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 June 30, 2004, the Company had outstanding 21,169,642 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

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 has operated at a loss since inception and most recently, for the three month periods ended March 31, 2004 and June 30, 2004, the Company’s operating activities have used cash of $9.3 million and $12.8 million, respectively With the Company’s history of operating losses and use of cash to support its operating activities, its primary sources of capital have come from both debt and equity financings that the Company has completed over the past several years. The Company’s principal sources of liquidity include its cash and cash equivalents and a line of credit facility with Silicon Valley Bank (the Bank). As of June 30, 2004, the Company had cash and cash equivalents totaling $23.6 million at June 30, 2004, of which approximately $2.7 million is restricted to support its outstanding obligations to the Bank and $4.4 million is located in accounts outside the United States. Accordingly, the Company’s readily available cash resources in the United States as of June 30, 2004 were $16.5 million. In August 2004, the Company’s rights offering expired and provided additional gross proceeds of $4.0 million of cash to support its domestic operations. Additionally, during the Company’s conference call announcing financial results for the second quarter 2004, the Company provided guidance with respect to efforts being undertaken to reduce its operating expenses in an effort to reduce its use of cash. The Company currently believes that it will be able to reduce the amount of cash used by its operating activities based upon its continuing restructuring activities and cost reduction efforts, but that, in the short-term, the Company may be required to find additional sources of capital through additional debt or equity financings or both to support its operating activities beyond December 31, 2004 although the Company’s ability to incur additional indebtedness is subject to certain limitations.

In December 2003, based on the level of the Company’s cash available for domestic operations and the rate of cash usage per quarter, the Company determined that it would not have sufficient cash resources available to continue beyond the first quarter of 2004 without raising additional funds through financing activities. Based on the Company’s financing activities in the fourth quarter of 2003 and the first quarter of 2004, the Company determined that it had sufficient cash to continue operations through the fourth quarter of 2004. The Company continues to believe that it has sufficient cash to continue operations through the fourth quarter of 2004. However, because the Company’s rights offering raised less funds that anticipated, and if the Company is unable to significantly further reduce expenses as planned, secure additional financing or increase revenues, the Company cannot be certain that it will be able to continue its current operations beyond the fourth quarter of 2004.

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 employee stock-based 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 Statement of Financial Accounting Standards (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 are recognized immediately if the fair value of the shares underlying the milestone has been previously recognized or over the remaining term, if not.

Pursuant to the requirements of SFAS No. 148, pro forma information regarding net loss and net loss per share is required to be presented as if the Company had accounted for employee stock option grants using the fair value method of 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, 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:

During the three months ended June 30, 2004, the Company issued a warrant in connection with the settlement of a lease dispute. The fair value of the warrant was $0.1 million, valued using the Black-Scholes option pricing model, assuming the fair value of the common stock and exercise price of $1.47 per share, a term of 2.8 years, dividend yield of 0% and expected volatility of 140%. The amount of the settlement was fully accrued for in the condensed consolidated balance sheet.

In March 2004, the EITF reached a consensus on EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, to create a model that uses more detailed criteria to evaluate whether to record a loss, and includes additional disclosure information about unrealized losses. The consensus also expands the scope of EITF 03-1 to investments in equity securities that are both outside the scope of SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, and not accounted for by the equity method. The impairment accounting guidance is effective for reporting periods beginning after June 15, 2004 and the disclosure requirements are effective for annual reporting periods ending after June 15, 2004. The Company is currently evaluating the impact of the adoption of this consensus on its results of operations and financial position.

In April 2004, the EITF issued 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 15, 2004. The adoption of EITF 03-06 did not have a material impact on the Company’s results of operations and financial position.

In May 2002, the Board of Directors approved a restructuring plan to reduce the Company’s expense levels consistent with the business climate at that time. 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 $0.3 million in facilities lease termination costs. The balance of the accrual at June 30, 2004 was approximately $0.2 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 included the consolidation of certain 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 June 30, 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. 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. Additionally, costs totaling $1.3 million were recognized during the second quarter of 2004, including $0.8 million in severance and related headcount reduction costs and $0.5 million in facility consolidation and other related costs. During the fourth quarter of 2003 and six months ended June 2004, cash payments and non-cash credits totaling $1.3 million and $2.5 million, respectively, were made associated with these restructuring activities. The remaining accrual of $0.4 million associated with this restructuring is expected to be utilized by the end of 2004.

Detail of the Company’s remaining liabilities related to its restructuring activities is as follows:

At June 30, 2004, the Company had $6.6 million of goodwill. In accordance with SFAS No. 142, the Company ceased amortizing its goodwill in January 2002.

During each of the three month periods ended June 30, 2003 and 2004, the Company recognized $0.6 million of interest expense related to the 5³/4% Convertible Subordinated Notes (the Subordinated Notes) due in April 2005. During each of the six month periods ended June 30, 2003 and 2004, the Company recognized interest expense related to these notes of $1.1 million. At June 30, 2004, the total balance of the Subordinated Notes outstanding was $38.4 million and the Company had $0.6 million in accrued interest payable. The Subordinated Notes are carried at cost and at June 30, 2004, had an approximate fair value of $34.7 million.

The holders of the Subordinated Notes may convert the notes into shares of the Company’s 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 Subordinated Notes have the option of requiring the Company 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 November 2003, the Company executed an agreement to exchange approximately $32.8 million in face value of the Subordinated Notes, held by a group of investors led by the 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), for approximately 21.9 million shares of Series E Preferred stock. At a special meeting in July 2004, the Company received shareholder approval for this transaction. As a result of the conversion, a non-cash charge equal to the fair value of the Series E Preferred stock less the carrying value of the related Subordinated Notes, net of unamortized issuance costs, will be recorded as of the date of the exchange to arrive at net loss and net loss attributable to common shares for the third quarter of 2004.

The following table sets forth the carrying value of the 10% Senior Convertible Notes (the Senior Notes) as of the date indicated:

In November 2003, the Company issued in a private placement $10.0 million of the Senior 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 Notes issued to General Atlantic Investors were 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 such Senior Notes and will be accreted over the initial year of the four-year term. As a result, during the three and six months ended June 30, 2004, the Company recorded to interest expense accretion of approximately $45,000 and $90,000, respectively. At a special meeting in July 2004, the Company received approval from its shareholders to convert the $10.0 million in principal amount of the Senior Notes held by the General Atlantic Partners, plus interest, 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 related to these notes will be recognized as of the date of conversion resulting from the beneficial conversion feature included in the Series E convertible preferred stock.

In January 2004, the Company issued $15.0 million in principal amount of the Senior 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 (collectively, the January 2004 Investors). At a special meeting in July 2004, the Company received approval from its shareholders to convert the $15.0 million in principal amount of the Senior Notes, plus interest, into 10 million shares of Series E convertible preferred stock at $1.50 per share. As a result, interest expense of approximately $1.5 million will be recognized related to these Senior Notes as of the date of conversion resulting from the beneficial conversion feature included in the Series E convertible preferred stock.

In March 2004, the Company issued $18.5 million in principal amount of the Senior Notes to investment entities affiliated with Crosslink Capital, Criterion Capital Management, Heights Capital Management and Apex Capital (collectively, the March 2004 Investors). At a special meeting in July 2004, the Company received approval from its shareholders to convert the $18.5 million in principal amount of the Senior Notes, plus interest, into 12.3 million shares of Series E convertible preferred stock at $1.50 per share. As a result, interest expense of approximately $8.4 million will be recognized related to these Senior Notes as of the date of conversion resulting from the beneficial conversion feature included in the Series E convertible preferred stock.

