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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the Fiscal Year Ended September 30, 2004

For the Transition Period From                      to                     

Commission File Number 0-21484

TARANTELLA, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code (831) 427-7222

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Preferred Share Purchase Rights Common Stock, no par value

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  ¨    No  x

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to contained to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment    ¨

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

The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the closing sale price of the Common Stock on November 30, 2004, was approximately $17,876,650.

As of November 30, 2004, registrant had 27,629,806 shares of Common Stock outstanding.

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TARANTELLA, INC.

Form 10-K

For the Fiscal Year Ended September 30, 2004

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PART I

Item 1.    Business

Forward-Looking Statements

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The forward-looking statements include, but are not limited to, statements concerning future liquidity and financing requirements, potential price erosion, plans to make acquisitions, dispositions or strategic investments, expectations of sales volume to customers, and plans to improve and enhance existing products and develop new products.

Certain information and statements contained in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of this report, including statements containing words such as “could”, “expects”, “may”, “anticipates”, “believes”, “estimates”, “plans”, and similar expressions, are forward-looking statements. The forward-looking statements of Tarantella, Inc. (also referred to as “Tarantella”, “The Company”, “we”, “us”, or “our”) are subject to risks and uncertainties. Some of the factors that could cause future results to materially differ from the recent results or those projected in the forward-looking statements include, but are not limited to, significant increases or decreases in demand for our products, increased competition, lower prices and margins, changes in customer buying patterns, failure to successfully develop and market new products and technologies, competitor introductions of superior products, continued industry consolidation, instability and currency fluctuations in international markets, product defects, failure to secure intellectual property rights, results of litigation, failure to retain and recruit key employees, adverse economic conditions, ability to carry forward certain deferred tax benefits, acts of war or global terrorism, and unexpected natural disasters.

Actual results could differ materially from those projected in the forward-looking report and those described in other reports under the Securities Exchange Act of 1934. Readers are referred to the “Sales Channels, Marketing and Distribution,” “Technical Support and Services,” “Research and Development,” “Competitive Strengths,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and sections contained in this Annual Report on Form 10-K, which identify some of the important factors or events that could cause actual results of performances to differ materially from those contained in the forward-looking statements.

We undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-K.

Available Information

Our website is http://www.tarantella.com. Through a link on the Investor Relations section of the website, the Company makes available the following filings as such reports become available on the Securities and Exchange Commission website: the Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Section 16 filings (Form 4) and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. The public may read and copy any materials filed with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C., 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The address of that site is http://www.sec.gov. Information contained on our website is not part of this report.

Company Background

The Company was incorporated in 1979 as a California corporation under the name The Santa Cruz Operation, Inc. (“SCO”). On May 4, 2001, SCO completed the sale of its Server Software and Professional Services Divisions to Caldera Systems, Inc., retaining the Tarantella Division. Upon the completion of the sale, SCO changed its corporate name to Tarantella, Inc.

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Tarantella is a leading provider of secure application access software to customers’ sites worldwide. Tarantella enables organizations to access and manage information, data and applications across all platforms, networks and devices. Tarantella bridges the gap between vendors and customers, ensuring that customers have complete access to business-critical information. Using Tarantella’s software, customers realize the benefits of secure corporate data, maximizing return on existing information technology (“IT”) assets and improved productivity. We market our products through the internet, key industry partnerships, and a worldwide network of consultants and resellers.

We are headquartered in Santa Cruz, California, operate development centers in the United States, the United Kingdom and India, and have sales presence in the U.S., U.K., Germany, the Netherlands, Canada, Brazil, France, Spain and Italy. We maintain exclusive distribution relationships in Japan as well as distribution and agent relationships in China, and Northern and Southeast Asia. In total, our products are available through resellers in more than 30 countries.

Our flagship product, Tarantella Secure Global Desktop^tm Enterprise Edition, a UNIX/Linux-based secure application access suite, is installed in corporations and governmental agencies around the world. We introduced Secure Global Desktop Enterprise Edition to the marketplace in 2001 as our Tarantella Enterprise 3 product.

We also offer a Windows-based application access product, Tarantella Secure Global Desktop^tm Terminal Services Edition. Terminal Services Edition is positioned as a companion to Microsoft Windows Terminal Services, and is intended for use by small to mid-sized business customers and departmental deployments with Windows-only infrastructure. Terminal Services Edition is distributed via an internet webstore as well as through our channel partners. In May 2004, we began a program offering a Terminal Services Edition user license at no fee, provided the licensee acquires two years of maintenance per user with the license. Terminal Services Edition was previously known as New Moon Canaveral iQ^tm from Tarantella^®. This product has been added to our portfolio of product offerings following our acquisition of New Moon Systems, Inc. in June 2003.

In March 2004, we acquired Caststream, Inc. and added its cast:stream^tm product to our list of offerings. cast:stream^tm is an integrated suite of applications that enable live and on-demand presentations including video and audio synchronized graphics and animation that enhances interactivity.

We also continue to offer our earlier client integration products that were introduced in the 1990s. These offerings are part of our Vision2K^tm suite of products.

Our strategy is to focus on the application access needs of Forbes Magazine Global 2000 firms and mobile service providers, and deliver purpose-built, non-invasive, non-disruptive infrastructure software solutions to meet the needs of new classes of users and applications, including new wireless applications, home information service providers and web services applications. From a sales perspective, we approach our target market through our worldwide, integrated sales process, including direct sales, channel partners and strategic alliances.

The scalability and flexibility of Secure Global Desktop Enterprise Edition in heterogeneous and demanding system architectures differentiates it from competing products. Secure Global Desktop Enterprise Edition software installs on all major UNIX and Linux platforms and delivers Windows, UNIX, Linux, Mainframe and web-based applications. Our products can also be used in place of, or to augment, Virtual Private Network (“VPN”) or extranet products. Our Secure Global Desktop Terminal Services Edition product was designed expressly as a companion to Microsoft Windows Terminal Services and is designed to satisfy the needs of small to medium-sized enterprises and departments of larger enterprises who find products such as Citrix’s Metaframe XP to be too complex and too expensive to implement. Secure Global Desktop Terminal Services Edition seamlessly installs in an organization’s existing Microsoft infrastructure to host Windows-based client software on centralized Microsoft Windows servers.

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Geographic Information

See Note 20 of Notes to Consolidated Financial Statements, “Industry and Geographic Segment Information” regarding the geographies in which we operate.

Tarantella Mission and Vision: Managed, Secure, Adaptive Application Access

We believe application access will play an increasingly prominent role in a ubiquitously wired world. As more companies find themselves with an increasingly distributed workforce, we see server-based application hosting as the most cost-effective way of delivering applications to businesses, homes and mobile users, regardless of time or location. Our mission is to become the world’s leading provider of managed, secure and adaptive application access software for Global 2000 companies and government agencies around the world.

Importance of Web-Based Application Access

Organizations today need secure, managed access to business-critical systems for employees, customers and partners. Mobile and remote worker numbers continue to grow and more companies are consolidating, often requiring diverse computer systems to work together immediately. Workers are dispersed, needing access to data from remote locations. Home workers and extended day workers require efficient, secure access to corporate data outside the office. The internet offers a cost-effective and reliable way for businesses to gain access to their data. This method, however, brings with it an urgent need for high-level security and manageability.

Data center disaster contingency plans must also allow for alternative user access modes when offices are no longer available. Valuable corporate information kept on desktops is at risk and companies need a centralized, managed business approach that is more cost-effective and secure.

Our product offerings address global enterprises’ needs for remote and mobile access, flexible business continuance plans and provide ways to cut the high costs and risks of managing distributed desktop computers. Our software suite is a powerful solution regardless of company size or platform environment.

Key Customer Benefits—Application Access and Server-Centric Computing, including:

Target Markets

Our software products provide secure access to business networks that are used by various types and sizes of companies. However, several target markets have emerged in which the Tarantella value proposition is particularly compelling, including large financial institutions, government agencies (federal, local, and defense departments), utilities and telecommunications.

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Our target customers generally employ heterogeneous or mixed information systems architectures, are often geographically dispersed with remote access requirements and are under operational pressures to reduce costs while optimizing a maximum return on assets. These companies require extremely high levels of security to protect their information assets as they provide remote access. Large companies with diverse application platforms and a widely distributed user base are an excellent fit for a Tarantella solution. The scalability and flexibility features of our software differentiate it from competitors who cannot scale to meet the demanding heterogeneous architectures of the largest enterprises.

Industry Background

We compete in the “Server-Based Computing” segment of the software industry. The core element of this market has achieved maturity in the vast majority of Fortune 1000 companies that have adopted server-based computing. However, we believe there will be continued interest in remote access solutions. Significant market drivers include an increase in wired and wireless connectivity to serve increasingly distributed users, the continuing market shift to Linux and Open Source technologies, and larger budgets as companies upgrade legacy enterprise applications. Our major competitor in this industry is Citrix Systems, Inc., who has a majority market share in the Windows-based server-based computing industry.

Competitive Strengths

The Tarantella Secure Global Desktop Enterprise Edition and Secure Global Desktop Terminal Services Edition solutions face strong competition from a range of point products from companies that include Citrix Systems, Inc., Hummingbird Ltd., and Attachmate Corporation. For example, Citrix is the market leader in providing remote access to Windows applications, while Hummingbird and Attachmate are viable competitors for UNIX and mainframes, respectively.

While each of these competitors is formidable in its own space, we offer an integrated approach, designed to meet enterprise requirements across the board. Our software solutions address the various needs of specific customer segments, regardless of company size or IT sophistication. Additionally, our products often work alongside those of our competition.

The scalability and flexibility of the solution in heterogeneous and demanding architectures differentiates Secure Global Desktop Enterprise Edition from its competitors. Our Enterprise Edition software installs on all major UNIX and Linux platforms and delivers Windows, UNIX, Linux, Mainframe and web-based applications. Our products can also be used in place of, or to augment, VPN or extranet products.

