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 September 30, 2004, the Company had outstanding 22,560,603 shares of common stock, $0.001 par value per share (including 46,989 shares of Class A Non-Voting preference shares of our Nova Scotia subsidiary Critical Path Messaging Co. which can be exchanged at any time for our common stock upon the election of the holder).

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 Company has operated at a loss since inception and most recently, for the three month periods ended March 31, 2004, June 30, 2004, and September 30, 2004, the Company’s operating activities have used cash of $9.3 million, $12.8 million, and $3.8 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 September 30, 2004, the Company had cash and cash equivalents totaling $20.2 million, of which $10.1 million was located in accounts outside the United States and which is not generally available for the Company’s domestic operations. Accordingly, the Company’s readily available cash resources in the United States as of September 30, 2004 were $10.1 million. Additionally, the Company is undertaking efforts to reduce its cost of revenues, operating expenses and 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 will need to find additional sources of capital through additional debt or equity financings or both to support its current operating activities beyond the first quarter of 2005 and repay the $5.6 million in principal amount of outstanding 5³/4% Convertible Subordinated Notes when they become due on April 1, 2005, 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 subsequent financing activities, the Company determined that it had sufficient cash to continue operations through the first quarter of 2005. The Company continues to believe that it has sufficient cash to continue operations through the first quarter of 2005. However, because the Company’s rights offering raised less than anticipated, and because the Company has been unable to sufficiently further reduce expenses, secure additional financing or increase revenues, the Company cannot be certain that it will be able to continue its current operations beyond the first quarter of 2005 and repay the $5.6 million in principal amount of outstanding 5³/4% Convertible Subordinated Notes when they become due on April 1, 2005.

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, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods or Services. 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, Accounting for Stock-based Compensation – Transition and Disclosure, 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 and activities under the Company’s Employee Stock Purchase Plan 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 and activities under the Company’s Employee Stock Purchase Plan, 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:

The Company calculated the fair value of the activity under the Employee Stock Purchase Plan using the Black-Scholes option pricing model, as prescribed by FAS 123, using the following assumptions:

In March 2004, the EITF reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-01”), 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. In September 2004, the EITF delayed the effective date for the recognition and measurement guidance previously discussed under EITF 03-01 as included in paragraphs 10-20 of the proposed statement. The proposed statement will clarify the meaning of other-than-temporary impairment and its application to investments in debt and equity securities, in particular investments within the scope of FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and investments accounted for under the cost method. The Company is currently evaluating the effect of this proposed statement on its financial position and results of operations.

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 September 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 September 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.

In August 2004, the Company expanded its restructuring activities in an effort to reduce both short-term and long-term cash requirements. These activities included the reduction of fixed costs through the restructuring of contracts, consolidation of certain activities to offices in Toronto, Canada and Dublin, Ireland from higher cost areas such as the San Francisco Bay area and the elimination of approximately 20% of employee positions and reduced use of third party contractors. This effort began in August 2004 and is expected to continue into the first quarter of 2005. As a result, the Company expects to record additional restructuring charges during the three months ending December 31, 2004. During the three months ended September 30, 2004, the Company recorded restructuring charges related to these activities totaling $2.6 million consisting primarily of $2.1 million for employee severance costs and $0.5 million of costs related to the closure or consolidation of certain facilities and operations.

During the three months ended September 30, 2004, the Company made cash payments totaling approximately $1.0 million and had non-cash charges of approximately $0.2 million. At September 30, 2004, the Company had a remaining balance in its restructuring accrual totaling $2.1 million. Detail of the Company’s remaining liabilities related to its restructuring activities is as follows:

At September 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 the three month periods ended September 30, 2003 and 2004, the Company recognized $0.6 million and $0.1 million, respectively, of interest expense related to the 5³/4% Convertible Subordinated Notes (the Subordinated Notes) due in April 2005. During the nine month periods ended September 30, 2003 and 2004, the Company recognized interest expense related to these notes of $1.6 million and $1.3 million, respectively.

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 of $12.8 million 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, was recorded as of the date of the exchange as loss on extinguishment of debt in the statement of operations.

At September 30, 2004, the total balance of the Subordinated Notes outstanding was $5.6 million and the Company had interest payable of $0.2 million. The Subordinated Notes are carried at cost and had an approximate fair value of $4.3 million at September 30, 2004.

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 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). 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). 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 Senior Notes plus all accrued and unpaid interest, into Series E convertible preferred stock at $1.50 per share. The following table provides the number of shares of Series E convertible preferred stock issued upon conversion:

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

As of September 30, 2003 and 2004, there were 29.9 million and 16.6 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 credit 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 credit facility was amended to increase the size of the borrowing availability under the credit facility to a maximum of $6.0 million and extend the maturity date to June 2005. In April 2004 the credit facility was amended as a result of non-compliance with certain financial covenants. The April 2004 amendment 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.

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. As a result, in August 2004 the credit facility was amended and the Company entered into a pledge and security agreement with the Bank pursuant to which the Company was required to cash collateralize letters of credit previously held under the credit facility, totaling approximately $2.7 million, during the third quarter of 2004. This cash is considered restricted as reported on the balance sheet as of September 30, 2004 and, as such, is unavailable for operating activities. Furthermore, while the Company still maintains this credit facility with the Bank, the August 2004 amendment terminates the Bank’s commitment to make loans under the credit facility, does not permit any further borrowing by the Company and removes all covenants.

In connection with the March 2004 amendment, 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 seven-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 July 2004, at the Company’s special meeting, shareholders approved a proposal to amend and restate the certificate of determination of preferences of Series D preferred stock (the Amended Series D) to, among other things, amend the Series D preferred stock liquidation preference upon a liquidation and change of control, eliminate the participation feature, reduce the conversion price from $4.20 to $1.50 and reduce the amount of dividends to which the holders of Series D preferred stock are entitled. The following table sets forth the carrying value of the Series D preferred stock at December 31, 2003, prior to the amended and restated certificate of determination, and the Amended Series D at September 30, 2004:

The Series D preferred stock and the Amended Series D preferred stock contain an embedded derivative instrument which is recorded as a liability on the Company’s balance sheet in accordance with current authoritative guidance. At December 31, 2003, the embedded derivative instrument was recorded in the carrying value of the Series D preferred stock, in accordance with the authoritative guidance at such time but has been reclassed in accordance with current authoritative guidance. 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 Other Income (Expense). At December 31, 2003 the estimated fair value of the liquidation preference was $24.9 million and at September 30, 2004, the estimated fair value of the liquidation preference in the Amended Series D preferred stock was $2.1 million.

