain worldwide operations and continued sluggishness in technology spending. Concerns about our long-term viability may cause our stock price to fall and impair our ability to raise additional capital and may create a concern among our current and future customers and vendors as to whether we will be able to fulfill our contractual obligations. As a result, current and future customers may determine not to do business with us, which would cause our revenues to decline.

The conversion of our preferred stock would result in a substantial number of additional shares of common stock outstanding, which could decrease the price of our common stock.

As of April 28, 2004, there were 4,188,587 shares of Series D preferred stock outstanding, which were convertible, at the option of the holders, into approximately 16.5 million shares of common stock. If we obtain shareholder approval, we will also amend the terms of the Series D preferred stock, including the conversion ratio, to increase the number of shares of common stock initially issuable upon conversion of the Series D preferred stock to approximately 45.4 million. In addition, if we obtain shareholder approval, we will be issuing approximately 52.8 million shares of Series E preferred stock that are initially convertible, at the option of the holders, into an equal number of shares of common stock. In addition, if all the subscription rights being offered in the proposed rights offering are exercised, the shares of Series E preferred stock issued in the rights offering will initially convert into up to approximately 14.0 million shares of common stock. Accordingly, if we obtain shareholder approval and we sell all the shares of preferred stock offered in the proposed rights offering, our preferred stock will initially be convertible into approximately 112.2 million shares of common stock. Even if we do not obtain shareholder approval, in addition to the approximately 16.5 million shares of common stock currently issuable upon conversion of the outstanding Series D preferred stock, approximately $33.5 million in principal amount of 10% convertible notes plus accrued dividends will be convertible, at the option of each note holder, into approximately 52.8 million shares of common stock. Increasing the number of additional shares of common stock that may be sold into the market by this amount could substantially decrease the price of our common stock.

As the preferred stock accrues dividends, the number of shares of common stock issuable upon conversion will increase, which may increase the dilution to our holders of common stock and further decrease the price of our common stock.

Currently, shares of Series D preferred stock accrue dividends at a compounded annual rate of 8%. If the maximum amount of dividends were to accrue to the Series D preferred stock prior to the automatic call for redemption date, a total of approximately 20.3 million shares of common stock, or an additional 3.8 million shares, would be issuable upon conversion. If our shareholders approve the amendment to the terms of the Series D preferred stock and we issue approximately 66.8 million shares of Series E preferred stock, all of which will accrue dividends at a rate of 5³/4% per year, and the maximum amount of dividends accrue prior to the automatic call for redemption date, the number of shares of common stock issuable upon conversion will increase by approximately 25.9 million shares to approximately 138.1 million shares.

Our preferred stock carries a substantial liquidation preference, which could significantly impact the return to common equity holders upon an acquisition.

In the event of liquidation, dissolution, winding up or change of control of Critical Path, if we issue shares of Series E preferred stock, the holders of Series E preferred stock would be entitled to receive $1.50 per share of Series E preferred stock plus all accrued dividends on such share before any proceeds from the liquidation, dissolution or winding up is paid with respect to any other series or class of our capital stock. Accordingly, if we obtain stockholder approval for the transactions contemplated by the convertible note purchase and exchange agreement and the January 2004 and March 2004 private placements, the approximately 52.8 million shares of Series E preferred stock that will be outstanding will initially have an aggregate liquidation preference of approximately $79.2 million. If all 14 million additional shares of Series E preferred stock are purchased pursuant to the proposed rights offering, the initial aggregate liquidation preference of the Series E preferred stock will increase to approximately $100.2 million. The aggregate amount of the preference will increase as the shares of Series E preferred stock accrue dividends based on simple interest at an annual rate of 5³/4%. After all of the then outstanding shares of Series E preferred stock have received payment of their liquidation preference, the holders of Series D preferred stock would be entitled to receive, at a minimum, $13.75 per share of Series D preferred stock plus all accrued dividends on such share before any proceeds from the liquidation, dissolution or winding up is paid to holders of our common stock. As of April 28, 2004, the shares of Series D preferred stock have an aggregate initial liquidation preference of approximately $69.2 million, which, as amended, will increase on a daily basis at an annual rate of 5³/4%. As amended, the shares of Series D preferred stock have a maximum aggregate initial liquidation preference of approximately $91 million. If we are acquired before the fourth anniversary of the date the shares of Series E preferred stock are first issued, the holders of Series D preferred stock will be entitled to receive an initial preference payment equal to approximately $91 million, regardless of the amount of dividends accrued at the time of the acquisition. Holders of our common stock will not receive any proceeds from a liquidation, winding up or dissolution, including from a change of control, until after the liquidation preferences of the our Series E preferred stock and our Series D preferred stock are paid in full. Consequently, the sale of all or substantially all of the shares of Critical Path may likely result in all or substantially all of the proceeds of such transaction being distributed to the holders of our Series E preferred stock and Series D preferred stock.

From time to time we engage in discussions with or receive proposals from third parties relating to potential acquisitions or strategic transactions that could constitute a change of control. While we have not engaged in any transaction of this type in the past, we will in the future continue to evaluate potential business combinations or strategic transactions which, if consummated, may constitute a change of control and trigger the liquidation preferences described above.

Issuance of Series E preferred stock and the amendment to the terms of our Series D preferred stock will cause us to record charges that increase the net loss attributable to our common shareholders, which may be material to our results of operations for the period in which they are recorded.

Based on our current estimates, the application of generally accepted accounting principles to account for the proposed rights offering, the conversion of the notes we privately sold in November 2003, January 2004 and March 2004 into Series E preferred stock, the amendment of the terms of our Series D preferred stock and the issuance of Series E preferred stock in exchange for some outstanding shares of Series D preferred stock will cause us to record charges that increase our net loss attributable to common shares. Because these charges will be based in part on the fair value of our common stock and the Series E preferred stock on the date or dates the Series E preferred stock is issued, and on the fair value of the Series D preferred stock on the date its rights and preferences are modified, we are only able to estimate the amount of the charges that will occur. Assuming that these transactions occurred on November 18, 2003, except for the issuance of the notes which occurred on November 26, 2003, January 16, 2004 and March 9, 2004 and the estimated fair market values of the common stock, the Series E preferred stock and the Series D preferred stock on such dates, we estimate that one-time charges would total approximately $54.9 million to be recorded in the period that shareholders approve the transactions, and that additional charges totaling $3.2 million would be recorded over the four-year redemption period of the Series E preferred stock if all of the shares offered of Series E preferred stock are purchased in the proposed rights offering. A change in the fair value of our common stock, or our Series E preferred stock, as of the date or dates we issue the Series E preferred stock, or our Series D preferred stock, as of the date we amend the terms of the Series D preferred stock, would cause these estimates to vary.

We face restrictions on our ability to use cash that we currently hold outside of the United States for purposes other than the operation of each of our respective foreign subsidiaries that hold such cash. For example, our ability to use cash held in our German subsidiary for any reason other than the operation of this subsidiary may result in certain tax liabilities and are subject to local laws that could prevent the transfer of cash from Germany to any other foreign or domestic account. At March 31, 2004, approximately $7.6 million was held outside of the United States. Our inability to utilize this cash could slow our ability to grow our business and reach our business objectives. We may also be forced to incur certain costs, such as tax liabilities, to be able to use this cash for domestic operations, which could cause our expenses to increase and our operating results to decline. In addition, a portion of our cash must be available to support our line of credit with Silicon Valley Bank and related letters of credit by the line of credit.

Due to our evolving business strategy and the nature of the messaging and directory infrastructure market, our future revenues are unpredictable and our quarterly operating results may fluctuate.

We cannot accurately forecast our revenues as a result of our evolving business strategy and the emerging nature of the Internet messaging infrastructure market. Forecasting is further complicated by recent strategic and operational restructurings, as well as fluctuations in license revenues as a percentage of total revenues from 30% in 2001 to 40% in 2002 and 31% in 2003. Our revenues in some past quarters fell and could continue to fall short of expectations if we experience delays or cancellations of even a small number of orders. We often offer volume-based pricing, which may affect our operating margins. A number of factors are likely to cause fluctuations in operating results, including, but not limited to:

In addition to the factors set forth above, operating results have been and will continue to be impacted by the extent to which we incur non-cash charges associated with stock-based arrangements with employees and non-employees. In particular, during the three months ended March 31, 2003 and 2004, we incurred stock-based compensation expense of $59,000 and $46,000, respectively, relating to the issuance of common stock and the grant of options and warrants to employees and non-employees. Grants of options and warrants also may be dilutive to existing shareholders.

Our revenues and operating results have declined and could continue to decline as a result of the elimination of product or service offerings through termination, sale or other disposition. Future decisions to eliminate, revise or limit any other offerings of a product or service would involve other factors that could cause our revenues to decline and our expenses to increase, including the expenditure of capital, the realization of losses, further reductions in our workforce, facility consolidation or the elimination of revenues along with the associated costs.

As a result of the foregoing, we do not believe that period-to-period comparisons of operating results are a good indication of future performance. It is likely that operating results in some quarters will be below market expectations. In this event, the price of our common stock is likely to prove volatile and/or subject to further declines.

If we fail to improve our sales and marketing results, we may be unable to grow our business, which could cause our operating results to decline.

Our ability to increase revenues will depend on our ability to continue successfully to recruit, train and retain experienced and effective sales and marketing personnel and for our personnel to achieve results once they are employed with us. Competition for experienced and effective personnel in certain markets is intense and we may not be able to hire and retain personnel with relevant experience. The complexity and implementation of our messaging and identity management infrastructure products and services require highly trained sales and marketing personnel to educate prospective customers regarding the use and benefits of our services. Current and prospective customers, in turn, must be able to educate their end-users. Any delays or difficulties encountered in our staffing and training efforts would impair our ability to attract new customers and enhance our relationships with existing customers, and ultimately, grow revenues. This would also adversely impact the timing and extent of our revenues from quarter to quarter and overall or could jeopardize sales altogether. Because we have experienced turnover in our sales force and have fewer resources than many of our competitors, our sales and marketing organizations may not be able to compete successfully against the sales and marketing organizations of our competitors. Moreover, our competitors frequently have larger and more established sales forces calling upon potential enterprise customers with more frequency. In addition, certain of our competitors have longer and closer relationships with the senior management of enterprise customers who decide whose technologies and solutions to deploy. If we do not successfully operate and grow our sales and marketing activities, our revenues and operating results could decline and the price of our common stock could continue to decline.

We have experienced significant turnover of senior management and our current executive management team has been together for a limited time, which could slow the growth of our business and cause our operating results to decline.

Throughout 2002, 2003 and 2004, we announced a series of changes in our management that included the departure of many senior executives, and there have also been many changes in our board of directors. Many of the members of our current board of directors and senior executives joined us in 2002 and 2003, and we may continue to make additional changes to our senior management team. Our chief executive officer, Mark Ferrer, joined us at the end of March 2004 and our chief financial officer, James Clark, joined us on February 4, 2004. Because of these changes, our management team has not worked together as a group and may not be able to work together effectively to successfully execute on revenue goals, implement our strategies and manage our operations. It may also take time for these new members of our management team to familiarize themselves with our operations that could slow the growth of our business and cause our operating results to decline. If our management team is unable to accomplish our business objectives, our ability to grow our business and successfully meet operational challenges could be severely impaired. We do not have long-term employment agreements with any of our executive officers. It is possible that this high turnover at our senior management levels may also continue for a variety of reasons. The loss of the services of one or more of our key senior executive officers could also affect our ability to successfully implement our business objectives, which could slow the growth of our business and cause our operating results to decline. For these reasons, our shareholders may lose confidence in our management team and decide to dispose of our common stock, which could cause the price of our common stock to decline.

We depend on strategic relationships and the loss of any key strategic relationships could reduce our ability to sell our products and services and our revenues to decline.

We depend on strategic relationships to expand distribution channels and opportunities and to undertake joint product development and marketing efforts. Our ability to increase revenues depends upon aggressively marketing our services through new and existing strategic relationships. In the third quarter of 2002, we entered into certain

partnership agreements in our hosted messaging business with the Hewlett-Packard Company for the development and marketing of a complete managed messaging solution. In coming quarters we will continue to invest heavily in this relationship and make changes in our operations, including completion of the outsourcing of our data operations, to accommodate the integration of this partnership. To the extent this integration does not proceed as anticipated or the anticipated benefits of this partnership are not borne out, our revenues may not reach the level expected from the amount of capital we have invested in this relationship and our financial results may decline. In addition, if service levels are not adequate in connection with the outsourcing of our data centers, our customers may terminate agreements and our revenues will decline. We have also invested heavily and continue to invest in this model of hosted services operations. To the extent this strategic decision and the business relationships surrounding its execution do not prove profitable and productive, our revenues and financial results could decline. We also depend on a broad acceptance of our software and outsourced messaging services on the part of potential resellers and partners and our acceptance as a supplier of outsourced messaging solutions. We also depend on joint marketing and product development through strategic relationships to achieve further market acceptance and brand recognition. Our agreements with strategic partners typically do not restrict them from introducing competing services. These agreements typically are for terms of one to three years, and automatically renew for additional one-year periods unless either party gives prior notice of its intention to terminate the agreement. In addition, these agreements are terminable by our partners without cause, and some agreements are terminable by us, upon a period of 30 to 120 days notice. Most of our hosted customer agreements also provide for the partial refund of fees paid or other monetary penalties in the event that our services fail to meet defined minimum performance standards. Distribution partners may choose not to renew existing arrangements on commercially acceptable terms, or at all. In addition to strategic relationships, we also depend on the ability of our customers aggressively to sell and market our services to their end-users. If we lose any strategic relationships, fail to renew these agreements or relationships, fail to fully exploit our relationships, or fail to develop new strategic relationships, we could encounter increased difficulty in selling our products and services.

A limited number of customers account for a high percentage of our revenues and if we lose a major customer or are unable to attract new customers, revenues could decline.

We expect that sales of our products and services to a limited number of customers will continue to account for a high percentage of our revenue for the foreseeable future. For example, for the first quarter, our top ten customers accounted for approximately 26% of our total revenues and for the years ended December 31, 2003, 2002 and 2001, our top 10 customers accounted for approximately 27%, 31% and 20%, respectively, of our total revenues. Our future success depends on our ability to retain our current customers, and to attract new customers, in our target markets. The loss of one or several major customers, whether through termination of agreements, acquisitions or bankruptcy, could significantly reduce our revenues. Our agreements with our customers typically have terms of one to three years often with automatic one-year renewals and can be terminated without cause upon certain notice periods that vary among our agreements and range from a period of 30 to 120 days notice.

In addition, a number of our customers, particularly for our hosted services business and in the technology industry, have also suffered from falling revenue. Especially in the telecommunications industry, which, during the three months ended March 31, 2004, accounted for approximately 40% of the revenues from our top ten customers and for the fiscal years ended December 31, 2003, 2002 and 2001 accounted for approximately 53%, 44% and 55%, respectively, of the revenues from our top ten customers. The relative financial performance of our customers will continue to impact our sales cycles and our ability to attract new business. Worldwide technology spending has also decreased in recent quarters across all industries. If our customers terminate their agreements for any reason before the end of the contract term, the loss of the customer could reduce our current and future revenues. Also, if we are unable to enter into agreements with new customers and develop business with our existing customers, our business will not grow and we will not generate additional revenues.

If we are unable to successfully compete in our product market, our ability to retain our customers and attract new customers could decline.

Because we have a variety of messaging and directory infrastructure products and services, we encounter different competitors at each level of our products and services. Our primary competitors for service providers seeking insourced or outsourced product-based solutions are Sun Microsystems’ iPlanet, OpenWave Systems, Inc.,

Mirapoint, Inc., Oracle Corporation, Microsoft Corporation and IBM Corporation’s Lotus Division. In the enterprise eBusiness directory category, we compete primarily with iPlanet, Microsoft Corporation and Novell Corporation, and our competitors in the meta-directory market are iPlanet, Microsoft, Novell and Siemens Corporation. Our competitors for corporate customers seeking outsourced hosted messaging solutions are e-mail service providers, such as CommTouch, Easylink Services Corporation (formerly Mail.com), USA.Net and application service providers who offer hosted communications services and hosted Microsoft Exchange services. If we are unable to successfully compete in our product market, our ability to retain our customers and attract new customers could decline.

We believe that some of the competitive factors affecting the market for messaging and identity management infrastructure solutions include:

We believe competition will continue to be fierce and further increase as current competitors aggressively pursue customers, increase the sophistication of their offerings and as new participants enter the market. Many of our current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we do and may enter into strategic or commercial relationships with larger, more established and better-financed companies. Any delay in our development and delivery of new services or enhancement of existing services would allow our competitors additional time to improve their service or product offerings, and provide time for new competitors to develop and market messaging and directory infrastructure products and services and solicit prospective customers within our target markets. Increased competition could result in pricing pressures, reduced operating margins and loss of market share, any of which could cause our financial results to decline.

We may not be able to respond to the rapid technological change of the messaging and identity management infrastructure industry.

The messaging and identity management infrastructure industry is characterized by rapid technological change, changes in user and customer requirements and preferences, and the emergence of new industry standards and practices that could render our existing services, proprietary technology and systems obsolete. We must continually develop or introduce and improve the performance, features and reliability of our services, particularly in response to competitive offerings. Our success depends, in part, on our ability to enhance our existing email and messaging services and to develop new services, functionality and technology that address the increasingly sophisticated and varied needs of prospective customers. If we do not properly identify the feature preferences of prospective customers, or if we fail to deliver email features that meet the standards of these customers, our ability to market our service successfully and to increase revenues could be impaired. The development of proprietary technology and necessary service enhancements entails significant technical and business risks and requires substantial expenditures and lead-time. We may not be able to keep pace with the latest technological developments. We may also be unable to use new technologies effectively or adapt services to customer requirements or emerging industry standards.

Our sales cycle is lengthy, and any delays or cancellations in order in a particular quarter could cause our operating results to be below expectations, which may cause our stock price to decline.

Because we sell complex and sophisticated technology, our sales cycle, in particular with respect to our software solutions, can be long and unpredictable, often taking between four to 18 months. Because of the nature of our product and service offerings it can take many months of customer education and product evaluation before a purchase decision is made. In addition, many factors can influence the decision to purchase our product and service offerings including budgetary restraints and decreases in capital expenditures, quarterly fluctuations in operating results of customers and potential customers, the emerging and evolving nature of the internet-based services and wireless services markets. Furthermore, general global economic conditions, and weakness in global securities markets, continuing recessionary spending levels, and a protracted slowdown in technology spending in particular, have further lengthened and affected our sales cycle. Such factors have led to and could continue to lead to delays and postponements in purchasing decisions and in many cases cancellations of anticipated orders. Any delay or cancellation in sales of our products or services could cause our operating results to be lower than those projected and cause our stock price to decline.

Failure to resolve pending securities claims and other material lawsuits may lead to continued costs and expenses and increased doubts from existing and potential customers and investors as to our prospects, which could cause our revenues and our stock price to decline.

We are a defendant in a shareholder lawsuit filed in San Diego Superior Court by shareholders of one of our former customers alleging we participated in fraudulent transactions to inflate artificially revenues of that customer. We are also a defendant in a number of securities class action lawsuits filed in the U.S. District Court for the Southern District of New York, alleging that prospectuses under which securities were sold contained false and misleading statements with respect to discounts and commissions received by underwriters. Should these lawsuits linger for a long period of time, whether ultimately resolved in our favor or not, or further lawsuits be filed against us, coverage limits of our insurance or our ability to pay such amounts may not be adequate to cover the fees and expenses and any ultimate resolution associated with such litigation. Likewise, we may not be able to conclude or settle such litigation on terms that coincide with the coverage limits of our insurance or ability to pay upon any final determination. It is also likely that our insurance may not cover some or all of the claims alleged in the pending lawsuits, which would require us, rather than our insurance carrier, to pay all or some of the expenses and damages, if any, relating to these claims. The size of these payments, individually or in the aggregate, could seriously impair our cash reserves and financial condition. The continued defense of these lawsuits also could result in continued diversion of our management’s time and attention away from business operations, which could cause our financial results to decline. A failure to resolve definitively current or future material litigation in which we are involved or in which we may become involved in the future, regardless of the merits of the respective cases, could also cast doubt as to our prospects in the eyes of our customers, potential customers and investors, which could cause our revenues and stock price to further decline.

Lingering effects of the recent SEC investigation could cause further disruption in our operations and lead to a decline in our financial results.

In 2001, the SEC investigated us and certain of our former officers and directors related to non-specified accounting matters, financial reports, other public disclosures and trading activity in our stock. In February 2002, the SEC concluded the investigation as to us. We consented, without admitting or denying liability, to a cease and desist order and an administrative order for violation of certain non-fraud provisions of the federal securities laws. In addition, since then the SEC and the Department of Justice charged five of our former employees with various violations of the securities laws. We believe that the investigation continues with respect to a number of other of our former executives and employees and expect that such investigation may result in further charges against former employees although we do not know the status of such investigation. Despite the conclusion of the investigation of us, lingering concerns about these actions have nevertheless cast doubt on our future in the eyes of customers and investors. In addition, a number of recent arrests, allegations and investigations in connection with accounting improprieties, insider trading and fraud at other public companies have created investor uncertainty and scrutiny in general as to the stability and veracity of public companies’ financial statements. Such lingering doubts stemming from our past accounting restatements and such general market uncertainty could cause the price of our common stock to continue to fluctuate and/or decline further.

Our failure to carefully manage expenses and growth could require us to use substantial resources and cause our operating results to decline.

In the past, our management of operational expenses, including the restructurings of our operations, and the growth of our business have placed significant strains on managerial, operational and financial resources and contributed to our history of losses. In addition, to manage any future growth and profitability, we may need to 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. If we cannot manage growth and expenses effectively, our business and operating results could decline.

Limitations of our director and officer liability insurance may cause us to use our capital resources, which could cause our financial results to decline or slow our growth.

Our current director and officer liability insurance, which was renewed in March 2004, and continues through March 2005, may not be adequate for the liabilities and expenses potentially incurred in connection with current and future claims. To the extent liabilities, expenses or settlements exceed the limitations or are outside of the scope of coverage, our business and financial condition could materially decline.

Under California law, in connection with our charter documents and indemnification agreements we entered into with our executive officers and directors, we must indemnify our current and former officers and directors to the fullest extent permitted by law. The indemnification covers any expenses and liabilities reasonably incurred in connection with the investigation, defense, settlement or appeal of legal proceedings. We have made payments and may continue to make payments in connection with the indemnification of officers and directors in connection with lawsuits and possibly pending investigations. See “Lingering effects of the recent SEC investigations could cause further disruption in our operations and lead to a decline in our financial results” on page 38. However, it is unlikely that our director and officer liability insurance will be available to cover such payments.

We may experience difficulty in attracting and retaining key personnel, which may negatively affect our ability to develop new services or retain and attract customers.

The loss of the services of key personnel may create a negative perception of our business and adversely affect our ability to achieve our business goals. Our success also depends on our ability to recruit, retain and motivate highly skilled sales and marketing, operational, technical and managerial personnel. Competition for these people is intense and we may not be able to successfully recruit, train or retain qualified personnel. If we fail to do so, we may be unable to develop new services or continue to provide a high level of customer service, which could result in the loss of customers and revenues. In addition, volatility and declines in our stock price may also affect our ability to retain key personnel, all of whom have been granted stock-based incentive compensation. In recent quarters we have also initiated reductions in our work force and job eliminations to balance the size of our employee base with anticipated revenue levels. Reductions in our workforce could make it difficult to motivate and retain remaining employees or attract needed new employees, and provide distractions affecting our ability to deliver products and solutions in a timely fashion and provide a high level of customer service and support.

We do not have long-term employment agreements with any of our key personnel. In addition, we do not maintain key person life insurance on our employees and have no plans to do so. The loss of the services of one or more of our current key personnel could make it difficult to successfully implement our business objectives.

If we are not successful in implementing strategic plans for our operations, our expenses may not be offset by our corresponding sales and our financial results could significantly decline.

In 2002, we incurred a number of restructuring charges related to the resizing of our business given market conditions and the current operating environment. These efforts included additional facilities and equipment lease terminations, continuing expense management and headcount reductions. In 2003, we continued to restructure our operations including consolidating some office locations and reducing our global workforce by approximately 175 positions, or approximately 30% of the workforce. We expect to continue to make determinations about the

strategic future of our business and operations, and our ability to execute on such plans effectively and to make such determinations prudently could affect our future operations. A failure to execute successfully on such plans and to plan appropriately could cause or expenses to continue to outpace our revenues and our financial condition could significantly decline.

We may experience a decrease in market demand due to the slowed economy in the United States, which has been further stymied by the concerns of terrorism, war and social and political instability.

Economic growth has slowed significantly. In addition, the terrorist attacks in the United States and turmoil and war in the Middle East have increased the uncertainty in the United States economy and may further add to the decline in the United States business environment. The war on terrorism, along with the effects of terrorist attacks and other similar events, and the war in Iraq, could contribute further to the slowdown of the already slumping market demand for goods and services, including digital communications software and services. If the economy continues to decline as a result of the recent economic, political and social turmoil, or if there are further terrorist attacks in the United States or elsewhere, or as a result of war in the Middle East and elsewhere, we may experience decreases in the demand for our products and services, which may cause our operating results to decline.

We may face continued technical, operational and strategic challenges preventing us from successfully integrating or divesting acquired businesses.

Acquisitions involve risks related to the integration and management of acquired technology, operations and personnel. In addition, in connection with our strategic restructuring, we elected to divest or discontinue many of the acquired businesses. Both the integration and divestiture of acquired businesses have been and will continue to be complex, time consuming and expensive processes, which may disrupt and distract our management. With respect to integration, we must operate as a combined organization utilizing common information and communication systems, operating procedures, financial controls and human resources practices to be successful. With respect to the divestitures, the timing and transition of those businesses and their customers to other entities has required and will continue to require resources from our legal, finance and corporate development teams as well as expenses associated with the conclusion of those transactions, winding up of entities and businesses. In addition to the added costs of the divestitures, we may not ultimately achieve anticipated benefits and/or cost reductions from such divestitures.

In the past, due to the significant underperformance of some of our acquisitions relative to expectation, we eliminated certain acquired product or service offerings through termination, sale or other disposition. Such decisions to eliminate or limit our offering of an acquired product or service involved and could continue to include the expenditure of capital, the realization of losses, further reduction in workforce, facility consolidation and the elimination of revenues along with the associated costs, any of which could cause our operating results to decline.

We currently license many third-party technologies and may need to license further technologies, which could delay and increase the cost of product and service developments.

We intend to continue to license certain technologies from third parties and incorporate them into our products and services, including web server technology, virus and anti-spam solutions, storage and encryption technology and billing and customer tracking solutions. The market is evolving and we may need to license additional technologies to remain competitive. We may not be able to license these technologies on commercially reasonable terms or at all. To the extent we cannot license needed technologies or solutions, we may have to devote our resources to the development of such technologies, which could delay and increase the cost of product and service developments.

In addition, we may fail to integrate successfully any licensed or hosted technology into our services. These third-party in-licenses may expose us to increased risks, including risks related to the integration of new technology, potential patent and copyright infringement issues, the diversion of resources from the development of proprietary technology, and an inability to generate revenues from new technology sufficient to offset associated acquisition and maintenance costs. In addition, an inability to obtain needed licenses could delay product and service development until equivalent technology can be identified, licensed and integrated. Any delays in services or integration problems could hinder our ability to retain and attract customers and cause our business and operating results to suffer.

Changes in the regulatory environment for the operation of our business or those of our customers could pose risks.

Few laws currently apply directly to activity on the Internet and the messaging business; however, new laws are proposed and other laws made applicable to Internet communications every year. In particular, the operations of our business faces risks associated with privacy, confidentiality of user data and communications, consumer protection, taxation, content, copyright, trade secrets, trademarks, antitrust, defamation and other legal issues. In particular, legal concerns with respect to communication of confidential data have affected our financial services and health care customers due to newly enacted federal legislation. The growth of the industry and the proliferation of Internet-based messaging devices and services may prompt further legislative attention to our industry and thus invite more regulatory control of our business. The imposition of more stringent protections or new regulations and application of laws to our business could burden our company and those with which we do business. Any decreased generalized demand for our services or the loss of, or decrease, in business by a key partner due to regulation or the expense of compliance with any regulation, could either increase the costs associated with our business or affect revenue, either of which could cause our financial condition or operating results to decline. Certain of our service offerings include operations subject to the Digital Millennium Copyright Act of 1998 and the European Union’s recent privacy directives. Our efforts to remain in compliance with DMCA and the EU privacy directives may not be sufficient. New legislation and case law may also affect our products and services and the manner in which we offer them, which could cause our revenues to decline.

In addition, the applicability of laws and regulations directly applicable to the businesses of our customers, particularly customers in the fields of banking and health care, will continue to affect us. The security of information about our customers’ end-users continues to be an area where a variety of laws and regulations with respect to privacy and confidentiality are enacted. As our customers implement the protections and prohibitions with respect to the transmission of end user data, our customers will look to us to assist them in remaining in compliance with this evolving area of regulation. In particular the Gramm-Leach-Bliley Act contains restrictions with respect to the use and protection of banking records for end-users whose information may pass through our system and the Health Insurance Portability and Accountability Act contains provisions that require our customers to ensure the confidentiality of their customers’ health care information.

Finally, the Sarbanes-Oxley Act of 2002 and new rules subsequently implemented by the Securities and Exchange Commission have required changes in corporate governance practices of public companies. In addition to final rules and rule proposals already made by the Securities and Exchange Commission, the Nasdaq Stock Market has adopted revisions to its requirements for listed companies. We are currently reviewing all of our accounting policies and practices, legal disclosure and corporate governance policies under the new legislation, including those related to our relationships with our independent auditors, enhanced financial disclosures, internal controls, board and board committee practices, corporate responsibility and loan practices, and intend fully to comply with such laws. We expect these new rules and regulations to make it more difficult for us to attract and retain qualified executive officers and qualified members of our board of directors, particularly to serve on our various committees of the Board including, in particular, the audit committee. Given the significant turnover of the members of our board of directors and the fact that some members would not qualify as “independent” under the new SEC rules and the listing standards adopted by the Nasdaq Stock Market to which we are subject, it may be difficult for us to maintain sufficient independent directors to comply with these new rules and regulations. For instance, we currently do not have a sufficient number of independent directors to constitute a majority of the board or to serve on the audit committee of the board under listing standards that will apply later this year. If we fail to comply, our common stock may be delisted from the Nasdaq National Market. Please see the discussion below titled “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.”

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 current requirements affecting us include (i) having total assets of at least $50 million, (ii) having total revenue of $50 million, and (iii) maintaining a minimum closing bid price per share of $1.00. On December 23, 2002, The Nasdaq Stock Market Inc. issued us a letter that we were not in compliance with

the minimum closing bid price requirement and, therefore, faced delisting proceedings. Since that time, we have worked with The Nasdaq Stock Market in an effort to maintain our listing. On July 24, 2003, The Nasdaq Stock Market notified us that we had regained compliance with the requirements for continued listing. Nevertheless, we may not be able to comply with the quantitative or quantitative maintenance criteria or any of the Nasdaq National Market’s listing requirements or other rules, or other markets listing requirements to the extent our stock is listed elsewhere, in the future. For instance, if we were to issue a large number of shares of common stock, the price per share of the common stock could fall. If we fail to maintain continued listing on the Nasdaq National Market and must move to a market with less liquidity, our stock price would likely further decline. If we are 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 may have liability for Internet content and we may not have adequate liability insurance.

As a provider of messaging and directory 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 via our services. We do not and cannot screen all of the content generated by our users, and we could be exposed to liability with respect to this content. Furthermore, some 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 United States. In some instances, we may be subject to criminal liability in connection with Internet content transmission.

Our current insurance may not cover claims of these types or may not be adequate to indemnify us for all liability that may be imposed. There is a risk that a single claim or multiple claims, if successfully asserted against us, could exceed the total of our coverage limits. There also is a risk that a single claim or multiple claims asserted against us may not qualify for coverage under our insurance policies as a result of coverage exclusions that are contained within these policies. Should either of these risks occur, capital contributed by our shareholders might need to be used to settle claims. Any imposition of liability, particularly liability that is not covered by insurance or is in excess of insurance coverage could result in substantial out-of-pocket costs to us, or could result in the imposition of criminal penalties.

Unknown software defects could disrupt our services and harm our business and reputation.

Our software products are inherently complex. Additionally, our product and service offerings depend on complex software, both internally developed and licensed from third parties. Complex software often contains defects or errors in translation, particularly when first introduced or when new versions are released or localized for international markets. We may not discover software defects in our products or that affect new or current services or enhancements until after they are deployed. Despite testing, it is possible that defects may occur in the software. These defects could cause service interruptions, which could damage our reputation or increase service costs, cause us to lose revenue, delay market acceptance or divert development resources.

Unplanned system interruptions and capacity constraints could reduce our ability to provide messaging services and could harm our business reputation.

Our customers have, in the past, experienced some interruptions in our hosted messaging service. We believe that these interruptions will continue to occur from time to time. These interruptions may be due to hardware failures, unsolicited bulk e-mail, or “spam,” attacks and operating system failures or other causes beyond our control. Our ability to retain existing customers and attract new customers will suffer and our revenues will decline if we experience frequent or long system interruptions that result in the unavailability or reduced performance of systems or networks or reduce our ability to provide email services. We expect to experience occasional temporary capacity constraints due to unanticipated sharply increased traffic, which may cause unanticipated system disruptions, slower response times, impaired quality and degradation in levels of customer service. If this were to continue to happen, our ability to retain existing customers and attract new customers could suffer dramatically and our revenues would decline.

We have entered into hosted messaging agreements with some customers that require minimum performance standards, including standards regarding the availability and response time of messaging services. If we fail to meet these standards, our customers could terminate their relationships with us and we could be subject to contractual monetary penalties.

If our system security is breached, our reputation could suffer and our revenues could decline.

A fundamental requirement for online communications is the secure transmission of confidential information over public networks. Third parties may attempt to breach our security or that of our customers. If these attempts are successful, customers’ confidential information, including customers’ profiles, passwords, financial account information, credit card numbers or other personal information could be breached. We may be liable to our customers for any breach in security and a breach could harm our reputation. We rely on encryption technology licensed from third parties. Our servers are vulnerable to computer viruses, physical or electronic break-ins and similar disruptions, which could lead to interruptions, delays or loss of data. We may be required to expend significant capital and other resources to license encryption technology and additional technologies to protect against security breaches or to alleviate problems caused by any breach. Failure to prevent security breaches may make it difficult to retain and attract customers and cause us to spend additional resources that could cause our operating results to decline.

We rely on trademark, copyright, trade secret laws, contractual restrictions and patents to protect our proprietary rights, and if these rights are not sufficiently protected, our ability to compete and generate revenue could be harmed.

We rely on a combination of trademark, copyright and trade secret laws, contractual restrictions, such as confidentiality agreements and licenses, and patents to establish and protect our proprietary rights, which we view as critical to our success. Our ability to compete and grow our business could suffer if these rights are not adequately protected. Despite the precautionary measures we take, unauthorized third parties may infringe or copy portions of our services or reverse engineer or obtain and use information that we regard as proprietary, which could harm our competitive position and market share. In addition, we have several patents pending in the United States and may seek additional patents in the future. However, the status of United States patent protection in the software industry is not well defined and will evolve as the U.S. Patent and Trademark Office grants additional patents. We do not know if our patent applications or any of our future patent applications will be issued with the scope of the claims sought, if at all, or whether any patents we have received or will receive will be challenged or invalidated.

In addition, the laws of some foreign countries may not protect proprietary rights to the same extent as do the laws of the United States. Our means of protecting proprietary rights in the United States or abroad may not be adequate and competitors may independently develop similar technology. Additionally, we cannot be certain that our products do not infringe issued patents that may relate to our products. In addition, because patent applications in the United States are not publicly disclosed until the patent is issued, applications may have been filed which relate to our software products.

Our reserves may be insufficient to cover receivables we are unable to collect.

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 economic conditions decline or if new or unanticipated government regulations are enacted which affect our customers, they may experience financial difficulties and 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. Any reserves that we may establish to cover losses due to delays in their inability to pay may not be sufficient to cover our losses. If losses due to delays or inability to pay are greater than our reserves, our capital resources may not be sufficient to meet our operating needs and our business could suffer.

If we do not successfully address the risks inherent in the conduct of our international operations, our revenues and financial results could decline.

We derived 62% of our revenues from international sales in 2003 and 54% of our revenues from international sales in 2002. 63% of our revenues were from international sales during the three months ended March 31, 2004. We intend to continue to operate in international markets and to spend significant financial and managerial resources to do so. In particular, in 2002 we purchased the remaining interests of our joint venture partners for our operations in Japan. We hope to expend revenues and plan to increase resources to grow our operations in the Asian market. If revenues from international operations do not exceed the expense of establishing and maintaining these operations, our business and our ability to increase revenue and improve our operating results could suffer. We have limited experience in international operations and may not be able to compete or operate effectively in international markets. We face certain risks inherent in conducting business internationally, including:

Any of these factors could harm our international operations and, consequently, our business and consolidated operating results. Specifically, failure to successfully manage international growth could result in higher operating costs than anticipated or could delay or preclude altogether our ability to generate revenues in key international markets.

The issuance of our Series E preferred stock to the General Atlantic Investors and the Cheung Kong Investors upon conversion of their convertible notes and the amendment of the terms of the Series D preferred stock will result in significant equity ownership by the General Atlantic Investors and the Cheung Kong Investors, which may limit the ability of our other shareholders to influence significant corporate decisions either of which could delay or prevent a change of control or depress our stock price.

If we obtain shareholder approval and convert the notes held by the General Atlantic Investors and the Cheung Kong Investors into Series E preferred stock and amend the terms of our Series D preferred stock, the General Atlantic Investors will beneficially own approximately 30% of our outstanding securities (which represents 20.8% of the voting power) and the Cheung Kong Investors will beneficially own approximately 26.2% of our outstanding securities (which represents 27.6% of the voting power). In addition, the General Atlantic Investors have the right, but not the obligation, to purchase 55% of the shares of Series E preferred stock not subscribed for by the holders of our common stock and the Cheung Kong Investors have the right, but not the obligation, to purchase 45% of the shares of Series E preferred stock not subscribed for by the holders of our common stock. Further, the General Atlantic Investors and the Cheung Kong Investors have the right to purchase shares of Series E preferred stock, if any, not purchased by the other. Accordingly, the percentage ownership of the General Atlantic Investors and the Cheung Kong Investors may increase as a result of the proposed rights offering. In addition, the holders of our Series D preferred stock, which is controlled by the General Atlantic Investors, are entitled to elect one director and, upon consummation of the transactions contemplated by the convertible note purchase and exchange agreement, the

Cheung Kong Investors will have the right to elect one director. As a result, the General Atlantic Investors and the Cheung Kong Investors, although not affiliated, will have the ability, acting together, to control the outcome of shareholder votes, including votes concerning the election of a majority of our directors, approval of merger transactions involving us and the sale of all or substantially all of our assets or other business combination transactions, charter and bylaw amendments and other significant corporate actions, which could delay or prevent a change in control or depress our stock price.

The issuance of our Series E preferred stock to the General Atlantic Investors and the Cheung Kong Investors upon conversion of their convertible notes and the amendment of the terms of the Series D preferred stock will result in significant equity ownership by the General Atlantic Investors and the Cheung Kong Investors, which may result in potential conflicts of interests, which could adversely affect the holders of our common stock, delay a change in control and depress our stock price.

The significant equity ownership by each of the General Atlantic Investors and the Cheung Kong Investors could create conflicts of interest between these majority shareholders and our other shareholders and between the General Atlantic Investors and the Cheung Kong Investors. For example, the General Atlantic Investors and the Cheung Kong Investors can approve a change in control transaction in order to receive payment of their liquidation preference even if our other shareholders oppose the transaction, which could depress the price of our common stock. Alternatively, the General Atlantic Investors and the Cheung Kong Investors may prevent or delay a corporate transaction that is favored by our other shareholders. In addition, it is also possible that the risk that the General Atlantic Investors and the Cheung Kong Investors may disagree on approving a significant corporate transaction, for example a change in control transaction, which could depress our stock price, limit the number of potential investors willing to pursue such a transaction with us or limit the price that investors might be willing to pay for future shares of our common stock.

The conversion price for our 10% senior convertible notes and the subscription price determined for our proposed rights offering is not necessarily an indication of our value.

The conversion price for our 10% senior convertible notes and the subscription price per share of the Series E preferred stock in the rights offering was the price proposed by the General Atlantic Investors and the Cheung Kong Investors in connection with our negotiation of the convertible note purchase and exchange agreement and was approved by the independent members of our board of directors (which excluded William E. McGlashan, Jr., our chief executive officer at the time and a related party of one of our holders of Series D preferred stock, and Raul J. Fernandez and William E. Ford, each of whom is affiliated with General Atlantic) based on the recommendation of the strategic alternatives committee of the board of directors. The conversion price for our 10% senior convertible notes and the subscription price do not necessarily bear any relationship to the book value of our assets, past operations, cash flows, losses, financial condition or any other established criteria for value.

The use of our net operating losses could be limited if we undergo an ownership change upon exercise of the subscription rights.

If the exercise of the subscription rights in the proposed rights offering causes us to undergo an “ownership change” for federal income tax purposes (i.e., an increase by more than 50% of the amount of stock held by one or more of our 5% shareholders during the past 3 years), our use of our pre-change net operating losses will generally be limited annually to the product of the long-term tax-exempt rate (currently 4.58%) and the value of our stock immediately before the ownership change. This could increase our federal income tax liability if we generate taxable income in the future.

Our stock price has demonstrated volatility and overall declines during recent quarters and continued volatility in the stock market may cause further fluctuations and/or decline in our stock price.

The trading price of our common stock has been and may continue to experience volatility, wide fluctuations and declines. For example, during the first quarter of 2004, the closing sale prices of our common stock on the Nasdaq National Market ranged from $1.31 on January 6, 2004 to $2.63 on February 19, 2004. Our stock price may further decline or fluctuate in response to any number of factors and events, such as announcements related to technological innovations, intense regulatory scrutiny and new corporate and securities and other legislation, strategic and sales

relationships, new product and service offerings by us or our competitors, litigation outcomes, changes in senior management, changes in financial estimates and recommendations of securities analysts, the operating and stock price performance of other companies that investors may deem comparable, news reports relating to trends in our markets and the market for our stock, media interest in accounting scandals and corporate governance questions, overall market conditions and domestic and international economic factors unrelated to our performance. In addition, the stock market in general, particularly with respect to technology stocks, has experienced extreme volatility and a significant cumulative decline in recent quarters. This volatility and decline has affected many companies, including our company, irrespective of the specific operating performance of such companies. These broad market influences and fluctuations may adversely affect the price of our stock, and our ability to remain listed on the Nasdaq National Market, regardless of our operating performance or other factors.

Our articles of incorporation and bylaws contain provisions that could delay or prevent a change in control.

Our articles of incorporation and bylaws contain provisions that could delay or prevent a change in control of our company. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. Some of these provisions:

In March 2001, we adopted a shareholder rights plan or “poison pill.” This plan could cause the acquisition of our company by a party not approved by our board of directors to be prohibitively expensive.

In addition, the General Atlantic Investors and the Cheung Kong Investors own a sufficient amount of our securities to be able to control the outcome of matters submitted to a vote of our shareholders, which could have the effect of discouraging or impeding an acquisition proposal.

If we account for employee stock options using the fair value method, it could significantly impact our results from operations.

There has been ongoing public debate whether stock options granted to employees should be treated as a compensation expense and, if so, how to properly value such charges. On March 31, 2004, the Financial Accounting Standard Board (FASB) issued an Exposure Draft, Share-Based Payment: an amendment of FASB statements No. 123 and 95, which would require a company to recognize, as an expense, the fair value of stock options and other stock-based compensation to employees beginning in 2005 and subsequent reporting periods. If we elect or are required to record an expense for our stock-based compensation plans using the fair value method as described in the Exposure Draft, we could have significant and ongoing accounting charges.

The following table presents the hypothetical changes in fair value in our outstanding convertible subordinated notes and senior convertible notes at March 31, 2004. The value of both instruments is sensitive to changes in interest rates. The modeling technique used measures the change in fair values arising from hypothetical parallel shifts in the yield curve of plus or minus 50 basis points ( BPS ), 100 BPS and 150 BPS over a twelve-month time horizon. The base value represents the traded fair market value of the notes (in thousands):

As of March 31, 2004, we had cash and cash equivalents of $37.1 million and no investments in marketable securities. Our long-term obligations consist of our $38.4 million five-year, 5³/4% Convertible Subordinated Notes due April 2005, $43.6 million four-year, 10% Senior Convertible Notes due November 2007, January 2008 and March 2008 and certain fixed rate capital leases. Accordingly, an immediate 10% change in interest rates would not affect our long-term obligations or our results of operations.

A significant portion of our international operations has a functional currency other than the United States dollar. Accordingly, we are exposed to foreign currency exchange rate risk inherent in our sales commitments, anticipated sales, and assets and liabilities of these operations. Fluctuations in exchange rates may harm our results of operations and could also result in exchange losses. The impact of future exchange rate fluctuations cannot be predicted with any certainty, however our exposure to foreign currency rate risk is primarily associated with fluctuations in the Euro. We realized a net gain on foreign exchange of $362,000 during the first quarter of 2004. To date, we have not sought to hedge the risks associated with fluctuations in exchange rates.

(a) Evaluation of disclosure controls and procedures. We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-14(c) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the Chief Executive Officer and the Chief Financial Officer have concluded that these controls and procedures are effective at the “reasonable assurance” level.

Based on their evaluation as of of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations noted above, our disclosure controls and procedures were effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared.

(b) Changes in internal control over financial reporting. There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation described in Item 4(a) above that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

We are a party to lawsuits in the normal course of its business. Litigation in general, and securities and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. Other than as described below, we are not a party to any other material legal proceedings.

Action in the Superior Court of San Diego. On December 24, 2003, we were named in a lawsuit filed by former shareholders of Remedy Corporation against current and former officers and directors of Peregrine Systems, Inc., Peregrine’s former accountants, some of Peregrine’s customers, including ourselves, and various other unnamed defendants. The second amended complaint alleges that we, as Peregrine’s customer, engaged in a series of fraudulent transactions with Peregrine that were not accounted for by Peregrine in conformity with GAAP and that this substantially inflated the value of Peregrine securities issued as consideration in Remedy’s merger with Peregrine in August 2001. The complaint alleges causes of action for fraud and deceit, negligent misrepresentation, violations of California Corporations Code provisions regarding sales of securities by means of false statements or omissions, violations of California Corporations Code provisions regarding securities sales made on the basis of undisclosed, material inside information, common law conspiracy to commit fraud, and common law aiding and abetting the commission of fraud. The complaint seeks an unspecified amount of compensatory and punitive damages, along with rescission of the Peregrine securities purchased in the Remedy merger, interest and attorneys fees. We believe the claims are without merit and intends to defend itself vigorously. Litigation in this matter is ongoing.

Securities Class Action in Southern District of New York. Beginning on July 18, 2001, a number of securities class action complaints were filed against us, and certain of our former officers and directors and underwriters connected with our initial public offering of common stock in the U.S. District Court for the Southern District of New York (In re Initial Public Offering Sec. Litig.). The purported class action complaints were filed by individuals who allege that they purchased our common stock at the initial and secondary public offerings between March 29, 1999 and December 6, 2000. The complaints allege generally that the prospectus under which such securities were sold contained false and misleading statements with respect to discounts and excess commissions received by the underwriters as well as allegations of “laddering” whereby underwriters required their customers to purchase additional shares in the aftermarket in exchange for an allocation of IPO shares. The complaints seek an unspecified amount in damages on behalf of persons who purchased our stock during the specified period. Similar complaints have been filed against 55 underwriters and more than 300 other companies and other individuals. The over 1,000 complaints have been consolidated into a single action. We have reached an agreement in principle with the plaintiffs to resolve the cases. The proposed settlement involves no monetary payment by us and no admission of liability. However it is subject to approval by the Court.

Securities and Exchange Commission Investigation. In 2001, the Securities and Exchange Commission investigated us and certain of our former officers, employees and directors with respect to non-specified accounting matters, financial reports, other public disclosures and trading activity in our securities. The SEC concluded its investigation of us in January 2002 with no imposition of fines or penalties and, without admitting or denying liability, we consented to a cease and desist order and an administrative order as to violation of certain non-fraud provisions of the federal securities laws. The investigation has also thus far resulted in charges being filed against five former officers and employees. We believe that the investigation of our former officers and employees may continue. While we continue to fully cooperate with any requests with respect to such investigation, we do not know the status of such investigation.

Lease Dispute. In July 2000, PeerLogic, Inc. signed a lease for office space in San Francisco, California. In December 2000, we acquired PeerLogic as a wholly owned subsidiary. After review, we determined that local zoning laws likely prohibited a business such as ours or PeerLogic from occupying the leased premises, and promptly sought a zoning determination from the San Francisco Zoning Administrator to resolve the matter. The Zoning Administrator determined that our proposed use of the leased premises was not permitted, but the landlord appealed this determination and prevailed before the San Francisco Board of Appeals. In July 2002, we filed a Petition for Writ of Mandamus with the San Francisco Superior Court, seeking reversal of the San Francisco Board of Appeals’ decision. In June 2003, the Court granted our petition and subsequently entered a judgment and writ remanding the matter to the San Francisco Board of Appeals and directing the Board of Appeals to make a new determination consistent with its judgment. The landlord subsequently appealed the Superior Court’s ruling.

In April 2002, the landlord filed suit in San Francisco Superior Court against us alleging, among other things, breach of the lease and tort claims related to the lease transaction. In its complaint, the landlord sought unspecified damages for back rent, attorneys’ fees, treble damages under certain statutes, and unspecified punitive damages. Between April 2002 and July 2003, we succeeded through several motions filed with the Court in having a number of the landlord’s claims dismissed and some of its requests for damages stricken, including treble damages. The landlord has chosen not to further amend its complaint. In August 2003, we filed our answer to the second amended complaint and a cross-complaint against the landlord, under which we sought compensatory damages and unspecified punitive damages for the landlord’s failure to disclose the zoning restrictions on the leased premises before the lease was signed. In early February, we reached an agreement in principle with the landlord to fully and finally settle this litigation in exchange for $100,000 in cash and a warrant to purchase 100,000 shares of common stock at a purchase price equal to current fair market value as of the date of settlement. A final written settlement agreement was executed by the parties on May 4, 2004. However, the cases have not yet been dismissed.

The uncertainty associated with these and other unresolved or threatened lawsuits could seriously harm our business and financial condition. In particular, the lawsuits or the lingering effects of previous lawsuits and the now completed SEC investigation could harm relationships with existing customers and our ability to obtain new customers and partners. The continued defense of lawsuits could also result in the diversion of management’s time and attention away from business operations, which could harm our business. Negative developments with respect to the settlements or the lawsuits could cause our stock price to further decline significantly. In addition, although we are unable to determine the amount, if any, that it may be required to pay in connection with the resolution of these lawsuits, and although we maintain adequate and customary insurance, the size of any such payments could seriously harm our financial condition.

Other Contractual Obligations We entered into other contractual obligations which total $10.8 million at March 31, 2004. These obligations are primarily associated with the maintenance of hardware and software products being utilized within engineering and hosted operations, and the management of data center operations and network infrastructure storage for our hosted operations. These obligations are expected to be completed over the next 4 years, including $8.3 million in 2004.

Indemnifications. We provide general indemnification provisions in our license agreements. In these agreements, we generally state that we will defend or settle, at our own expense, any claim against the customer by a third party asserting a patent, copyright, trademark, trade secret or proprietary right violation related to any products that we have licensed to the customer. We agree to indemnify our customers against any loss, expense or liability, including reasonable attorney’s fees, from any damages alleged against the customer by a third party in its course of using products sold by us. We have not received any claims under this indemnification and do not know of any instances in which such a claim may be brought against us in the future.

Under California law, in connection with both our charter documents and indemnification agreements we entered into with its executive officers and directors, we must indemnify our current and former officers and directors to the fullest extent permitted by law. The indemnification covers any expenses and liabilities reasonably incurred in connection with the investigation, defense, settlement or appeal of legal proceedings. We have made payments in connection with the indemnification of officers and directors in connection with currently pending lawsuits and have reserved for estimated future amounts to be paid in connection with legal expenses and others costs of defense of pending lawsuits.

In March 2004, in connection with an amendment to the credit facility with Silicon Valley Bank to increase the size of the credit limit to a maximum of $6.0 million and extend the maturity date to June 30, 2005, we agreed to issue warrants to purchase up to 100,000 shares of our common stock to Silicon Valley Bank. These warrants were fully exercisable upon grant, had an exercise price of $2.07 per share and have an expiration date of March 12, 2011. The issuance of the warrants was exempt from registration under Section 4(2) of the Securities Act and Regulation D promulgated thereunder.

In March 2004, we issued $18.5 million in principal amount of 10% senior convertible notes to investment entities affiliated with Crosslink Capital, Criterion Capital Management, Heights Capital Management and Apex Capital. These notes are convertible into approximately 12.3 million shares of Series E convertible preferred stock at $1.50 per share only if we receive shareholder approval. If we do not obtain shareholder approval, these notes will be convertible, at the option of each note holder, into shares of our common stock at $2.18 per share, provided the note holder will not be able to convert its notes into shares of common stock to the extent the note holder, together with its affiliates, would own 9.9% or more of our common stock after conversion. The investors were qualified institutional buyers and the issuance of the notes was exempt from registration under Section 4(2) of the Securities Act and Regulation D promulgated thereunder.

In February 2004, in settlement of litigation with a landlord regarding office space in San Francisco, California, we reached an agreement in principle to issue a warrant to purchase up to 100,000 shares of common stock at $2.34 per share, the fair market value of our common stock on that day. We intend to issue the warrant and underlying shares of common stock based on an exemption from registration provided by Section 4(2) of the Securities Act and Regulation D thereunder.

In January 2004, we issued an aggregate of $15 million in principal amount of 10% convertible notes to Permal U.S. Opportunities Limited, Zaxis Equity Neutral, L.P., Zaxis Institutional Partners, L.P., Zaxis Offshore Limited, Zaxis Partners, L.P. and Passport Master Fund, L.P. These notes are convertible into approximately 10 million shares of Series E preferred stock at $1.50 per share only if we receive shareholder approval. If we do not obtain shareholder approval, these notes will be convertible, at the option of each note holder, into shares of our common stock at $1.65 per share, provided the note holder will not be able to convert its notes into shares of common stock to the extent the note holder, together with its affiliates, would own 9.9% or more of our common stock after conversion. The investors were qualified institutional buyers and the issuance of the notes was exempt from registration under Section 4(2) of the Securities Act and Regulation D promulgated thereunder.

In each case where we have indicated that we relied on Section 4(2) of the Securities Act and Regulation D promulgated under that Act, our reliance was based on the fact that (1) the issuance of the securities did not involve a public offering, (2) there were no more than 35 investors, (3) each investor represented to us that it was either an “accredited investor” (as defined in Regulation D) and/or that it had such knowledge and experience in financial and business matters that it is capable of evaluating the merits and risks of the investment and to make an informed investment decision, (4) each investor agreed that the securities acquired cannot be sold without registration under the Securities Act, except in reliance upon an exemption from that Act and applicable securities laws, (5) each investor represented to us its intention to acquire the securities for investment only and not with a view to distribution, (6) appropriate legends were affixed to the certificates representing the securities, (7) the offers and sales were made in compliance with Rules 501 and 502 of Regulation D, and (8) each investor acknowledged that it had adequate access to sufficient information about us to make an informed investment decision.

In connection with William E. McGlashan, Jr.’s termination as our Chief Executive Officer and continuation as our Chairman of the Board, our board of directors approved entering into a Separation Agreement with him that amends and restates provisions of his employment and change of control agreements. With respect to the promissory note and stock pledge agreement in principal amount of $1.74 million that we entered into with Mr. McGlashan in May 2002 to fund his early exercise of options to purchase 250,000 shares of our common stock, we agreed to permit Mr. McGlashan to repay the loan by surrendering all of the shares of common stock acquired by early exercise.

Pursuant to the terms of the early exercise agreement and promissory note, we applied the fair market value of his vested shares as of April 14, 2004 and the original purchase price of $6.96 to the unvested shares, with an aggregate value of approximately $1.25 million, towards the repayment of this loan. We agreed to forgive in full the remaining $537,000 of principal and interest on the loan in exchange for Mr. McGlashan’s agreeing to serve as our Chairman of the Board; to terminate our previous commitment to provide a loan of up to $1.5 million to purchase a residence, which was never funded; and to provide a general release of claims to us. As provided in Mr. McGlashan’s current agreement, all of the options held by Mr. McGlashan will have one year of accelerated vesting. The Separation Agreement provides that the options will be exercisable for three years following his termination.

Our board of directors has called a special meeting of our shareholders for June 11, 2004. Our board of directors is soliciting proxies for the special meeting pursuant to a proxy statement that was mailed to our shareholders on or about May 7, 2004. Shareholders of record on April 30, 2004 will be entitled to vote at the special meeting. We are seeking to approve:

If the matters above are approved by our shareholders, we will exchange 69,149 shares of Series D preferred stock for 733,333 shares of Series E preferred stock pursuant to a settlement agreement that we entered into with MBCP PeerLogic, LLC and its affiliates on November 21, 2003.

Our board of directors declared a dividend of rights to purchase preferred stock to shareholders of record on April 30, 2004. Each record shareholder will receive 0.65 subscription rights for each share of our common stock held on the record date. Each subscription right entitles the holder to purchase one share of our Series E preferred stock at the subscription price of $1.50 per share. Each share of Series E preferred stock is convertible into the number of shares of common stock obtained by dividing $1.50 plus the amount of dividends accreted to the Series E preferred stock from the date of issuance through the most recent semi-annual dividend accrual date by $1.50. We filed a registration statement for the Series E preferred stock to be issued pursuant to the rights offering, which the Securities and Exchange Commission declared effective on May 5, 2004. If shareholders approve the matters set forth above at a special meeting to be held on June 11, 2004, we currently intend to consummate the rights offering on or around June 25, 2004.

In January 2004, William S. Cohen and Raul J. Fernandez resigned from our board of directors, and in February 2004, Peter L.S. Currie, who is affiliated with the General Atlantic Investors, one of our principal shareholders, was appointed to fill a vacancy. In March 2004, Chris Gorog resigned from our board of directors and Frost R.R. Prioleau was appointed to fill the vacancy. In February 2004, William M. Smartt resigned as our Executive Vice President and Chief Financial Officer and James Clark, formerly chief financial officer of Diversified Healthcare Services, Inc., was hired as his successor. Most recently, in March 2004, we appointed Mark Ferrer, formerly president and chief executive officer of Vastera, Inc., to assume the position of Chief Executive Officer formerly held by William McGlashan, Jr., who continues to serve as Chairman of the Board of Directors.

At the end of March 2004, we appointed Mark Ferrer to assume the position of Chief Executive Officer formerly held by William McGlashan, Jr. Mr. McGlashan continues to serve as Chairman of the Board of Directors. We entered into an employment agreement with Mr. Ferrer pursuant to which we agreed to pay him an annual base salary of $375,000. Mr. Ferrer is also eligible to receive annual bonus compensation of 50% of his base salary for achieving performance objectives established by our board of directors (or a committee) or as high as 150% of Mr. Ferrer’s base salary for extraordinary performance as determined by the board of directors (or a committee). Pursuant to Mr. Ferrer’s employment agreement, on March 29, 2004, we granted him options to purchase up to 1,061,052 shares of our common stock at $2.11 per share and 707,368 shares of restricted common stock. We also agreed that, upon consummation or termination of our proposed rights offering and subject to the approval of our board of directors, Mr. Ferrer would receive an additional grant of stock options at fair market value on the date of grant and restricted stock so that Mr. Ferrer would continue to hold options to purchase up to 1.5% of our outstanding stock and restricted shares of common stock equal to 1% of our outstanding stock to take into account the dilutive effect of those transactions.

In addition, the employment agreement provides that if we terminate Mr. Ferrer’s employment without cause or Mr. Ferrer becomes disabled or resigns following a constructive termination, he will be entitled to 12 monthly payments totaling 12 months of salary and a pro-rata amount of his prior year’s bonus, if any (based on the number of days served during the year of termination). Under these circumstances, Mr. Ferrer will also be entitled to receive healthcare benefits for 12 months following his termination and any unvested stock options and restricted stock will vest as to the amount that would have vested had Mr. Ferrer continued to work for us for an additional 12 months. If Mr. Ferrer is terminated within three months before or 12 months following a change of control of Critical Path, he will be entitled to a lump sum payment equal to 1.5 times his base salary, continued healthcare benefits for 18 months and accelerated vesting of 12 months of stock options and the greater of 75% or 12 months accelerated vesting of restricted stock.

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


CRITICAL PATH, INC.

By:		/s/ JAMES A. CLARK
		James A. Clark Executive Vice President and Chief Financial Officer (Duly Authorized Officer and Principal Financial and Accounting Officer)


		Page
PART I
Item 1.	Condensed Consolidated Financial Statements (Unaudited)	1
	Condensed Consolidated Balance Sheets	1
	Condensed Consolidated Statements of Operations	2
	Condensed Consolidated Statements of Cash Flows	3
	Notes to Condensed Consolidated Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	47
Item 4.	Controls and Procedures	47
PART II
Item 1.	Legal Proceedings	48
Item 2.	Changes in Securities and Issuer Purchases of Securities	50
Item 5.	Other Information	51
Item 6.	Exhibits and Reports on Form 8-K	53
	Signature	55
	Certifications


	December 31, 2003			March 31, 2004
	(Unaudited) (In thousands, except per share amounts)
ASSETS
Current assets
Cash and cash equivalents	$	18,984		$	37,131
Accounts receivable, net		16,880			16,704
Prepaid and other current assets		4,664			5,355

Total current assets		40,528			59,190
Property and equipment, net		14,821			13,304
Goodwill		6,613			6,613
Other assets		5,763			7,751

Total assets	$	67,725		$	86,858

LIABILITIES, MANDATORILY REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS’ DEFICIT
Current liabilities
Accounts payable	$	5,022		$	4,102
Accrued liabilities		20,755			22,280
Deferred revenue		8,856			9,966
Line of credit facility		2,298			—
Capital lease and other obligations, current		1,721			1,587

Total current liabilities		38,652			37,935
Deferred revenue		1,343			1,360
Convertible notes payable		48,376			81,921
Capital lease and other obligations, long-term		1,295			1,009

Total liabilities		89,666			122,225

Commitments and contingencies
Mandatorily redeemable Series D preferred stock, par value $0.001 Shares authorized: 5,000 Shares issued and outstanding: 4,000 Liquidation value at March 31, 2004: $68,831		55,301			55,288

Shareholders’ deficit
Common stock and paid-in-capital, par value $0.001 Shares authorized: 125,000,000 Shares issued and outstanding: 20,037 and 21,182		2,154,295			2,153,182
Common stock warrants		5,947			5,947
Notes receivable from shareholders		(870	)		(1,015	)
Unearned compensation		—			(1,484	)
Accumulated deficit		(2,238,728	)		(2,248,714	)
Accumulated other comprehensive income		2,114			1,429

Total shareholders’ deficit		(77,242	)		(90,655	)

Total liabilities, mandatorily redeemable preferred stock and shareholders’ deficit	$	67,725		$	86,858


	Three Months Ended
	March 31, 2003			March 31, 2004
	(Unaudited) (In thousands, except per share amounts)
Net revenues
Software license	$	5,047		$	4,251
Hosted messaging		5,386			4,343
Professional services		3,220			2,659
Maintenance and support		4,381			5,825

Total net revenues		18,034			17,078

Cost of net revenues
Software license		1,797			911
Hosted messaging		6,263			6,381
Professional services		3,450			3,094
Maintenance and support		1,929			1,449
Stock-based expense — Hosted messaging		8			5
Stock-based expense — Professional services		3			—
Stock-based expense — Maintenance and support		6			—

Total cost of net revenues		13,456			11,840

Gross profit		4,578			5,238

Operating expenses
Sales and marketing		9,309			6,939
Research and development		4,623			5,779
General and administrative		3,226			3,122
Stock-based expense — Sales and marketing		18			14
Stock-based expense — Research and development		15			18
Stock-based expense — General and administrative		9			9
Restructuring and other expenses		3,189			1,065

Total operating expenses		20,389			16,946

Loss from operations		(15,811	)		(11,708	)
Interest and other income (expense), net		(6,427	)		3,667
Interest expense		(769	)		(1,580	)

Loss before income taxes		(23,007	)		(9,621	)
Provision for income taxes		(194	)		(366	)

Net loss		(23,201	)		(9,987	)
Accretion on mandatorily redeemable preferred stock		(3,665	)		(3,147	)

Net loss attributable to common shares	$	(26,866	)	$	(13,134	)

Net loss per share attributable to common shares — basic and diluted	$	(1.37	)	$	(0.63	)

Weighted average shares — basic and diluted		19,666			21,014


	Three Months Ended
	March 31, 2003			March 31, 2004
	(Unaudited) (In thousands)
Operating
Net loss	$	(23,201	)	$	(9,987	)
Recovery of doubtful accounts		(165	)		(93	)
Depreciation and amortization		4,624			2,658
Stock-based costs and expenses		59			46
Change in fair value of preferred stock instrument		6,200			(3,160	)
Amortization of non-cash interest expense		—			60
Restructuring charges — non-cash		142			—
Accounts receivable		3,144			(448	)
Other assets		(3,321	)		(362	)
Accounts payable		(1,296	)		(798	)
Accrued liabilities		96			1,475
Deferred revenue		(1,292	)		1,295

Net cash used in operating activities		(15,010	)		(9,314	)

Investing
Notes receivable from officers		7			3
Property and equipment purchases		(4,319	)		(1,090	)
Sale of marketable securities		9,573			—
Restricted cash		2,729			—

Net cash provided by (used in) investing activities		7,990			(1,087	)

Financing
Proceeds from issuance of convertible notes, net		—			31,156
Proceeds from issuance of common stock, net		5			163
Proceeds from (payments on) line of credit facility		4,900			(2,298	)
Principal payments on note and lease obligations		(307	)		(287	)

Net cash provided by financing activities		4,598			28,734

Net change in cash and cash equivalents		(2,422	)		18,333
Effect of exchange rates on cash and cash equivalents		333			(186	)
Cash and cash equivalents at beginning of period		33,498			18,984

Cash and cash equivalents at end of period	$	31,409		$	37,131


	Three Months Ended March 31,
	2003			2004
	(In thousands, except per share amounts)
Net loss attributable to common shares — as reported	$	(26,866	)	$	(13,134	)
Add:
Stock-based employee compensation expense included in reported net loss attributable to common shares, net of related tax effects		59			46
Deduct:
Total stock-based employee compensation (expense) income determined under a fair value based method for all grants, net of related tax effects		515			(2,426	)

Net loss attributable to common shares — pro forma		(26,292	)		(15,514	)

Basic and diluted net loss per share attributable to common shares — as reported		(1.37	)		(0.63	)
Basic and diluted net loss per share attributable to common shares — pro forma	$	(1.34	)	$	(0.74	)


A California Corporation		I.R.S. Employer No. 91-1788300


	Three Months Ended March 31,
	2003		2004
Risk-free interest rate	2.6	%	3.0	%
Expected lives (in years)	4.0		4.0
Dividend yield	0.0	%	0.0	%
Expected volatility	111.0	%	146.0	%


	Liability at December 31, 2003		Adjustments		Restructuring Charges		Noncash Charges		Cash Payments			Liability at March 31, 2004
Workforce reduction	$	0.2	$	—	$	1.0	$	—	$	(0.8	)	$	0.4
Facility and operations consolidation and other charges		0.6		—		0.1		—		(0.1	)		0.6

Total	$	0.8	$	—	$	1.1	$	—	$	(0.9	)	$	1.0


	March 31, 2004
10% Senior Convertible Notes	$	42,750
Amount allocated to derivative instrument		750
Accretion on 10% Senior Convertible Notes		61

Carrying value of 10% Senior Convertible Notes	$	43,561


	December 31, 2003			March 31, 2004
	(In thousands)
Series D Preferred Stock — 2001 Transaction	$	55,000		$	55,000
Series D Preferred Stock — MBCP PeerLogic		3,755			3,755
Less: Issuance costs		(3,075	)		(3,075	)

Series D Preferred Stock, net of issuance costs		55,680			55,680
Less amounts allocated to:
Common stock warrants		(5,250	)		(5,250	)
Beneficial conversion feature		(41,475	)		(41,475	)
Add liquidation preference		19,640			16,480
Add amortization and accretion		26,706			29,853

Carrying value of Series D Preferred Stock and embedded change-in-control feature	$	55,301		$	55,288


	Fiscal Year
	Total		2004		2005		2006		2007		2008 and Beyond
	(In thousands)
Contractual Cash Obligations:
Convertible notes, including interest (1)	$	105,468	$	6,809	$	7,059	$	43,429	$	14,250	$	33,921
Line of credit facility		—		—		—		—		—		—
Operating lease obligations		20,872		5,038		4,725		4,532		1,443		5,134
Capital lease obligations		1,827		742		650		435		—		—
Other purchase obligations (2)		10,772		8,254		1,342		1,061		115

Total Contractual Cash Obligations	$	138,939	$	20,843	$	13,776	$	49,457	$	15,808	$	39,055


	Valuation of Borrowing Given an Interest Rate Decrease of X Basis Points						No Change in Interest Rate		Valuation of Borrowing Given an Interest Rate Increase of X Basis Points
	150 BPS		100 BPS		50 BPS		No Change in Interest Rate		50 BPS		100 BPS		150 BPS
5³/4% Convertible subordinated notes	$	35,226	$	35,055	$	34,885	$	34,716	$	34,548	$	34,380	$	34,214
10% senior convertible notes	$	44,612	$	43,994	$	43,777	$	43,561	$	43,346	$	43,133	$	42,921



4.47		Form of Warrant to Purchase up to 100,000 shares of Common Stock, by and between Max Limited and the Registrant

10.62		Separation Agreement and Mutual Release, dated as of April 14, 2004, by and between the Registrant and William McGlashan

10.63		Amendment to Employment Agreement, dated December 20, 2002, by and between the Registrant and Michael Zukerman

10.64		Change of Control Severance Agreement, dated as of May 29, 2003, by and between the Registrant and Michael J. Zukerman

10.65		Amendment to Employment Agreement, dated December 23, 2003, by and between the Registrant and Michael J. Zukerman

10.66		Waiver Agreement made and entered into as of December 23, 2003, by and between Registrant and Michael J. Zukerman

10.67		Confidential Settlement Agreement and Mutual Release, effective February 4, 2004, by and between Max Limited, LLC, and the Registrant; Prince Acquisition Corp.; and PeerLogic, Inc.

10.68		Fourth Amendment to Amended and Restated Loan and Security Agreement dated as of April 15, 2004 by and between Registrant and Silicon Valley Bank

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002

32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002