Secure Global Desktop Terminal Services Edition was designed as a companion to Microsoft Terminal Services targeted to the needs of small and medium-sized enterprises and departments of larger enterprises seeking a simple and cost-effective alternative to such products as Citrix’s Metaframe XP. Secure Global Desktop Terminal Server Edition seamlessly installs in an organization’s existing Microsoft infrastructure to host Windows-based client software on centralized Microsoft Windows servers.

Strategic Relationships

Strong industry partners augment our Tarantella enterprise value proposition.

Tarantella entered into an agreement with IBM in September 2004, pursuant to which our Tarantella Secure Global Desktop Enterprise Edition software has been accepted into the IBM Server Proven Program and is a member of the IBM Leaders for Linux program. Furthermore, pursuant to the Agreement, Tarantella is a member of IBM’s prestigious Software Vendor Logo program. IBM features Secure Global Desktop Enterprise Edition on the IBM price list for direct sales through IBM and the IBM sales representatives are compensated for selling it. We have developed several strategic marketing initiatives with IBM, and have signed distribution/partner agreements with their largest reseller in the US (Mainline Information Systems) and in Europe (Morse plc).

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Secure Global Desktop Enterprise Edition is also Sun Tone Certified, and we are a featured technology/development partner for Sun Ray, Java Desktop System, SPARC Solaris and the Java Enterprise Server. In addition, Sun Professional Services has a worldwide contract to resell licenses of Tarantella Secure Global Desktop Enterprise Edition. We also have a worldwide joint marketing agreement with Sun Microsystems and have signed distribution agreements with some of the largest Sun distributors in the world, including GE Access in the U.S., and Morse plc in the U.K.

We recently announced an OEM agreement with Novell, Inc. to bundle Novell’s SUSE Enterprise Server 9 Linux distribution with Enterprise Edition to form a “software appliance.” This software appliance will be marketed initially via OEMs, but is also expected to form the basis for new channel products such as Morse’s Secure Global Desktop for BladeCenter product.

We are a Microsoft Gold Certified ISV Partner and licensee of the Remote Desktop Protocol specification. We view Secure Global Desktop Terminal Services Edition as an important complement to Microsoft Windows Terminal Services. Terminal Services Edition completes the Terminal Services experience for end users.

In addition to IBM, Sun, Novell and Microsoft, we also have built strategic relationships with Oracle, Computer Associates and a variety of thin client vendors, such as ChipPC, eSeSix, Igel, Maxspeed, Neoware, Netvoyager, Priam, VXL, and Wyse. Our Technology Alliance Group (“TAG”) program demonstrates our dedication to forging strong alliances with these vendors, and our TAG certification ensures compatibility with either Secure Global Desktop Enterprise Edition or Secure Global Desktop Terminal Services Edition. Members of the Tarantella TAG Program include: Aventail, Sun Microsystems, Neoware, Wyse, Fujitsu Siemens, CodeWeavers, and Hewlett Packard. These strategic relationships, both new and ongoing, provide us with additional credibility and leverage in selling to the enterprise market.

Our Products

We offer a comprehensive, server-centric computing product line serving a broad cross-section of customers. This is accomplished by market bifurcation and by addressing distinct customer segments with purpose-built software solutions: Secure Global Desktop Enterprise Edition and Secure Global Desktop Terminal Services Edition. As a result, our software solutions deliver the benefits of application access and server-centric computing to organizations with the simplest computing and network environments as well as to those with the largest and most complex.

Product Offerings

Our product offerings include Tarantella’s flagship products Secure Global Desktop Enterprise Edition, and Secure Global Desktop Terminal Services Edition software products, in addition to our cast:stream suite of applications and the established Vision2K suite of products, as described below:

Secure Global Desktop Enterprise Edition

Secure Global Desktop Enterprise Edition software focuses on organizations with large, heterogeneous and complex IT environments with overriding requirements for flexibility, scalability and application and data security. Customers of Secure Global Desktop Enterprise Edition software generally have well-developed UNIX support infrastructure and capabilities. Our patented technology was designed for the internet and enterprise intranets. Our Adaptive Internet Protocol is designed to optimize the tradeoffs between bandwidth and application performance to give users the best possible experience over any speed connection.

The Tarantella architecture is based on a three-layer approach, whereby the Tarantella server sits in between the application layer (server) and the client layer (user). The non-intrusive nature of our solution allows installation in the network infrastructure without impacting existing applications or clients.

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Secure Global Desktop Enterprise Edition software provides secure, universal access to corporate applications, whether modern or legacy, including those that run on Microsoft Windows, UNIX, Linux, mainframe or midrange servers. With Secure Global Desktop Enterprise Edition software, users access applications remotely from a client device (anything from a thin client to a top-of-the-range PC) needing only a web browser (such as a current version of Microsoft Internet Explorer or Netscape Navigator), with Java technology enabled. A native client version is also available to operate without a web browser. The centralized management capabilities of Secure Global Desktop Enterprise Edition scales to accommodate rapid corporate change, technological advancement and expanding remote access needs. The product can span global multi-site IT architectures, unifying and simplifying IT complexity and diversity, providing an enhanced level of business continuity via increased application availability.

Secure Global Desktop Enterprise Edition software’s elegant, three-tier “drop-in” architecture means there is no need to modify clients, networks, applications or the servers on which they run, making the software ideal for heterogeneous platform environments and large-scale deployment scenarios. Users access all applications through a single, unified and familiar web-based interface. Global resources are opened up without increasing vulnerability, change is managed rapidly and complex IT infrastructures can be simplified without major disruption, expensive development or costly administration.

Secure Global Desktop Enterprise Edition software enables users to access business applications over the internet, without jeopardizing corporate security, affecting the end user, disrupting the existing infrastructure or requiring costly alternatives, such as a VPN. Secure Socket Layer security, encryption technology and firewall and proxy server traversal are included.

Secure Global Desktop Terminal Services Edition

Secure Global Desktop Terminal Services Edition provides server-based computing for small to mid-sized companies and departments of larger companies that primarily use Microsoft Windows operating systems and platforms in their IT infrastructure. Secure Global Desktop Terminal Services Edition’s design focus is on simple installation and deployment, ease of administration and seamless integration with a Microsoft infrastructure. Secure Global Desktop Terminal Services Edition is a simple, intelligent and cost-effective application access solution for Microsoft-based IT companies.

Secure Global Desktop Terminal Services Edition helps organizations fully leverage their investment in Microsoft infrastructure by extending the Windows Terminal Services capabilities available within Microsoft Windows Server 2000 and 2003. The software enhances Windows Terminal Services’ client experience by adding features like seamless windows, enhanced printing and file saving functionality, as well as application access through web-based browsers, Windows desktops or the Windows Start Menu. At the network level, Secure Global Desktop Terminal Services Edition enables Windows Terminal Services to more effectively scale to multiple servers and higher user counts by providing:

Secure Global Desktop Terminal Services Edition easily integrates into existing Microsoft environments, providing an affordable solution to centralize the hosting of applications, both over a local area network or to remote users.

cast:stream Suite of Applications

cast:stream provides a logical extension to our focus on remote access and communication in a distributed digital world. The cast:stream suite of applications provides users with a robust method of broadcasting digital

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presentations to an audience wherever they may be. cast:stream delivers both live and on-demand presentations including video and audio with synchronized graphics and animation that enhances interactivity. Participants remain engaged with the presenter through advanced communication and collaboration tools, such as instant messaging and real-time polling feedback.

The presenter controls the live broadcast through the cast:stream Moderator application. In addition to cueing up slides and rich media, the Moderator also provides the presenter with audience feedback and broadcast status information.

The cast:stream Server application synchronizes slides with streaming video and audio, to provide a coordinated and uninterrupted presentation for viewers.

The cast:stream Player application provides the viewer with an immersive user experience, displaying video of the presenter simultaneously with slides and rich media. The Player also allows the viewer to send text messages to the presenter and other participants in real-time during a broadcast for a fully interactive experience.

After a live broadcast is over, the cast:stream Editor application can be used to edit the broadcast for creating on-demand presentations that can be viewed online from a website or offline on a CD, DVD or hard drive.

Vision2K Suite of Products

Integrating the Windows and UNIX worlds, our established Vision2K software suite extends the power and dependability of UNIX servers to the Windows desktop environment and provides character-based and graphical user interface access to UNIX applications.

The Vision2K suite of products consists of:

Sales Channels, Marketing and Distribution

Our target customers comprise the Global 2000 and government agencies worldwide. With our current worldwide customer sites, we have developed an integrated, three-pronged sales and distribution strategy: direct, channel and web sales. Utilizing an extremely focused direct sales force, as well as enterprise distribution channels, our sales force effectively leverages value-added distributors and resellers, systems integrators, original equipment manufacturers (OEMs) and independent software vendors (ISVs). We select channel partners based on expertise, experience and access to the target markets. In most large opportunities, channel partners and our sales representatives work together on identifying, selling and closing these targeted accounts.

In addition to our enterprise sales process, we sell to small and medium-sized businesses through our PartnerConnect^tm program, with registered and associate partners primarily managed by value-added distributors. Our sales network includes the support of over 500 resellers and channel partners globally.

Finally, we use a “web store” as an alternative channel to sell licenses and support agreements for our Secure Global Desktop Terminal Services Edition. By visiting Tarantella’s web site (http://www.tarantella.com/products/) potential users can download a 30-day evaluation copy of the software, install it and decide if it meets

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their needs. If it does, by again visiting the web store, users can acquire a license key to fully enable the software when they purchase two years of maintenance for the software. After the two year maintenance period concludes, users may renew the maintenance agreement. If the user does not renew the maintenance agreement, the software remains fully enabled, but the user will no longer receive updates and revisions to the software.

We believe web-based marketing and sales can be important new tools for reaching potential users of Tarantella’s products. In addition, we promote our products in print media geared to IT professionals, as well as at trade shows and through other forms of advertising.

Our software is primarily delivered electronically via the internet or shipped to our customers on a compact disc.