The Senior Notes contain a financial covenant that required the Company to maintain a minimum monthly average operating cash flow, over any given fiscal quarter, for its operations in the Americas of not greater that negative $3.0 million. At June 30, 2004, the Company was in compliance with this covenant. Additionally, the Company could not incur, create or assume indebtedness or liens under the Senior Notes, with specified exceptions. Also, with some exceptions, under the Senior Notes it could not: (i) merge with another entity, (ii) make any restricted payments, including dividends, distributions and the redemption any of its options or capital stock, (iii) enter into any transactions with any affiliates, (iv) make investments, (v) change the nature of the Company’s business, (vi) permit the Company’s domestic subsidiaries to hold real or personal property in excess of specified amounts or (vii) create any new subsidiaries.

There were no tax effects allocated to any components of comprehensive loss during the three and six months ended June 30, 2003 or 2004.

As of June 30, 2003 and 2004, there were 30.2 million and 59.4 million, respectively, potential common shares 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 (the Bank), to be utilized for working capital and general corporate operations. The credit facility was amended in March 2003 and again in July 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 in July 2003 and extended the maturity of the credit facility to January 2004. In December 2003, the Company was not in compliance with a certain financial covenant which was subsequently waived by the Bank.

In January 2004, the Company executed an amendment with the Bank, which reduced the size of the credit line to a maximum of $5.0 million and extended the maturity date to October 2004. In March 2004 the Company executed an additional amendment with the Bank, which increased the size of the credit line to a maximum of $6.0 million and extended the maturity date to June 2005. Additionally, the line of credit included a minimum cash balance at the Bank of $3.0 million. The Company has not classified this as restricted cash as it is legally unrestricted. 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 the Bank. These warrants were fully exercisable upon grant, had an exercise price of $2.07 per share and have an expiration date in March 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 $0.2 million to interest expense during the first quarter of 2004.

In April 2004, the Company entered into an amendment to its credit facility with the Bank pursuant to which the 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. As of June 30, 2004, there was no balance outstanding but there were letters of credit held under the credit facility totaling approximately $2.7 million.

During the three months ended June 30, 2004, the Company was not in compliance with a certain financial covenant relating to the minimum Americas revenue for the months ended April 30, May 31 or June 30, 2004. The Company and the Bank are working together to resolve the Company’s current default. The Company currently believes that it will be required to cash collateralize the letters of credit, totaling approximately $2.7 million, and that the borrowing availability will be reduced to $2.7 million, the default will be waived and all financial covenants under the credit facility will be removed.

The 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 the Company’s lenders of any of its 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 carrying value of the Series D preferred stock at December 31, 2003 and June 30, 2004 is calculated 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 June 30, 2004, the estimated fair value of the liquidation preference was $24.8 million and $15.3 million, respectively. During the three and six months ended June 30, 2003, net charges of $0.4 million and $6.6 million, respectively, were recorded as a result of the increase in the fair value of the liquidation preference. During the three and six months ended June 30, 2004, net credits of $(6.4) million and $(9.5) million, respectively, were recorded as a result of the decrease in the fair value of the liquidation preference.

The following table sets forth the accretion on mandatorily redeemable preferred stock for the periods indicated:

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 of 2004, the Company recorded unearned compensation of $1.5

million which will be charged to operating expense over the four year vesting term of the restricted stock grant. During the three and six months ended June 30, 2004, the Company recorded stock-based compensation expense of $9,000 and $0.3 million, respectively, associated with the vesting of these shares.

In April 2004, the Company entered into a separation agreement with its chief executive officer, under the terms of which, the Company forgave a note receivable from the executive of $1.7 million, the executive surrendered 250,000 shares of the Company’s common tock, the Company paid $0.4 million to the executive and extended the exercise period of 430,424 stock options to April 2007. As a result, the Company recorded compensation expense of $1.5 million during the quarter.

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 operative 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 generally accepted accounting principles (GAAP) and that this substantially inflated the value of Peregrine securities issued as consideration in Remedy’s merger with Peregrine approximately one year later 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, 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.

United States Securities and Exchange Commission Investigation. In 2001, the United States Securities and Exchange Commission (the SEC) 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.

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 $9.8 million at June 30, 2004. These obligations are primarily associated with the maintenance of hardware and software products being utilized within engineering, hosted messaging operations and the management of data center operations and network infrastructure storage for the Company’s hosted messaging operations. These obligations are expected to be completed over the next 4 years, including $1.2 million for the remainder of 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.

The Company’s board of directors called a special meeting of shareholders for June 11, 2004, which was adjourned to July 2, 2004 for lack of a quorum. At the reconvened special meeting on July 2, 2004, at which a quorum was present, the Company’s shareholders approved the following proposals:

As a result of obtaining shareholder approval on the above items, the Company also exchanged approximately 85,000 shares of Series D preferred stock for approximately 800,000 shares of Series E preferred stock. All of these actions will cause the Company to record non-cash charges, based upon generally accepted accounting principles, that will increase the Company’s net loss attributable to common shareholders. In addition, the above items will reduce the Company’s convertible debt balance by $76.4 million and result in a significant increase to the Company’s mandatorily redeemable preferred stock balance. The Company is currently in the process of calculating the actual amount of such charges.

On August 2, 2004, the Company’s rights offering to purchase up to $21.0 million of Series E preferred stock expired. The Company issued approximately 2.6 million shares pursuant to the rights offering, representing approximately $4.0 million in gross proceeds to the Company, excluding fees and costs incurred by the Company in connection with the rights offering.

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.

Critical Path, Inc. was incorporated in California on February 1997. Critical Path, along with its subsidiaries (which, as noted above, we collectively refer to 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.

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 a third-party provider; 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.

We have operated at a loss since our inception and as of June 30, 2004, we had an accumulated deficit of approximately $2.3 billion, inclusive of a $1.3 billion charge for impairment of long-lived assets recorded in fiscal year 2000. We have undertaken numerous restructuring initiatives in an effort to align our operating structure not only to the business and economic environments through which we have operated but also in response to our changing business in an effort to generate net income. For example:

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 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, in the fourth quarter of 2003 and first quarter of 2004 we secured additional funds through several rounds of financing that involved the sale of senior secured notes convertible into a new series of preferred stock.

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.

We have operated at a loss since our inception and most recently, for the three month periods ended September 30, 2003, December 31, 2003, March 31, 2004 and June 30, 2004, our operating activities have used cash of $4.3 million, $5.7 million, $9.3 million and $12.8 million, respectively. With our history of operating losses and use of cash to support our operating activities, our primary sources of capital have come from both debt and equity financings that we have completed over the past several years. Our principal sources of liquidity include our cash and cash equivalents and a line of credit facility with Silicon Valley Bank. As of June 30, 2004, we had cash and cash equivalents totaling $23.6 million at June 30, 2004, of which approximately $2.7 million is restricted to support our outstanding obligations to the bank and $4.4 million is located in accounts outside the United States. Accordingly, our readily available cash resources in the United States as of June 30, 2004 were $16.5 million. In August 2004, our rights offering expired and provided an additional gross proceeds of $4.0 million of cash to support our domestic operations. Additionally, during our conference call announcing our financial results for the second quarter 2004, we provided guidance with respect to efforts we are undertaking to reduce our operating expenses in an effort to reduce our use of cash. We currently believe that we will be able to reduce the amount of cash used by our operating activities based upon our continuing restructuring activities and cost reduction efforts, but that, in the short-term, we may be required to find additional sources of capital through additional debt or equity financings or both to support our operating activities beyond December 31, 2004 although our ability to incur additional indebtedness is subject to certain limitations as discussed in the section below titled “Ability to incur additional indebtedness.”

In December 2003, based on the level of our cash available for domestic operations and the rate

of cash usage per quarter, we determined that we would not have sufficient cash resources available to continue beyond the first quarter of 2004 without raising additional funds through financing activities. Based on our financing activities in the fourth quarter of 2003 and the first quarter of 2004, we determined that we had sufficient cash to continue operations through the fourth quarter of 2004. We continue to believe that we have sufficient cash to continue operations through the fourth quarter of 2004. However, because the rights offering raised less funds than anticipated, if we are unable to significantly further reduce expenses as planned, secure additional financing or increase revenues, we cannot be certain that we will be able to continue our current operations beyond the fourth quarter of 2004.

As of June 30, 2004, there were no outstanding borrowings under the credit facility but there were letters of credit held under the credit facility totaling approximately $2.7 million. During the three months ended June 30, 2004, we were not in compliance with a certain financial covenant relating to the minimum Americas revenue for the months ended April 30, May 31 or June 30, 2004. We are currently engaged in discussion with Silicon Valley Bank to resolve our current default under the credit facility. We currently believe that we will be required to cash collateralize the letters of credit, totaling approximately $2.7 million, and that the borrowing availability will be reduced from $6.0 million to $2.7 million, the default will be waived and all financial covenants under the credit facility will be removed. For additional information with respect to the credit facility, see Note 7 of Notes to Unaudited Condensed Consolidated Financial Statements.

We currently expect our long-term liquidity and capital resources may increase if we are successful reducing our operating costs and capital requirements. In addition to our recent restructuring activities, we are also pursuing the possibility of increasing our long-term liquidity and capital resources through the restructuring of our foreign subsidiaries, thereby providing us access to the cash held by our foreign subsidiaries, renegotiating with the bank to increase the borrowing capacity of our credit facility as well as raising additional capital. We have recently engaged Perseus Advisors as our investment bankers to assist us in raising additional capital. Our ability to incur additional indebtedness is subject to certain provisions as discussed in the section as detailed below in the section titled “Ability to incur additional indebtedness.”

Cash and cash equivalents. The following table sets forth our cash and cash equivalents balance as of the dates indicated:

Total cash and cash equivalents increased primarily as a result of cash raised through the issuance of 10% senior convertible notes partially offset by cash used to support our operating and investing activities.

Our operating activities used $22.1 million of cash during the six months ended June 30, 2004. This cash was used to support our net loss, adjusted for non-cash items (such as depreciation and amortization of $0.9 million, changes in the value of a preferred stock instrument of $(9.6) million and stock based expenses of $1.3 million) and a $4.7 million increase in our accounts receivable balance partially offset by increases in our accrued liabilities of $3.3 million and deferred revenue of $3.2 million. Our net loss was primarily a result of our operating costs, including both cost of revenues and operating expenses which are primarily comprised of employee costs, third party contractor costs and restructuring costs, being greater than our revenues. Our accounts receivable balance has increased primarily as a result of an increasing proportion of our revenues being generated in Europe where collection periods are typically more extended along with certain customers delaying payments in an effort to manage their quarter-end cash positions.

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, or DSOs. The following table sets forth our accounts receivable balances and DSOs as of the dates indicated:

A number of non-cash items have been charged to expense and impacting our net losses during the six months ended June 30, 2004. These items include depreciation and amortization of property and equipment, amortization of unearned stock-based compensation and other stock-based compensation charges and changes in the value of a preferred stock instrument. 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.

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 investing activities used $1.5 million of cash during the six months ended June 30, 2004 primarily as a result of purchases of equipment used to support hosted messaging operations infrastructure. As of June 30, 2004, we had no commitments for capital equipment purchases. To the extent we purchase capital equipment, we expect to fund these purchases through the use of our available cash resources.

Our financing activities provided $28.4 million of cash during the six months ended June 30, 2004 primarily as a result of the issuance of $30.2 million 10% senior convertible notes (net of costs) and $1.0 million of proceeds from the issuance of our common stock partially offset by $2.3 million of payments on our line of credit facility and $0.5 of payments on our capital equipment leases. In January and March 2004, we raised gross proceeds of $15.0 million and $18.5 million, respectively, of cash through the issuance of 10% senior convertible notes and $1.0 million through a combination of employee stock option exercises and activities under our employee stock purchase plan (ESPP). See Note 11, Subsequent Events, of Notes to Unaudited Condensed Consolidated Financial Statements for information with respect to the conversion of the 10% senior convertible notes into shares of Series E preferred stock.

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.

In November 2003, we issued in a private placement $10.0 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. (referred to collectively as the General Atlantic Investors); in January 2004, we issued $15.0 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,; and, 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.

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: (i) our failure to pay any amounts due under notes when they are due and payable, (ii) our default on any indebtedness with a principal amount of at least $500,000, (iii) our voluntary or involuntary bankruptcy, (iv) any judgment for the payment of money of more than $500,000, (v) the attachment by our lenders of any of our assets, or (vi) 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: (i) merge with another entity, (ii) make any restricted payments, including dividends, distributions and the redemption any of our options or capital stock, (iii) enter into any transactions with any affiliates, (iv) make investments, (v) change the nature of our business, (vi) permit our domestic subsidiaries to hold real or personal property in excess of specified amounts or (vii) 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.

At a special meeting held in July 2004, we received approval from our shareholders to convert the $43.5 million in principal amount of 10% senior convertible notes, plus interest into approximately 30.5 million shares of Series E preferred stock at $1.50 per share. The Series E preferred stock ranks senior in preference to all of our existing equity and accrues dividends at an annual rate of 5 3/4% 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 Group (which we refer to as the Cheung Kong Investors) which would have extended the maturity of the $32.8 million in face value of 5 3/4% convertible subordinated notes held by the Cheung Kong Investors from April 1, 2005 to April 1, 2006. In the event our shareholders did not approve the exchange of the 5 3/4% 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 5 3/4% convertible subordinated notes held by the Cheung Kong Investors would increase to 7 1/2% for the period beginning April 1, 2005 and ending April 1, 2006, and we would be required to pay fees totaling $1.5 million.

At a special meeting in July 2004, the Company received approval from its shareholders to convert the $32.8 million in face value of its 5 3/4% convertible subordinated notes due in April 2005 held by the Cheung Kong Investors into approximately 21.9 million shares of Series E preferred stock.

In a separate agreement, members of the Cheung Kong Investors 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 on August 16, 2004, which is 10 business days after the close of the recently completed rights offering.

Under the terms of our line of credit, we are not permitted to incur additional indebtedness without the approval, by the bank in its sole discretion, that the terms of the debt are adequately subordinated to the obligations due under the bank credit facility. In addition, we must seek the consent of the holders of a majority of our Series D preferred stock and of a majority of the Cheung Kong Investors in order to incur any additional indebtedness.

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.

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 June 30, 2004, we had 401 employees as compared to 418 employees at December 31, 2003 and 436 employees at June 30, 2003. We do not believe that our historical fluctuations in revenues, expenses, or personnel are indicative of future results. The following table sets forth our results of operations for the three and six months ended June 30, 2003 and 2004.

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.

Total net revenues decreased during the three and six months ended June 30, 2004 as compared to the three and six months ended June 30, 2003 primarily as a result of decreased revenue from the license sale of our software solutions, hosted messaging solutions and professional services partially offset by increased revenue from the sale of maintenance contracts and support services.

Our international revenues accounted for approximately 69% and 66% of net revenues during the three and six months ended June 30, 2004, respectively, as compared to 58% and 61% during the three and six months ended June 30, 2003, respectively.