During the three months ended September 30, 2004, the Company issued a total of approximately 55.9 million shares of Series E preferred stock. In July 2004, the Company issued approximately 30.6 million shares of Series E preferred stock to convert $45.5 million of the Senior Notes plus accrued interest, issued 21.9 million shares of Series E preferred stock to convert $32.8 million of the Subordinated Notes and issued approximately 0.8 million shares of Series E preferred stock to convert certain holders of Series D preferred stock into Series E preferred stock. In August 2004, the Company issued approximately 2.6 million shares of Series E preferred stock in connection with its rights offering from which the Company received gross proceeds of approximately $4.0 million.

The Series E preferred stock ranks senior to all preferred and common stock of the Company in priority of dividends, rights of redemption and payment upon liquidation. The principal terms of the Series E preferred stock include an automatic redemption on July 9, 2008, cumulative dividends at a rate of 5³/4% per year,

dividends are not paid in cash but are added to the value of the Series E preferred stock on June 30 and December 31 each year, and conversion into shares of common stock calculated based on the quotient of the Series E accreted value divided by the Series E conversion price, $1.50.

At issuance, the total amount of costs associated with converting the Company’s debt into Series E preferred stock and costs associated with the rights offering, totaling approximately $4.6 million, will accrete over the term of the Series E preferred stock. Additionally, the conversion of the $45.5 million Senior Notes into the Series E preferred stock was deemed to have a beneficial conversion feature totaling approximately $16.3 million. The value of the beneficial conversion feature, at issuance, was initially recorded as a reduction of the carrying amount of the Series E preferred stock and will accrete over the term of the Series E preferred stock.

The carrying value of the Series E preferred stock at September 30, 2004 is as follows:

The following table sets forth the accrued dividends and accretion of the redemption value on the madatorily redeemable preferred stock for the periods indicated:

In March 2004 and August 2004, the Company issued 707,368 and 680,823 shares of restricted common stock, respectively, 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 and third quarters of 2004, the Company recorded unearned compensation of $1.5

million and $0.4 million, respectively, which will be charged to operating expense over the four year vesting term of the restricted stock grant. During the three and nine months ended September 30, 2004, the Company recorded stock-based compensation expense of $0.3 million and $0.5 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.

From time to time, the Company has been subject to litigation including the pending litigation described below. The Company’s current estimated range of liability related to some of the pending litigation below is based on claims for which management can estimate the amount and range of loss. The Company has recorded the minimum estimated liability related to those claims, where there is a range of loss. Because of the uncertainties related to both the amount and range of loss on the remaining pending litigation, management is unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, the Company will assess its potential liability and revise its estimates. Pending or future litigation could be costly, could cause the diversion of management’s attention and could upon resolution, have a material adverse effect on the business, results of operations, financial condition and cash flow. 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 fraudulent transaction with Peregrine that was 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 operative complaint alleges causes of action against Critical Path for fraud and deceit, violations of California Corporations Code provisions regarding aiding and abetting securities fraud, 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. The Company has not recorded a liability against this claim as of September 30, 2004.

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. The Company has not recorded a liability against this claim as of September 30, 2004.

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 Company has not recorded a liability against this claim as of September 30, 2004.

On August 9, 2004, the Company received a demand letter from the Cable & Wireless Liquidating Trust, or the Trust, notifying the Company of the Trust’s claim that Cable & Wireless, USA, Inc. made a preferential payment to the Company of approximately $1.1 million within the 90-day preference period before Cable & Wireless filed for bankruptcy. The Company does not believe that it received any preferential payments from Cable & Wireless and communicated its position to the Trust in a letter dated September 3, 2004. To the Company’s knowledge, no formal proceedings have been commenced based on this dispute. However, the Company intends to defend itself vigorously if the Trust pursues this claim. The Company has not recorded a liability against this claim as of September 30, 2004.

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’s other contractual obligations total approximately $10.5 million at September 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 $2.4 million for the remainder of 2004. Included in the contractual cash obligations of $10.5 million at September 30, 2004 and the $7.7 million for the remainder of 2004 is approximately $5.4 million which will be eliminated at the conclusion of a mutual disengagement process in which we are involved with a certain vendor and the execution of a termination agreement.

In September 2004, we received a courtesy notice (the Notice) from the landlord of our headquarters facility in San Francisco, California notifying us that the landlord had found a new tenant for our offices located at 350 The Embarcadero per the landlords substitution right in the First Amendment to Lease between SRI Hills Plaza Venture, LLC and Critical Path, Inc. (the Amendment). Per the schedule provided in the Notice, we believe we will receive formal notification on December 1, 2004 that we are to vacate our facilities at 350 The Embarcadero and move into new office space provided for us at 2 Harrison Street, Suite #200 no later than April 1, 2005. In connection with the landlord’s substitution right and our relocation, we will be required to make certain lease termination payments totaling approximately $1.3 million, which will be recorded as a restructure charge in the period in which we receive formal notification, as per the Amendment. We believe we will make this payment in April 2005.

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.

In addition, the Company is engaged in certain legal and administrative proceedings incidental to our normal business activities and believes that these matters will not have a material adverse effect on our financial position, results of operations or cash flows.

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

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

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

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

Critical Path, Inc. was incorporated in California on February 1997. Critical Path, along with its subsidiaries (which 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 September 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.

Management continues to focus 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, raise concerns about our short-term ability to fund operations. 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 and in the third quarter of 2004 completed a rights offering. 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 will be required to find additional sources of capital through additional debt or equity financings, or both, to support our current operating activities beyond the first quarter of 2005 and to repay the $5.6 million in principal amount of outstanding 5³/4% Convertible Subordinated Notes when they become due on April 1, 2005. If we are unable to raise sufficient funds, we will have to undertake various restructuring alternatives, including reducing our operations, liquidating assets and/or seeking the protection of applicable bankruptcy laws. Our ability to incur additional indebtedness is subject to certain limitations as discussed in the section below titled “Ability to incur additional indebtedness.”

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, June 30, 2004, and September 30, 2004, our operating activities have used cash of $4.3 million, $5.7 million, $9.3 million, $12.8 million, and $3.9 million, respectively. With our history of operating losses and cash used 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. As of September 30, 2004, we had cash and cash equivalents totaling $20.2 million, of which $10.1 million was located in accounts outside the United States and which is not generally available for our domestic operations. Accordingly, our readily available cash resources in the United States as of September 30, 2004 were $10.1 million. In August 2004, we completed our rights offering which provided additional gross proceeds of $4.0 million of cash to support our domestic operations. Additionally, we are undertaking efforts to reduce our operating expenses and cost of revenues 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 will be required to find additional sources of capital through additional debt or equity financings, or both, to support our current operating activities beyond the first quarter of 2005 and to repay the $5.6 million in principal amount of outstanding 5³/4% Convertible Subordinated Notes when they become due on April 1, 2005. If we are unable to raise sufficient funds, we will have to undertake various restructuring alternatives, including reducing our operations, liquidating assets and/or seeking the protection of applicable bankruptcy laws. Our ability to incur additional indebtedness is subject to certain limitations as discussed in the section below titled “Ability to incur additional indebtedness.”