Research and Development

Our product development is comprised of one integrated organization with three sites located in Santa Cruz, California; Leeds, United Kingdom; and Pune, India. We have developed or acquired skills in complex internet infrastructure areas including web-based technologies, communications, security, Java^tm technology, virtual user interfaces, networking and adaptive protocols, as well as deep expertise in Microsoft platforms such as Windows Terminal Services, Active Directory, Microsoft Windows Server 2000 and 2003, Microsoft SQL, COM, and DCOM. The combined product team has developed strong links with application server vendors, including Microsoft, IBM, Sun and Oracle, as well as with client vendors manufacturing a range of products from traditional desktop and complex workstation clients to thin clients and wireless handheld devices.

We hold seven issued U.S. patents, including “Method of Displaying an Application on a Variety of Client Devices in a Client/Server Network,” “Universal Application Server for Providing Applications on a Variety of Client Devices in a Client/Server Network,” “Network Traffic by Instruction Packet Size Reduction,” “System for Detecting of Peripheral Input Activity and Dynamically Adjusting Flushing Rate of Corresponding Output Device in Response to Detected Activity,” “System and Method for Virtualizing and Controlling I/O of Applications,” “Virtualizing and Controlling Input and Output of Computer Programs,” and “Client-Server Application Partitioning with Metering Technique for Distributed Computing.” We also have a number of patent applications pending, including “Color Quality and Packet Shaping Features for Displaying an Application on a Variety of Client Devices,” “System and Method for Dynamic Allocation of Computing Tasks,” “System and Method for Dynamic Content Allocation,” “Improved Client Server Technique for Distributed Computing,” “System and Method for Managing Access of Distributed Resources,” and “Client-Server Application Partitioning with Metering Technique for Distributed Computing.”

Tarantella devotes resources to ongoing product testing and quality assurance to support product reliability. We believe our ability to integrate product technologies, to incorporate a wide variety of standards into our products and to continue to offer enhancements to our existing products is essential to maintaining a competitive advantage in the marketplace.

Technical Support and Services

Our products are used in business-critical environments that require us to provide customer support and services that are essential to our full product offering. Our services are designed to support customers ranging from small businesses to large enterprises, both at the end user and reseller levels. We offer a variety of support programs and services through our worldwide customer support and services staff as well as through our authorized third-party education staff, support and channel partners, including:

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We sell support services to end users, generally on an annual contract basis. Options are available for customers to tailor support solutions to meet their specific needs. Electronic access to support services is available via the internet. Software updates, enhancements and bug fixes are also available electronically. We also support end users via Authorized Tarantella Service Providers. In addition, we provide support services to distributors, value added resellers, OEMs and integrators.

Employees

As of September 30, 2004, Tarantella had 100 full time equivalent employees, including 17 in product development, 50 in sales and marketing, 12 in customer support services and 21 in distribution services and administration. In addition, Tarantella employs 15 product development contractors in Pune, India.

See also Note 19 of Notes to Consolidated Financial Statements for the effect of the recent restructuring on employees.

Brief Company History

Item 2.    Properties

We occupy leased office space in the United States, the United Kingdom, Germany, Spain and Italy, consisting of an aggregate of approximately 28,000 square feet. Our office lease in Santa Cruz, California, will expire on June 30, 2005 and we are looking for other suitable facilities. We believe the remaining facilities and those we expect to move into will be adequate for our needs in the foreseeable future.

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Item 3.    Legal Proceedings

On October 29, 2004, we entered into a Settlement Agreement and General Release of all Claims with a former employee who had filed a lawsuit against us in August 2003, pursuant to which the plaintiff gave Tarantella and its officers, directors, affiliates, subsidiaries, agents, employees, attorneys, successor and assigns a full release from all claims, rights, demands, actions, obligations, liabilities, and causes of action of any and every kind, nature and character whatsoever, whether based on a tort, contract, statute, or any other theory of recovery, and whether for compensatory or punitive damages which the plaintiff may now have, has ever had, or may in the future have, arising or in any way connected with the plaintiff’s employment or contractual relationship with Tarantella, or the manner in which those relationships terminated in exchange for a settlement amount of $680,000. This amount was expensed in fiscal 2004. A Notice of Settlement was filed October 21, 2004 and a Request for Dismissal with Prejudice was filed on or around November 9, 2004 in the Superior Court of California, Santa Clara County.

No other material legal proceedings are pending to which we are a party.

Item 4.    Submission of Matters to a Vote of Security Holders

Not applicable.

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PART II

Item 5.    Market for Registrant’s Common Stock and Related Stockholder Matters

The following required information is filed as a part of this Annual Report on Form 10-K:

The Company’s common stock is currently quoted on the Over-the-Counter (“OTC”) Bulletin Board, under the symbol “TTLA.OB”. The following table sets forth the range of high and low closing sale prices for the Common Stock for the periods indicated:

On December 14, 2004, there were approximately 11,800 holders of record of Tarantella common stock, and 27,650,380 shares issued and outstanding.

The information required by this Item regarding equity compensation is incorporated by reference to the information set forth in Item 12 of this Annual Report on Form 10-K.

Dividend Policy

The Company has never declared or paid cash dividends on its capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of its business and do not anticipate paying any cash dividends in the foreseeable future.

Securities Authorized for Issuance Under Equity Compensation Plans

Securities Authorized for Issuance Under Equity Compensation Plans as of September 30, 2004

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Brief Description of Plans:

2002 Incentive Stock Option Plan.    As of September 30, 2004, we had authorized 5,802,733 shares of common stock for issuance under the 2002 Incentive Stock Option Plan (the “Option Plan”). Our board of directors administers the Option Plan and determines the terms of the options granted under the Option Plan, including the exercise price, number of shares subject to each option and the exercisability thereof. As of September 30, 2004 there were 1,059,333 shares available for issuance.

The exercise price of all incentive options granted under the Option Plan must be at least equal to the fair market value. Options granted under the Option Plan generally become exercisable over a four-year period. The term of each option is ten years.

Director Option Plan.    Our Director Option Plan, which provides for the grant of non-statutory stock options to our non-employee directors, was originally adopted by the board of directors in March 1993 and approved by the shareholders in May 1993. Our board of directors renewed the Director Option Plan in November 2002, and our shareholders voted to renew it in February 2003. We have reserved a total of 300,000 shares of common stock for issuance under the Director Option Plan. The Director Option Plan is currently administered by the board of directors. Under the Director Option Plan, each non-employee director automatically receives a non-statutory option to purchase 8,000 shares of our common stock on the date upon which such person first becomes a director (the “Initial Grant”). In addition, each non-employee director who remains in continuous status as a non-employee director is automatically granted a non-statutory option (the “Annual Grant”) to purchase 1,200 shares of common stock on the first day of each fiscal year pursuant to our Director Option Plan. As of September 30, 2004, there were 193,700 shares available for issuance under the Director Option Plan.

Our outside directors may elect to receive cash compensation in lieu of an Annual Grant. Each outside director who makes such an election shall receive cash compensation each quarter payable at a rate determined by the board. Options granted under our Director Option Plan have a term of ten (10) years unless terminated sooner upon termination of the optionee’s status as a director or otherwise pursuant to the Director Plan. Such options are not transferable by the optionee other than by will or the laws of descent or distribution, and each option is exercisable during the lifetime of the director only by such director. The exercise price of each option granted under the Director Option Plan is equal to the fair market value of the common stock on the date of grant. Initial Grant options granted under the Director Plan vest cumulatively at the rate of one-twentieth (1/20th) of the shares subject to the option for every three months after the date of grant. Annual Grant options vest at a rate of one-fourth (1/4th) of the shares subject to the option for every three months after the date of grant.

Employee Stock Purchase Plan.    We have an Employee Stock Purchase Plan (“ESPP”) for all eligible employees which is administered by our board of directors. Under the ESPP, shares of our common stock may be purchased at six-month intervals at 85% of the fair market value on the first or last day of each six-month period whichever is lower. Employees may purchase shares through payroll deductions of up to 10% of gross compensation during an offering period. During fiscal 2004, fiscal 2003 and fiscal 2002, employees purchased 49,761, 81,972 and 123,814 shares at an average per share price of $1.36, $0.72 and $1.34, respectively. The number of shares reserved for issuance under the ESPP was increased by 50,000 shares in February 2002, (as calculated on a post-reverse split basis) and by 250,000 shares in May 2004. The number of shares reserved for future issuance as of September 30, 2004 was 283,747.

2003 Stock Option Plan.    On April 2, 2003, our board of directors adopted the 2003 Stock Option Plan and authorized 200,000 shares of common stock for issuance under the plan. An additional 1,300,000 shares were added to the 2003 Stock Option Plan in December 2003. Our board of directors administers the 2003 Stock Option Plan and determines the terms of the options granted under the 2003 Stock Option Plan, including the exercise price, number of shares subject to each option and the exercisability thereof. As of September 30, 2004, there were 80,966 shares available for issuance. Options granted under the 2003 Stock Option Plan generally become exercisable over a four-year period. The term of each option is ten years.

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Recent Sales of Unregistered Securities.

Since June 2001, the Registrant has sold the following securities without registration under the Securities Act of 1933:

On June 5, 2003 we issued 1,592,014 unregistered shares of our common stock valued at $3.6 million in connection with our acquisition of all of the outstanding capital stock of New Moon Systems, Inc. and to satisfy New Moon’s obligations to the former employees of New Moon. The New Moon shareholders shall also receive a minimum cash earnout of approximately $1.7 million over a period from January 1, 2004 to December 31, 2006 based on a royalty of 30% of New Moon product revenues, net of direct costs. After the shareholders have been paid the minimum earnout, they will be entitled to an additional royalty of 15% of New Moon product revenues, net of direct costs, during this period. In the event the minimum earnout is not achieved by the conclusion of the quarter ending December 31, 2006, Tarantella shall pay along with the final earnout payment an amount equal to the minimum earnout less all aggregate earnouts paid to date, less any off-sets and any escrow claim deficiencies. We also incurred approximately $0.3 million of direct merger costs, for a total purchase price of approximately $5.7 million. Our common stock issued to the New Moon Systems shareholders in the acquisition was issued pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended, pursuant to Regulation D promulgated thereunder.

