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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

Commission File Number: 000-26223

TUMBLEWEED COMMUNICATIONS CORP.

(Exact name of registrant as specified in its charter)

700 SAGINAW DRIVE

REDWOOD CITY, CA 94063

(Address of principal executive offices, including zip code)

(650) 216-2000

(Registrant’s telephone number, including area code)

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 the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The number of shares of common stock outstanding as of October 31, 2004 was 47,986,355.

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SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are subject to the “safe harbor” created by those sections. The forward-looking statements are based on our current expectations and projections about future events. Discussions containing such forward-looking statements may be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “predicts,” “projects,” “potential,” “continue,” “expects,” “anticipates,” “future,” “intends,” “plans,” “believes,” “estimates,” or the negative of these terms and other comparable terminology, including, but not limited to, the following:

These forward-looking statements are only predictions, not historical facts. These forward-looking statements involve certain risks and uncertainties, as well as assumptions. Actual results, levels of activity, performance, achievements and events could differ materially from those stated, anticipated or implied by such forward-looking statements. The factors that could contribute to such differences include those discussed under the caption “Risks And Uncertainties That You Should Consider Before Investing In Tumbleweed” in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained herein, as well as those discussed in our Form 10-K and other filings with the Securities and Exchange Commission. You should consider the risks factors and uncertainties under the caption “Risks and Uncertainties That You Should Consider Before Investing in Tumbleweed,” among other things, in evaluating our prospects and future financial performance. The occurrence of the events described in the risk factors could harm the business, results of operations and financial condition of Tumbleweed. These forward-looking statements are made as of the date of this Quarterly Report on Form 10-Q. We disclaim any obligation to update or alter these forward-looking statements, whether as a result of new information, future events or otherwise, or any obligation to explain the reasons why actual results may differ.

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TUMBLEWEED COMMUNICATIONS CORP.

INDEX

TRADEMARKS

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

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PART I—FINANCIAL INFORMATION

ITEM 1—FINANCIAL STATEMENTS (unaudited)

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in thousands)

(unaudited)

See accompanying Notes to Condensed Consolidated Financial Statements

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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

(in thousands, except per share data)

(unaudited)

See accompanying Notes to Condensed Consolidated Financial Statements

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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

See accompanying Notes to Condensed Consolidated Financial Statements

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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(1) Organization

The condensed consolidated financial statements included herein have been prepared by Tumbleweed Communications Corp. (“Tumbleweed”) without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with Tumbleweed’s audited financial statements and notes thereto included in its Annual Report on Form 10-K for the fiscal year ended December 31, 2003, filed with the SEC on March 15, 2004.

The unaudited condensed consolidated financial statements included herein reflect all adjustments (which include normal, recurring adjustments) which are, in the opinion of management, necessary to state fairly the financial position of Tumbleweed and its subsidiaries as of September 30, 2004, the results of operations for the three and nine months ended September 30, 2004 and 2003, respectively, and cash flows for the nine months ended September 30, 2004 and 2003, respectively. The results for the three and nine months ended September 30, 2004 and 2003, respectively, are not necessarily indicative of the results expected for the full fiscal year.

The accompanying consolidated condensed financial statements include the accounts of Tumbleweed and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The results of operations of Tumbleweed’s wholly-owned subsidiaries, Valicert, Inc. (“Valicert”), Incubator, Limited (“Incubator”), and Corvigo, Inc. (“Corvigo”), have been included commencing June 23, 2003, March 15, 2004, and March 18, 2004, the effective dates of those acquisitions, respectively.

(2) Stock-Based Compensation

Tumbleweed accounts for its stock-based compensation arrangements for employees using the intrinsic value method pursuant to Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees. As such, deferred stock-based compensation is recorded for fixed plan stock options when the fair value of the underlying common stock on the date of grant exceeds the stock option exercise price or the purchase price for issuance or sales of common stock. Deferred stock-based compensation is being amortized on an accelerated basis over the vesting period of the individual award consistent with the method described in Financial Accounting Standards Board (“FASB”) Interpretation 28.

In the three months ended September 30, 2004, Tumbleweed recorded deferred stock-based compensation of $38,000 to recognize the fair value of stock options granted to a non-employee for professional services. The assumptions used to value the option grant were a contractual term of 10.0 years, volatility of 100%, risk-free interest rate of 3.21%, and dividend yield of 0%. In the three months ended June 30, 2004, Tumbleweed recorded deferred stock-based compensation of $183,000 to recognize the fair value of stock options granted to a non-employee for professional services. The assumptions used to value the option grant were a contractual term of 10.0 years, volatility of 100%, risk-free interest rate of 2.58%, and dividend yield of 0%.

In the three months ended March 31, 2004, Tumbleweed recorded deferred stock-based compensation of $1,397,000 for the difference at the effective date of acquisition of Corvigo between the exercise price and the fair value of the common stock underlying the unvested options assumed upon the acquisition, multiplied by the ratio representing the remaining vesting period of the options assumed. In the three months ended June 30, 2003, Tumbleweed recorded deferred stock-based compensation of $528,000 for the difference at the effective date of acquisition of Valicert between the exercise price and the fair value of the common stock underlying the unvested options assumed upon the acquisition.

Tumbleweed recognized stock-based compensation expense of approximately $141,000 and $75,000, in the three months ended September 30, 2004 and 2003, respectively, and approximately $522,000 and $124,000, in the nine months ended September 30, 2004 and 2003, respectively. Had stock-based compensation expense for its stock-based compensation plan been determined consistent with the fair value approach set forth in Statement of Financial Accounting Standards (“SFAS”) 123, Accounting for Stock-Based Compensation, Tumbleweed’s net losses for the three and nine months ended September 30, 2004 and 2003, respectively, would have been as follows (in thousands, except per share amounts):

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Notes to Condensed Consolidated Financial Statements—(Continued)

For purposes of computing pro forma net loss, the fair value of each option grant was estimated on the date of grant using a Black-Scholes option pricing model. The assumptions used to value the option grants are stated as follows:

(3) Net Loss Per Share

Tumbleweed excludes potentially dilutive securities from its diluted net loss per share computation when their effect would be antidilutive to net loss per share amounts. The following potential common shares were excluded from the net loss per share computation (in thousands):