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 first quarter of 2005. However, because the rights offering raised less than anticipated, if we are unable to secure additional financing we cannot be certain that we will be able to continue our current operations beyond the first quarter of 2005 and repay the $5.6 million in principal amount of outstanding 5³/4% Convertible Subordinated Notes when they become due on April 1, 2005. If we are unable to raise sufficient funds, we will have to undertake various restructuring alternatives including reducing our operations, liquidating assets and/or seeking the protection of applicable bankruptcy laws.

During the three months ended September 30, 2004 we had no borrowings under the credit facility because the borrowing availability had been eliminated and we were required to cash collateralize our letters of credit, totaling approximately $2.7 million. For additional information with respect to the credit facility, see Note 7 of Notes to Unaudited Condensed Consolidated Financial Statements.

In addition to our recent restructuring activities, we are also pursuing raising additional capital, and 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. However, we do not expect to be able to gain access to cash held by our foreign subsidiaries through this restructuring in the near term. We have 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 in January and March 2004 and the cash raised through our rights offering partially offset by cash used to support our operating and investing activities.

Our operating activities used $25.9 million of cash during the nine months ended September 30, 2004. This cash was used to support our net loss, adjusted for non-cash items (such as depreciation and amortization of $7.3 million, changes in the value of a preferred stock instrument of $(9.2) million, stock based expenses of $1.6 million, amortization related to our preferred stock of $3.9 million, $12.8 million loss on the extinguishment of debt and $2.2 million of non-cash related restructuring charges), of $26.7 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 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:

DSOs increased primarily as a result of the increasing proportion of revenue from customers outside the United States to whom we generally offer payment terms customary to the region in which the customers are located. These terms are typically longer than the payment terms offered to customers in the United States.

A number of non-cash items have been charged to expense and impacted our net losses during the nine months ended September 30, 2004. These items include depreciation and amortization of property and equipment, amortization of unearned stock-based compensation and other stock-based compensation charges, changes in the value of a preferred stock instrument, amortization related to our preferred stock and losses on the extinguishment of debt from the conversion to equity instruments. 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 our operating results, our ability to collect our accounts receivable on an efficient basis and timing of payments to our vendors for accounts payable.

We 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 $4.9 million of cash during the nine months ended September 30, 2004 primarily as a result of purchases of equipment used to support hosted messaging operations infrastructure and the cash used to collateralize our letters of credit $2.7 million for certain facility leases. As of September 30, 2004, we had no commitments for capital equipment purchases. To the extent we require capital equipment, we expect to fund these purchases through the use of our available cash resources or through leasing arrangements if available on terms we find acceptable.

Our financing activities provided $32.1 million of cash during the nine months ended September 30, 2004 primarily as a result of the net proceeds from the issuance of $30.2 million 10% senior convertible notes in January and March 2004, $4.0 million in proceeds from our rights offering in August 2004 and $1.0 million of proceeds from the issuance of our common stock through a combination of employee stock option exercises and activities under our employee stock purchase plan (ESPP) partially offset by $2.3 million of payments on our line of credit facility and $0.7 of payments on our capital equipment leases.

We receive cash from the exercise of stock options and the sale of stock under our ESPP. 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. At a special meeting in July 2004, the Company received approval from its shareholders to convert the Senior Notes plus all accrued and unpaid interest, into Series E convertible preferred stock at $1.50 per share. As a result of the conversion, there was no outstanding principal or interest outstanding related to the Senior Notes at September 30, 2004.

In November 2003, we 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, we received shareholder approval for this transaction. As a result of the conversion, a non-cash charge of $12.8 million 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, was recorded as of the date of the exchange as loss on extinguishment of debt in the statement of operations.

At September 30, 2004, the total balance of the remaining Subordinated Notes outstanding was $5.6 million and the Company had interest payable of $0.2 million. The Subordinated Notes are carried at cost and at September 30, 2004, had an approximate fair value of $4.3 million.

On August 2, 2004, we consummated a rights offering pursuant to which we issued 2.6 million shares of Series E Preferred Stock with a purchase price of $1.50 per share, representing approximately $4.0 million in gross proceeds excluding underwriter discounts and commissions and other costs incurred in connection with the rights offering.

Under the terms of our line of credit, we are required to obtain the consent of Silicon Valley Bank to incur additional indebtedness. Additionally, under the terms of the Series D preferred stock, we must seek the consent of the holders of a majority of our Series D preferred stock 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 September 30, 2004, we had 336 employees as compared to 418 employees at December 31, 2003 and 419 employees at September 30, 2003. We do not believe that our historical fluctuations in revenues, expenses, or personnel are indicative of future results. In the Company’s press release and Form 8-K dated October 28, 2004, the Company reported a net loss attributable to common shareholders of $29.0 million and $54.6 million for the three and nine months ended September 30, 2004 , respectively. These reported results differ from the results reported in this Form 10-Q primarily as a result of accretion of the redemption value of the Amended Series D preferred stock. The correct net loss attributable to common shareholders for the three and nine months ended September 30, 2004 is $30.1 million and $55.6 million, respectively.

The following table sets forth our results of operations for the three and nine months ended September 30, 2003 and 2004.

We derive most of our revenues from our messaging and identity management communications solutions. These solutions include both licensed software products and hosted messaging services and related professional services consulting and maintenance and support. In addition, we derive revenue from the resale of third party software. 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 increased during the three months ended September 30, 2004 as compared to the three months ended September 30, 2003 primarily as a result of increased revenue from the licensing of our messaging solutions and third party software and increased revenue from our professional services. Total net revenues decreased during the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003 primarily as a result of decreased revenue from the sale of our hosted messaging solutions partially offset by increased revenue from the sale of maintenance contracts and support services.

Our international revenues accounted for approximately 71% and 68% of net revenues during the three and nine months ended September 30, 2004, respectively, as compared to 58% and 60% during the three and nine months ended September 30, 2003, respectively.

We expect that revenue in the three months ending December 31, 2004 will be in line with or greater than revenues for the three months ended September 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 the recognition of revenue from T-Mobile for whom we have been deferring revenue recognition on a project that has been ongoing for a number of months.