On December 9, 2003, we entered into an agreement whereby we issued 570,250 shares of our restricted and unregistered common stock at $0.93 per share to five of our senior executives and directors in lieu of a substantial portion of their calendar year 2004 cash compensation. The aggregate value of the shares issued to the executives and directors is $530,332.50, based on the market price of our common stock as of the date of the issuance. Our common stock issued to the five senior executives was issued pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended, under Section 4(2) thereof.

On January 23, 2004, we entered into an Independent Contractor Agreement whereby we issued 90,000 shares of our unregistered common stock at a value of $1.95 per share to InteSec Group LLC. InteSec will perform certain services for us in consideration for the issuance of the shares. The aggregate value of the shares issued to InteSec is $175,500, based on the market price of our common stock as of the date of the issuance. Our common stock issued to InteSec was issued pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended, under Section 4(2) thereof.

On September 30, 2003, we issued 1,950,000 unregistered shares of our common stock at a price of $1.156 per share, and warrants to purchase an additional 1,950,000 shares of our common stock at $1.395 per share. The warrants carry a five-year term. Our common stock and warrants issued to the selling shareholders were issued pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended, pursuant to Regulation D promulgated thereunder.

On December 10, 2003, we entered into a private placement transaction pursuant to which we issued 2,750,000 unregistered shares of our common stock at a price of $1.00 per share, and warrants to purchase an additional 550,000 shares of our common stock at $1.39 per share. The warrants carry a five year term. The shares and warrant shares were issued under two separate purchase agreements. Our common stock and warrants issued to the selling shareholders were issued pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended, pursuant to Regulation D promulgated thereunder.

On February 23, 2004, we completed a private placement transaction pursuant to which we issued 11,678,580 shares of our common stock at a price of $1.40 per share, and warrants to purchase an additional 2,335,716 shares of our common stock at $1.70 per share. The shares and warrant shares were issued under two separate purchase agreements. The warrants carry a five-year term. Additional warrants were issued in the February 2004 private placement as consideration for the placement agents, and are exercisable for up to 322,500 shares of our common stock at $1.70 per share, and carry a five-year term. Our common stock and warrants issued to the selling shareholders and the placement agents were issued pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended, pursuant to Regulation D promulgated thereunder.

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On March 29, 2004, we issued 140,000 unregistered shares of our common stock to Olympus Securities LLC at a price of $1.00 per share in lieu of payment of a finders fee for the December 2003 private placement. The aggregate price of the shares issued to Olympus Securities is $140,000. Our common stock issued to Olympus was issued pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended, pursuant to Regulation D promulgated thereunder.

On March 29, 2004, we acquired all of the outstanding capital stock of Caststream, Inc. in exchange for 100,000 shares of our common stock at a price of $2.27 per share, and warrants to purchase up to 100,000 shares of our common stock at a price of $2.10. Our common stock and warrants issued to the selling shareholders were issued pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended, pursuant to Regulation D promulgated thereunder.

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Item 6.    Selected Financial Data

You should read the selected financial data set forth below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. We derived the financial data for the years ended September 30, 2004, 2003 and 2002 from our audited financial statements included elsewhere in this Annual Report.

SELECTED FIVE YEAR FINANCIAL DATA

The significant change in the above selected financial data in fiscal 2001 is due to the sale of the Server and Professional Services divisions to Caldera International in May 2001. See Note 14 of Notes to Consolidated Financial Statements.

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the Company’s consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K, as well as the Management’s Discussion and Analysis of Financial Condition and Result of Operations included in this Annual Report on Form 10-K for the fiscal year ended September 30, 2004. In addition to historical information contained herein, this discussion and analysis contains forward-looking statements. These statements involve risks and uncertainties and can be identified by the use of forward-looking terminology such as “estimates,” “projects,” “anticipates,” “plans,” “future,” “may,” “will,” “should,” “predicts,” “potential,” “continue,” “expects,” “intends,” “believes,” and similar expressions. Examples of forward-looking statements include those relating to financial risk, management activities and the adequacy of financial resources for operations. These and other forward-looking statements are only estimates and predictions. While the Company (also referred to as “Tarantella,” “we,” “us,” or “our”) believes that the expectations reflected in the forward-looking statements are reasonable, our actual results could differ materially due to a number of factors, including those set forth in the section entitled “Risk Factors” and elsewhere in this Annual Report on Form 10-K. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s expectations only as of the date hereof.

Overview

We are a leading provider of internet infrastructure software that enables web-based access to enterprise applications.

Our products provide managed and secure web access to enterprise mainframe, Windows, AS/400, Linux, and UNIX applications. Our products allow businesses to leverage their existing information technology assets to provide cost savings, improved productivity, and the flexibility to accommodate the rapid changes in today’s organizations.

Applications of Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and the accompanying notes. Note 3 to the consolidated financial statements for the fiscal year ended September 30, 2004 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements for the fiscal years in the period ended September 30, 2004. The amounts of assets and liabilities reported on the balance sheets and the amounts of revenues and expenses reported for each of the fiscal periods are affected by estimates and assumptions which are used for, but not limited to, the accounting for revenue, product returns and a valuation allowance for deferred tax assets. Actual results could differ from these estimates. The following critical accounting policies are significantly affected by judgments, assumptions and estimates used in the preparation of the consolidated financial statements.

Revenue Recognition

We account for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2 Software Revenue Recognition, as amended. The application of SOP 97-2 requires judgment, including whether (i) a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists for those elements, or (ii) the end users receive certain elements of our products over a period of time. These elements include post-delivery support and the right to receive unspecified upgrades/enhancements of our products on a when-and-if-available basis. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements and the fair value of the respective elements could materially impact the amount of our earned and

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unearned revenue. Judgment is also required (i) to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products, and (ii) in our on-going evaluation of our customer’s credit worthiness at the time of sale.

New Moon and Caststream Acquisitions

In connection with the New Moon Systems, Inc. (“New Moon”) and Caststream acquisitions, we allocated the purchase price associated with each acquisition to the tangible and intangible assets acquired, liabilities assumed and in-process research and development based on their estimated fair values. We engaged two third-party appraisal firms to assist us in determining the fair values of the assets acquired and the liabilities assumed. Such valuations require us to make significant estimates and assumptions, especially with respect to intangible assets. The critical estimates we used in allocating the purchase price and valuing certain intangible assets included but were not limited to: future expected cash flows from customer contracts, acquired developed technologies and patents, expected costs to develop the in-process research and development into commercially viable products, estimated cash flows from the projects when completed, and the trade name and the market position of the acquired products and assumptions about the period of time the trade name will continue to be used in the New Moon product portfolio, and determining the appropriate discounts rates and other assumptions. Our estimate of fair value at the time when they were made is based upon assumptions that we believed to be reasonable, but which are inherently uncertain and unpredictable.

Goodwill and Other Intangible Assets

SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis and between annual tests in certain circumstances. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. We will perform the annual goodwill impairment test as of July 1^st every year to determine if there is any goodwill impairment. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for each reporting unit.

Restructuring charges

Over the last several years we have undertaken significant restructuring initiatives, which have required us to develop formalized plans for exiting certain business activities. These plans have required us to record estimated expenses for severance, lease cancellations, long-term asset write downs, and other restructuring costs. Given the significance and the timing of the execution of such activities, this process is complex and involves periodic reassessments of original estimates. Our policies, as supported by current authoritative guidance, require us to continually evaluate the adequacy of the remaining liabilities under our restructuring activities. As we continue to evaluate the business, there may be additional charges for new restructuring activities as well as changes in estimates of amounts previously recorded.

Returns and Reserves and Allowance for Doubtful Accounts

Our recognition of revenue from sales to distributors is affected by agreements giving distributors the right to return up to ten percent of the amount of the last ninety days of the distributor’s software sales. Historically, the return rate has averaged less than the ten percent. We record a provision for product returns for related sales in the same period as the related revenues are recorded. These estimates are based on historical sales returns, analysis of credit memo data and other known factors. If the historical data we use to calculate these estimates does not properly reflect future returns, revenue could be affected. Accordingly, estimating product returns requires significant management judgment. In addition, different return rate estimates that we reasonably could have used would have had a material impact on our reported sales and thus have had a material impact on the presentation of the results of operations.

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Payments from customers are continuously monitored and allowances are maintained for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. When evaluating the adequacy of allowances for doubtful accounts, various factors are taken into consideration, including accounts receivable aging, customer credit-worthiness, historical bad debts, and geographic and political risk. While our credit losses have historically been within our expectations and the allowance established, we might not continue to experience the same credit loss rates that we have in the past. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

As of September 30, 2004, our net accounts receivable balance was $2.1 million, net of allowances of $0.1 million.

Income Taxes

SFAS 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could materially affect our financial position or our results of operations.

We have operations in many countries other than the United States. Transfer prices for services provided between the United States and these countries have been documented as reasonable, however, tax authorities could challenge these transfer prices and assess additional taxes on prior period transactions. Any such assessment could require that we record an additional tax provision in our statement of operations.

Income tax assets and liabilities are determined by taxable jurisdiction. We evaluate net deferred tax assets in each tax jurisdiction by estimating the likelihood of generating future profits to realize these assets. When necessary, a valuation allowance is recorded to reduce tax assets to an amount for which realization is more likely than not. The provision for income taxes represents taxes payable for the current period, plus the net change in deferred tax amounts.

De-Listing Status

On October 20, 2003, we announced that we had received notification from the Nasdaq Listing Qualifications Panel that our stock would discontinue trading on the Nasdaq SmallCap Market effective with the open of business on Tuesday, October 21, 2003. Our stock began trading Over the Counter on the Pink Sheets in October 2003.

This action followed our appeal to Nasdaq for a listing extension after not meeting the stated time requirements to file SEC Form 10-Q for our third quarter of fiscal 2002. The Nasdaq Panel determination to delist our stock was based on our filing delinquency, public interest concerns, and the nature of the ongoing internal revenue investigation. On December 8, 2003, we filed an appeal to reverse that portion of the Nasdaq Panel’s decision relating to its public interest concerns. On February 27, 2004, the Nasdaq advised us that our appeal had been denied.