(4) Business Combinations

On March 18, 2004, Tumbleweed completed the acquisition of Corvigo, an anti-spam appliance vendor. The acquisition was entered into to strengthen Tumbleweed’s position in the anti-spam and e-mail security markets and to accelerate Tumbleweed’s distribution plans through the addition of resellers already selling the Corvigo appliance. Since March 18, 2004, Corvigo’s results of operations have been included in Tumbleweed’s consolidated condensed financial statements. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the assets acquired and liabilities assumed based on their estimated fair values on the acquisition date. The purchase price of $42.3 million consisted of an exchange of 4,732,284 shares of Tumbleweed’s common stock with a fair value of $32.8 million based on the fair value of Tumbleweed’s common stock on the date of the acquisition, cash paid of $6.0 million, an exchange of 386,000 options to purchase Tumbleweed’s common stock with a fair value of $2.7 million, including the intrinsic value of unvested options of $1.4 million, severances for former Corvigo employees of $97,000, and other acquisition-related costs of $727,000, consisting primarily of legal fees, banking fees, and accounting fees.

The following is a summary of the allocation of the purchase price in the acquisition of Corvigo (in thousands):

On March 15, 2004, Tumbleweed completed the acquisition of Incubator, a reseller of Tumbleweed’s products. The acquisition was entered into to expand Tumbleweed’s sales in Europe. Since March 15, 2004, Incubator’s results of operations have been included in Tumbleweed’s consolidated condensed financial statements. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the assets acquired and liabilities assumed based on their estimated fair values on the acquisition date. The purchase price of $1.7 million consisted of an exchange of 224,278 shares of Tumbleweed’s common stock with a fair value of $1.6 million based on the fair value of Tumbleweed’s stock on the date of the acquisition and other acquisition-related costs of $119,000 consisting of legal fees.

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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements—(Continued)

The following is a summary of the allocation of the purchase price in the acquisition of Incubator (in thousands):

As part of the acquisition of Incubator, Tumbleweed agreed that in the event that a certain sales goal is met in Tumbleweed’s European sales region in the year ending December 31, 2004, Tumbleweed’s purchase price for Incubator would increase by the exchange of additional shares of Tumbleweed’s common stock worth $770,000 plus 10% of the amount of Tumbleweed’s European sales in excess of the sales goal for the year ending December 31, 2004. In addition, in the event that certain sales goals are met in Tumbleweed’s European sales region for both the year and the two year period, respectively, ending December 31, 2005, Tumbleweed’s purchase price for Incubator would increase by the exchange of additional shares of Tumbleweed’s common stock worth $1,000,000 plus 10% of the amount of Tumbleweed’s European sales in excess of the sales goal for the year ending December 31, 2005. During the three months ended September 30, 2004, Tumbleweed’s Board of Directors approved a non-recoverable grant of stock to the former owners of Incubator worth $183,000 based on the fair value of Tumbleweed’s stock on the date of the stock grant as consideration for progress towards the European sales goal in the first six months of 2004. The value of the grant is included in Tumbleweed’s Sales and marketing expenses for the three months ended September 30, 2004. As a result of this stock grant, Tumbleweed’s contingent purchase price for Incubator decreased by the $183,000 paid.

On June 23, 2003, Tumbleweed acquired Valicert, which develops and licenses secure Internet communications and identity validation software for file transfer, financial messaging, and business process integration. The acquisition was entered into to combine the two companies into a single, more competitive industry participant. Since June 23, 2003, Valicert’s results of operations have been included in Tumbleweed’s consolidated condensed financial statements. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the assets acquired and liabilities assumed based on their estimated fair values on the acquisition date. The purchase price of $17.0 million consisted of an exchange of 9,713,634 shares of Tumbleweed’s common stock with a fair value of $13.0 million based on the average fair value of Tumbleweed’s stock two days before and two days after the announcement date of February 18, 2003, assumed stock options with a fair value of $1.7 million, severances for former Valicert employees of $276,000, and other acquisition-related costs of $2.0 million, consisting primarily of legal fees, investment banking fees, financial printing fees, accounting fees, and proxy mailing fees.

The following is a summary of the allocation of the purchase price in the acquisition of Valicert (in thousands):

A summary of intangible assets as of September 30, 2004 follows (in thousands):

The amounts above exclude intangible assets related to the acquisition of Valicert for purchase orders (license) and in-process research and development in the amount of $300,000 and $100,000, respectively, as these amounts were written off in full in 2003. The amounts above also exclude an acquired workforce intangible asset of $476,000 resulting from the issuance by Tumbleweed in September 2003 of 86,538 shares of stock to a company to recruit certain of its contract engineers to Tumbleweed as employees in Tumbleweed’s research and development center in Bulgaria. This intangible asset was amortized in full as of September 30, 2004.

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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements—(Continued)

The estimated amortization for each of the fiscal years subsequent to September 30, 2004, is as follows (in thousands):

Goodwill represents the excess of the purchase price over the fair value of acquired net tangible and identified intangible assets. In accordance with the provisions of SFAS 142, Goodwill and Other Intangible Assets, the goodwill acquired in the Valicert, Incubator, and Corvigo acquisitions will not be amortized, but instead, the goodwill balances will be tested for impairment at least annually and more frequently if certain impairment conditions exist. Any future impairment loss related to the goodwill recorded in connection with the acquisitions of Valicert, Incubator, and Corvigo will not be deductible by Tumbleweed for federal income tax purposes. During the three months ended September 30, 2004 and June 30, 2004, respectively, Tumbleweed increased its goodwill balance by $83,000 and $11,000, respectively, due to actual expenditures for acquisition-related costs related to the Corvigo acquisition being higher than previously estimated. During the three months ended June 30, 2004, Tumbleweed increased its goodwill balance by $15,000 due to actual expenditures for acquisition-related costs related to the Incubator acquisition being higher than previously estimated.