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

due to increased employee expenses of $0.4 million partially offset by reductions in depreciation expenses of $0.2 million resulting from the write-down and completion of depreciation on certain existing fixed assets as well as period over period reductions in facilities expenses of $0.1 million. The cost of net maintenance and support revenues decreased during the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003 primarily due to reductions in depreciation expenses of $0.6 million resulting from the write-down and completion of depreciation on certain existing fixed assets partially offset by increased consulting expenses of $0.2 million. Depreciation expenses included in maintenance and support costs totaled $19,000 and $0.1 million during the three and nine months ended September 30, 2004 as compared to $0.2 million and $0.7 million during the three and nine months ended September 30, 2003. Maintenance and support staff increased to 28 employees at September 30, 2004 from 25 employees at September 30, 2003.

During the three and nine months ended September 30, 2004 our gross margins were 35% and 30%, respectively, as compared to 34% and 31% for the three and nine months ended September 30, 2003. Gross margins increased during the three months ended September 30, 2004 as compared to the three months ended September 30, 2003 primarily as a result of increased period over period revenue. Gross margins decreased for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003 primarily as a result of the decline in revenues.

We currently believe that gross margins for the three months ending 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 on-going restructuring activities 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 nine months ended September 30, 2004 as compared to the same periods ended September 30, 2003 primarily due to period over period reductions in depreciation expenses of $0.3 million and $1.2 million resulting from the write-down and completion of depreciation on certain existing fixed assets as well as cost savings generated through our various restructuring initiatives, including the termination of certain employees, resulting in period over period reductions in related personnel expenses of $1.3 million and $4.4 million, the reduction of certain marketing programs costs of $0.1 million and $0.3 million, and the elimination of certain outside consulting arrangements, resulting in period over period reductions in associated consulting expenses of $0.2 million and $0.1 million. Depreciation expenses included in sales and marketing expenses totaled $0.1 million and $0.6 million during the three and nine months ended September 30, 2004 as compared to $0.5 million and $1.8 million during the three and nine months ended September 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 nine months ended September 30, 2004 as compared to the three and nine months ended September 30, 2003 primarily due to increased period over period depreciation expenses of $0.4 million and $0.9 million resulting from new capital expenditures, increased period over period employee expenses of $32,000 and $0.4 million, increased period over period facilities expenses of $0.3 million and $0.4 million, and, during the nine months ended September 30, 2004, increased consulting expenses of $0.7 million. Depreciation expenses included in research and development expenses totaled $1.1 million and $2.9 million during the three and nine months ended September 30, 2004 as compared to $0.8 million and $2.0 million during the three and nine months ended September 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 decreased during the three and nine months ended September 30, 2004 as compared to the same periods ended September 30, 2003 primarily due to period over period reductions in depreciation expenses of $0.2 million and $0.6 million resulting from the write-down and completion of depreciation on certain fixed assets as well as cost savings generated through our various restructuring initiatives, including the consolidation of facilities, resulting in period over period reductions in associated facilities costs of $0.5 million and $0.9 million, and the termination of certain employees, resulting in period over period reductions in related personnel expenses of $0.2 million and $0.7 million. These reductions were partially offset by an accrual for past-due state and local business taxes of $0.4 million and $1.2 million, increased outside service expenses of $0.4 million and $0.3 million, and, during the nine months ended September 30, 2004, a one-time charge of $0.6 million in connection with the severance agreement with our former chief executive officer in the second quarter of 2004. Depreciation expenses included in general and administrative expenses totaled $0.1 million and $0.4 million during the three and nine months ended September 30, 2004 as compared to $0.3 million and $1.0 million during the three and nine months ended September 30, 2003.

We expect that our selling and marketing, research and development and general administrative expenses may decrease for the three month period ending December 31, 2004 as a result of our on-going restructuring activities and 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 third parties. Stock-based expenses increased to approximately $0.3 million and $1.6 million during the three and nine months ended September 30, 2004 as compared to $0 and $59,000 during the three and nine months ended September 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 $0.3 million and $1.6 million was allocated to operating expenses during the three and nine months ended September 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 nine months ended September 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 nine months ended September 30, 2004 we recorded $2.6 million and $5.0 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 short-term and long-term cash requirements. These activities included the reduction of fixed costs through the restructuring of contracts, consolidation of certain activities to offices in Toronto, Canada and Dublin, Ireland from higher cost areas such as the San Francisco Bay area and the elimination of approximately 20% of employee positions and use of third party contractors. This effort began in August 2004 and is expected to continue into the fourth quarter of 2004. As a result, we expect to record additional restructuring charges during the three months ending December 31, 2004. During the three months ended September 30, 2004, we recorded restructuring charges related to these activities totaling $2.6 million consisting primarily of $2.1 million for employee severance costs and $0.5 million of costs related to the closure or consolidation of certain facilities and operations. In September 2004, we received a courtesy notice (the Notice) from the landlord of our headquarters facility in San Francisco, California notifying us that the landlord had found a new tenant for our offices located at 350 The Embarcadero per the landlords substitution right in the First Amendment to Lease between SRI Hills Plaza Venture, LLC and Critical Path, Inc. (the Amendment). Per the schedule provided in the Notice, we are to receive formal notification on December 1, 2004 that we are to vacate our facilities at 350 The Embarcadero and move into new office space provided for us at 2 Harrison Street, Suite #200 no later than April 1, 2005. In connection with the landlord’s substitution right and our relocation, we will be required to make certain lease termination payments totaling approximately $1.3 million, which will be recorded as a restructure charge in the period in which we receive formal notification, as per the Amendment. We expect to make this payment in April 2005.

Other income (expense), net consists primarily of 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 consists primarily of interest earnings on cash, cash equivalents and short-term investments. Interest income was flat during the three and nine months ended September 30, 2004 as compared to the three and nine months ended September 30, 2003 on relatively consistent cash balances available for investing.

Interest expense consists primarily of the interest expense and amortization of issuance costs related to our 10% Senior Convertible Notes issued in November 2003, January, 2004, and March 2004, 5³/4% Convertible Subordinated Notes issued in March 2000, interest and fees on our line of credit facility with Silicon Valley Bank, and interest on certain capital leases.

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

Loss on extinguishment of debt is a non-cash charge taken in connection with the conversion of approximately $32.8 million of convertible notes payable into 21.9 million shares of Series E preferred stock. See Note 4, “5³/4% Convertible Subordinated Notes,” in the Notes to Unaudited Condensed Consolidated Financial Statements for additional information with respect to our loss on extinguishment of debt.

Our provision for income taxes decreased during the three months ended September 30, 2004 as compared to the three months ended September 30, 2003 and increased during the nine months ended September 30, 2004 as compared to the nine months ended September 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 a 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.

In July 2004, at our special meeting, shareholders approved proposals to amend and restate the certificate of determination of preferences of Series D preferred stock (the Amended Series D) and convert $45.5 million of principal and accrued interest on our Senior Notes and convert $32.8 million of convertible notes payable into shares of Series E preferred stock. At issuance, the Series E preferred stock issued in exchange for the Senior Notes was deemed to have a beneficial conversion feature totaling $16.3 million. This amount was recorded as a reduction of the carrying amount of Series E preferred stock and will accrete over the term of the Series E preferred stock. We also had to record as a reduction to the carrying value of the Amended Series D, the dividends which had accrued on the old Series D preferred stock totaling approximately $12.2 million. This amount was recorded as a reduction of the carrying amount of the Amended Series D and will accrete over the term of the Amended Series D preferred stock. Additionally, our Amended Series D and new Series E preferred stock accrued dividends at a rate of 5 3/4 %. See Notes 4 and 8 in the Notes to Unaudited Condensed Consolidated Financial Statements for additional information with respect to our accretion on redeemable preferred stock.

During the three and nine months ended September 30, 2004, the accretion on redeemable convertible preferred shares totaled $4.2 million and $10.7 million, respectively, comprised of $2.8 million and $5.3 million, respectively, in accrued dividends, and accretion of $1.4 million and $5.4 million, respectively. During the three and nine months ended September 30, 2003, the accretion on redeemable convertible preferred shares totaled $3.0 million and $9.5 million, respectively, comprised of $1.5 million and $3.7 million, respectively, in accrued dividends and accretion of $1.5 million and $5.8 million, respectively.

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

In March 2004, the EITF reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-01”), 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. In September 2004, the EITF delayed the effective date for the recognition and measurement guidance previously discussed under EITF 03-01 as included in paragraphs 10-20 of the proposed statement. The proposed statement will clarify the meaning of other-than-temporary impairment and its application to investments in debt and equity securities, in particular investments within the scope of FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and investments accounted for under the cost method. We are currently evaluating the effect of this proposed statement on our financial position and results of operations.

We will need to raise additional capital and/or initiate other significant operational strategies in order to continue our operations.

We believe that our existing capital resources will not be sufficient to maintain our current operations beyond the first quarter of 2005 and to repay the $5.6 million of principal amount of 5³/4% Convertible Subordinated Notes due April 1, 2005. Accordingly, it is necessary for us to complete a financing or other strategic transaction in order to continue our current operations beyond that time. If we are unable to raise sufficient funds or complete a strategic transaction in the near future, we will have to undertake various restructuring alternatives, including reducing our operations, liquidating assets and/or seeking the protection of applicable bankruptcy laws, in which event our common stock is likely to have little or no value. Such a financing or strategic transaction may not be available in sufficient amounts or on terms acceptable to us. Even if we are able to obtain additional financing in the near term, we may be required to raise additional funds in the future or restructure our operations particularly if we are unable to generate positive cash flow as a result of our operations.

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. We have recently made plans to move portions of our currently outsourced data operations in-house and to other service providers in order to lower costs and improve service. If we are not able to successfully transition these operations, or if we encounter delays or difficulties in the transition of operations to other facilities or personnel, we may fail to fully realize any anticipated cost savings or efficiencies.

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

We are evaluating our internal controls systems in order to allow management to report on, and our Registered Public Accounting Firm to attest to, our internal controls for our annual report for the year ended December 31, 2004 required 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 significant 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. We are focusing 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. We have incurred, and expect in the future to incur, additional expenses and diversion of management’s time as a result of performing the system and process evaluation testing and remediation in order to

comply with the management certification and auditor attestation requirements. We believe it is likely that significant deficiencies will be identified or that we will be unable to complete all of our testing and any remediation, either of which may prevent compliance with the requirements of Section 404 of the Sarbanes-Oxley Act and the SEC rules promulgated under it. If our management or auditors determine that our controls are not effective as defined in Section 404, investors may lose confidence in our internal control or we may become subject to regulatory sanctions or investigations, which could harm our operating results and the market price of our common stock.

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 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 September 30, 2004, approximately $10.1 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 and is therefore unavailable for our operating activities.

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, (iii) maintaining a minimum market value of our common stock of $15 million, and (iv) maintaining a minimum closing bid price per share of $1.00. On September 9, 2004, 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. Even if we are able to regain compliance with the closing bid price requirement for continued listing, as a result of a reverse stock split or otherwise, we may nevertheless be unable to comply with this or the other quantitative maintenance criteria or any of the Nasdaq National Market’s listing requirements or other rules, or other markets listing requirements to the extent our stock is listed elsewhere, in the future. For example, recently the market value of our common stock has fallen below the required $15 million for several consecutive days. 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 November 9, 2004, there were 4,102,355 shares of series D preferred stock outstanding, which were convertible into approximately 46.7 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 53.3 million shares of Series E preferred stock, which are convertible as of November 9, 2004, at the option of the holders, into approximately 54.3 million 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 as of November 9, 2004, convertible into approximately 2.7 million 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 21.4 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 $85.4 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 November 9, 2004, would result in an aggregate liquidation preference of approximately $70.0 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 will 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.

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 nine months ended September 30, 2004, we incurred stock-based compensation expense of $0.3 million and $1.6 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, 2003, and 2004, 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. For example, we depend on a broad acceptance of our software and outsourced messaging services on the part of potential resellers and partners. 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. 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 third quarter of 2004, our top ten customers accounted for approximately 39% 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 September 30, 2004, accounted for approximately 55% 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 36. 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. In 2004, we expanded our restructuring activities in an effort to reduce both short-term and long-term cash requirements. These activities included the reduction of fixed costs through the restructuring of contracts, consolidation of certain activities to offices in Toronto, Canada and Dublin, Ireland from higher cost areas such as the San Francisco Bay area and the elimination of approximately 20% of employee positions and reduced use of third party contractors. 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 68% of our revenues from international sales in 2002, 2003 and the nine months ended September 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 25.5% of our outstanding securities (which represents approximately 18.6% of the voting power) and the Cheung Kong Investors beneficially own approximately 22.6% 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 have the right to nominate 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 third quarter of 2004, the closing sale prices of our common stock on the

Nasdaq National Market ranged from $0.59 on September 27, 2004 to $1.33 on July 1, 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 at September 30, 2004. The value of theinstrument 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 September 30, 2004, we had cash and cash equivalents of $20.2 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 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 significant 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. We are focusing 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. We have incurred, and expect in the future to incur, additional expenses and diversion of management’s time as a result of performing the system and process evaluation, testing and remediation in order to comply with the management certification requirements. We believe it is likely that sufficient deficiencies will be identified or that we will be unable to complete all of our testing and any remediation either of which may prevent compliance with the requirements of Section 404 of the Sarbanes-Oxley Act and the SEC rules promulgated under it. If our management or auditors determine that our controls are not effective as defined in Section 404, investors may lose confidence in our internal control and we may become subject to regulatory sanctions or investigations, which could harm our operating results and the market price of our common stock.

We are a party to lawsuits in the normal course of our 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 fraudulent transaction with Peregrine that was 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 operative complaint alleges causes of action against us for fraud and deceit, violations of California Corporations Code provisions regarding aiding and abetting securities fraud, 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. Our other contractual obligations total approximately $5.2 million at September 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 $2.4 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.

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 5³/4% 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 and August 11, 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 a total of 86,232 shares of Series D preferred stock for 829,873 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.

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.

On October 29, 2004, we entered into a severance agreement with Tracy Currie regarding the termination of his employment on January 2, 2005. This agreement restates Mr. Currie’s right to receive $125,000 severance pay, representing six months’ salary, as provided in his existing employment contract less $13,000 for money owed to us. The agreement also grants Mr. Currie 20,000 shares of restricted stock, provided that he successfully transitions his responsibilities to others by his termination date as determined by our chief executive officer. The agreement restates that Mr. Currie has a 90-day period in which to exercise all stock options, as provided in his employment contract. Mr. Currie also executed a release of all claims against us.

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
	Condensed Consolidated Statement of Shareholders’ Equity (Deficit)	4
	Notes to Unaudited Condensed Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	43
Item 4.	Controls and Procedures	44

PART II
Item 1.	Legal Proceedings	45
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	47
Item 4.	Submission of Matters to a Vote of Security Holders	48
Item 5.	Other Information	50
Item 6.	Exhibits and Reports on Form 8-K	50
	Signature	52


	December 31, 2003			September 30, 2004
	(In thousands, except share and per share amounts; unaudited)
ASSETS
Current assets
Cash and cash equivalents	$	18,984		$	20,152
Accounts receivable, net		16,880			15,730
Prepaid and other current assets		4,664			5,919

Total current assets		40,528			41,801
Property and equipment, net		14,821			10,085
Goodwill		6,613			6,613
Restricted cash		—			2,702
Other assets		5,763			3,599

Total assets	$	67,725		$	64,800

LIABILITIES, MANDATORILY REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS’ DEFICIT
Current liabilities
Accounts payable	$	5,022		$	4,877
Accrued liabilities		20,755			22,676
Deferred revenue		8,856			9,925
Line of credit facility		2,298			—
Capital lease and other obligations, current		1,721			1,310
Convertible notes payable, current		—			5,565

Total current liabilities		38,652			44,353
Deferred revenue		1,343			1,249
Convertible notes payable		48,376			—
Embedded derivative liability		24,890			2,092
Capital lease and other obligations, long-term		1,295			64

Total liabilities		114,556			47,758

Commitments and contingencies (Note 10)
Mandatorily redeemable preferred stock, par value $0.001
		30,411			118,621

Shareholders’ deficit
Common stock and paid-in-capital, par value $0.001
Shares authorized: 200,000,000
Shares issued and outstanding: 21,078 and 22,561		2,154,295			2,177,914
Common stock warrants		5,947			5,947
Notes receivable from shareholders		(870	)		—
Unearned compensation		—			(1,352	)
Accumulated deficit		(2,238,728	)		(2,283,947	)
Accumulated other comprehensive income (loss)		2,114			(141	)

Total shareholders’ deficit		(77,242	)		(101,579	)

Total liabilities, mandatorily redeemable preferred stock and shareholders’ deficit	$	67,725		$	64,800


	Three months ended September 30,						Nine months ended September 30,
	2003			2004			2003			2004
	(In thousands, except per share amounts; unaudited)
Net revenues
Software license	$	4,264		$	4,744		$	14,903		$	14,403
Hosted messaging		4,583			4,621			14,825			12,675
Professional services		2,574			3,092			8,949			8,687
Maintenance and support		4,744			5,038			13,658			15,825

Total net revenues		16,165			17,495			52,335			51,590

Cost of net revenues
Software license		541			1,322			3,060			3,941
Hosted messaging		6,196			5,995			19,562			18,946
Professional services		2,734			2,667			9,094			8,796
Maintenance and support		1,263			1,422			4,579			4,193
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

Total cost of net revenues		10,734			11,406			36,312			36,056

Gross profit		5,431			6,089			16,023			15,534

Operating expenses
Sales and marketing		7,150			5,242			24,390			18,216
Research and development		4,608			5,260			14,044			16,383
General and administrative		3,228			2,854			9,774			9,746
Stock-based expense — Sales and marketing		—			—			18			45
Stock-based expense — Research and development		—			—			15			18
Stock-based expense — General and administrative		—			308			9			1,498
Restructuring and other expenses		953			2,590			5,034			4,799

Total operating expenses		15,939			16,254			53,284			50,705

Loss from operations		(10,508	)		(10,165	)		(37,261	)		(35,171	)
Other income (expense), net		(4,049	)		(2,781	)		(7,151	)		7,448
Interest income		105			125			306			297
Interest expense		(852	)		(467	)		(2,404	)		(4,112	)
Loss on extinguishment of debt		—			(12,783	)		—			(12,783	)
Gain on investments, net		—			—			349			—

Loss before income taxes		(15,304	)		(26,071	)		(46,161	)		(44,321	)
Provision for income taxes		(273	)		(88	)		(754	)		(900	)

Net loss		(15,577	)		(26,159	)		(46,915	)		(45,221	)
Accretion on mandatorily redeemable preferred stock		(3,025	)		(4,193	)		(9,529	)		(10,689	)

Net loss attributable to common shareholders	$	(18,602	)	$	(30,352	)	$	(56,444	)	$	(55,910	)

Net loss per share attributable to common shareholders — basic and diluted	$	(0.92	)	$	(1.43	)	$	(2.84	)	$	(2.65	)

Weighted average shares — basic and diluted		20,126			21,171			19,889			21,075


	Nine months ended September 30,
	2003			2004
	(in thousands; unaudited)
Cash flow from operating activities:
Net loss	$	(46,915	)	$	(45,221	)
Recovery of doubtful accounts		(136	)		(87	)
Depreciation and amortization		13,045			7,306
Stock-based costs and expenses		59			1,566
Change in fair value of preferred stock instrument		11,480			(5,297	)
Amortization of non-cash interest expense		—			100
Gain on sale of investments, net		(349	)		—
Gain on release of funds held in escrow		(3,750	)		—
Gain on fixed asset disposals		—			(19	)
Forgiveness of notes receivable		—			171
Restructuring charges — non-cash		530			2,166
Loss on extinguishment of debt		—			12,783
Change in operating assets/liabilities
Accounts receivable		8,055			(1,191	)
Other assets		(1,466	)		(1,548	)
Accounts payable		(5,297	)		(39	)
Accrued liabilities		(1,336	)		2,235
Deferred revenue		(3,134	)		1,139

Net cash used in operating activities		(29,214	)		(25,936	)

Cash flow from investing activities:
Notes receivable from officers		132			240
Property and equipment purchases		(10,549	)		(2,448	)
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			(2,702	)

Net cash provided by (used in) investing activities		7,808			(4,910	)

Cash flow from financing activities:
Proceeds from issuance of convertible notes, net		—			30,165
Proceeds from rights offering		—			3,965
Proceeds from issuance of common stock, net		985			1,010
Proceeds from (payments on) line of credit facility		4,900			(2,299	)
Principal payments on note and lease obligations		(644	)		(721	)

Net cash provided by financing activities		5,241			32,120

Net change in cash and cash equivalents		(16,165	)		1,273
Effect of exchange rates on cash and cash equivalents		914			(106	)
Cash and cash equivalents at beginning of period		33,498			18,984

Cash and cash equivalents at end of period	$	18,247		$	20,152


	Three months ended September 30,						Nine months ended September 30,
	2003			2004			2003			2004
	(in thousands; except per share amounts)
Net loss attributable to common shares — as reported	$	(18,602	)	$	(30,352	)	$	(56,444	)	$	(55,910	)
Add:
Stock-based employee compensation expense included in reported net loss attributable to common shares, net of related tax effects		—			308			59			1,566
Deduct:
Total stock-based employee compensation expense determined under a fair value based method for all grants, net of related tax effects		(4,366	)		(1,188	)		(9,505	)		(6,670	)

Net loss attributable to common shareholders — pro forma	$	(22,968	)	$	(31,232	)	$	(65,890	)	$	(61,014	)

Basic and diluted net loss per share attributable to common shareholders — as reported	$	(0.92	)	$	(1.43	)	$	(2.84	)	$	(2.65	)

Basic and diluted net loss per share attributable to common shareholders — pro forma	$	(1.14	)	$	(1.48	)	$	(3.31	)	$	(2.90	)


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


								Shareholders' deficit
	Mandatorily redeemable preferred stock							Common stock and additional paid in capital			Common stock warrants		Notes receivable from shareholders			Unearned compensation			Accumulated deficit and other comprehensive income (loss)			Total
	Series D			Amended Series D		Series E		Common stock and additional paid in capital			Common stock warrants		Notes receivable from shareholders			Unearned compensation						Total
	(in thousands; unaudited)
Balance at December 31, 2003	$	30,411		$	—	$	—	$	2,154,295		$	5,947	$	(870	)	$	—		$	(2,236,614	)	$	(77,242	)
Conversion of Series D preferred stock to Amended Series D and Series E preferred stock		(37,276	)		56,356		1,244		(2,490	)		—		—			—			—			(2,490	)
Accretion of dividend on mandatorily redeemable preferred stock		2,948			891		1,068		(4,907	)		—		—			—			—			(4,907	)
Accretion to redemption value of mandatorily redeemable preferred stock		3,917			667		971		(5,555	)		—		—			—			—			(5,555	)
Issuance of Series E preferred stock upon conversion of notes payable and accrued interest, net of issuance costs of $4,616		—			—		57,424		28,798			—		—			—			—			28,798
Common stock issued under Employee Stock Purchase Plan		—			—		—		230			—		—			—			—			230
Exercise of stock options and warrants		—			—		—		780			—		—			—			—			780
Proceeds from issuance of Series E preferred stock rights offering		—			—		—		3,965			—		—			—			—			3,965
Issuance of restricted stock		—			—		—		1,929			—		—			—			—			1,929
Issuance of warrants to purchase common stock		—			—		—		344			—		—			—			—			344
Stock-based compensation related to stock options		—			—		—		66			—		—			—			—			66
Lapse of early exercise repurchase rights		—			—		—		459			—		—			—			—			459
Reclassification of vested portion of shareholder notes		—			—		—		—			—		(145	)		—			—			(145	)
Forgiveness of shareholder note		—			—		—		—			—		1,015			—			—			1,015
Unearned compensation related to grants of restricted stock		—			—		—		—			—		—			(1,622	)		—			(1,622	)
Amortization of unearned compensation		—			—		—		—			—		—			270			—			270
Foreign currency translation adjustments		—			—		—		—			—		—			—			(2,253	)		(2,253	)
Net loss		—			—		—		—			—		—			—			(45,221	)		(45,221	)

Balance at September 30, 2004	$	—		$	57,914	$	60,707	$	2,177,914		$	5,947	$	—		$	(1,352	)	$	(2,284,088	)	$	(100,641	)


	Three months ended September 30,				Nine months ended September 30,
	2003		2004		2003		2004
Risk free interest rate	1.7	%	3.1	%	1.7 -3.0	%	2.4 - 3.5	%
Expected lives (in years)	4.0		4.0		4.0		4.0
Dividend yield	0.0	%	0.0	%	0.0	%	0.0	%
Expected volatility	141.1	%	135.4	%	97.8 - 141.1	%	119.6 -138.5	%


	Workforce reductions			Facility and operations consolidation and other charges			Total
	(in thousands)
Beginning accrual balance at December 31, 2003	$	249		$	521		$	770
Restructure charge		3,869			1,105			4,974
Cash payments		(2,927	)		(401	)		(3,328	)
Non-cash credits		—			(353	)		(353	)

Ending balance at September 30, 2004	$	1,191		$	872		$	2,063


	Senior notes						Converted into shares of Series E preferred stock
	Principal		Accrued interest		Total		Converted into shares of Series E preferred stock
	(in thousands)
General Atlantic Investors	$	10,000	$	628	$	10,628	7,333
January 2004 Investors		15,000		729		15,729	10,483
March 2004 Investors		18,500		627		19,127	12,748

	$	43,500	$	1,984	$	45,484	30,564


Series E preferred stock	$	79,621
Less: Issuance costs		(4,616	)

Series E preferred stock, net of issuance costs		75,005
Less amounts allocated to:
Beneficial conversion feature		(16,337	)
Add amortization and accretion		2,039

Carrying value of Series E preferred stock at September 30, 2004	$	60,707


	December 31, 2003		September 30, 2004		Increase /(decrease)
	December 31, 2003		September 30, 2004		$		%
	(in thousands)
Cash and cash equivalents	$	18,984	$	20,152	$	1,168	6.2	%


	Three months ended September 30,						Increase/ (decrease)					Nine months ended September 30,						Increase/(decrease)
	2003			2004			$			%		2003			2004			$			%
	(In thousands, except % increase/(decrease) and per share amounts; unaudited)
Net revenues
Software license	$	4,264		$	4,744		$	480		11	%	$	14,903		$	14,403		$	(500	)	-3	%
Hosted messaging		4,583			4,621			38		1	%		14,825			12,675			(2,150	)	-15	%
Professional services		2,574			3,092			518		20	%		8,949			8,687			(262	)	-3	%
Maintenance and support		4,744			5,038			294		6	%		13,658			15,825			2,167		16	%

Total net revenues		16,165			17,495			1,330		8	%		52,335			51,590			(745	)	-1	%

Cost of revenues
Software license		541			1,322			781		144	%		3,060			3,941			881		29	%
Hosted messaging		6,196			5,995			(201	)	-3	%		19,562			18,946			(616	)	-3	%
Professional services		2,734			2,667			(67	)	-2	%		9,094			8,796			(298	)	-3	%
Maintenance and support		1,263			1,422			159		13	%		4,579			4,193			(386	)	-8	%
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 and other expenses		—			—			—		—			—			175			175		—

Total cost of revenues		10,734			11,406			672		6	%		36,312			36,056			(256	)	-1	%

Gross profit		5,431			6,089			658		12	%		16,023			15,534			(489	)	-3	%

Operating expenses
Sales and marketing		7,150			5,242			(1,908	)	-27	%		24,390			18,216			(6,174	)	-25	%
Research and development		4,608			5,260			652		14	%		14,044			16,383			2,339		17	%
General and administrative		3,228			2,854			(374	)	-12	%		9,774			9,746			(28	)	—
Stock-based expense — Sales and marketing		—			—			—		—			18			45			27		150	%
Stock-based expense — Research and development		—			—			—		—			15			18			3		20	%
Stock-based expense — General and administrative		—			308			308		—			9			1,498			1,489		16,544	%
Restructuring and other expenses		953			2,590			1,637		172	%		5,034			4,799			(235	)	-5	%

Total operating expenses		15,939			16,254			315		2	%		53,284			50,705			(2,579	)	-5	%

Loss from operations		(10,508	)		(10,165	)		(343	)	-3	%		(37,261	)		(35,171	)		(2,090	)	-6	%
Other income (expense), net		(4,049	)		(2,781	)		(1,268	)	-31	%		(7,151	)		7,448			14,599		204	%
Interest income		105			125			20		19	%		306			297			(9	)	-3	%
Interest expense		(852	)		(467	)		(385	)	-45	%		(2,404	)		(4,112	)		1,708		71	%
Loss on extinguishment of debt		—			(12,783	)		12,783		—			—			(12,783	)		12,783		—
Gain on investments, net		—			—			—		—			349			—			(349	)	-100	%

Loss before income taxes		(15,304	)		(26,071	)		10,767		70	%		(46,161	)		(44,321	)		(1,840	)	-4	%
Provision for income taxes		(273	)		(88	)		(185	)	-68	%		(754	)		(900	)		146		19	%

Net loss		(15,577	)		(26,159	)		10,582		68	%		(46,915	)		(45,221	)		(1,694	)	-4	%
Accretion on mandatorily redeemable preferred stock		(3,025	)		(4,193	)		1,168		39	%		(9,529	)		(10,689	)		1,160		12	%

Net loss attributable to common shareholders	$	(18,602	)	$	(30,352	)	$	11,750		63	%	$	(56,444	)	$	(55,910	)	$	(534	)	-1	%

Net loss per share attributable to common shareholders	$	(0.92	)	$	(1.43	)	$	0.51		55	%	$	(2.84	)	$	(2.65	)	$	(0.19	)	-7	%

Weighted average shares – basic and diluted		20,126			21,171		$	1,045		5	%		19,889			21,075		$	1,186		6	%


	Three months ended September 30,									Nine months ended September 30,
					Increase/ (decrease)									Increase/ (decrease)
	2003		2004		$			%		2003		2004		$			%
	(In thousands, except % increase/(decrease) and per share amounts)
10% Senior Convertible Notes	$	—	$	113	$	113		—		$	—	$	1,979	$	1,979		—
5³/4% Convertible Subordinated Notes		556		127		(429	)	-77	%		1,653		1,225		(428	)	-26	%
Amortization of debt issuance costs		69		69		—		—			206		428		222		108	%
Line of credit facility		145		100		(45	)	-31	%		331		285		(46	)	-14	%
Capital leases and other long-term obligations		16		1		(15	)	-94	%		58		15		(43	)	-74	%
Other		66		57		(9	)	-14	%		156		180		24		15	%

Total interest expense	$	852	$	467	$	(385	)	-45	%	$	2,404	$	4,112	$	1,708		71	%


	Fiscal Year
	Total		Remainder of 2004			2005			2006		2007		2008 and Beyond
	(in thousands)
Convertible subordinated notes, including interest⁽¹⁾	$	5,885	$	160		$	5,725		$	—	$	—	$	—
Mandatorily redeemable preferred stock		187,612		—			—			—		—		187,612
Operating lease obligations		22,419		1,133			4,810	⁽³⁾		4,686		1,524		10,266
Capital lease obligations		1,293		324			880			89		—		—
Other purchase obligations⁽²⁾		10,544		7,734	⁽⁴⁾		1,634	⁽⁴⁾		1,061		115		—

	$	227,753	$	9,351		$	13,049		$	5,836	$	1,639	$	197,878


	Valuation of Borrowing Given an Interest Rate Decrease of X Basis Points						No Change in Interest Rate		Valuation of Borrowing Given an Interest Rate Increase of X Basis Points
	150 BPS		100 BPS		50 BPS		No Change in Interest Rate		50 BPS		100 BPS		150 BPS
5³/4% convertible subordinated notes	$	4,360	$	4,350	$	4,339	$	4,329	$	4,319	$	4,308	$	4,298


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



10.69		Critical Path, Inc. Amended and Restated 1998 Stock Plan Notice of Restricted Stock Award

10.70		Nonstatutory Stock Option Agreement by and between the Registrant and Mark Ferrer for grant effective March 29, 2004

10.71		Incentive Stock Option Agreement by and between the Registrant and Mark Ferrer for grant effective March 29, 2004

10.72		Restricted Stock Agreement by and between the Registrant and Mark Ferrer for grant effective March 29, 2004

10.73		Nonstatutory Stock Option Agreement by and between the Registrant and Mark Ferrer for grant effective August 16, 2004

10.74		Restricted Stock Agreement by and between the Registrant and Mark Ferrer for grant effective August 16, 2004

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

99.1		Severance Agreement and Release of Claims by and between the Registrant and Tracy Currie dated October 29, 2004.