On April 6, 2004, we were once again current with our periodic reporting obligations under the Securities and Exchange Act of 1934, as amended, which is required for our shares to trade on the OTC Bulletin Board. On August 25, 2004, we announced that we had received notification that our shares were approved for trading on the OTC Bulletin Board, and that trading had begun at the open of the market on August 24, 2004 under our new symbol TTLA.OB.

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Now that we have resumed compliance with the periodic reporting requirements of the Exchange Act, we will attempt to meet the listing requirements for the Nasdaq SmallCap Market, however some requirements such as minimum bid price and market capitalization are outside of our control.

Management Changes

On December 11, 2003, we announced that our board of directors had appointed Francis E. Wilde as Chief Executive Officer (CEO), President and a member of our board of directors. Mr. Wilde succeeds Douglas Michels, who continues with us as a strategic advisor to Tarantella, focusing initially on merger and acquisition opportunities. Mr. Michels will also continue as a director of Tarantella.

In December 2003, Gregory Quinn and E. Joseph Vitetta, Jr. joined us as our Vice President North American Operations and Strategic Alliances and Vice President Corporate Development, respectively. In January 2004, Mr. Vitetta was also appointed Corporate Secretary, and in October 2004, also assumed the role of Managing Director of EMEA. Stephen Bannerman joined us in December 2003 as Vice President Corporate Marketing, and his title was subsequently changed to Chief Marketing Officer. Joseph Makoid joined us in January 2004 as our Vice President OEM Sales. Messrs. Quinn, Bannerman, Vitetta and Makoid all report directly to Mr. Wilde. On January 6, 2004, we announced the appointment of John M. Greeley as Chief Financial Officer (CFO), reporting directly to Mr. Wilde. Mr. Greeley assumed the CFO responsibilities from Mr. Alok Mohan, who had been serving as acting CFO since September 8, 2003.

In January 2004, Thomas P. Rhodes joined us as our Vice President-General Counsel. Mr. Rhodes reported to Mr. Greeley. Mr. Rhodes subsequently left our employment in July 2004.

In September 2004, Christopher Scheybeler resigned as our Chief Technology Officer and left the company, and Mr. Bannerman assumed his responsibilities for product development.

In September 2004, Edmundo Costa resigned his position as Vice President Sales and assumed the role of a consultant for us.

Results of Operations

Net Revenues

Our net revenues are derived from software licenses and fees for services, which include engineering services, consulting, custom engineering, support and training.

Net revenues were $12.5 million in fiscal 2004, a decrease of 11% from $14.0 million in fiscal 2003. In fiscal 2003, net revenues decreased by 2% from $14.2 million in fiscal 2002. Revenue declined in fiscal 2004 due to a decrease in license revenue of $2.8 million, partially offset by increased services revenue of $1.3 million. Revenue declined slightly in fiscal 2003 versus fiscal 2002 due to a decrease in prepaid royalty transactions to OEM’s and ISV’s. In fiscal 2002, we had $3.2 million in revenue for prepaid royalties. In fiscal 2003, this number decreased to $1.7 million. The decrease of 47% in prepaid royalty transactions in fiscal 2003 was due to customers still consuming prepaid royalties purchased in fiscal 2002. Our revenues were also impacted by the continuing general reduction in information technology (“IT”) spending by companies for application server software and service initiatives. For the fiscal year ended September 30, 2004, no single customer accounted for 10% or more of our net revenues, for the fiscal year ended September 30, 2003, Northrop Grumman Computing accounted for 14% of our net revenues and for the fiscal year ended September 30, 2002, Netilla Networks, Inc. accounted for 10% of our net revenues.

International revenues continue to be a significant portion of net revenues, comprising 58%, 53% and 44% of the revenues for fiscal 2004, fiscal 2003 and fiscal 2002, respectively.

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License Revenues.    License revenues were $8.2 million in fiscal 2004 as compared to $11.0 million in fiscal 2003 and $11.4 million in fiscal 2002, representing a decrease of 25% in fiscal 2004 over 2003 and a decrease of 3.5% in fiscal 2003 over 2002. License revenues were 65% of total net revenues for fiscal 2004 and 78% and 80% of total net revenues for fiscal 2003 and 2002, respectively. The decline in license revenues of $2.8 million in fiscal 2004 is primarily due to lower overall license sales over $0.4 million to customers, including sales to U.S. government customers and independent software vendors (“ISV”). In fiscal 2003 one single transaction with the US government resulted in revenues of $1.3 million. Because of the size of our revenues, these types of large transactions can cause significant fluctuations in our net revenues. The decline in license revenues in fiscal 2003 is due to a decrease in prepaid royalty transactions to OEMs and ISVs. These transactions resulted in $3.2 million in revenue in 2002, but only $1.7 million in 2003.

Services Revenues:    Services revenues were $4.3 million in fiscal 2004, as compared to $3.0 million in fiscal 2003 and $2.9 million in fiscal 2002, representing an increase of 42% in fiscal 2004 over fiscal 2003, and an increase of 6% in fiscal 2003 over fiscal 2002. Services revenues were 35% of total net revenues for fiscal 2004 and 22% and 20% of total net revenues for fiscal 2003 and fiscal 2002, respectively. The increase in services revenues in fiscal 2004 is the result of an increased percentage of customers purchasing service contracts with new product, as well as an increase in the number of customers renewing service contracts with us. The increase in the purchase of service contracts with new product is due to the bundling of product with one year of service during fiscal 2004. The increase in the services renewal rate is a direct result of a new inside sales group hired to target customers with lapsed service agreements. The increase in services revenues in fiscal 2003 over fiscal 2002 was primarily due to an increased percentage of customers purchasing service contracts.

Cost of Revenues

Our overall cost of revenues as a percentage of net revenues can be affected by changes in net revenue contribution between product families, geographic regions and channels of distribution, since both price and cost characteristics associated with these revenue streams can vary greatly. We can also experience fluctuations in gross margin as net revenues increase or decrease since certain costs of revenues including technology, services, and distribution act as fixed costs within certain volume ranges.

Cost of License Revenues.    Cost of license revenues includes royalties paid to certain software vendors, amortization of acquired technologies, product packaging, documentation and all costs associated with the acquisition of components and shipping. Cost of license revenues as a percentage of license revenues increased to 9% due to higher consulting and staffing costs coupled with a rise in facility cost allocations and costs associated with rebranding our products, versus having remained flat from fiscal 2003 to fiscal 2002 at 3%.

Impairment of Intangibles.    During fiscal 2003 we acquired various intangible assets as the result of a business combination. These included various trade names and developed technologies related to marketed products. Per our accounting policy, we reevaluated the estimated economic value of these assets and determined that an impairment of $0.4 million had been incurred as of July 1, 2004. See Notes 3 and 17 to Notes to Consolidated Financial Statements.

Cost of Services Revenues.    Cost of services revenues includes documentation, consulting and personnel related expenses associated with providing such services. Costs of services revenues as a percentage of services revenues decreased to 36% due to higher sales and lower percentage cost per revenue dollar in fiscal 2004, versus having decreased to 40% in fiscal 2003 from 41% in fiscal 2002. The improvement in cost of services revenues in fiscal 2004, 2003 and 2002 is also a result of reduced staffing levels in the support organization due to realignment of this organization.

Research and Development

We invest in research and development both for new products and to provide continuing enhancements to current products. Research and development expenses increased slightly to $4.4 million in fiscal 2004, versus

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having decreased 24% to $4.3 million in fiscal 2003 from $5.6 million in fiscal 2002. Research and development expenses represented 35% of net revenues for fiscal 2004, 31% of net revenues for fiscal 2003, and 40% of net revenues for fiscal 2002. The increase in fiscal 2004 of $0.1 million is primarily due to new product validation costs and various increased facility and travel cost, partly offset by lower expenses from decreased staffing. The decrease in research and development expenses in fiscal 2003 is due to lower labor costs, which decreased $0.5 million from fiscal 2002 to fiscal 2003. The lower labor costs were driven by lower headcount, which decreased by 41% as a result of several planned reductions in force. Labor costs were also lower because there was a 15% pay reduction for all employees in research and development. In addition to lower labor costs, there was a reduction of allocations for facilities and IT costs. Expenses allocated to research and development decreased by $0.6 million in fiscal 2003. The reason for the decrease in allocations is that there was lower headcount in the allocated departments and there was an elimination of redundant facilities.

Selling, General and Administrative

Selling, general and administrative expenses increased 22% to $18.6 million in fiscal 2004, compared with $15.2 million in fiscal 2003 and $19.6 million in fiscal 2002. Selling, general and administrative expenses represented 149% of net revenues in fiscal 2004, 108% in fiscal 2003 and 138% in fiscal 2002. The increase in selling, general and administrative expenses of $3.4 million in fiscal 2004 versus fiscal 2003 was mainly due to increased costs of sales and administrative personnel and consultants, and higher spending on outside professional services related to various legal and auditing requirements.

The decrease in selling, general and administrative expenses in fiscal 2003 versus fiscal 2002 was mainly due to lower labor costs, which decreased by $2.1 million. The lower labor costs were driven by lower headcount, which decreased by 39% as a result of several planned reductions in force. Labor costs were also lower because there was a 15% pay reduction for all employees in marketing and general and administrative and a 7.5% pay reduction for all employees in sales. In addition to lower labor costs, there was a reduction of allocations for facilities and IT costs. Expenses allocated to selling, general and administrative decreased by $0.9 million in fiscal 2003. The reason for the decrease in allocations is that there was lower headcount in the allocated departments and there was an elimination of redundant facilities. The decrease in labor and allocation costs in selling, general and administrative expenses was partially offset by increased legal and audit fees. We incurred expenses of $0.7 million during fiscal 2003 for the internal revenue investigation and the related audit.

Allowance for doubtful accounts at the end of September 30, 2004 was $0.1 million, or 5% of gross accounts receivable. Allowance for doubtful accounts at the end of September 30, 2003 was $0.5 million, or 15% of gross accounts receivable. Allowance for doubtful accounts at the end of September 30, 2002 was $0.3 million, or 11% of gross accounts receivable. The decrease in allowance for doubtful accounts during fiscal 2004 was primarily due to an aggressive program to resolve our outstanding over 30 days accounts receivable items. There was also a $0.1 million decrease in reserves for returns authorized but not yet returned.