Pro Forma Results

The following pro forma summary presents Tumbleweed’s consolidated results of operations for the three and nine months ended September 30, 2004 and 2003, as if the acquisitions of Valicert, Incubator, and Corvigo had been consummated at the beginning of the earliest period presented. The pro forma consolidated results of operations include certain pro forma adjustments, including amortization of intangible assets, amortization of deferred compensation and the elimination of certain merger-related charges incurred by Valicert, prior to the merger with Tumbleweed, in the three months ended March 31, 2003. The pro forma results do not give effect to the deferred revenue adjustments on revenue as the adjustments are directly related to the mergers and the effects are non-recurring. Under the purchase method of accounting, the deferred revenue balances of Valicert, Incubator, and Corvigo were reduced by $1.0 million, $390,000, and $793,000, respectively, to the fair value of the related obligations as of the acquisition dates of June 23, 2003; March 15, 2004; and March 18, 2004, respectively. These adjustments have had the effect of reducing the amount of revenue the combined company recognized in the three and nine months ended September 30, 2004 and 2003, respectively, and will also affect the amount of revenue the combined company will recognize in future periods compared to the amount of revenue Valicert, Incubator, and Corvigo would have recognized in the same periods absent the mergers.

Pro forma results for the three and nine months ended September 30, 2004 and 2003, respectively, are as follows (in thousands, except per share amounts):

The pro forma results are not necessarily indicative of those that would have actually occurred had the acquisition taken place at the beginning of the periods presented. Pro forma results include merger-related and other costs of $533,000 and $549,000 for the three months ended September 30, 2004 and 2003, respectively, and $1.0 million and $2.4 million for the nine months ended September 30, 2004 and 2003, respectively.

Merger-related and Other Costs

Merger-related and other costs of $533,000 for the three months ended September 30, 2004 consist of $327,000 of severance costs for Tumbleweed employees terminated in connection with the Corvigo acquisition, $183,000 related to anticipated losses on an operating lease assumed in the Corvigo acquisition, and $23,000 of other merger-related costs. The operating lease covers approximately 12,000 square feet of office space in Palo Alto, California. The lease is for a term ending in 2007 with current monthly rent payments of approximately $22,000. Anticipated future sublease rental income is expected to be less than the rent expense due to

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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements—(Continued)

a weak office rental market in and around Palo Alto. The $183,000 charge was recorded due to a revised estimate of the period required to locate and contract with a sublessee and sublease rates. As a result of the new estimate, the existing accrual for the loss on the lease was found to be insufficient and the remaining balance for that liability was reclassified from Accrued liabilities to Accrued merger-related and other costs to be tracked along with the liability resulting from the revised estimate recorded in the three months ending September 30, 2004.

Merger-related and other costs of $1.0 million for the nine months ended September 30, 2004 consist of $703,000 of severance costs for Tumbleweed employees terminated in connection with the Corvigo acquisition and the sale of Tumbleweed’s offshore development subsidiary in India to a third party on June 2, 2004, $183,000 related to anticipated losses on an operating lease assumed in the Corvigo acquisition, $26,000 for a loss on the sale of Tumbleweed’s offshore development center subsidiary in India, and $90,000 of other merger-related costs. Tumbleweed’s offshore development center subsidiary in India was acquired in the acquisition of Valicert and supported Tumbleweed’s engineering, customer support, and consulting functions. This subsidiary was sold to consolidate Tumbleweed’s offshore development in its existing Bulgaria location.

During the last three quarters of 2003, Tumbleweed recorded merger-related and other costs of $2.9 million consisting of $1.1 million of severance costs for Tumbleweed employees terminated in connection with the Valicert acquisition, $596,000 of merger-related marketing programs, $174,000 of other merger-related costs, and a $996,000 charge related to anticipated losses on an operating lease. The operating lease was assumed during the acquisition of Interface, Inc. in 2000 and covers approximately 13,000 square feet of office space in Slough, United Kingdom. The lease is for a term ending in 2020 with quarterly rent payments of approximately $65,000. This office space had been subleased to a tenant who was providing Tumbleweed with quarterly rent payments of approximately $65,000 until the sublease was terminated effective July 2003. Anticipated future sublease rental income is expected to be less than the rent expense due to a weak office rental market in and around Slough. The following table describes merger-related and other costs recorded in 2004 and 2003 (in thousands):

Severance costs will be paid in 2004 and 2005. Payments for other merger-related costs will be paid in 2004. Payments for anticipated remaining losses on the operating leases are expected to occur over the life of the leases, the longer of which ends in 2020.

(5) Comprehensive Loss

Comprehensive loss includes Tumbleweed’s net loss as well as foreign currency translation adjustments, recorded net of tax. Comprehensive loss for the three months and nine months ending September 30, 2004 and 2003, respectively, is as follows (in thousands):

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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements—(Continued)

(6) Segment Information

As defined by SFAS 131, Disclosure About Segments of an Enterprise and Related Information, Tumbleweed’s chief operating decision-maker is its Chief Executive Officer. This officer reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenue by geographic region for purposes of making operating decisions and assessing financial performance. The consolidated financial information reviewed is the information presented in the accompanying consolidated statement of operations. Tumbleweed operates in a single reporting segment.

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

Substantially all of Tumbleweed’s long-lived assets are located in the United States.

(7) Contingencies

In December 2001, certain plaintiffs filed a class action lawsuit in the United States District Court for the Southern District of New York on behalf of purchasers of the common stock of Valicert, alleging violations of federal securities laws. In re Valicert, Inc. Initial Public Offering Securities Litigation, No. 01-CV-10889 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, No. 21 MC 92 (SAS). The operative amended complaint is brought on purported behalf of all persons who purchased Valicert common stock from the date of its July 27, 2000 initial public offering through December 6, 2000. It names as defendants Valicert, its former chief executive officer, its chief financial officer (the “Valicert Defendants”), as well as an investment banking firm that served as an underwriter for the IPO. The complaint alleges liability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that the registration statement for the IPO did not disclose that: (1) the underwriter agreed to allow certain customers to purchase shares in the IPO in exchange for excess commissions to the paid to the underwriter; and (2) the underwriter arranged for certain customers to purchase additional shares in the aftermarket at predetermined prices. The complaint also appears to allege that false or misleading analyst reports were issued. The complaint does not claim any specific amount of damages. Similar allegations have been made in lawsuits relating to more than 300 other initial public offerings conducted in 1999 and 2000, all of which have been consolidated for pretrial purposes. In February 2003, the Court issued a ruling on all defendants’ motions to dismiss, denying Valicert’s motion to dismiss the claims under the Securities Act of 1933, but granting Valicert’s motion to dismiss the claims under the Securities Exchange Act of 1934.

In June 2003, Valicert accepted a settlement proposal presented to all issuer defendants in this case. Under the proposed settlement, the plaintiffs will dismiss and release all claims against the Valicert Defendants in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuers in all the consolidated cases, and the assignment or surrender of control to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Under the guaranty, the insurers will be required to pay the amount, if any, by which $1 billion exceeds the aggregate amount ultimately collected by the plaintiffs from the underwriter defendants in all of the cases. If the plaintiffs fail to recover $1 billion and payment is required under the guaranty, Valicert would be responsible to pay its pro rata portion of the shortfall, up to the amount of the deductible retention under its insurance policy, which is $500,000. The timing and amount of payments that Valicert could be required to make under the proposed settlement will depend on several factors, principally the timing and amount of any payment required by the insurers pursuant to the $1 billion guaranty. The proposed settlement is subject to approval of the Court, which cannot be assured. The accompanying condensed consolidated financial statements do not include a reserve for any potential loss, as Tumbleweed does not consider a loss to be probable at this time.

In June 2003, Tumbleweed was served with a summons and first amended complaint, captioned Liu v. Credit Suisse First Boston, et alia, alleging the violation of federal and state securities laws, purportedly on behalf of persons who acquired the common stock of Tumbleweed (other than purchasers of Tumbleweed’s initial public offering) from August 6, 1999 to October 18, 2000. The case is now pending in the United States District Court for the Southern District of New York. In September 2004, the Court granted plaintiffs’ motion for leave to file a third amended complaint, and Tumbleweed filed a motion to dismiss this case pursuant to Fed. R. Civ. P. 12(b). An adverse outcome in this case could harm Tumbleweed’s business and operating results. Moreover, the costs in defending this lawsuit could harm future operating results. The accompanying condensed consolidated financial statements do not include a reserve for any potential loss, as Tumbleweed does not consider a loss to be probable at this time.

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Notes to Condensed Consolidated Financial Statements—(Continued)

All costs incurred as a result of these legal proceedings and claims are charged to expense as incurred. Tumbleweed indemnifies its customers from third party claims of intellectual property infringement relating to the use of its products. Historically, costs related to these guarantees have not been significant and Tumbleweed is unable to estimate the potential impact of these guarantees on its future results of operations.

(8) Recent Accounting Pronouncements

In March 2004, the FASB issued No. 03-1 (“EITF 03-01”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provides new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-01; Tumbleweed will evaluate the impact of EITF 03-01 once final guidance is issued.

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

The following discussion should be read in conjunction with the consolidated condensed financial statements and the accompanying notes to this Quarterly Report on Form 10-Q and Tumbleweed’s Annual Report on Form 10-K for 2003 filed with the SEC, including any amendments to our Annual Report filed with the SEC, as well as Management’s Discussion and Analysis of Financial Condition and Results of Operations included therein. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and those listed under “Risks and Uncertainties That You Should Consider Before Investing In Tumbleweed.”

Overview

Tumbleweed Communications Corp. (“Tumbleweed” or “we”) is a leading provider of email and data security products for enterprises and government agencies. Our solutions are used by these organizations when email, file transfer or Web communications are mission-critical. By making Internet communications secure, reliable and automated, our products help customers significantly reduce their cost of doing business.

We have more than 1,000 enterprise customers who use our products to connect with over ten thousand corporations and millions of end-users. Tumbleweed’s market focus is in the financial services, healthcare and insurance, government and enterprise markets. Our customers include ABN Amro Bank, Bank of America Securities, Catholic Healthcare West, JP Morgan Chase & Co., The Regence Group (Blue Cross/Blue Shield), St. Luke’s Episcopal Healthcare System, the US Food and Drug Administration, the US Navy and Marine Corps, and Wells Fargo Bank.

Our software solutions are:

Overview of the Three and Nine Month Periods Ended September 30, 2004

Our operating results during the three and nine months ended September 30, 2004 showed improvement relative to the same three and nine months in 2003 in both revenue and operating cash flow. Our growth in revenue of 30% and 53% in the three and nine months ended September 30, 2004, respectively, from the same three and nine months in 2003, was driven by a number of factors including increased customer adoption of our email firewall products, revenues from the secure file transfer and identity validation products we acquired in the Valicert acquisition, revenue from the MailGate product acquired in the Corvigo acquisition, and growth

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in our targeted customer sectors in the financial services, health care, and government industries. Our increase in net loss of 52% in the three month period ended September 30, 2004, from the same three months in 2003 was due to an increase in intangible asset amortization and stock-based compensation expense, both primarily related to the Corvigo acquisition, as well as an increase in sales and marketing expenses which have helped drive our increase in revenue. Our reduction in net loss of 23% in the nine months ended September 30, 2004, from the same nine months in 2003, was due to our growth in revenues and our continuing focus on generating cost efficiencies including our development center in Bulgaria which has allowed us to augment our research and development and services offerings at a relatively lower cost structure. Operating cash flow improved by 92% in the nine months ended September 30, 2004 due to our reduction in net loss and lower accounts receivable balance due to an increase in collections from our customers.

Key Performance Indicators

Our key performance indicators are customer orders received (bookings), recognized revenue, and deferred revenue. We measure bookings as the dollar value of contractual agreements entered into with customers in the period that result in either revenue recognized in the period, deferred revenue at the end of the period, or expected billings in future periods. Generally, an increase in our bookings will result in an increase in our revenue and/or deferred revenue. The timing of bookings is uncertain as we sell to enterprises and government entities and the process of contractual negotiation is critical and may be lengthy.

Backlog

Our backlog consists of deferred revenue as well as contractual commitments that are not due and payable as of the balance sheet date, or for which collectibility is in doubt, and/or for which the product or service has not yet been delivered. Our backlog excludes all items relating to consulting services. Backlog was $19.0 million and $15.3 million at September 30, 2004 and December 31, 2003, respectively. We believe that $14.1 million of the backlog at September 30, 2004 will be recognized as revenue in the next twelve months.