Our expectations for revenue in the three months ended September 30, 2004 currently range from a slight decrease to an increase from the three months ended June 30, 2004 and that revenues for the three months ending December 31, 2004 will be in line with or greater than revenues for the three months ended June 30, 2004. If revenue increases occur, we believe that such increases will be the result of our ability to sell and deploy enhanced messaging solutions that meet the needs of our customers as well as obtaining final acceptance from certain customers for whom we have been deferring revenue recognition on

Cost of revenues increased during the three months ended June 30, 2004 as compared to the three months ended June 30, 2003 primarily as a result of increased third-party royalty costs due to the resale of third-party products partially offset by reduced hosted messaging cost of revenues. Cost of revenues decreased during the six months ended June 30, 2004 as compared to the six months ended June 30, 2004 primarily as a result of decreased hosted messaging, professional services and maintenance and support cost of revenues.

During the three and six months ended June 30, 2004 our gross margins were 25% and 28%, respectively, as compared to 33% and 29% for the three and six months ended June 30, 2003. Gross margins decreased during the three months ended June 30, 2004 as compared to the three months ended June 30, 2003 primarily as a result of the increased third party royalty costs related to our increased license sales of certain third party products. Gross margins decreased for the six months ended June 30, 2004 as compared to the six months ended June 30, 2003 primarily as a result of our revenues declining at a greater rate than our cost of revenues.

We currently believe that gross margins may increase during the three months ended September 30, 2004 from the three months ended June 30, 2004 and that gross margins for the three months ended December 31, 2004 may increase from the three months ended September 30, 2004. If these gross margin improvements occur, we believe that they will be due to increases in our revenues, the reduction of our costs as a result of our current restructuring activities, which began in August 2004 as well as a lower proportion of revenue from third party products which carry an associated royalty cost. We believe these restructuring activities will reduce our fixed costs by restructuring contracts, consolidating certain activities to our offices in Toronto, Canada and Dublin, Ireland from higher cost areas such as the San Francisco Bay area and reducing our workforce and use of third party contractors.

Sales and Marketing. Sales and marketing expenses consist primarily of employee costs, including commissions, travel and entertainment, advertising, public relations, other promotional costs as well as other direct and allocated indirect costs. Sales and marketing expenses decreased during the three and six months ended June 30, 2004 as compared to the same periods ended June 30, 2003 primarily due to period over period reductions in depreciation expenses of $0.4 million and $0.9 million resulting from the write-down and completion of depreciation on certain existing fixed assets as well as cost savings generated through our 2002 and 2003 restructuring initiatives, including the termination of certain employees, resulting in period over period reductions in related personnel expenses of $1.3 million and $3.1 million, the consolidation of facilities, resulting in period over period reductions in associated facilities costs of $7,000 and $0.2 million, the reduction of certain marketing programs costs of $0.1 million and $0.2 million, and, during the three months ended June 30, 2004, the elimination of certain outside consulting arrangements, resulting in a period over period reduction in associated consulting expenses of $96,000. Depreciation expenses included in sales and marketing expenses totaled $0.2 million and $0.5 million during the three and six months ended June 30, 2004 as compared to $0.6 million and $1.3 million during the three and six months ended June 30, 2003.

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 as well as other direct and allocated indirect costs. Research and development expenses increased during the three and six months ended June 30, 2004 as compared to the three and six months ended June 30, 2003 primarily due to increased period over period depreciation expenses of $0.1 million and $0.6 million, resulting from new capital expenditures, increased period over period employee expenses of $0.2 million and $0.3 million, increased period over period consulting expenses of $85,000 and $0.7 million (primarily software development expenses that had previously been capitalized), and increased period over period facilities costs of $0.1 million and $96,000. Depreciation expenses included in research and development expenses totaled $0.8 million and $1.8 million during the three and six months ended June 30, 2004 as compared to $0.7 million and $1.2 million during the three and six months ended June 30, 2003.

General and Administrative. General and administrative expenses consist primarily of employee costs, fees for outside professional services and other direct and allocated indirect costs. General and administrative expenses increased during the three and six months ended June 30, 2004 as compared to the same periods ended June 30, 2003 primarily due to the accrual for past-due state and local business taxes of $0.9 million and one-time charges of $0.6 million in connection with the severance agreement with our former chief executive officer in the second quarter of 2004. These increases were partially offset by period over period reductions in depreciation expenses of $0.2 million and $0.4 million resulting from the write-down and completion of depreciation on certain fixed assets as well as cost savings generated through our 2002 and 2003 restructuring initiatives, including the consolidation of facilities, resulting in period over period reductions in associated facilities costs of $0.6 million and $0.3 million, the termination of certain employees, resulting in period over period reductions in related personnel expenses of $.01 million and $0.5 million as well as the elimination of certain outside consulting arrangements, resulting in period over period reductions in consulting expenses of $0.3 million and $67,000. Depreciation expenses included in general and administrative expenses totaled $0.1 million and $0.3 million during the three and six months ended June 30, 2004 as compared to $0.4 million and $0.7 million during the three and six months ended June 30, 2003.

We expect that our selling and marketing, research and development and general administrative expenses may decrease for each of the three month periods ending September 30, 2004 and December 31, 2004 as a result of our most recent restructuring activities begun in August 2004 as well as our on-going expense saving efforts.

Stock-based expenses are comprised of stock-based charges related to modifications made to employee stock option plans, stock option grants to non-employee contractors and warrants issued to consultants. Stock-based expenses increased to approximately $1.2 million and $1.3 million during the three and six months ended June 30, 2004 as compared to $0 and $59,000 during the three and six months ended June 30, 2003 primarily as a result of the severance agreement between us and our former chief executive officer. Based on the functions of the employees and consultants participating in the related option grants, $0 and $5,000 was allocated to cost of net revenues and $1.2 million and $1.3 million was allocated to operating expenses during the three and six months ended June 30, 2004. $0 and $17,000 was allocated to cost of net revenues and $0 and $42,000 was allocated to operating expenses during the three and six months ended June 30, 2003.

Restructuring expenses consist primarily of employee severance costs as well as facility consolidation and lease termination costs incurred primarily as a result of the Company’s restructuring actions. For the three and six months ended June 30, 2004 we recorded $1.3 million and $2.4 million of restructuring expense primarily related to employee severance, facility consolidation and other related costs in connection with our on-going initiatives. See Note 2 in the Notes to Unaudited Condensed Consolidated Financial Statements for additional information with respect to our restructuring activities.

In August 2004, we expanded our restructuring activities in an effort to reduce both our short-term and long-term cash requirements by reducing our fixed costs through the restructuring of contracts, consolidation of certain activities to our offices in Toronto, Canada and Dublin, Ireland from higher cost areas such as the San Francisco Bay area and the reduction of our workforce and use of third party contractors. This effort will begin in August 2004 and continue into the fourth quarter of 2004. As a result, we expect to record additional restructuring charges during the three month periods ending September 30 and December 31, 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 $22,000 and $0.2 million, respectively, during the three and six months ended June 30, 2004 as compared to $85,000 and $0.2 million, respectively, during the three and six months ended June 30, 2003, resulting in period over period decreases of $63,000 and $29,000. These decreases were due to lower cash balances available for investing. We recognized a net gain from foreign currency transactions associated with our international operations of $0.6 million and $1.0 million, respectively, during the three and six months ended June 30, 2004 as compared to a net gain of $0.1 million during the three months ended June 30, 2003 and a net loss of $41,000 during the six months ended June 30, 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 June 30, 2003 and 2004, the estimated fair value of the liquidation preference was $19.2 million and $15.3 million, respectively, resulting in a net charge to other expense during the three and six months ended June 30, 2003 of $0.4 million and $6.6 million, respectively, as compared to $6.4 million and $9.6 million during the three and six months ended June 30, 2004.

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, 5 ¾% 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.

The following table sets forth our interest expense for the three and six months ended June 30, 2003 and 2004.

Our provision for income taxes increased during the three and six months ended June 30, 2004 as compared to the three and six months ended June 30, 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.

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 $65.0 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 $42.0 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 three and six months ended June 30, 2004, the accretion on redeemable convertible preferred shares totaled $3.3 million and $6.5 million, respectively, comprised of $1.3 million and $2.6 million, respectively, in accrued dividends, and accretion of $2.1 million and $3.9 million, respectively. During the three and six months ended June 30, 2003, the accretion on redeemable convertible

preferred shares totaled $2.8 million and $6.5 million, respectively, comprised of $1.5 million and $2.2 million, respectively, in accrued dividends and accretion of $1.3 million and $4.3 million, respectively.

The table below sets forth our significant obligations and commitments as of June 30, 2004.

In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on EITF 03-1, The meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, to create a model that uses more detailed criteria to evaluate whether to record a loss, and includes additional disclosure information about unrealized losses. The consensus also expands the scope of EITF 03-1 to investments in equity securities that are both outside the scope of Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities, and not accounted for by the equity method. The impairment accounting guidance is effective for reporting periods ending after June 15, 2004. We are currently evaluating the impact of the adoption of this consensus on our results of operations and financial position.

In July 2004, the EITF issued a draft abstract, EITF Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share, which addressed the issue of when the dilutive effect of contingently convertible debt instruments (Co-Cos) should be included in diluted earnings per share. The draft abstract reflects the Task Force’s tentative conclusion that Co-Cos should be included in diluted earnings per share computations regardless of whether the market price trigger has been met. The tentative conclusion reached by the Task Force will not be finalized until it is ratified by the Financial Accounting Standards Board (FASB), which is expected to be in September 2004.

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

Historically, we have recorded recurring losses from operations and negative cash flow from operations. If we do not significantly reduce expenses as we have planned, secure additional financing or increase revenues, we cannot be certain that we will be able to continue our current operations beyond the fourth quarter of 2004. 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 in the near term. 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.

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.

Our failure to carefully manage expenses and restructuring activities 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, have placed significant strains on managerial, operational and financial resources and contributed to our history of losses. In addition, 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 restructuring activities and expenses effectively, our business and operating results could decline.

Our business will suffer if we fail to remedy identified deficiencies in our internal control over financial reporting.

In preparation for the annual report of management regarding our evaluation of our internal control over financial reporting required to be included in our annual report for the year ended December 31, 2004 by Section 404 of the Sarbanes-Oxley Act of 2002, we have engaged outside consultants and adopted a project work plan to assess the adequacy of our internal control over financial reporting, remediate any weaknesses that may be identified, validate that controls are functioning as documented and implement a continuous reporting and improvement process for internal control over financial reporting. We may discover deficiencies that require us to improve our procedures, processes and systems in order to ensure that our internal controls are adequate and effective and that we are in compliance with the requirements of Section 404 of the Sarbanes-Oxley Act. For example, in the coming months, we expect to focus on matters relating to segregation of duties, the level of manual control processes, the consistency of use of systems and policies and documentation of controls and procedures. If these deficiencies are not adequately addressed, or if we are unable to complete all of our testing and any remediation in time for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act and the SEC rules under it, we could fail to receive an unqualified opinion on internal control over financial reporting from our independent registered public accounting firm, which could

Additionally, the Public Company Accounting Oversight Board (PCAOB) recently adopted standards governing management’s required evaluation of its internal control over financial reporting and the independent auditors’ review of those controls and management’s evaluation. These standards result in a number of companies, including us, identifying significant deficiencies or material weaknesses in their internal control, which, if left unremediated, could preclude the independent auditors from delivering an unqualified opinion on internal control under the PCAOB’s rules.

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. On August 6, 2004, the closing price of our common stock was $0.80, representing the seventh consecutive day our stock had closed below $1.00. If our common stock closes at a price below $1.00 for 30 consecutive trading days, The Nasdaq Stock market could initiate delisting proceedings for our common stock. 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.

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.

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.

Having obtained shareholder approval on July 2, 2004, we amended the terms of the Series D preferred stock, including the conversion ratio, to increase the number of shares of common stock issuable upon conversion of the Series D preferred stock. As of August 6, 2004, there were 4,105,044 shares of series D preferred stock outstanding, which were convertible into approximately 46 million shares of common stock. In addition, in July 2004, upon conversion of our 10% convertible notes and the exchange of some of our Series D preferred stock, we issued approximately 53.2 million shares of Series E preferred stock, which are initially convertible, at the option of the holders, into an equal number of shares of common stock. Additionally, in August 2004, at the closing of our rights offering, we issued approximately 2.6 million shares of Series E preferred stock to exercising rights holders, which are initially convertible into an equal number of shares of common stock. This increase in 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 and shares of Series E preferred stock accrue dividends at a rate of 5³/4% per year . If the maximum amount of dividends accrue on the outstanding shares of Series D preferred stock and Series E preferred Stock prior to the automatic call for redemption date, the number of shares of common stock issuable upon conversion will increase by approximately 23.2 million shares to approximately 125.0 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, 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, the approximately 55.9 million shares of Series E preferred stock outstanding currently have an aggregate liquidation preference of approximately $84.2 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 the greater of $13.75 per share of Series D preferred stock plus all accrued dividends on such share (which, as of August 6, 2004, would result in an aggregate liquidation preference of $69.0 million) and $22 per share (which currently would equal a liquidation preference of $90.3 million) before any proceeds from the liquidation, dissolution, winding up or change in control is paid to holders of our common stock. 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.

We expect that the application of generally accepted accounting principles to account for the 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. These charges will be based in part on the fair value of our common stock and the Series E preferred stock on the dates the Series E preferred stock was issued, and on the fair value of the Series D preferred stock on the date its rights and preferences were modified. We are currently calculating the amount of charges that we will record. We previously disclosed that, assuming 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 estimated 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 had been purchased in the 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 June 30, 2004, approximately $4.4 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, approximately $2.7 million 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 difficult to predict 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 and six months ended June 30, 2004, we incurred stock-based compensation expense of $1.2 million and $1.3 million, 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 second quarter of 2004, our top ten customers accounted for approximately 35% 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 June 30, 2004, accounted for approximately 45% 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 orders 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.

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. If we fail to comply, our common stock may be delisted from the Nasdaq National Market. Please see the discussion above 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 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.

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 54%, 62% and 66% of our revenues from international sales in 2002, 2003 and the six months ended June 30, 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 significant equity ownership by the General Atlantic Investors and the Cheung Kong Investors may limit the ability of our other shareholders to influence significant corporate decisions which could delay or prevent a change of control or depress our stock price.

Following the conversion of the notes held by the General Atlantic Investors and the Cheung Kong Investors into Series E preferred stock and the amendment of the terms of our Series D preferred stock, the General Atlantic Investors beneficially own approximately 29.5% of our outstanding securities (which represents approximately 20.4% of the voting power) and the Cheung Kong Investors beneficially own approximately 25.5% of our outstanding securities (which represents approximately 26.8% of the voting power). 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 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 significant equity ownership by the General Atlantic Investors and the Cheung Kong Investors 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 use of our net operating losses could be limited if an ownership change occurred during the preceding three-year period.

The use of our net operating losses could be limited if an “ownership change” occurred during the preceding three-year period as a result of, for example, the issuance of Series E preferred stock upon conversion of the 10% notes, the amendment to the terms of the Series D preferred stock or the exercise of the subscription rights. In general, under applicable federal income tax rules, an “ownership change” is considered to have occurred if the percentage of the value of our stock owned by our “5% shareholders” increased by more than 50 percentage points over the lowest percentage of the value of our stock owned by such shareholders over the preceding three-year period.

Due to the fact that a full valuation allowance has been provided for the net deferred tax asset relating to our net operating losses, we have never analyzed whether events such as the issuance of Series E preferred stock upon conversion of the 10% notes, the amendment to the terms of the Series D preferred stock and/or the exercise of the subscription rights in the rights offering caused us to undergo an ownership change for federal income tax purposes. If such an ownership change were considered to have occurred, our use of our pre-change net operating losses would generally be limited annually to the product of the long-term tax-exempt rate as of the time the ownership change occurred and the value of our stock immediately before the ownership change. (The current long-term tax-exempt rate is 4.72%.) This could increase our federal income tax liability if we generate taxable income in the future. There can be no assurance that the Internal Revenue Service would not be able to successfully assert that we have undergone one or more ownership changes in the preceding three-year period.

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 second quarter of 2004, the closing sale prices of our common stock on the

Nasdaq National Market ranged from $1.32 on June 22, 2004 to $5.08 on April 5, 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 June 30, 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 June 30, 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 June 30, 2004, we had cash and cash equivalents of $23.6 million and no investments in marketable securities. Our long-term obligations consist of our $5.6 million five-year, 5 ³/4% Convertible Subordinated Notes due April 2005 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 $0.6 million during the second 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 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.

Beginning with the year ending December 31, 2004, Securities and Exchange Commission rules promulgated under Section 404 of the Sarbanes-Oxley Act of 2002 require us to provide an annual report of management on internal control over financial reporting. This report must contain a statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting for our company, a statement identifying the framework used by management to conduct the required evaluation of the effectiveness of our

internal control over financial reporting, management’s assessment of the effectiveness of our internal control over financial reporting as of the end of our most recent fiscal year, including a statement as to whether or not our internal control over financial reporting is effective and a statement that our independent auditors have issued an attestation report on management’s assessment of our internal control over financial reporting. In seeking to achieve compliance with Section 404 within the prescribed period, management has engaged outside consultants and adopted a detailed project work plan to assess the adequacy of our internal control over financial reporting, remediate any control weaknesses that may be identified, validate through testing that controls are functioning as documented and implement a continuous reporting and improvement process for internal control over financial reporting.

As a result of this initiative, which we began in May 2004, we are in the process of documenting processes and controls and are evaluating the design effectiveness of our internal control over financial reporting. We may discover deficiencies that require us to improve our procedures, processes and systems in order to ensure that our internal controls are adequate and effective and that we are in compliance with the requirements of Section 404 of the Sarbanes-Oxley Act. For example, in the coming months, we expect to focus on matters relating to segregation of duties, the level of manual control processes, the consistency of use of systems and policies and documentation of controls and procedures. If these deficiencies are not adequately addressed, or if we are unable to complete all our testing and remediation in time for full compliance with the requirements of Section 404 of the Sarbanes-Oxley Act and the SEC rules under it, we could fail to receive an unqualified opinion on internal control over financial reporting from our independent registered public accounting firm, which could adversely affect our business, reputation and results of operations.

Additionally, the Public Company Accounting Oversight Board (PCAOB) recently adopted standards governing management’s required evaluation of its internal control over financial reporting and the independent auditors’ review of those controls and management’s evaluation. These standards may result in a number of companies, including us, identifying significant deficiencies or material weaknesses in their internal control, which, if left unremediated, could preclude the independent auditors from delivering an unqualified opinion on internal control under the PCAOB’s rules.

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 operative 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 approximately one year later 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, 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 intend to defend ourselves 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.

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 $9.8 million at June 30, 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 $1.2 million for the remainder of 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 May 2004, in settlement of litigation with a landlord regarding office space in San Francisco, California, we issued 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 the date the settlement was reached and approved. The warrant was issued and the shares of common stock issuable upon exercise of the warrant will be issued based on an exemption from registration under Section 4(2) of the Securities Act and Regulation D thereunder.

On July 9, 2004, following shareholder approval of the issuance of Series E preferred stock to holders of our 10% senior convertible notes and the exchange of a portion of our outstanding 5 ³/4% convertible subordinated notes for Series E preferred stock, in reliance on Section 4(2) of the Securities Act and Regulation D promulgated under that Act:

On July 9, 2004, pursuant to a settlement agreement with MBCP PeerLogic LLC and other named plaintiffs in a lawsuit in the U.S. District Court for the Southern District of New York against us and certain of our former officers, we exchanged 83,543 shares of Series D preferred stock for 803,860 shares of Series E preferred stock. The plaintiffs’ claims against us were voluntarily dismissed with prejudice, and without costs or attorneys’ fees to any party. Our counterclaims against plaintiffs were also dismissed with prejudice, and without costs or attorneys’ fees to any party. We relied on Section 4(2) of the Securities Act and Regulation D promulgated under that Act to effect this exchange.

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.

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 called a special meeting of our shareholders for June 11, 2004, which was adjourned to July 2, 2004 for lack of a quorum. At the reconvened special meeting on July 2, 2004, at which a quorum was present, shareholders approved the following proposals:

There were no “broker non-votes” returned in respect of any of the proposals.

Our board of directors declared a dividend of rights to purchase preferred stock to shareholders of record on April 30, 2004. Each record shareholder received 0.65 transferable subscription rights for each share of our common stock held on the record date. Each subscription right entitled 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. In August 2004, our rights offering expired. We issued approximately 2.6 million shares of Series E preferred stock pursuant to the rights offering, representing approximately $4.0 million in gross proceeds, excluding fees and costs incurred by us in connection with the rights offering.

(b) Disclosure regarding Nominating Committee Functions and Communications between Security Holders and Boards of Directors.

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 Unaudited Condensed Consolidated Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	42
Item 4.	Controls and Procedures	43

PART II
Item 1.	Legal Proceedings	44
Item 2.	Changes in Securities and Issuer Purchases of Securities	46
Item 4.	Submission of Matters to a Vote of Security Holders	47
Item 5.	Other Information	48
Item 6.	Exhibits and Reports on Form 8-K	49
	Signature	51


	December 31, 2003			June 30, 2004
	(In thousands, except per share amounts; unaudited)
ASSETS
Current assets
Cash and cash equivalents	$	18,984		$	23,550
Accounts receivable, net		16,880			21,624
Prepaid and other current assets		4,664			5,846

Total current assets		40,528			51,020
Property and equipment, net		14,821			11,587
Goodwill		6,613			6,613
Other assets		5,763			7,520

Total assets	$	67,725		$	76,740

LIABILITIES, MANDATORILY REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS’ DEFICIT
Current liabilities
Accounts payable	$	5,022		$	4,704
Accrued liabilities		20,755			24,094
Deferred revenue		8,856			11,849
Line of credit facility		2,298			—
Capital lease and other obligations, current		1,721			926
Convertible notes payable, current		—			5,610

Total current liabilities		38,652			47,183
Deferred revenue		1,343			1,304
Convertible notes payable		48,376			76,356
Capital lease and other obligations, long-term		1,295			706

Total liabilities		89,666			125,549

Commitments and contingencies (Note 10)
Mandatorily redeemable Series D preferred stock, par value $0.001
Shares authorized: 75,000 Shares issued and outstanding: 4,000 Liquidation value at June 30, 2004: $68,831		55,301			52,236

Shareholders’ deficit
Common stock and paid-in-capital, par value $0.001
Shares authorized: 200,000,000
Shares issued and outstanding: 21,078 and 21,170		2,154,295			2,151,172
Common stock warrants		5,947			5,947
Notes receivable from shareholders		(870	)		—
Unearned compensation		—			(1,224	)
Accumulated deficit		(2,238,728	)		(2,257,788	)
Accumulated other comprehensive income		2,114			848

Total shareholders’ deficit		(77,242	)		(101,045	)

Total liabilities, mandatorily redeemable preferred stock and shareholders’ deficit	$	67,725		$	76,740


	Three months ended June 30,						Six months ended June 30,
	2003			2004			2003			2004
	(In thousands, except per share amounts; unaudited)
Net revenues
Software license	$	5,592		$	5,407		$	10,639		$	9,658
Hosted messaging		4,856			3,711			10,242			8,054
Professional services		3,155			2,936			6,375			5,595
Maintenance and support		4,533			4,962			8,914			10,787

Total net revenues		18,136			17,016			36,170			34,094

Cost of net revenues
Software license		722			1,708			2,519			2,619
Hosted messaging		7,103			6,570			13,366			12,951
Professional services		2,910			3,034			6,360			6,128
Maintenance and support		1,387			1,322			3,316			2,771
Stock-based expense — Hosted messaging		—			—			8			5
Stock-based expense — Professional services		—			—			3			—
Stock-based expense — Maintenance and support		—			—			6			—
Restructuring and other expenses		—			175			—			175

Total cost of net revenues		12,122			12,809			25,578			24,649

Gross profit		6,014			4,207			10,592			9,445

Operating expenses
Sales and marketing		7,931			6,035			17,240			12,974
Research and development		4,813			5,344			9,436			11,123
General and administrative		3,320			3,771			6,546			6,890
Stock-based expense — Sales and marketing		—			30			18			44
Stock-based expense — Research and development		—			—			15			18
Stock-based expense — General and administrative		—			1,182			9			1,191
Restructuring and other expenses		892			1,144			4,081			2,209

Total operating expenses		16,956			17,506			37,345			34,449

Loss from operations		(10,942	)		(13,299	)		(26,753	)		(25,004	)
Interest and other income (expense), net		3,526			6,733			(2,901	)		10,400
Interest expense		(783	)		(2,065	)		(1,552	)		(3,645	)
Gain on investments, net		349			—			349			—

Loss before income taxes		(7,850	)		(8,631	)		(30,857	)		(18,249	)
Provision for income taxes		(287	)		(445	)		(481	)		(811	)

Net loss		(8,137	)		(9,076	)		(31,338	)		(19,060	)
Accretion on mandatorily redeemable preferred stock		(2,839	)		(3,348	)		(6,504	)		(6,495	)

Net loss attributable to common shareholders	$	(10,976	)	$	(12,424	)	$	(37,842	)	$	(25,555	)

Net loss per share attributable to common shareholders — basic and diluted	$	(0.55	)	$	(0.59	)	$	(1.91	)	$	(1.21	)

Weighted average shares — basic and diluted		19,873			21,157			19,769			21,074


	Six months ended June 30,
	2003			2004
	(in thousands; unaudited)
Operating
Net loss	$	(31,338	)	$	(19,060	)
Recovery of doubtful accounts		(133	)		(120	)
Depreciation and amortization		9,228			4,935
Stock-based costs and expenses		59			1,258
Change in fair value of preferred stock instrument		6,560			(9,560	)
Amortization of non-cash interest expense		—			96
Gain on sale of investments, net		(349	)		—
Gain on release of funds held in escrow		(3,750	)		—
Loss on fixed asset disposals		—			56
Forgiveness of notes receivable		—			171
Restructuring charges — non-cash		492			544
Accounts receivable		2,364			(6,121	)
Other assets		(3,314	)		(620	)
Accounts payable		(2,726	)		(57	)
Accrued liabilities		(109	)		3,170
Deferred revenue		(1,860	)		3,229

Net cash used in operating activities		(24,876	)		(22,079	)

Investing
Notes receivable from officers		132			240
Property and equipment purchases		(7,488	)		(1,715	)
Proceeds from sale of investments		2,173			—
Proceeds from release of funds held in escrow		3,750			—
Proceeds from sale of marketable securities		9,573			—
Restricted cash		2,729			—

Net cash provided by (used in) investing activities		10,869			(1,475	)

Financing
Proceeds from issuance of convertible notes, net		—			30,165
Proceeds from issuance of common stock, net		5			1,009
Proceeds from (payments on) line of credit facility		4,900			(2,298	)
Principal payments on note and lease obligations		(544	)		(485	)

Net cash provided by financing activities		4,361			28,391

Net change in cash and cash equivalents		(9,646	)		4,837
Effect of exchange rates on cash and cash equivalents		696			(271	)
Cash and cash equivalents at beginning of period		33,498			18,984

Cash and cash equivalents at end of period	$	24,548		$	23,550


	Three months ended June 30,						Six months ended June 30,
	2003			2004			2003			2004
	(in thousands; except per share amounts)
Net loss attributable to common shares — as reported	$	(10,976	)	$	(12,424	)	$	(37,842	)	$	(25,558	)
Add:
Stock-based employee compensation expense included in reported net loss attributable to common shares, net of related tax effects		—			1,212			59			1,258
Deduct:
Total stock-based employee compensation expense determined under a fair value based method for all grants, net of related tax effects		(4,624	)		(1,307	)		(5,139	)		(3,741	)

Net loss attributable to common shareholders — pro forma	$	(15,600	)	$	(12,519	)	$	(42,922	)	$	(28,041	)

Basic and diluted net loss per share attributable to common shareholders — as reported	$	(0.55	)	$	(0.59	)	$	(1.91	)	$	(1.21	)

Basic and diluted net loss per share attributable to common shareholders — pro forma	$	(0.78	)	$	(0.59	)	$	(2.17	)	$	(1.33	)


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


	Workforce reductions			Facility and operations consolidation and other charges			Total
	(in thousands)
Beginning accrual balance at December 31, 2003	$	249		$	521		$	770
Restructure charge		1,794			589			2,383
Cash payments		(1,924	)		(384	)		(2,308	)
Non-cash credits		—			(196	)		(196	)

Ending balance at June 30, 2004	$	119		$	530		$	649


	June 30, 2004
	(in thousands)
10% senior convertible notes	$	42,750
Amount allocated to derivative instrument		750
Accretion on the Senior Notes		106

Carrying value of the Senior notes	$	43,606


	Interest Expense				Interest payable at June 30, 2004
	Three months ended June 30, 2004		Six months ended June 30, 2004		Interest payable at June 30, 2004
	(in thousands)
General Atlantic Investors	$	250	$	503	$	503
January 2004 Investors		375		692		692
March 2004 Investors		466		581		581

	$	1,091	$	1,776	$	1,776


	December 31, 2003			June 30, 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			10,080
Add amortization and accretion		26,706			33,201

Carrying value of Series D preferred stock and embedded change-in-control feature	$	55,301		$	52,236


	Three months ended June 30,				Six months ended June 30,
	2003		2004		2003		2004
	(in millions)
Accrued dividends	$	1.5	$	1.3	$	2.2	$	2.6
Accretion of the beneficial conversion feature		1.3		2.1		4.3		3.9

	$	2.8	$	3.4	$	6.5	$	6.5


	December 31, 2003		June 30, 2004		Increase / (decrease)
	December 31, 2003		June 30, 2004		$		%
	(in thousands)
Cash and cash equivalents	$	18,984	$	23,550	$	4,566	24.1	%


	Three months ended June 30,						Increase/ (decrease)					Six months ended June 30,						Increase/(decrease)
	2003			2004			$			%		2003			2004			$			%
	(In thousands, except % increase/(decrease) and per share amounts; unaudited)
Net revenue
Software license	$	5,592		$	5,407		$	(185	)	-3	%	$	10,639		$	9,658		$	(981	)	-9	%
Hosted messaging		4,856			3,711			(1,145	)	-24	%		10,242			8,054			(2,188	)	-21	%
Professional services		3,155			2,936			(219	)	-7	%		6,375			5,595			(780	)	-12	%
Maintenance and support		4,533			4,962			429		9	%		8,914			10,787			1,873		21	%

Total net revenue		18,136			17,016			(1,120	)	-6	%		36,170			34,094			(2,076	)	-6	%

Cost of revenue
Software license		722			1,708			986		137	%		2,519			2,619			100		4	%
Hosted messaging		7,103			6,570			(533	)	-8	%		13,366			12,951			(415	)	-3	%
Professional services		2,910			3,034			124		4	%		6,360			6,128			(232	)	-4	%
Maintenance and support		1,387			1,322			(65	)	-5	%		3,316			2,771			(545	)	-16	%
Stock-based expense — Hosted messaging		—			—			—		—			8			5			(3	)	-38	%
Stock-based expense — Professional services		—			—			—		—			3			—			(3	)	-100	%
Stock-based expense — Maintenance and support		—			—			—		—			6			—			(6	)	-100	%
Restructuring expense		—			175			175		—			—			175			175		—

Total cost of revenue		12,122			12,809			687		6	%		25,578			24,649			(929	)	-4	%

Gross profit (loss)		6,014			4,207			(1,807	)	-30	%		10,592			9,445			(1,147	)	-11	%
Operating expenses
Selling and marketing		7,931			6,035			(1,896	)	-24	%		17,240			12,974			(4,266	)	-25	%
Research and development		4,813			5,344			531		11	%		9,436			11,123			1,687		18	%
General and administrative		3,320			3,771			451		14	%		6,546			6,893			347		5	%
Stock-based expense — Sales and marketing		—			30			30		—			18			44			26		144	%
Stock-based expense — Research and development		—			—			—		—			15			18			3		20	%
Stock-based expense — General and administrative		—			1,182			1,182		—			9			1,191			1,182		13133	%
Restructuring expense		892			1,144			252		28	%		4,081			2,209			(1,872	)	-46	%

Total operating expenses		16,956			17,506			550		3	%		37,345			34,452			(2,893	)	-8	%

Operating income (loss)		(10,942	)		(13,299	)		2,357		22	%		(26,753	)		(25,007	)		(1,746	)	-7	%
Interest and other income (expense), net		3,526			6,733			3,207		91	%		(2,901	)		10,400			13,301		-458	%
Interest expense		(783	)		(2,065	)		1,282		164	%		(1,552	)		(3,645	)		2,093		135	%
Gain (loss) on investments		349			—			(349	)	-100	%		349			—			(349	)	-100	%

Income (loss) before provision for income taxes		(7,850	)		(8,631	)		781		10	%		(30,857	)		(18,252	)		(12,605	)	-41	%
Provision for income taxes		(287	)		(445	)		158		55	%		(481	)		(811	)		330		69	%

Net income (loss)		(8,137	)		(9,076	)		939		12	%		(31,338	)		(19,063	)		(12,275	)	-39	%
Accretion on mandatorily redeemable preferred stock		(2,839	)		(3,348	)		509		18	%		(6,504	)		(6,495	)		(9	)	0	%

Net income (loss) attributable to Common shareholders	$	(10,976	)	$	(12,424	)	$	1,448		13	%	$	(37,842	)	$	(25,558	)	$	(12,284	)	-32	%

Net income (loss) per share	$	(0.41	)	$	(0.43	)	$	0.02		5	%	$	(1.59	)	$	(0.90	)	$	(0.68	)	-43	%

Net income (loss) per share attributable to common shares	$	(0.55	)	$	(0.59	)	$	0.04		6	%	$	(1.91	)	$	(1.21	)	$	(0.70	)	-37	%

Shares used in the per share calculations		19,873			21,157			1,284		6	%		19,769			21,074			1,317		7	%


	Three months ended June 30,									Six months ended June 30,
					Increase/ (decrease)									Increase/ (decrease)
	2003		2004		$			%		2003		2004		$			%
	(In thousands, except % increase/(decrease) and per share amounts)
10% Senior Convertible Notes	$	—	$	1,210	$	1,210		—		$	—	$	2,017	$	2,017		—
5 3/4% Convertible Subordinated Notes		550		551		2		0	%		1,097		1,098		2		0	%
Amortization of debt issuance costs		69		134		65		95	%		137		222		84		61	%
Line of credit facility		96		115		19		19	%		186		185		(1	)	0	%
Capital leases and other long-term obligations		19		—		(19	)	-100	%		42		—		(42	)	-100	%
Other		48		55		7		15	%		90		123		33		37	%

Total interest expense	$	783	$	2,065	$	1,283		164	%	$	1,552	$	3,645	$	2,093		135	%


	Fiscal Year
	Total		Remainder of 2004		2005		2006		2007		2008 and beyond
Convertible Subordinated notes, including interest ⁽¹⁾	$	103,576	$	4,917	$	7,059	$	43,429	$	14,250	$	33,921
Line of credit facility		—		—		—		—		—		—
Operating lease obligations		18,563		2,567		4,762		4,639		1,461		5,134
Capital lease obligations		1,543		458		650		435		—		—
Other purchase obligations ⁽²⁾		9,821		7,303		1,342		1,061		115		—

	$	133,503	$	15,245	$	13,813	$	49,564	$	15,826	$	39,055


	Three months ended June 30,				Six months ended June 30,
	2003		2004		2003		2004
Risk free interest rate	1.7	%	3.0	%	1.7 -3.0	%	3.0	%
Expected lives (in years)	4.0		4.0		4.0		4.0
Dividend yeild	0.0	%	0.0	%	0.0	%	0.0	%
Expected volatility	97.8	%	146.0	%	97.8 -101.0	%	146.0	%


	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
5 ¾% convertible subordinated notes	$	35,094	$	34,968	$	34,842	$	34,716	$	34,590	$	34,466	$	34,342
10% senior convertible notes	$	44,612	$	43,994	$	43,777	$	43,561	$	43,346	$	43,133	$	42,921


*Period*	Total Number of Shares Purchased ⁽¹⁾	Average Price Paid per Share			Total Number of Shares Purchased as Part of Publicly Announced Program	Maximum Number of Shares that May Yet Be Purchased Under the Program
Apr. 1 – Apr. 30, 2004	250,000	$	5.00	⁽¹⁾	—	—
May 1 – May 31, 2004	—		—		—	—
June 1 – June 30, 2004	—		—		—	—
*Total*	250,000	$	5.00	⁽¹⁾	—	—


Proposal	For ⁽¹⁾	Against	Abstentions
Proposal 1	13,575,194	877,970	148,899
Proposal 2	13,516,140	927,026	158,897
Proposal 3	13,527,774	925,951	148,328
Proposal 4	13,504,016	935,833	162,214
Proposal 5	13,398,964	1,057,324	145,775
Proposal 6	13,475,464	969,681	156,918
Proposal 7	13,353,897	953,773	294,393



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