Legal Settlement and Litigation Costs

In fiscal 2004 we incurred legal settlement and litigation costs of $1.2 million. At the end of fiscal 2003 a suit was brought against us by a former employee. During October 2004 we entered into settlement of this matter and for which we believe we are fully accrued as of September 30, 2004. See Item 3 Legal Proceedings and Note 11 to Notes to Consolidated Financial Statements.

Restructuring Charges

Restructuring charges of $1.6 million, $2.2 million and $2.3 million were incurred in fiscal 2004, fiscal 2003 and fiscal 2002, respectively. These restructurings in fiscal 2004, fiscal 2003 and fiscal 2002 were made to align spending with lower than expected revenues and to facilitate our business strategies.

Restructuring charges of $1.6 million in fiscal 2004 included severance costs for a reduction in staffing of 15 employees, and expenses associated with vacated facility space. We also made provision adjustments to prior

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restructurings because we have been unable to sublet space in the Santa Cruz, California office. We have now fully reserved for the vacated portion of the Santa Cruz, California, office space through June 2005, the end of the lease period.

Restructuring charges of $2.2 million were incurred in fiscal year 2003, including $1.7 million relating to worldwide restructurings undertaken in the first, third and fourth quarters of fiscal 2003 and provision adjustments of $0.5 million made in the fourth quarter of fiscal 2003. The fiscal 2003 restructurings included a reduction in staffing of 62 employees, expenses associated with the closing of several foreign offices and the write-off of fixed assets.

Restructuring charges of $2.3 million were incurred in fiscal year 2002 relating to a worldwide restructuring undertaken in the first quarter of fiscal 2002 and provision adjustments made in the fourth quarter of fiscal 2002. The restructuring included a reduction in staffing of 52 employees, a reserve for unused facilities at our corporate headquarters, and costs associated with closing several foreign offices. We also made provision adjustments to prior restructurings because we have been unable to sublet space in the Santa Cruz, California office.

Other Income (Expense)

Other income and expense consists of interest income net of interest expense, foreign exchange gains and losses, and realized gains and losses on investments, as well as other miscellaneous income and expense items. Net interest income was $76,000 in fiscal 2004 compared to net interest income of $46,000 in fiscal 2003 and $0.5 million in fiscal 2002. Net interest income increased in fiscal 2004 due to the increase in cash during the year from $3.2 million at the end of fiscal 2003 to $9.6 million at the end of fiscal 2004, primarily as a result of our private placements during fiscal 2004. Net interest income decreased in fiscal 2003 due to the decrease in cash from $7.0 million at the end of fiscal 2002 to $3.2 million at the end of fiscal 2003. In fiscal 2004 we had net other income of $0.4 million compared to net other expense of $0.1 million in fiscal 2003 and $2.5 million in fiscal 2002. The $0.4 million of net other expense in fiscal 2004 was primarily due to gain on sale of an equity investment, partially offset by recognizing an impairment on an equity investment. The $0.1 million of net other expense in fiscal 2003 was due mainly to charges related to the impairment of certain investments. In fiscal 2002, our other income/(expense) included equity losses of $4.0 million for its share of Caldera International losses; also a loss of $2.4 million was recorded against the gain on the sale of divisions to Caldera. This loss included expense of $3.0 million for the early redemption of a note receivable from Caldera.

Income Taxes

In fiscal 2004, 2003 and 2002, our effective income tax benefit (expense) rates were (1%), (3%) and 7%, respectively. The fiscal 2004 tax provision of $0.1 million reflects foreign income taxes. The fiscal 2003 tax provision of $0.3 million reflects foreign income taxes of $0.5 million less the favorable resolution of foreign tax issues of $0.2 million. The fiscal 2002 tax benefit of $1.1 million reflects a benefit of $0.3 million due to a change in U.S. law and a benefit of $1.3 million due to the resolution of foreign audit issues, less foreign income taxes of $0.5 million.

Net Loss

Our reported net loss of $15.7 million in fiscal 2004 compared to a net loss of $9.7 million in fiscal 2003, and a net loss of $16.2 million in fiscal 2002. Net loss increased by $6.0 million in fiscal 2004 over fiscal 2003 and reflects lower licensing revenues of $2.8 million, a cost of revenues increase of $1.2 million including an impairment of intangible assets for $0.4 million, and an operating expenses increase of $4.0 million including a legal settlement and litigation costs of $1.2 million. Partially offsetting fiscal 2004 higher costs were increased services revenues of $1.3 million, lower restructuring charges and a gain on the sale of certain equity investments. Net losses were lower in fiscal 2003 than in fiscal 2002 because we implemented several cost reduction measures to reduce our breakeven point. Net losses were higher in fiscal 2002 because fiscal 2002 included $6.5 million in losses from the sale of divisions to Caldera.

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Liquidity and Capital Resources

We have incurred net losses from operations of approximately $15.7 million during fiscal 2004 and $9.7 million during fiscal 2003 and revenues have declined from $14.0 million in fiscal 2003 to $12.5 million in fiscal 2004. For fiscal 2004 losses from operations were $16.0 million and $9.3 million during fiscal 2003. Net cash used for operating activities was $11.3 million in fiscal 2004 and $9.3 million used in fiscal 2003. We have an accumulated deficit of $140.5 million as of September 30, 2004. These conditions, among others, raise questions about our ability to continue to fund losses from operations in the future.

We have financed our operations through private offerings of our common stock and bank borrowings. As of September 30, 2004, our principal source of liquidity included cash and cash equivalents of $9.6 million, representing 58% of total assets. During the second quarter of fiscal 2004, we closed our available bank line of credit of $1.5 million under which we had no outstanding borrowings. The increase in cash and cash equivalents of $6.5 million in fiscal 2004 is primarily due to two private placements of common stock and warrants which resulted in net proceeds to us of approximately $17.8 million, partially offset by net cash used in operating activities of $11.3 million.

Our net cash used for operating activities was $11.3 million, $9.3 million and $17.2 million during fiscal 2004, fiscal 2003 and fiscal 2002, respectively. The increase in net cash used for operating activities of $2.0 million comparing fiscal 2004 to fiscal 2003 is primarily due to lower revenues and higher operating costs. The decrease in net cash used for operating activities of $7.9 million comparing fiscal 2003 to fiscal 2002 is primarily due to significantly lower operating costs.

Our days sales outstanding (DSO) at the end of fiscal 2004, fiscal 2003 and fiscal 2002 was 57 days, 87 days and 71 days, respectively. DSO is calculated using revenues for the fourth quarter of each fiscal year and net accounts receivable at September 30. The improvement in our DSO as of the end of fiscal 2004 was due to a lower trade accounts receivable over 30 days outstanding. The increase in DSO at the end of fiscal 2003 was due to one transaction totaling $0.6 million, for a large Italian customer, which was paid late. DSO is impacted about 1.4 days for every $50,000 that is uncollected, so this transaction added 15 days to the Company’s DSO calculation for fiscal 2003.

Net cash provided by investing activities was insignificant in fiscal 2004, compared to net cash provided by investing activities of $3.0 million and $12.4 million in fiscal 2003 and fiscal 2002, respectively. During fiscal 2004 proceeds from the sale of investments offset purchases of tangible assets and software and licenses. Net cash provided by investing activities during fiscal 2003 primarily related to cash acquired as part of our New Moon acquisition. Net cash provided by investing activities during fiscal 2002 primarily related to the sale of investments.

Net cash provided by financing activities was $17.7 million in fiscal 2004, compared to net cash provided by financing activities of $2.4 million for fiscal 2003 and net cash used for financing activities of $0.3 million for fiscal 2002. Net cash provided by financing activities in fiscal 2004 and fiscal 2003 was primarily due to proceeds from private placements of common stock and warrants.

During fiscal 2004 we completed two private placements of our common stock and warrants. On December 10, 2003, we entered into a private placement transaction pursuant to which we sold common stock and warrants resulting in gross proceeds of approximately $2,750,000. In connection with the financing, we paid placement fees in the amount of $232,303. On February 23, 2004, we completed a private placement of common stock and warrants for gross proceeds of $16,350,000, for which we incurred fees in the amount of $1,198,000, and issued warrants to the placement agents to purchase up to 322,500 shares of common stock at $1.70 per share.

During fiscal 2003, the Company completed a private placement of common stock and warrants resulting in gross proceeds to the Company of approximately $2,254,200 for which we paid fees of $155,345.

See Note 12 of Notes to Consolidated Financial Statements regarding our private placements.

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We had capital lease commitments of $31,000 in fiscal 2004, which were paid by March 31, 2004. There are no capital lease commitments beyond fiscal 2004. We have operating lease commitments of $1.4 million for fiscal 2005, and no operating lease commitments past fiscal 2007. See Note 11 of our Notes to Consolidated Financial Statements for more information.

On April 15, 2004 we signed an agreement to surrender the property in Leeds, UK, which reduced our total future operating lease commitments from $10.4 million to $1.6 million. After signing the agreement, our various remaining operating lease commitments now extend to 2007. The Company has no capital lease commitments at fiscal year end 2004. See Note 11 of Notes to Consolidated Financial Statements for more information.

The following summarizes our contractual lease obligations at September 30, 2004, and the effects such obligations are expected to have on liquidity and cash flow in future periods:

We have an obligation to pay former New Moon shareholders a minimum cash earnout of approximately $1.7 million over a period from January 1, 2004 to December 31, 2006 based on a royalty of 30% of New Moon product revenues, net of direct costs. During fiscal 2004 we rebranded the New Moon product as Terminal Services Edition. After the shareholders have been paid the minimum earnout, they are entitled to an additional royalty of 15% of Terminal Services Edition revenues, net of direct costs, during this period. In the event the minimum earnout is not achieved by the conclusion of the quarter ending December 31, 2006, we shall pay along with the final earnout payment an amount equal to the minimum earnout less all aggregate earnouts paid to date, less any off-sets and any escrow claim deficiencies. We have recorded this minimum cash earnout amount as Royalties payable—former New Moon shareholders in our consolidated financial statements.