Outlook

We believe that our near-term success will depend particularly on our ability to increase customer adoption of our email firewall, secure file transfer, anti-spam, and identity validation products, our ability to successfully integrate the Valicert, Incubator, and Corvigo acquisitions, our ability to improve supply chain effectiveness associated with our appliance products, and our ability to maintain control over expenses and cash. We believe that key risks include overall economic conditions and the overall level of information technology spending; economic and business conditions within our target customer sectors in the financial services, health care, and government industries; timing of the closure of customer contracts; growing our sales internationally; expanding our reseller channel; and competitive factors in our rapidly changing industry. Our prospects must be considered in light of the risks, expenses and difficulties encountered by companies at an early stage of development, particularly given that we operate in new and rapidly evolving markets, have completed several acquisitions and face an uncertain economic environment. We may not be successful in addressing such risks and difficulties. Please refer to the “Risks and Uncertainties” section for additional information.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

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

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

Revenue Recognition

We derive our revenue from three sources: (i) product revenue, which includes license fees, subscription-based license fees, and transaction-based license fees; (ii) service revenue, which includes support and maintenance fees, consulting fees, and training fees; and (iii) intellectual property and other revenue which includes patent license agreement fees and the sale of distribution rights. As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period based on the judgments and estimates made by our management.

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We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, Software Revenue Recognition (“SOP 97-2”), as amended by SOP 98-9, Modification of SOP 97-2, “Software Revenue Recognition” With Respect to Certain Transactions (“SOP 98-9”).

We make significant judgments related to revenue recognition. Specifically, in connection with each transaction involving our products, we must evaluate whether: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) our fee is fixed or determinable, and (iv) collectibility is probable. We apply these criteria as discussed below.

We allocate revenue on software transactions (referred to as an “arrangement” in the accounting literature) involving multiple elements to each undelivered element based on their respective fair values. The residual is allocated to the product license. Our determination of fair value of each element in multiple element arrangements is based on vendor-specific objective evidence (VSOE). We limit our assessment of VSOE for each element to the price charged when the same element is sold separately.

Valuation of Allowance for Doubtful Accounts

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

Valuation of Long-Lived Assets and Goodwill

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

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We evaluate goodwill on an annual basis for indications of impairment based on our fair value as determined by our market capitalization in accordance with SFAS 142, Goodwill and Other Intangible Assets. If this evaluation indicates that the value of the goodwill may be impaired, we make an assessment of the impairment of the goodwill using the two-step method prescribed by SFAS 142. Any such impairment charge could be significant and have a material adverse effect on our reported financial statements. We did not record any impairment charges on our goodwill during the three and nine months ended September 30, 2004 or 2003, respectively. As of September 30, 2004, we had goodwill of $49.5 million.

Accrual for Anticipated Operating Lease Losses

In the three months ended June 30, 2003 we recognized a charge of $996,000 related to potential losses on an operating lease in Slough, United Kingdom that was included in our consolidated statement of operations as Merger-related and other costs. The charge was estimated to include required dilapidations, remaining lease liabilities, and brokerage fees, offset by estimated sublease income. In the three months ended September 30, 2004 we recognized a charge of $183,000 related to potential losses on an operating lease in Palo Alto, California that was included in our consolidated statement of operations as Merger-related and other costs. The charge was estimated to include remaining lease liabilities and brokerage fees, offset by estimated sublease income. Estimates related to sublease costs and income are based on assumptions regarding the period required to locate and contract with a sublessee and sublease rates. Each reporting period we review these estimates, and to the extent that our assumptions change, the ultimate charge for the loss on these operating leases could vary from our current estimates.

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RESULTS OF OPERATIONS

Three and Nine Month Periods Ended September 30, 2004 and 2003

Revenue. Revenue, which consists of product revenue, service revenue and intellectual property and other revenue, results from new contracts and backlog. We define backlog as deferred revenue, contractual commitments that are not due and payable as of the balance sheet date, or for which collectibility is in doubt, and/or for which the product or service has not yet been delivered. Product revenue consists of license fees, subscription-based license fees, and transaction-based license fees. Service revenue includes support and maintenance fees, consulting fees, and training fees. Intellectual property and other revenue consists of patent license agreement fees and the sale of distribution rights. Total revenue for the three months ended September 30, 2004 increased to $11.2 million from $8.6 million for the same three months in 2003. The increase in total revenue was primarily due to a $2.2 million increase in support and maintenance revenue and a $180,000 increase in patent license agreement revenue. Total revenue for the nine months ended September 30, 2004 increased to $31.4 million from $20.5 million for the same nine months in 2003. The increase in total revenue was primarily due to a $7.0 million increase in support and maintenance revenue, a $2.7 million increase in license revenue, and a $862,000 increase in patent license agreement revenue.

Product revenue increased to $5.2 million for the three months ended September 30, 2004 from $5.1 million for the same three months in 2003. Product revenue increased to $13.7 million for the nine months ended September 30, 2004 from $11.0 million for the same nine months in 2003. While product revenue was largely unchanged in the three months ended September 30, 2004, relative to the same three months in 2003, the increase in product revenue for the nine months ended September 30, 2004 relative to the same nine months in 2003 was primarily due to an increase in license revenue of $2.7 million. The increase in license revenue for the nine month period was driven by increased sales of the secure file transfer and identity validation products that we acquired in the Valicert acquisition and the MailGate product that we acquired in the Corvigo acquisition, with less comparable revenue in 2003 since the Valicert acquisition occurred late in the second quarter of 2003 and the Corvigo acquisition occurred in 2004. In addition, license revenue increased as a result of increased sales of our email firewall products.

Service revenue increased to $5.4 million for the three months ended September 30, 2004 from $3.2 million for the same three months in 2003. Service revenue increased to $16.1 million for the nine months ended September 30, 2004 from $8.6 million for the same nine months in 2003. The increases in service revenue were primarily due to increases in support and maintenance revenue of $2.2 million and $7.0 million, respectively, for the three and nine months ended September 30, 2004. The increases in support and maintenance revenue were due to revenue growth in our installed customer base, an expansion of our customer base due to the Valicert acquisition, and the successful customer acceptance of our dynamic anti-spam service which was released during the three months ended June 30, 2003 and is sold on a subscription service fee basis.