We believe, based on our current plans, existing cash and cash equivalents, and expected results from operations, that our existing funds may be sufficient to meet our operating requirements through fiscal 2005. However, given the uncertainty of projecting future revenue levels, additional financing may be required during fiscal 2005 and thereafter. We cannot be assured that additional financing will be available if required.

Risk Factors

Set forth below and elsewhere in this filing and in other documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements in this filing. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations.

Fluctuations in our operating results on a quarterly or annual basis could cause the market price of our common stock to decline.

The results of operations for any quarter or fiscal year are not necessarily indicative of the results to be expected in future periods. Our operating results have in the past been, and will continue to be, subject to quarterly and annual fluctuations as a result of a number of factors, including but not limited to:

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As a consequence, operating results for any particular future period are difficult to predict, and such unpredictability may cause the price of our stock to fluctuate or decline. We participate in a highly dynamic industry and future results could be subject to significant volatility, particularly on a quarterly basis. Our revenue and operating results may be unpredictable due to our shipment patterns. We operate with little backlog of orders because our products are generally shipped as orders are received. In general, a substantial portion of our revenues have been booked and shipped in the third month of each fiscal quarter, with a concentration of these revenues in the latter half of that third month. In addition, the timing of closing large license contracts and the release of new products and product upgrades increase the risk of quarter to quarter fluctuations and the uncertainty of quarterly operating results. Our staffing and operating expense levels are based on an operating plan and are relatively fixed throughout the quarter. As a result, if revenues are not realized in the quarter as expected, our expected operating results and cash balances could be adversely affected, and such effect could be substantial and could result in an operating loss and depletion of our cash balances.

We may never achieve profitability in the future.

We divested our server software and professional services divisions in May 2001. Since the divestiture, we have not achieved profitability, and may never generate sufficient revenues to achieve profitability. As of September 30, 2004 we had an accumulated deficit of $140.5 million. Many of our operating expenses are relatively fixed in nature, particularly in the short term. We expect to continue to incur significant operating expenses in connection with our ongoing sales and marketing efforts. We also expect to incur noncash charges relating to amortization of intangibles related to past acquisitions. We must therefore generate revenues sufficient to offset these increased expenses in order for us to become profitable. We cannot assure you that we will successfully generate sufficient revenues or that we will ever achieve profitability. If we do achieve profitability, we may not be able to sustain our profitability.

We compete in the highly competitive internet infrastructure market.

The industry has become increasingly competitive and, accordingly, our results may also be adversely affected by the actions of existing or future competitors, including the development of new technologies, the

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introduction of new products, and the reduction of prices by such competitors to gain or retain market share. Our results of operations could be adversely affected if we are required to lower our prices significantly or our products or technologies are rendered obsolete or less attractive to customers.

We depend on the development and acceptance of new products in a rapidly changing market.

The market of our products is characterized by rapidly changing technology, evolution of new industry standards, and frequent introductions of new product enhancements. Our success will depend upon our continued ability to enhance our existing products, to introduce new products on a timely and cost-effective basis to meet the evolving customer requirements, to achieve market acceptance for new product offerings, and to respond to emerging industry standards and other technological changes. There can be no assurance that we will be successful in developing new products or enhancing our existing products, or that such new or enhanced products, will receive market acceptance. Our success also depends upon our ability to license from third parties and to incorporate into our products new technologies that become industry standards. There can be no assurance that we will continue to obtain such licenses on favorable terms or at all, or that we will successfully incorporate such third-party technologies into our own products. We anticipate new releases of our products in our current fiscal year ending September 2005. There can be no assurance that such new releases will not be affected by technical problems or “bugs”, as is common in the software industry. Furthermore, there can be no assurance that these or other future product introductions will not be delayed. Delays in the availability, or a lack of market acceptance, of new or enhanced products could have an adverse affect on our business. There can be no assurance that product introductions in the future will not disrupt product revenues and adversely affect operating results.

We are exposed to general economic and market conditions that affect the software industry.

Any significant downturn in our customers’ markets, or domestic and global conditions, which results in a decline in demand for software and services could harm the Company’s business. The recent state of the economy has had a negative impact on the software industry. This could result in customers continuing to delay or cancel orders for software. Any of these occurrences could have a significant impact on our operating results, revenues and costs and may cause the market price of our common stock to decline or become more volatile. Our future operating results may be affected by various uncertain trends and factors that are beyond our control. These include adverse changes in general economic conditions and rapid or unexpected changes in the technologies affecting our products. The process of developing new high technology products is complex and uncertain and requires accurate anticipation of customer needs and technological trends.

Any inability to hire, retain or integrate key personnel will impact our business.

We rely heavily on the contributions of our senior management and other key management and technical personnel. The competition for such employees is extremely intense, particularly in the technology-centric regions where we operate. We may not be able to hire, retain and integrate such key personnel. The loss of any individual member of our management team or other key employees may create disruptions in our business.

Furthermore, we have historically used stock options and other forms of equity-related compensation as a key component to our employee compensation program in order to align employees’ interests with the interests of shareholders, encourage employee retention, and provide competitive compensation packages. In recent periods, a majority of our employee stock options have had exercise prices in excess of our stock price, which may affect our ability to retain or attract present and prospective employees. In addition, the Financial Accounting Standards Board recently issued changes to United States Generally Accepted Accounting Principles that will require us and other companies to record a charge to earnings for employee stock option grants and other equity incentives. These and other developments in the provision of equity compensation to employees could make it more difficult to attract, retain and motivate employees and result in additional expenses to us.

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Our lease on the corporate headquarters building expires in June 2005, and we have not entered into a new lease.

The lease on our corporate headquarters building in Santa Cruz, California, expires in June 2005. Our management believes it is in our best interest to locate a new, appropriately-sized building. Our management is looking for new office space for our corporate headquarters, but we have not yet entered into a new lease, and may not be able to secure space on terms that are favorable to us, if at all. Furthermore, moving from one building to another may be disruptive to our business, which could affect our results of operations.

Cost of revenues may be affected by changes in the mix of product and services.

Our overall cost of revenues may be affected by changes in the mix of net revenue contribution between licenses and services, geographic regions and channels of distribution, as the costs associated with these revenues may be substantially different. We may also experience a change in margin as net revenues increase or decrease since technology costs and services costs are fixed within certain volume ranges.

Our operational results may be affected by price variations.

Our results of operations could be adversely affected if we were to lower our prices significantly. In the event we reduce our prices, our standard terms for selected distributors would be to provide credit for inventory ordered in the previous 180 days, such credits to be applied against future purchases. As a matter of policy, we do not allow product returns for a refund. Product returns are generally allowances for stock balancing and are accompanied by compensating and offsetting orders. Revenues are net of a provision for estimated future stock balancing and excess quantities above levels we believe are appropriate in our distribution channels.

Our revenues may be affected by seasonality of revenues in the European and government market.

We experience seasonality of revenues for both the European and the U.S. federal government markets. European revenues during the quarter ending June 30 are historically lower or relatively flat compared to the prior quarter. This reflects a reduction of customer purchases in anticipation of reduced selling activity during the summer months. Sales to the US federal government generally increase during the quarter ending September 30. This seasonal increase is primarily attributable to increased purchasing activity by the U.S. federal government prior to the close of its fiscal year. Additionally, net revenues for the first quarter of the fiscal year are typically lower or relatively flat compared to net revenues of the prior quarter.

We are dependent upon information received from third parties in order to determine reserves for product returns.

We depend on information received from our distribution partners in evaluating the inventory levels at distribution partners in the determination of reserves for the return of materials not sold, stock rotation and price protection. We have invested significant effort into developing systems and procedures for determining the appropriate reserve level. However, if we do not receive timely or accurate information, our ability to monitor the inventory levels will be affected and may negatively impact our business.

If we fail to manage the distribution of our products and services properly, or if our distributors’ financial condition or operations weaken, our revenue could suffer.

We market products directly and through our resellers and distributors. Since direct sales may compete with the sales made by resellers and distributors, these resellers and distributors may elect to use other suppliers that do not directly sell their own products. Any increase in our commitment to direct sales could cause conflict with some of our channel partners. Further, some of our resellers and distributors may have insufficient financial resources and may not be able to withstand changes in business conditions, including economic weakness and

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industry consolidation. Revenue from indirect sales could suffer if our distributors’ and resellers’ financial condition weakens.

Our business depends on our proprietary rights and there is a risk that such rights will be infringed.

We attempt to protect our software with a combination of patent, copyright, trademark, trade secret protection, employee and third party nondisclosure agreements, license agreements, and other methods of protection. Despite these precautions, it may be possible for unauthorized third parties to copy certain portions of our products or reverse engineer or obtain and use information that we regard as proprietary. Further, certain provisions of our licenses, including provisions protecting against unauthorized use, copying, transfer, and disclosure of the licensed product, may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect our intellectual property rights to the same extent as do the laws of the United States. If we are unable to protect our proprietary rights, our competitive position may be adversely affected.

Risks of claims from third parties for intellectual property infringement could adversely affect our business.

As the number of software products in the industry increases and the functionality of these products further overlaps, we believe that software products will increasingly become subject to infringement claims. There can be no assurance that third parties will not assert infringement claims against us and/or against our suppliers of technology. In general, our suppliers have agreed to indemnify us in the event any such claim involves supplier-provided software or technology, but any such claim, whether or not involving a supplier, could require us to enter into royalty arrangements or result in costly litigation.

Our business may be adversely affected by events outside our control.

From time to time, we have experienced disruption of our internal systems due to viruses, which caused denial of service to our customers and ourselves. While we have not been the target of software viruses specifically designed to impede the performance of our products, such viruses could be created and deployed against our products in the future. Similarly, experienced computer programmers or hackers could attempt to penetrate our network security or the security of our web sites. A hacker who penetrates our network or web sites could misappropriate propriety information or cause interruptions of services. We might be required to expend significant capital and resources to protect against, or to alleviate, problems caused by virus creators and/or hackers. In addition, war, power shortages, natural disasters, acts of terror, and regional and global health risks could impact our ability to conduct business in certain regions around the world. Any of these events could have an adverse affect on our business, results of operations, and financial condition.