Intellectual property and other revenue increased to $584,000 for the three months ended September 30, 2004 from $404,000 for the same three months in 2003. Intellectual property and other revenue increased to $1.5 million for the nine months ended September 30, 2004 from $935,000 for the same nine months in 2003. The increases in intellectual property and other revenue were due to increases in patent license agreement revenue of $180,000 and $862,000, respectively, for the three and nine months ended September 30, 2004. This increase for the nine months ended September 30, 2004 was partially offset by $281,000 of revenue from the sale of distribution rights in 2003 with no comparable revenue in 2004.

Cost of revenue. Cost of revenue is comprised of product costs and service costs and the amortization of core/developed technology, maintenance agreements, and purchase orders (license) relating to the Valicert, Incubator, and Corvigo acquisitions. Product costs are primarily comprised of royalties paid to third parties for software licensed by us for inclusion in our products and the cost of hardware included in our appliance products. Service costs are comprised primarily of employee and employee-related costs for customer support and consulting and contract development projects with third parties. Total cost of revenue increased to $2.0 million for the three months ended September 30, 2004 from $1.6 million for the same three months in 2003. The increase in total cost of revenue was due to a $293,000 increase in the amortization of intangible assets and a $198,000 increase in product costs, partially offset by a $41,000 decrease in service costs. Total cost of revenue increased to $5.5 million for the nine months ended September 30, 2004 from $4.5 million for the same nine months in 2003. The increase in total cost of revenue was due to a $793,000 increase in the amortization of intangible assets and a $330,000 increase in product costs, partially offset by a $165,000 decrease in service costs.

Product costs increased to $453,000 for the three months ended September 30, 2004 from $255,000 for the same three months in 2003. Product costs increased to $1.1 million for the nine months ended September 30, 2004 from $748,000 for the same nine months in 2003. The increases in product costs for the three and nine months were primarily due to an increase in costs of hardware included in our appliance products due to an increase in the sales of appliance products in 2004. The increase in sales of appliance products was driven by sales of the MailGate product acquired in the Corvigo acquisition. We expect product costs to increase on a year-over-year basis in the remainder of 2004 due to the inclusion of the costs of hardware included in sales of our appliance products.

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Service costs decreased to $1.0 million for the three months ended September 30, 2004 from $1.1 million for the same three months in 2003. Service costs decreased to $3.1 million for the nine months ended September 30, 2004 from $3.2 million for the same nine months in 2003. The decrease in service costs for the three and nine months was primarily due to the sale, in the three months ended June 30, 2004, of our offshore development center subsidiary in India, which had supported our engineering, customer support, and consulting functions. This subsidiary was sold to consolidate our offshore development in our existing Bulgaria location. As a result of the sale of the subsidiary there were no service costs in India in the three months ended September 30, 2004.

Amortization of intangible assets included in cost of revenue consists of the amortization of intangible assets for core/developed technology, maintenance agreements, and purchase orders (license) recorded as a result of the Valicert, Incubator, and Corvigo acquisitions. Amortization of intangible assets included in cost of revenue increased to $510,000 in the three months ended September 30, 2004 from $217,000 for the same three months in 2003. Amortization of intangible assets included in cost of revenue increased to $1.3 million in the nine months ended September 30, 2004 from $534,000 for the same nine months in 2003. The increases in the amortization of intangible assets included in cost of revenue was due to the acquisitions of Corvigo and Incubator in March of 2004 and the acquisition of Valicert in June of 2003 since there was no related amortization for the Corvigo and Incubator intangible assets in the nine months ended September 30, 2003 and no related amortization for the Valicert intangible assets in the first quarter of 2003. We expect amortization of intangible assets included in cost of revenue to increase on a year-over-year basis in the fourth quarter of 2004 as a result of the acquisitions of Corvigo and Incubator in March of 2004.

Research and development expenses. Research and development expenses are primarily comprised of employee and employee-related costs and other costs required for the development and quality assurance of our products. Research and development expenses for the three months ended September 30, 2004 increased to $2.9 million from $2.6 million for the same three months in 2003. Research and development expenses for the nine months ended September 30, 2004 increased to $8.8 million from $6.6 million for the same nine months in 2003. The increases in research and development expenses were primarily due to increases in employee and employee-related costs. Employee and employee-related costs increased by $460,000 and $2.1 million, respectively, in the three and nine months ended September 30, 2004 due to an increase in average engineering headcount to 125 employees for the three months ended September 30, 2004 from 99 employees for the same three months in 2003 and an increase in average engineering headcount to 137 employees for the nine months ended September 30, 2004 from 73 employees for the same nine months in 2003. The increase in average engineering headcount was driven by our efforts to broaden and upgrade our products including the addition of employees from the Valicert and Corvigo acquisitions. The increase in employee and employee-related costs for the three months ended September 30, 2004 was partially offset by a decrease in consulting expenses of $87,000 and a decrease in legal expenses of $60,000, both of which were related to the conversion of a number of contract engineers to Tumbleweed employees in our development center in Bulgaria in September 2003.

Sales and marketing expenses. Sales and marketing expenses are primarily comprised of employee and employee-related costs, including commissions, travel expenses, and costs associated with marketing programs. Sales and marketing expenses for the three months ended September 30, 2004 increased to $6.5 million from $4.4 million for the same three months in 2003. Sales and marketing expenses for the nine months ended September 30, 2004 increased to $17.4 million from $11.1 million for the same nine months in 2003. The increases in sales and marketing expenses were primarily due to increases in employee and employee-related costs, including commissions, as well as marketing programs and travel expenses. Employee and employee-related costs, including commissions, increased by $1.3 million and $4.7 million, respectively, in the three and nine months ended September 30, 2004 due to an increase in commissions and an increase in average sales and marketing headcount to 84 employees for the three months ended September 30, 2004 from 60 employees for the same three months in 2003, and an increase in average sales and marketing headcount to 78 employees for the nine months ended September 30, 2004 from 50 employees for the same nine months in 2003. The increase in average sales and marketing headcount was due to our efforts to increase our marketing resources and expand our sales presence, including the acquisitions of Valicert, Incubator, and Corvigo. Marketing programs increased by $409,000 and $865,000, respectively, in the three and nine months ended September 30, 2004 due to an increase in marketing initiatives targeted at growing our revenues. Travel expenses increased by $173,000 and $196,000, respectively, in the three and nine months ended September 30, 2004 due to an increase in travel costs associated with our increased revenue.

General and administrative expenses. General and administrative expenses consist primarily of employee and employee-related and support costs for our administrative, finance, legal, and human resources departments as well as public reporting costs, bad debt expense, and professional fees including intellectual property enforcement and protection costs. General and administrative expenses for the three months ended September 30, 2004 decreased to $1.3 million from $1.6 million for the same three months in 2003. General and administrative expenses for the nine months ended September 30, 2004 decreased to $3.7 million from $4.5 million for the same nine months in 2003. The decreases in general and administrative expenses were primarily due to decreases in legal expenses and office expenses. Legal expenses decreased by $91,000 and $461,000, respectively, in the three and nine months ended September 30, 2004 primarily due to costs associated with the eBay patent matter in the three and nine months ended September 30, 2003. The settlement of our lawsuit and signing of a cross-license agreement with eBay in the three months ended December 31, 2003 reduced costs associated with this matter in the three and nine months ended September 30, 2004. Office expenses decreased by

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$105,000 and $477,000, respectively, in the three and nine months ended September 30, 2004 primarily due to the renewal of our headquarters lease in third quarter of 2003 where we received a lower monthly rent cost in exchange for an extension of the lease term.

Stock-based compensation expense. Stock-based compensation expense consists of the amortization of deferred stock-based compensation recorded as a result of unvested options assumed in the Valicert and Corvigo acquisitions, stock option grants to non-employees, options granted to employees at exercise prices less than the fair value of the underlying stock on the grant date, and the vesting acceleration of certain employees’ stock options, net of credits related to stock options granted to employees who were later terminated before the options vested. Stock-based compensation expense for the three months ended September 30, 2004 increased to $141,000 from $75,000 for the same three months in 2003. Stock-based compensation expense for the nine months ended September 30, 2004 increased to $522,000 from $124,000 for the same nine months in 2003. The increases in stock-based compensation expense were due to the amortization of deferred stock-based compensation resulting from unvested options assumed in the Valicert and Corvigo acquisitions and grants of stock options to a non-employee in the three and nine months ended September 30, 2004 with no comparable expense from the Corvigo acquisition and non-employee grant in 2003 and no comparable expense from the Valicert acquisition in the first quarter of 2003. We expect stock-based compensation expense to increase on a year-over-year basis in the remainder of 2004 as a result of the amortization of deferred compensation recognized as a result of Corvigo acquisition as well as the option grants to a non-employee.

Amortization of intangible assets and write-off of in-process research and development. Amortization of intangible assets included in operating expenses consists of the amortization of intangible assets for customer base and reseller agreements and trademarks and tradenames recorded as a result of the Valicert, Incubator, and Corvigo acquisitions. Amortization of intangible assets included in operating expenses for the three months ended September 30, 2004 increased to $421,000 from $206,000 for the same three months in 2003. Amortization of intangible assets included in operating expenses for the nine months ended September 30, 2004 increased to $1.1 million from $226,000 for the same nine months in 2003. The increases in the amortization of intangible assets included in operating expenses was due to the acquisitions of Corvigo and Incubator in March 2004 and the acquisition of Valicert in June of 2003 since there was no related amortization for the Corvigo and Incubator intangible assets in the nine months ended June 30, 2003 and no related amortization for the Valicert intangible assets in the first quarter of 2003. We expect amortization of intangible assets included in operating expenses to increase on a year-over-year basis in the remainder of 2004 as a result of the acquisitions of Corvigo and Incubator in March 2004.

Merger-related and other costs. Merger-related and other costs of $533,000 for the three months ended September 30, 2004 consist of $327,000 of severance costs for Tumbleweed employees terminated in connection with the Corvigo acquisition, $183,000 related to anticipated losses on an operating lease assumed in the Corvigo acquisition, and $23,000 of other merger-related costs. The operating lease covers approximately 12,000 square feet of office space in Palo Alto, California. The lease is for a term ending in 2007 with current monthly rent payments of approximately $22,000. Anticipated future sublease rental income is expected to be less than the rent expense due to a weak office rental market in and around Palo Alto. The $183,000 charge was recorded due to a revised estimate of the period required to locate and contract with a sublessee and sublease rates. Merger-related and other costs of $1.0 million for the nine months ended September 30, 2004 consist of $703,000 of severance costs for Tumbleweed employees terminated in connection with the Corvigo acquisition and the sale of our offshore development center subsidiary in India to a third party on June 2, 2004, $183,000 related to anticipated losses on an operating lease assumed in the Corvigo acquisition, $26,000 for a loss on the sale of our offshore development center subsidiary in India, and $90,000 of other merger-related costs. Merger-related and other costs of $549,000 for the three months ended September 30, 2003, consist of $285,000 of merger-related marketing programs, $223,000 of severance costs for Tumbleweed employees terminated in connection with the Valicert acquisition, and $41,000 of other merger-related costs. Merger-related and other expenses of $2.4 million for the nine months ended September 30, 2003, consist primarily of $1.1 million of severance costs for Tumbleweed employees terminated in connection with the Valicert acquisition, $285,000 of merger-related marketing programs, $41,000 of other merger-related costs, and a $996,000 charge related to anticipated losses on an operating lease. The operating lease was assumed during the acquisition of Interface, Inc. in 2000 and covers approximately 13,000 square feet of office space in Slough, United Kingdom. The lease is for a term ending in 2020 with quarterly rent payments of approximately $65,000. This office space had been subleased to a tenant who was providing Tumbleweed with quarterly rent payments of approximately $65,000 until the sublease was terminated effective July 2003. Anticipated future sublease rental income is expected to be less than the rent expense due to a weak office rental market in and around Slough.

Other income (loss), net. Other income (loss), net, is generally comprised of interest income earned on investment securities and interest expense incurred on outstanding debt. Additionally in the three months ended September 30, 2004, this category included losses on disposal of assets of $113,000, primarily resulting from the sale of certain computer equipment, and in the nine months ended September 30, 2004 included a gain of $66,000 related to the recovery of amounts due from current and former employees previously deemed uncollectible, and a gain of approximately $100,000 from the sale of a product line. In the three and nine months ended September 30, 2003 this category included a gain of approximately $500,000 recorded from the sale, net of related commissions, of an intellectual property asset acquired in the acquisition of Valicert. The change to a loss of $113,000 in the three

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months ended September 30, 2004 from a gain of $512,000 for the same three months in 2003 and the decrease in income to $141,000 in the three months ended September 30, 2004 from $577,000 for the same nine months in 2003 was primarily due to these four items.

LIQUIDITY AND CAPITAL RESOURCES

Since inception, we have financed our operations primarily through the issuance of equity securities. As of September 30, 2004, we had approximately $20.6 million in cash and cash equivalents.

Net cash used in operating activities for the nine months ended September 30, 2004 decreased to $619,000 from $8.2 million for the same nine months in 2003. Net cash used in operating activities for the nine months ended September 30, 2004 was primarily the result of our net loss of $6.6 million and adjustments to reconcile net loss to net cash used in operating activities including a decrease in accounts receivable balances of $2.5 million as a result of improved collections, and non-cash charges for depreciation and amortization expenses of $3.6 million and stock-based compensation expense of $522,000. The reduction in net cash used in operating activities was primarily due to a reduction in our net loss of $1.9 million, the reduction in accounts receivable balances, and increases in non-cash charges for depreciation and amortization expenses and stock-based compensation expense of $1.8 million and $398,000, respectively, partially offset by a decrease in accrued liabilities due to the payment of an additional payroll in the three months ended September 30, 2004 that resulted in an additional outflow of cash of $1.0 million. This extra payment related to a timing event, and although it did decrease cash, had no impact on expenses.

Net cash used in investing activities for the nine months ended September 30, 2004 was $4.5 million. Net cash used in investing activities was comprised of $3.5 million for the acquisitions of Incubator and Corvigo, net of cash acquired, and $965,000 of purchases of property and equipment. The $3.5 million outflow for the acquisitions of Incubator and Corvigo includes the impact of a $6.0 million cash payment to Corvigo shareholders as part of the purchase price for Corvigo. Net cash provided by investing activities for the nine months ended September 30, 2003 was comprised of inflows related to the acquisition of Valicert, partially offset by purchases of property and equipment.

Net cash provided by financing activities for the nine months ended September 30, 2004 decreased to $374,000 from $1.6 million for the same nine months in 2003. Net cash provided by financing activities for the nine months ended September 30, 2004 was comprised of an inflow of $574,000 for the proceeds from the issuance of common stock as a result of the exercises of stock options and warrants, partially offset by an outflow of $200,000 related to repayments on outstanding debt originally assumed in the acquisition of Valicert. Net cash provided by financing activities for the nine months ended September 30, 2003 resulted primarily from the proceeds from the issuance of common stock as a result of the exercises of stock options and warrants of $1.7 million and a net cash outflow related to the refinancing of outstanding debt assumed in the acquisition of Valicert.

As of September 30, 2004, our principal commitments consisted of obligations related to outstanding operating leases, a bank loan, and unconditional purchase obligations. We do not anticipate a substantial increase in operating lease obligations in the immediate future.

In June 1999, we entered into an operating lease covering approximately 40,000 square feet of office space in Redwood City, California that was scheduled to expire in November 2004. During the three months ended September 30, 2003 we renewed this lease in advance of the scheduled termination date at a lower monthly rent cost in exchange for an extension of the lease term. The renewed lease expires in July 2008 with current monthly rent payments of approximately $73,000.

As a result of the Interface acquisition, we assumed an operating lease in Slough, United Kingdom. The lease is for a term ending in 2020 with current quarterly rent payments of approximately $65,000. We subleased this office space to a tenant who was providing us with quarterly rent payments of approximately $65,000 until the sublease was terminated effective July 2003. Anticipated future sublease rental income is expected to be less than the rent expense due to a weak office rental market in and around Slough. In the second quarter of 2003 we recognized a charge of $996,000 related to anticipated losses on this lease that was included in our consolidated statement of operations as Merger-related and other costs. We are currently attempting to find a new sublessee.

As a result of the Corvigo acquisition, we assumed an operating lease in Palo Alto, California. The lease is for a term ending in 2007 with current monthly rent payments of approximately $22,000. Anticipated future sublease rental income is expected to be less than the rent expense due to a weak office rental market in and around Palo Alto. In the three months ended September 30, 2004 we recognized a charge of $183,000 related to anticipated losses on this lease that was included in our consolidated statement of operations as Merger-related and other costs. The $183,000 charge was recorded due to a revised estimate of the period required to locate and contract with a sublessee and sublease rates. We are currently attempting to find a sublessee.

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In the acquisition of Valicert, we assumed debt of $855,000 resulting from equipment leases with two financing companies. During the three months ended September 30, 2003 this debt was refinanced with an $800,000 loan from the same bank from whom we previously had obtained equipment loan facilities. The new debt bears interest at prime rate plus 0.63%, is due and payable in 36 equal monthly installments, and is secured by certain of our assets.

Our capital requirements depend on numerous factors, including revenue generated from operations and market acceptance of our products and services, the resources devoted to the development of our products and services and to sales and marketing and other operating activities. We believe that our existing capital resources should enable us to maintain our current and planned operations for at least the next twelve months. Our current cash reserves, however, may be insufficient if we experience either lower than expected revenues or extraordinary or unexpected cash expenses, or for other reasons. Funding, if pursued, may not be available on acceptable terms or at all. If adequate funds are not available, we may be required to curtail significantly or defer one or more of our operating goals or programs, or take other steps that could harm our business or future operating results.

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

We regularly evaluate acquisition candidates that have products, technologies, or customers that may complement our own, and expect to continue this practice.

At September 30, 2004, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

Contractual Obligations and Commercial Commitments

Future cash payments for contractual obligations and commercial commitments as of September 30, 2004, are as follows (in thousands):