Our results of operations may be affected by international economic conditions and fluctuations in foreign currency exchange rates.

Although our revenues are predominantly in U.S. dollars, substantial portions of our revenues are derived from sales to customers outside the United States. Trade sales to international customers represented 58%, 53% and 44% of total revenues for fiscal 2004, 2003 and 2002, respectively. Our revenues can be affected by general economic conditions in the United States, Europe and other international markets. Also, portions of our revenue and operating expenses are transacted in foreign currencies. Our operating strategy and pricing take into account changes in exchange rates over time. However, our results of operations may be significantly affected in the short term by fluctuations in foreign currency exchange rates.

Our results of operations may be affected by the assessment of additional taxes.

We have operations in many countries other than the United States. Transfer prices for services provided between the United States and these countries have been documented as reasonable, however, tax authorities

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could challenge these transfer prices and assess additional taxes on prior transactions. Any such assessment could require that we record an additional tax liability in our statement of operations.

If we are unable to effectively integrate and develop the operations of our recent acquisitions, our business may suffer.

We acquired Caststream, Inc. (“Caststream”) in March 2004. We are in the process of integrating the operations, certain employees, products and technology of Caststream into our business, and we face various risks as a result of these acquisitions including, but not limited to:

If we are not able to successfully integrate and develop the business of Caststream, our business may be negatively affected in future periods, which may cause our stock price to decline. In addition, if the value of the intangible assets and goodwill acquired becomes impaired, we will be required to write down the value of the assets, which would negatively affect our financial results. We may incur liabilities from Caststream that include liabilities for intellectual property infringement or indemnification of Caststream’s customers for similar claims, which could materially and adversely affect our business.

We could make future acquisitions that may result in additional risks to us.

We may continue to make investments in complementary companies, products or technologies. If we acquire a company or a division of a company, we may experience difficulty integrating that company or division’s personnel and operations, which could negatively affect operating results. In addition:

In connection with future acquisitions, we may be required to assume the liabilities of the acquired companies, including liabilities for intellectual property infringement or indemnification of customers of acquired businesses for similar claims, which could materially and adversely affect the business. We may have to incur debt or issue equity securities to pay for any future acquisition, the issuance of which may involve restrictive covenants or be dilutive to existing shareholders.

Our stock is subject to substantial price and volume fluctuations due to a number of factors, many of which are beyond our control, and those fluctuations may prevent shareholders from reselling their stock at a profit.

The stock market in general, and the market for shares of technology companies in particular, has experienced extreme price and volume fluctuations, which have often been unrelated to the operating performance of the affected companies. Strategic factors such as new product introductions, acquisitions or restructurings by us or our competitors may have a significant impact on the market price of our common stock. Furthermore, quarter-to-quarter fluctuations in operating results may have a significant impact on the market

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price of the stock. These conditions, as well as factors that generally affect the market for stocks of high technology companies, could cause the price of our stock to fluctuate substantially over short periods.

Our stock was delisted from the Nasdaq SmallCap Market on October 21, 2003, and is now listed on the Over-the-Counter Bulletin Boards. Since then, the trading volume for our common stock has been low and there may not be a market for the resale of our common stock.

Our stock was de-listed by the Nasdaq on October 21, 2003, and is now listed on the Over-the-Counter Bulletin Board under the symbol TTLA.OB. Trading our stock may be more difficult due to the OTC market’s limited trading activity, and there may not be a market for the resale of our common stock. This could cause a further decline in our stock price. Declines in the market price of our stock could greatly impair our ability to raise capital through equity or debt financing.

We have issued a significant number of shares of our common stock and warrants to purchase shares of our common stock over the past several years, substantially diluting our outstanding common stock. A substantial portion of those shares will be eligible for sale on the open market, which may cause the trading price of our common stock to fluctuate or decline.

In connection with several transactions since June 2003, we have issued over 24,000,000 shares of our common stock and warrants to purchase shares of our common stock to investors, employees and shareholders of acquired companies. While certain shares and warrants are subject to trading restrictions, the majority of them are not. Therefore, we have little control over the timing of any sales of shares by any of the selling shareholders. As a result, the market price of our common stock may fall if a large portion of those shares is sold in the public market. If we continue to issue shares of our common stock, or if a substantial portion of the outstanding warrants are exercised, further diluting the number of shares outstanding, this may cause the price of our common stock to decline.

Our stock price may be volatile, and you may not be able to resell shares of our common stock at or above the price you paid, or at all.

The trading price of our common stock could be subject to wide fluctuations due to the factors discussed in this risk factors section and elsewhere in this Annual Report on Form 10-K. In addition, the stock market in general, and technology companies in particular, have experienced extreme price and volume fluctuations. The average trading volume of our common stock is low, and current trading prices and valuations may not be sustainable. These broad market and industry factors may decrease the market price of our common stock, regardless of our actual operating performance. In addition, in the past, following periods of volatility in the overall market and the market price of a company’s securities, securities class action litigation has often been instituted against companies that have experienced significant declines in share price. This type of litigation, if instituted against us, could result in substantial costs and a diversion of our management’s attention and resources.

It may be difficult for us to raise needed capital in the future.

We may require substantial additional capital to finance future growth and fund ongoing operations through the remainder of fiscal 2005 and beyond. Due to risks and uncertainties in the market place, we may need to raise additional capital. We may raise additional funds through public or private financing, strategic relationships or other arrangements. We cannot be certain that the funding, if or when needed, will be available on attractive terms, or at all. Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products. If we fail to raise capital when needed, our business will be negatively affected, which could cause the price of our common stock to decline.

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Our corporate actions are substantially controlled by principal shareholders.

Our principal shareholders beneficially own approximately 51% of our outstanding common stock. These shareholders, if they acted together, could exert substantial control over matters requiring approval by our shareholders, including electing directors and approving mergers or other business combination transactions. This concentration of ownership may also influence the outcome of a change in control of our company, which could deprive our shareholders of an opportunity to receive a premium for their stock as part of a sale of our company and might reduce our stock price. These actions may be taken even if they are opposed by our other shareholders.

We will continue to incur increased costs as a result of being a public company subject to the Sarbanes-Oxley Act of 2002 (“SOA”), as well as new rules implemented by the Securities and Exchange Commission (“SEC”).

As a public company, we incur significant legal, accounting and other expenses. In addition, the SOA, as well as new rules subsequently implemented by the SEC, have required changes in corporate governance practices of public companies. We expect these new rules and regulations to increase our legal and financial compliance costs and to make certain activities more time-consuming and costly. For example, as a result of the SOA and related rules adopted by the SEC, we have created additional board committees and are adopting comprehensive new policies regarding internal controls and disclosure controls and procedures. We are currently evaluating and monitoring developments with respect to these new rules and are working towards becoming SOA section 404 compliant. However, we cannot predict or estimate the full amount of additional costs related to these activities that we are likely to incur or the timing of such costs, or if we will become SOA section 404 compliant.

Recent Accounting Pronouncements

In December 2003 the Financial Accounting Standards Board (“FASB”) issued Interpretation 46R (“FIN 46R”), a revision to Interpretation 46 (“FIN 46”), “Consolidation of Variable Interest Entities”. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46R clarifies some of the provisions of FIN 46 and exempts certain entities from its requirements. FIN 46R was effective for us during the quarter ending March 31, 2004. We have no interest in variable interest entities, so the adoption of FIN 46 and FIN 46R had no affect on our financial position or results of operations.

In July 2004, the FASB ratified Emerging Issues Task Force (“EITF”) consensus on Issue No. 02-14, “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock”, which provides guidance regarding application on the equity method of accounting to investments other than common stock. EITF Issue No. 02-14 will be effective beginning in our first quarter of fiscal 2005. We do not believe the adoption of EITF Issue No. 02-14 will have a material impact on our financial position or results of operations.

In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123R “Share-Based Payment” (“SFAS 123R”), a revision to SFAS No. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”), and superseding APB Opinion No. 25 “Accounting for Stock Issued to Employees” and its related implementation guidance. SFAS 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, including obtaining employee services in share-based payment transactions. SFAS 123R applies to all awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date. Adoption of the provisions of SFAS 123R is effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. Tarantella has not yet evaluated the potential impact that the adoption of SFAS 123R will have on its consolidated financial position and results of operations.

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Item 7A.    Quantitative and Qualitative Disclosures about Market Risk

Market-Rate Sensitive Instruments and Risk Management

We are exposed to market risk related to changes in interest rates, foreign currency exchange rates, and equity security prices. We do not use derivative financial instruments for speculative or trading purposes.

Interest-Rate Risk

As of September 30, 2004 the Company had cash of $9.6 million, consisting of cash and highly liquid money market instruments with maturities of less than 90 days. Because of the short maturities of these instruments, a sudden change in market interest rates would not have a material impact on the fair value of the portfolio. We would not expect operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest on our portfolio.

Foreign Exchange Risks

Currently, we denominate sales to some European customers in Euros and also incur expenses related to our European operations in British Pounds and Euros. Through May 2001, we used forward foreign exchange contracts to manage foreign exchange exposures associated with underlying assets, liabilities and anticipated transactions. Since the completion of the transaction in which we sold the Server Software and Professional Services divisions to Caldera International, we do not believe the foreign exchange risk is great enough to warrant the purchase of forward foreign exchange contracts. A hypothetical change of 10% in the foreign currency exchange rates would not have a material impact on our consolidated financial position or results of operations.

Equity Security Price Risk

As of September 30, 2004 the Company has investments in small number of privately held companies, the carrying value of which is now zero. Historically, we do not hedge our investments in equity securities.

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Item 8.    Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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TARANTELLA, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

See accompanying notes to consolidated financial statements.

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TARANTELLA, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands)

See accompanying notes to condensed consolidated financial statements.

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TARANTELLA, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY