CRITICAL PATH INC - 10-Q Quarterly Report

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

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

As of March 31, 2005, the Company had outstanding 29,744,082 shares of common stock, $0.001 par value per share (including 43,029 shares of Class A Non-Voting preference shares of our Nova Scotia subsidiary Critical Path Messaging Co. which can be exchanged at any time for our common stock upon the election of the holder).

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

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

The consolidated financial statements include the accounts of the Company, and its wholly owned and majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

These interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, and the rules and regulations of the Securities and Exchange Commission (SEC) for interim financial statements and accounting policies, consistent, in all material respects, with those applied in preparing our audited consolidated financial statements included in our Annual Report on Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2004. The unaudited financial information furnished herein reflects all adjustments, consisting only of normal recurring adjustments, that in our opinion are necessary to fairly state our consolidated financial position, the results of operations, and cash flows for the periods presented. This Quarterly Report on Form 10-Q should be read in conjunction with our audited financial statements for the year ended December 31, 2004, included in the 2004 Form 10-K. The condensed consolidated statement of operations for the three months ended March 31, 2005 are not necessarily indicative of results to be expected for any subsequent periods or for the entire fiscal year ending December 31, 2005.

The Company has focused on capital financing initiatives in order to maintain current and planned operations. The Company has operated at a loss since inception and the history of losses from operations and cash flow deficits, in combination with the cash balances, raise concerns about the Company’s ability to fund operations. Consequently, in 2003 and first quarter of 2004 the Company secured additional funds through several rounds of financing that involved the sale of senior secured notes, in the third quarter of 2004 the Company completed a rights offering, in the fourth quarter of 2004 the Company drew $11.0 million from an $18.0 million round of debt financing and most recently, in March 2005, the Company drew down the remaining $7.0 million from the $18.0 million round of debt financing. The Company is not required to make any payments of principal or interest under this $18.0 million debt financing until maturity in December 2007. If the Company is unable to increase revenues or if the Company is unable to reduce the amount of cash used by the Company’s operating activities during 2005, the Company may be required to undertake additional restructuring alternatives, or seek additional debt financing, although the ability to incur additional indebtedness is subject to certain limitations as discussed in the section below captioned “Ability to incur additional indebtedness.” Additionally, on April 12, 2005, the Nasdaq Stock Market, Inc., issued the Company a letter that it was not in compliance with the minimum closing bid price requirement and therefore faced delisting proceedings if the Company could not meet the minimum closing bid price requirement by October 10, 2005. Even if the Company was are able to regain compliance, this notice may also impact the Company’s ability to raise additional capital if needed. The Company does not believe equity financing on terms reasonably acceptable to the Company is currently available.

With the Company’s history of operating losses and cash used to support operating activities, the primary sources of capital have come from both debt and equity financings that have been completed over the past several years. The Company’s principal sources of liquidity include cash and cash equivalents. As of March 31, 2005, the Company had cash and cash equivalents available for operations totaling $27.2 million, of which $7.7 million was located in accounts outside the United States and which is not readily available for domestic operations. However, the Company intends to pursue the investigation of restructuring our foreign subsidiaries which, if successful, may provide us easier access to the repatriation of a greater portion of the cash located in accounts outside the United States. Additionally, the Company is currently evaluating the newly enacted American Jobs Creation Act of 2004 (the AJCA) and is not yet in a position to decide whether, or to what extent, the AJCA will enable the Company to repatriate foreign earnings that have not yet been remitted to the United States. Accordingly, the readily available cash resources in the United States, as of March 31, 2005, was $19.6 million. This included the remaining $7.0 million drawn from the $18.0 million round of debt financing completed in December 2004. As of March 31, 2005, we had $2.8 million of cash classified on our balance sheet as restricted cash which is primarily related to cash collateralized letters of credit totaling approximately $2.7 million. This cash is not readily available for operations; however, the Company believes that they will be able to reduce the letters of credit by approximately $1.8 million upon relocating the headquarters facility.

Based on the Company’s recent financing activities, the Company believes that there is sufficient cash to meet cash operating requirements for the next 12 months, including the $1.3 million lease termination payment discussed below in Note 2–Restructuring Activities along with the $5.7 million repayment of the outstanding 5³/4% Convertible Subordinated Notes (the 5³/4% Notes) and interest due and paid on April 1, 2005 as well as the on-going investments in capital equipment to support the transition of the Company’s hosted messaging environment from an out-sourced model to one that the Company performs in-house and to support the Company’s research and development efforts. For the long-term, the Company believes that the operating activities will be able to provide the liquidity and capital resources sufficient to support the Company’s business.

At March 31, 2005, the Company had no borrowings under the Company’s credit facility with Silicon Valley Bank because the borrowing availability had been eliminated and the Company was required to cash collateralize the Company’s letters of credit related to facility leases totaling approximately $2.7 million.

Under the terms of the Company’s line of credit, the Company is required to obtain the consent of Silicon Valley Bank to incur additional indebtedness. Additionally, subject to limited exceptions, the Company must seek the consent of it’s investors in order to incur any additional indebtedness.

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

Pursuant to the requirements of Statement of Financial Accounting Standards (SFAS) No. 148, Accounting for Stock-based Compensation – Transition and Disclosure, pro forma information regarding net loss and net loss per share is required to be presented as if the Company had accounted for employee stock option grants and activities under the Company’s Employee Stock Purchase Plan using the fair value method of SFAS No. 123, as amended by SFAS No. 148. Had compensation cost been recognized based on the fair value at the date of grant for options granted and activities under the Company’s Employee Stock Purchase Plan, the pro forma amounts of the Company’s net loss and net loss per share would have been as follows:

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

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

In April 2005, the SEC amended the compliance dates for SFAS No. 123R, Shared-Based Payment. The new rule allows public companies to implement SFAS No. 123R at the beginning of their next fiscal year that begins after June 15, 2005. The Company will be required to adopt SFAS No. 123R in the first quarter of 2006 and begin to recognize stock-based compensation related to employee equity awards in its condensed consolidated statements of operations using a fair value based method on a prospective basis. Since the Company currently accounts for equity awards granted to its employees using the intrinsic value method under APB No. 25, the Company expects the adoption of SFAS No. 123R will have a significant adverse impact on its financial position and results of operations.

In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB No. 107). SAB No. 107 covers key topics related to the implementation of SFAS No. 123R which include the valuation models, expected volatility, expected option term, income tax effects of SFAS No. 123R, classification of stock-based compensation cost, capitalization of compensation costs, and disclosure requirements. The Company expects the adoption of SAB No. 107 will have a significant adverse impact on its financial position and results of operations upon the adoption of SFAS No. 123R in the first quarter of 2006.

In March 2005, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations (FIN No. 47). FIN No. 47 clarifies that a company should record a liability for a conditional asset retirement obligation when incurred if the fair value of the obligation can be reasonably estimated. This interpretation further clarified conditional asset retirement obligation, as used in SFAS No. 143, Accounting for Asset Retirement Obligations, as a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN No. 47 is effective for companies no later than the end of their fiscal year ending after December 15, 2005. The Company does not expect the adoption of FIN No. 47 to have an impact on its financial position and results of operations.

In December 2004, the FASB issued SFAS No. 153, Exchange of Nonmonetary Assets, which is an amendment to APB Opinion No. 29. The guidance in APB Opinion No. 29, Accounting for Nonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in that opinion, however, included certain exceptions to that principle. This statement amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The adoption of SFAS No. 153 is not expected to have a material impact on the Company’s financial position or results of operations.

In November 2003, the Company announced that it was restructuring certain of its facility lease obligations in an effort to reduce its long-term cash obligations. In addition, the Company identified 16 positions, primarily held by management-level employees, which were to be eliminated. Costs totaling $1.9 million were recognized during the fourth quarter of 2003 associated with these initiatives, including $1.4 million in lease restructuring and termination costs and $0.5 million in severance and related headcount reduction costs. Costs totaling $1.1 million were recognized during the first quarter of 2004 associated with these initiatives, including $0.1 million in lease restructuring and termination costs and $1.0 million in severance and related headcount reduction costs. Additionally, costs totaling $1.3 million were recognized during the second quarter of 2004, including $0.8 million in severance and related headcount reduction costs and $0.5 million in facility consolidation and other related costs.

In August 2004, the Company expanded its restructuring activities in an effort to reduce both short-term

and long-term cash requirements. These activities included the reduction of fixed costs through the restructuring of contracts, consolidation of certain activities to offices in Toronto, Canada and Dublin, Ireland from higher cost areas such as the San Francisco Bay area and the elimination of approximately 20% of employee positions and reduced use of third party contractors. During the three months ended September 30, 2004, the Company recorded restructuring charges related to these activities totaling $2.6 million, consisting primarily of $2.1 million for employee severance costs and $0.5 million for costs related to the closure or consolidation of certain facilities and operations. Additional restructuring charges totaling $0.9 million were recorded during the three months ended December 31, 2004, primarily associated with the restructuring of the Company’s hosted messaging operations. This effort began in August 2004 and is expected to be completed in the first half of 2005.

During the first quarter of 2005, we recorded a restructuring charge totaling $1.6 million, of which, $1.3 million is related to the relocation of our headquarters facility as discussed below and the balance related to consolidation of data centers and the elimination of certain employee positions.

In September 2004, we received a non-binding notice from the landlord of our headquarters facility in San Francisco, California that the landlord had found a new tenant for our offices located at 350 The Embarcadero per the landlords substitution right in the First Amendment to Lease between SRI Hills Plaza Venture, LLC and Critical Path, Inc. (the Amendment). On March 15, 2005, we received the Substitution Notice from the landlord as required per the Amendment. In accordance with the Substitution Notice, we expect to vacate our facilities at 350 The Embarcadero and move into new office space provided for us at 2 Harrison Street, Suite #200 by no later than June 29, 2005. On May 5, 2005, we entered into the Second Amendment to Lease with PPF Off 345 Spear Street, L.P., to amend the Lease dated as of November 16 2001, as amended, under which we lease our headquarter facilities in San Francisco, California. Under the terms of the second amendment, we will be moving into new office space provided for us at 2 Harrison Street, San Francisco, California and vacating our current headquarters no later than June 29, 2005. The new office space to which we will relocate consists of approximately 22,881 square feet and will be leased for a term of five years commencing on the date we move into the new facility (which is no later than June 29, 2005). In connection with the second amendment, we are required to make a lease termination payment totaling approximately $1.3 million on May 30, 2005; however, the annual rent, on a cash basis, for our new headquarter facility will decline from approximately $2.5 million per year to less than approximately $0.7 million per year on average over the term of the lease. Additionally, we will incur costs related to the physical move and build out of the new facility which we currently estimate will cost approximately $0.2 million. At March 31, 2005, we had a $1.6 million liability related to our restructuring activities the majority of which we expect will be paid during 2005.

The following restructuring costs were incurred by the Company during the three months ended March 31, 2005:

During the three months ended March 31, 2005, the Company made cash payments totaling approximately $0.6 million and had non-cash charges of approximately $0.2 million. At March 31, 2005, the Company had a remaining balance in its restructuring accrual totaling $1.6 million which it expects will be paid during 2005.

At March 31, 2005, the Company had $6.6 million of goodwill. In accordance with SFAS No. 142, the Company ceased amortizing its goodwill in January 2002.

During the three months ended March 31, 2005, the Company recognized interest expense of $0.1 million related to its 5³/4% Convertible Subordinated Notes (the 5³/4% Notes). On the due date of the 5³/4% Notes, April 1, 2005, the Company repaid the outstanding principal and accrued interest totaling $5.7 million.

In December 2004, the Company issued $11.0 million in principal amount of 13.9% Promissory Notes (the 13.9% Notes) to General Atlantic Partners 74, L.P., Gapstar, LLC, GAP Coinvestment Partners II, L.P., GAPCO GmbH & Co. KG., Cenwell Limited, Campina Enterprises Limited, Great Affluent Limited, Dragonfield Limited, Lion Cosmos Limited and Richmond III, LLC (collectively “the investors”). As part of the financing transaction, the Company issued warrants to purchase 235,712 shares of Series F preferred stock at a per share purchase price of $14 per share, which is equivalent to $1.40 per share on a common equivalent basis.

On March 29, 2005, the Company issued the remaining $7.0 million in principal amount of the 13.9% Notes to the investors. As part of this financing transaction, the Company also issued warrants to purchase 149,998 shares of Series F preferred stock at a per share purchase price of $14 per share, which is equivalent to $1.40 per share on a common equivalent basis.

The 13.9% Notes accrue interest at a rate of 13.9% per annum, however; the Company is not obligated to make interest payments on the notes prior to their maturity date of December 30, 2007. The 13.9% Notes are due and payable on the earlier to occur of the maturity of the 13.9% Notes on December 30, 2007, when declared due and payable upon the occurrence of an event of default, or a change of control of the Company.

The $7.0 million in proceeds from the financing transaction were allocated to the 13.9% Notes and warrants based upon their relative estimated fair values. The estimated fair value of the warrants issued in connection with the $7.0 million 13.9% Notes of $0.6 million has been classified as a derivative instrument and recorded as a liability on the Company’s balance sheet in accordance with current authoritative guidance. In accordance with the provisions of SFAS No. 133, Accounting for Derivative Instruments, the Company is required to adjust the carrying value of the instrument to its fair value at each balance sheet date and recognize any change since the prior balance sheet date as a component of Other Income (Expense). Because these notes were issued at the end of the three months ended March 31, 2005, the warrant derivative liability is being carried on the Company’s books at its initial fair value of $0.6 million at March 31, 2005.

These 13.9% Notes were carried on the balance sheet as long-term “Notes payable” as follows at March 31, 2005:

The Company recorded accrued interest of $0.4 million related to the 13.9% Notes during the three months ended March 31, 2005. These notes are carried at cost and had an approximate fair value of $4.1 million at March 31, 2005.

There were no tax effects allocated to any components of comprehensive loss during the three months ended March 31, 2004 or 2005.

As of March 31, 2004 and 2005, there were 76.2 million and 119.5 million, respectively, potential common shares that were excluded from the determination of diluted net loss per share, as the effect of such shares on a weighted average basis is anti-dilutive.

In December 2001, the Company completed a financing transaction with a group of investors and their affiliated entities. In connection with this financing transaction, the Company issued 4 million shares of its Series D Cumulative Redeemable Convertible Preferred Stock (“Series D preferred stock”), in a private offering, resulting in gross cash proceeds of approximately $30 million, and the simultaneous retirement of approximately $65 million in face value of the Company’s outstanding convertible subordinated notes. The investors were led by General Atlantic Partners LLC and affiliates and included Hutchison Whampoa Limited and affiliates and Vectis Group LLC and affiliates. In addition, General Atlantic LLC was granted warrants to purchase 625,000 shares of the Company’s Common Stock in connection with this offering.

At issuance, costs of $3.1 million were recorded as a reduction of the carrying amount of the Series D preferred stock and will accrete over the term of the Series D preferred stock. Additionally, at issuance, the Series D preferred stock was deemed to have an embedded beneficial conversion feature which was limited to the net proceeds allocable to preferred stock of approximately $42 million. The value of the beneficial conversion feature, at issuance, was initially recorded as a reduction of the carrying amount of the Series D preferred stock and will accrete over the term of the Series D preferred stock.

The Series D preferred stock issued in the financing transaction ranks senior to all of the Company’s Common Stock in priority of dividends, rights of redemption and payment upon liquidation. The fair value ascribed to the preferred stock was based on actual cash paid by independent investors and the approximate fair value of the 5³/4% Notes retired in connection with the offering. The principal terms of the preferred stock included an automatic redemption on November 8, 2006, cumulative dividends at a rate of 8% per year, compounded on a semi-annual basis and payable in cash or additional shares of Series D preferred stock, conversion into shares of Common Stock calculated based on the Accreted Value which is, the purchase price plus accrued dividends divided by $4.20, and preference in the return of equity in any liquidation or change of control.

The purchase agreement provides for a preferential return of equity to the Series D preferred stockholders, before any return of equity to the common shareholders, and also provides for the Series D preferred stockholders to participate on a pro rata basis with the common shareholders, in any remaining equity, once the preferential return has been satisfied. Under the terms of this provision, the preferential return of equity is equal to the purchase price of the Series D preferred stock plus all dividends that would have accrued during the term of the preferred stock, even if a change in control occurs prior to the redemption date. The right to receive a preferential return lapses if either: (i) Critical Path is sold for a price per share of Series D preferred stock, had each such share been converted into Common Stock prior to change in control of at least four times the Accreted Value, or (ii) Critical Path’s stock trades on NASDAQ for 60 days prior to the change-in-control at an average price of not less than four times the Accreted Value. As part of the Company’s November 2003 private placement of 10% Senior Secured Convertible Notes, the Company agreed to seek shareholder approval to amend the terms of the Series D preferred stock to, among other things, amend the Series D preferred stock liquidation preference upon a liquidation and change of control, to eliminate the participation feature, to reduce the conversion price from $4.20 to $1.50 and to reduce the amount of dividends to which the holders of Series D preferred stock are entitled.

The warrants are exercisable at any time after November 8, 2002 until November 8, 2006 at an exercise price of $4.20, and convert into one share of the Company’s Common Stock. A portion of the proceeds received for the Series D preferred stock was allocated to the warrants and the preferred stock, based upon their relative fair market values. As a result of this allocation, approximately $5.25 million of the proceeds were allocated to the warrants, which was recorded as a reduction of the carrying value of the Series D preferred stock. Using the Black-Scholes option pricing model, assuming a four-year term, 200% volatility, a risk-free rate of 6.0% and no dividend yield, the fair market value of the warrants was $6.2 million. As part of the Company’s November 2003 private placement of 10% Senior Secured Convertible Notes (Senior Notes), the Company agreed to seek shareholder approval to amend the warrants to reduce the exercise price per share from $4.20 to $1.50.

In July 2004, at a special meeting of shareholders, the Company’s shareholders approved proposals to amend and restate the certificate of determination of preferences of Series D preferred stock (the

Amended Series D). As part of this amendment, the automatic redemption date was changed to July 2008 and the dividend accrual rate was reduced to 5³/4%. The Company recorded as a reduction to the carrying value of the Amended Series D, the dividends which had accrued on the Series D preferred stock totaling approximately $12.2 million. This amount was recorded as a reduction of the carrying amount of the Amended Series D and will accrete over the term of the Amended Series D. Additionally, the Amended Series D preferred stock contains a liquidation preference of $22 per share.

In January 2005, the Company converted 581,818 shares of Series D preferred stock, plus accrued dividends of $2.0 million, held by the Vectis Group LLC and affiliates into $10.0 million or 6,701,943 shares of common stock.

The following table sets forth the carrying value and liquidation values of the Amended Series D preferred stock at December 31, 2004 and March 31, 2005:

During the three months ended September 30, 2004, the Company issued a total of approximately 55.9 million shares of Series E Redeemable Convertible Preferred Stock (Series E preferred stock). In July 2004, the Company issued approximately 30.6 million shares of Series E preferred stock to convert $45.5 million of the Senior Notes plus accrued interest, issued 21.9 million shares of Series E preferred stock to convert $32.8 million of the 5³/4% Notes and issued approximately 0.8 million shares of Series E preferred stock to convert certain holders of Series D preferred stock into Series E preferred stock. In August 2004, the Company issued approximately 2.6 million shares of Series E preferred stock in connection with its rights offering from which the Company received gross proceeds of approximately $4.0 million.

The Series E preferred stock ranks senior to all preferred and common stock of the Company in priority of dividends, rights of redemption and payment upon liquidation. The principal terms of the Series E preferred stock include an automatic redemption on July 9, 2008, cumulative dividends at a rate of 5³/4% per year, dividends are not paid in cash but are added to the value of the Series E preferred stock on June 30 and December 31 each year, and conversion into shares of common stock calculated based on the quotient of the Series E accreted value divided by the Series E conversion price, $1.50.

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

The carrying value of the Series E preferred stock at December 31, 2004 and March 31, 2005 is as follows:

In December 2004, the Company’s Board of Directors authorized the issuance of up to 450,000 shares of Series F Redeemable Convertible Preferred Stock (Series F preferred stock). The Series F preferred stock will rank equally with the Series E preferred stock, and will rank senior to all other capital stock with respect to rights on liquidation, dissolution and winding up. The Series F preferred stock will accrue dividends at a simple annual rate of 5³/4% of the purchase price of $14.00 (equivalent to $1.40 per share on a common equivalent basis), whether or not declared by the board of directors. Dividends in respect of the Series F preferred stock will not be paid in cash but will be added to the value of the Series F preferred stock and will be taken into account for purposes of determining the liquidation and change in control preference, conversion rate and voting rights.

The Company must declare or pay dividends on the Series F preferred stock when the Company declares or pay dividends to the holders of common stock. Holders of Series F preferred stock are entitled to notice of all shareholders’ meetings and are entitled to vote on all matters submitted to the Shareholders for a vote, voting together with the holders of the common stock and all other classes of capital stock entitled to vote, voting as a single class (except where a separate vote is required by the Company’s amended and restated articles of incorporation, its bylaws or California law). The holders of Series F preferred stock will be entitled to vote as a separate class on any amendment to the terms or authorized number of shares of Series F preferred stock, the issuance of any equity security ranking senior to the Series F preferred stock and the redemption of or the payment of a dividend in respect of any junior security. At any time, holders of Series F preferred stock may elect to convert their Series F preferred stock into shares of common stock. Each share of Series F preferred Stock is currently convertible into ten shares of common stock. After three years from the date the Series E preferred stock is first issued, the Company may call for redemption of the Series F preferred stock under certain circumstances. On the fourth anniversary of the date the Series E preferred stock is first issued, the Company must call for redemption of the Series F preferred stock.

At March 31, 2005, no shares of Series F preferred stock were outstanding. Warrants to purchase 385,710 shares of Series F preferred stock were issued and outstanding as of March 31, 2005 in connection with the issuance of the 13.9% Notes.

Accretion on mandatorily redeemable preferred stock represents the accrued dividends and accretion of the beneficial conversion features of our outstanding Series D and E preferred stock as well as the accretion to the redemption value of the outstanding Series D preferred stock. The following table sets forth the accretion on mandatorily redeemable preferred stock for the periods indicated:

The Company leases office space and equipment under noncancelable operating and capital leases with various expiration dates through 2014. Rent expense for the three months ended March 31, 2005 totaled $1.3 million. Future minimum lease payments under noncancelable operating and capital leases are as follows:

In connection with the Company’s acquisition of Critical Path Pacific in June 2002, the Company assumed a capital lease with a termination date of August 2006. The capital lease obligation totaled $1.6 million at December 31, 2003. During 2004, the Company negotiated the early termination of this capital lease and will make capital lease payments totaling approximately $0.5 million through 2005.

The Company entered into other contractual obligations which total $3.9 million million at March 31, 2005. These obligations are primarily associated with the future purchase of equipment and software, the maintenance of hardware and software products being utilized within engineering and hosted operations, and the management of data center operations and network infrastructure storage for the Company’s hosted operations. These obligations are expected to be completed over the next 4 years, including $3.1 million in 2005.

During the first quarter of 2005, we recorded a restructure charge totaling $1.6 million, of which, $1.3 million is related to the relocation of our headquarters facility as discussed below and the balance related to consolidation of data centers and the elimination of certain employee positions.

In September 2004, we received a notice from the landlord of our headquarters facility in San Francisco, California that the landlord had found a new tenant for our offices located at 350 The Embarcadero per the landlords substitution right in the First Amendment to Lease between SRI Hills Plaza Venture, LLC and Critical Path, Inc. (the Amendment). On March 15, 2005, we received the Substitution Notice from the landlord as required per the Amendment. In accordance with the Substitution Notice, we expect to vacate our facilities at 350 The Embarcadero and move into new office space provided for us at 2 Harrison Street, Suite #200 by no later than June 29, 2005. In connection with the landlord’s substitution right and our relocation, we will be required to make a lease termination payment totaling approximately $1.3 million on May 30, 2005; however, the annual rent, on a cash basis, for our headquarters facility will decline from approximately $2.5 million per year to approximately $0.7 million per year. Additionally, we will incur costs related to the physical move and build out of the new facility which we currently estimate will cost approximately $0.2 million.

Certain net revenues are derived from contractual relationships that typically have one to three year terms. Certain agreements require minimum performance standards regarding the availability and response time of email services. If these standards are not met, such contracts are subject to termination and the Company could be subject to monetary penalties.

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

Action in the Superior Court of San Diego. In December 2003, the Company was named in a lawsuit filed by former shareholders of Remedy Corporation against current and former officers and directors of Peregrine Systems, Inc., Peregrine’s former accountants, some of Peregrine’s customers, including us, and various other unnamed defendants. The operative complaint alleges that the Company, as Peregrine’s customer, engaged in a fraudulent transaction with Peregrine that was not accounted for by Peregrine in conformity with generally accepted accounting principles (GAAP) and that this substantially inflated the value of Peregrine securities issued as consideration in Remedy’s merger with Peregrine approximately one year later in August 2001. The operative complaint alleges causes of action against the Company for fraud and deceit, violations of California Corporations Code provisions regarding aiding and abetting securities fraud, common law conspiracy to commit fraud, and common law aiding and abetting the commission of fraud. The complaint seeks an unspecified amount of compensatory and punitive damages, along with rescission of the Peregrine securities purchased in the Remedy merger, interest and attorneys fees. Effective as of January 2005, the Company entered into a settlement agreement providing that the claims against us would be dismissed immediately without prejudice. Thereafter, upon our satisfaction of certain conditions, the plaintiffs are obligated to dismiss the claims with prejudice. Such conditions consist principally of informal discovery such as, for example, providing access to employees and consultants who may have knowledge relevant to the plaintiff’s continuing case against the remaining defendants and providing documents which may be relevant to such case. The settlement involved no cash or other financial consideration. The Company had not recorded a liability against this claim as of March 31, 2005.

Securities Class Action in Southern District of New York. Beginning in July 2001, a number of securities class action complaints were filed against us, and certain of our former officers and directors and underwriters connected with our initial public offering (IPO) of common stock in the U.S. District Court for the Southern District of New York (In re Initial Public Offering Sec. Litig.). The purported class action complaints were filed by individuals who allege that they purchased our common stock at the initial and secondary public offerings between March 29, 1999 and December 6, 2000. The complaints allege generally that the prospectus under which such securities were sold contained false and misleading statements with respect to discounts and excess commissions received by the underwriters as well as allegations of “laddering” whereby underwriters required their customers to purchase additional shares in the aftermarket in exchange for an allocation of IPO shares. The complaints seek an unspecified amount in damages on behalf of persons who purchased our common stock during the specified period. Similar complaints have been filed against 55 underwriters and more than 300 other companies and other individuals. The over 1,000 complaints have been consolidated into a single action. We have reached an agreement in principle with the plaintiffs to resolve the cases. The proposed settlement involves no monetary payment and no admission of liability. However, the settlement is subject to approval by the Court. The Company had not recorded a liability against this claim as of March 31, 2005.

Cable & Wireless Liquidating Trust. In August 2004, we received a demand letter from the Cable & Wireless Liquidating Trust, or the Trust, notifying us of the Trust’s claim that Cable & Wireless, USA, Inc. made preferential payment to us of approximately $1.1 million within the 90-day preference period before Cable & Wireless filed for bankruptcy. We do not believe that we received any preferential payments from Cable & Wireless and communicated our position to the Trust in a letter dated September 3, 2004. To our knowledge, no formal proceedings have been commenced based on this dispute. However, the Company intends to defend itself vigorously if the Trust pursues this claim. The Company had not recorded a liability against this claim as of March 31, 2005.

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

Under California law, in connection with the Company’s charter documents and indemnification agreements the Company entered into with its executive officers and directors, the Company must indemnify its current and former officers and directors to the fullest extent permitted by law. The indemnification covers any expenses and liabilities reasonably incurred in connection with the investigation, defense, settlement or appeal of legal proceedings. The Company has made payments in connection with the indemnification of officers and directors in connection with past lawsuits and governmental investigations.

The following table sets forth the Company’s property and equipment balances by category for the periods indicated:

During the three months ended March 31, 2005, the Company accelerated the depreciation on certain assets related to a messaging provisioning platform after it was determined the assets would be taken out of service before the end of their originally estimated useful life. Depreciation expense totaled $2.6 million and $2.9 million for the three months ended March 31, 2004 and 2005, respectively.

On April 12, 2005, The Nasdaq Stock Market Inc. issued the Company a letter that it was not in compliance with the minimum closing bid price requirement and, therefore, faced delisting proceedings if the Company could not meet the minimum closing bid price requirement by October 10, 2005.

ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report on Form 10-Q and the following disclosures contain forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, as amended and in effect from time to time. The words “anticipates,” “expects,” “intends,” “plans,” “believes,” “seek,” “proposed,” and “estimate” and similar expressions are intended to identify forward-looking statements. These are statements that relate to future periods and include statements regarding our ability to operate in the future, our ability to obtain funding, the adequacy of funds to meet anticipated operating needs, our future strategic, operational and financial plans, possible financing, strategic or business combination transactions, anticipated or projected revenues, expenses and operational growth, markets and potential customers for our products and services, the continued seasonality of our business, plans related to sales strategies and global sales efforts, the anticipated benefits of our relationships with strategic partners, growth of our competition, our ability to compete, investments in product development, anticipated restructuring and costs associated with our leases for our current facilities, our litigation strategy, use of future earnings, the features, benefits and performance of our current and future products and services, plans to reduce operating costs through continued expense reduction, the anticipated effect of the transition of our hosted messaging environment from an out-sourced model to one that we perform in-house, the effect of the repayment of debt, our ability to improve our internal control over financial reporting, and our belief as to our ability to successfully emerge from the restructuring and refocusing of our operations. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Factors that might cause future results to differ materially from those projected in the forward-looking statements include, but are not limited to, our management of expenses and restructuring activities, failure to obtain additional financing on favorable terms or at all, the effect of the conversion of our preferred stock, the liquidation preference of our preferred stock, the accrual of dividends for our preferred stock, risks associated with our internal controls over financial reporting and our ability to address any material weaknesses in our internal controls over financial reporting, risks associated with an inability to maintain continued compliance with Nasdaq National Market listing requirements and delisting actions by such market, difficulties of forecasting future results due to our evolving business strategy, failure to meet sales and revenue forecasts, the emerging nature of the market for our products and services, turnover within and integration of senior management, board of directors members and other key personnel, difficulties in our strategic plans to exit certain products and services offerings, failure to expand our sales and marketing activities, potential difficulties associated with strategic relationships, investments and uncollected bills, general economic

conditions in markets in which we do business, risks associated with our international operations, inability to predict future trading prices of our common stock which have fluctuated significantly in the past, foreign currency fluctuations, unplanned system interruptions and capacity constraints, software defects, and those discussed in “Additional Factors That May Affect Future Operating Results” and elsewhere in this report. Readers are cautioned not to place undue reliance on these forward-looking statements. The forward-looking statements speak only as of the date hereof. We expressly disclaim any obligation to publicly release the results of any revisions to these forward-looking statements to reflect events or circumstances after the date of this filing.

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

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

We deliver software and services that enable the rapid deployment of highly scalable value-added solutions for messaging and identity management. Our messaging and identity management solutions help organizations expand the range of digital communications services they provide while helping to reduce overall costs. Our messaging solutions, which are available both as licensed software and as hosted services, provide integrated access to a broad range of communication and collaboration applications from wireless devices, web browsers, desktop clients, and voice systems. Our identity management solutions are designed to reduce burdens on helpdesks, simplify the deployment of key security infrastructure, enable compliance with new regulatory mandates and help reduce the cost and effort of deploying applications and services to distributed organizations, mobile users, suppliers and customers.

Our target markets for our messaging and identity management solutions include wireless carriers and providers as well as enterprises and government agencies. We generate most of our revenues from telecommunications operators and from large enterprises. We believe wireless carriers, Internet service providers, or ISPs, and fixed-line service providers purchase our products and services primarily to offer new services to their subscribers. While they may also purchase our products and services to lower their cost of operating existing services or infrastructure, their spending is often tied to the level of investment they are willing to make on new revenue-generating services. Large enterprises typically buy our products and services to reduce their costs of operations particularly for handling distributed workforces or consolidations of multiple organizations, improve the security of their infrastructure, facilitate compliance with new regulatory mandates, and to enable new applications to be deployed for their employees or users.

Software license sales. Our messaging applications are usually sold as a perpetual license on a per-user basis, one for each person who might access the capabilities provided by the software. Our identity management software is usually sold as a perpetual license according to the number of data elements and different business systems being managed. These layered applications are usually licensed per user.

Hosted messaging services. For our hosted messaging services, customers pay initial setup fees and regular monthly, quarterly or annual subscriptions for the services they would like to be able to access.

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

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

We believe that wireless carriers and service providers are increasingly seeking to offer more differentiated services and diversify into new markets. In addition, enterprises and government agencies are faced with similar needs to deliver a broader range of information services while reducing the costs of operating such services and ensuring that privacy and security are maintained. We believe this provides a growth opportunity for the messaging and directory infrastructure market. However, the growth of this market and our business is also faced with many challenges, including the emerging nature of the market, the demand for licensed solutions for messaging and identity management products and outsourced messaging services, rapid technological change, competition and the recent decline in worldwide technology spending.

We have operated at a loss since our inception and as of March 31, 2005, we had an accumulated deficit of approximately $2.3 billion, which includes a $1.3 billion non-cash charge for impairment of goodwill and other long-lived assets that we recorded in fiscal year 2000. We have undertaken numerous restructuring initiatives in an effort to align our operating structure not only to the business and economic environments through which we have operated but also in response to our changing business in an effort to generate net income. For example:

In September 2004, we received a non-binding notice from the landlord of our headquarters facility in San Francisco, California notifying us that the landlord had found a new tenant for our offices located at 350 The

Embarcadero per the landlords substitution right in the First Amendment to Lease between SRI Hills Plaza Venture, LLC and Critical Path, Inc. (the Amendment). On March 15, 2005, we received the Substitution Notice from the landlord as required per the Amendment. In accordance with the Substitution Notice, we expect to vacate our facilities at 350 The Embarcadero and move into new office space provided for us at 2 Harrison Street, Suite #200 by no later than June 29, 2005. On May 5, 2005, we entered into the Second Amendment to Lease with PPF Off 345 Spear Street, L.P., to amend the Lease dated as of November 16 2001, as amended, under which we lease our headquarter facilities in San Francisco, California. Under the terms of the second amendment, we will be moving into new office space provided for us at 2 Harrison Street, San Francisco, California and vacating our current headquarters no later than June 29, 2005. The new office space to which we will relocate consists of approximately 22,881 square feet and will be leased for a term of five years commencing on the date we move into the new facility (which is no later than June 29, 2005). In connection with the second amendment, we are required to make a lease termination payment totaling approximately $1.3 million on May 30, 2005; however, the annual rent, on a cash basis, for our new headquarter facility will decline from approximately $2.5 million per year to less than approximately $0.7 million per year on average over the term of the lease. Additionally, we will incur costs related to the physical move and build out of the new facility which we currently estimate will cost approximately $0.2 million.

At March 31, 2005, we had a $1.6 million liability related to our restructuring activities, the majority of which we expect will be paid during 2005.

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

There have been no material changes to our critical accounting policies and estimates as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2004.

We have focused on capital financing initiatives in order to maintain current and planned operations. We have operated at a loss since inception and our history of losses from operations and cash flow deficits, in combination with our cash balances, raise concerns about our ability to fund our operations. Consequently, in 2003 and first quarter of 2004 we secured additional funds through several rounds of financing that involved the sale of senior secured notes, in the third quarter of 2004 we completed a rights offering and in the fourth quarter of 2004 we drew $11.0 million from an $18.0 million round of debt financing and most recently, in March 2005, we drew down the remaining $7.0 million from the $18.0 million round of debt financing. We are not required to make any payments of principal or interest under this $18.0 million debt financing until maturity in December 2007. If we are unable to increase our revenues or if we are unable to reduce the amount of cash used by our operating activities during 2005, we may be required to undertake additional restructuring alternatives, or seek additional debt financing although our ability to incur additional indebtedness is subject to certain limitations as discussed in the section below captioned “Ability to incur additional indebtedness.” Additionally, on April 12, 2005, the Nasdaq Stock Market, Inc., issued us a letter that we were not in compliance with the minimum closing bid price requirement and therefore faced delisting proceedings if we could not meet the minimum closing bid price requirement by October 10, 2005. Even if we are able to regain compliance, this notice may also impact our ability to raise additional capital if needed. We do not believe equity financing on terms reasonably acceptable to us is currently available.

The following table sets forth our net losses attributable to common shareholders and the cash used to support our operating activities for the periods indicated:

With our history of operating losses and cash used to support our operating activities, our primary sources of capital have come from both debt and equity financings that we have completed over the past several years. Our principal sources of liquidity include our cash and cash equivalents. As of March 31, 2005, we had cash and cash equivalents available for operations totaling $27.2 million, of which $7.7 million was located in accounts outside the United States and which is not readily available for our domestic operations. However, we intend to pursue the investigation of restructuring our foreign subsidiaries which, if successful, may provide us easier access to the repatriation of a greater portion of the cash located in accounts outside the United States. Additionally, we are currently evaluating the newly enacted American Jobs Creation Act of 2004 (the AJCA) and are not yet in a position to decide whether, or to what extent, the AJCA will enable us to repatriate foreign earnings that have not yet been remitted to the United States. Accordingly, our readily available cash resources in the United States as of March 31, 2005 were $19.6 million, which included the remaining $7.0 million we drew from the $18.0 million round of debt financing completed in December 2004. As of March 31, 2005, we had $2.8 million of cash classified on our balance sheet as restricted cash which is primarily related to cash collateralized letters of credit totaling approximately $2.7 million. This cash is not readily available for our operations; however, we believe that we will be able to reduce our letters of credit by approximately $1.8 million upon relocating our headquarters facility.

Based on our recent financing activities, we believe that we have sufficient cash to meet our cash operating requirements for the next 12 months, including the $1.3 million lease termination payment discussed above in the section captioned “Restructuring Initiatives” along with the $5.7 million repayment of our outstanding 5³/4% Convertible Subordinated Notes (the 5³/4% Notes) and interest due and paid on April 1, 2005 as well as the on-going investments in capital equipment to support the transition our hosted messaging environment from an out-sourced model to one that we perform in-house and to support our research and development efforts. For the long-term, we believe that our operating activities will be able to provide the liquidity and capital resources sufficient to support our business.

At March 31, 2005 we had no borrowings under our credit facility with Silicon Valley Bank because the borrowing availability had been eliminated and we were required to cash collateralize our letters of credit with Silicon Valley Bank related to certain facility leases which total approximately $2.7 million.

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

Total cash and cash equivalents increased primarily as a result of our financing activities, partially offset by cash used to support our operating and investing activities as set forth in the table below (in thousands):

Net cash used by operating activities. Our operating activities used $1.6 million of cash during the three months ended March 31, 2005. This cash was used to support our net loss of $7.4 million, adjusted for non-cash items such as: depreciation and amortization of $3.4 million, decreases in the fair value of a preferred stock instrument of ($1.7) million, stock-based expenses of $0.3 million, a $1.5 million increase in our restructure accrual and a $1.9 million increase in deferred revenue. Our net loss attributable to common shareholders was primarily a result of our operating costs, including both cost of revenues and operating expenses which are primarily comprised of employee costs, third party contractor costs and restructuring costs, being greater than our revenues.

Our primary source of operating cash flow is the collection of accounts receivable from our customers and the timing of payments to our vendors and service providers. We measure the effectiveness of our collections efforts by an analysis of the average number of days our accounts receivable are outstanding, or DSOs. The following table sets forth our accounts receivable balances and DSOs as of the dates indicated:

Accounts receivable balances decreased sequentially primarily due to our collections being greater than our billings. This decrease was partially offset by increased DSOs as a result of slower collections in Europe as well as an increasing proportion of revenue from customers outside the United States to whom we generally offer payment terms customary to the region in which the customers are located. While these payment terms are normal within the region in which they are provided, they are generally longer than the terms offered to customers in the United States. We believe that our DSOs are within industry norms, given the regions in which we operate, however; to the extent our international revenues increase as a proportion of total revenues, our DSOs may also increase which would negatively impact our liquidity and capital resources.

A number of non-cash items, such as: depreciation and amortization, changes in the value of a preferred stock instrument, stock-based expenses, accretion related to our preferred stock, loss on extinguishment of debt and certain restructuring charges, have been charged to expense and impacted our net losses during the three months ended March 31, 2005. To the extent these non-cash items increase or decrease in amount and increase or decrease our future operating results, there will be no corresponding impact on our cash flows. Our operating cash flows will be impacted in the future based on our operating results, our ability to collect our accounts receivable on an efficient basis, and the timing of payments to our vendors for accounts payable.

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

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

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

Net cash used by investing activities. Our investing activities used $0.4 million of cash during the three months ended March 31, 2005 for purchases of equipment primarily used to support the hosted messaging operations infrastructure and research and development efforts. We will be required to continue to make investments in capital equipment during 2005 as we transition our hosted messaging environment from an out-sourced model to one that we perform in-house and to support our on-going research and development efforts. We expect to fund these purchases through the use of our available cash resources or through leasing arrangements if available on terms we find acceptable. Additionally, we intend to fund through the use of our available cash resources any leasehold improvements that exceed the allowance for tenant improvements provided by our landlord for the new office space into which we will be moving our headquarters facility in 2005.

Cash provided by financing activities. Our financing activities provided $6.6 million of cash during the three months ended March 31, 2005 primarily as a result of the remaining $7.0 million we drew from the $18.0 million round of debt financing we closed in the fourth quarter of 2004 partially offset by $0.4 million of payments on our capital equipment leases.

Our cash balances at June 30, 2005 will be less than our cash balances at March 31, 2005 primarily due to the $5.7 million repayment of the 5³/4% Notes and interest which was due and paid on April 1, 2005.

Under the terms of our line of credit, we are required to obtain the consent of Silicon Valley Bank to incur additional indebtedness. Additionally, subject to limited exceptions, we must seek the consent of our investors in order to incur any additional indebtedness.

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

The table below sets forth our significant cash obligations and commitments as of March 31, 2005.

In view of the rapidly evolving nature of our business, prior acquisitions, organizational restructuring, and limited operating history, we believe that period over period comparisons of revenues and operating results, including gross profit margin and operating expenses as a percentage of total net revenues, are not meaningful and should not be relied upon as indications of future performance. We do not believe that our historical fluctuations in revenues, expenses, or personnel are indicative of future results.

The following table sets forth our results of operations for the three months ended March 31, 2004 and 2005.

Total net revenues increased primarily as a result of increased revenue from the licensing of our messaging platform, the sale of our hosted messaging solutions and increased professional services revenues partially offset by decreased revenue from the sale of maintenance contracts and support services.

The following table sets forth our total revenues and percent of revenue by region for the three months ended March 31, 2004 and 2005:

European revenues increased in total and as a proportion of our total revenue primarily due to growing demand within our existing European customer base and revenue recognized from our hosted messaging services with T-Mobile and Virgin.net. Revenue in North America decreased in total and as a proportion of our total revenue primarily due to decreased sales of hosted messaging services as a result of customers terminating or reducing their hosted messaging services with us as discussed above as well as decreased maintenance and support revenues.

Cost of net revenue decreased primarily as a result of reduced hosted messaging and professional services costs partially offset by increased software licensing and maintenance and support costs and increased stock-based expenses.

Our total gross margin, which is gross profit divided by total net revenue, increased to 41% for the three months ended March 31, 2005 from 31% for the three months ended March 31, 2004. This increase is primarily due to the decrease in our net cost of revenue and the increase in our net revenue as discussed above.

Total operating expenses decreased primarily due to reduced selling and marketing and research and development expenses partially offset by increased general and administrative, stock-based and restructuring expenses.

Included in general and administrative expenses are costs related to the initial implementation and compliance with the requirements of Sarbanes-Oxley 404 (section 404). Excluding our own time and resources, we expect that our costs to comply with section 404, excluding costs related to the audit of our financial statements, will be in excess of $2.2 million and we estimate that we have spent approximately $1.5 million of cash up to March 31, 2005 related to the initial compliance efforts to meet the requirements of section 404. As a result of complying with section 404, we expect that general and administrative expenses will increase in future periods during 2005.

Total restructuring expense increased primarily as a result of the $1.3 million lease termination payment as discussed in the above section captioned “Restructuring Initiatives” which we recorded as a charge related to facility and operations consolidations. This increase was partially offset by the reduced cost of employee severance benefits as the number of positions eliminated was reduced. At March 31, 2005, we had a $1.6 million liability related to our restructuring activities, the majority of which we expect will be paid during 2005.

Our operating expenses have decreased primarily due to our restructuring activities undertaken during 2004 and on-going efforts to control our costs.

Other income (expense), net consists primarily of gains and losses on foreign exchange transactions and changes in the fair value of the derivatives in our preferred stock instruments. In accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments, we are required to adjust the carrying value of the derivatives to their fair value at each balance sheet date and recognize any change since the prior balance sheet date as a component of other income or expense. The following table sets forth the components of other income (expense), net for the periods indicated.

Foreign exchange gain (loss) will change primarily based upon fluctuations in the foreign currency rates between the U.S. dollar and the Euro. During the three months ended March 31, 2004, the Euro strengthened considerably against the dollar which generated gain from foreign currency transactions associated with our international operations. During the three months ended March 31, 2005, the Euro strengthened only minimally against the dollar which generated a smaller gain from foreign currency transactions during the three months ended March 31, 2005 when compared to the three months ended March 31, 2004.

Our Series D preferred stock issued in 2001 and warrants to purchase shares of our Series F preferred stock issued in December 2004 and March 2005 contain derivative instruments. In accordance with the provisions of SFAS No. 133, Accounting for Derivative Instruments, we are required to adjust the carrying value of the instruments to their fair value at each balance sheet date and recognize any change since the prior balance sheet date as a component of other income or expense. The value of the derivative instruments declined less during the three months ended March 31, 2005 than it did during the three months ended March 31, 2004 resulting in a reduction of the gain year-over-year. The estimated fair value of these derivative instruments at March 31, 2005 was $3.7 million.

Interest income consists primarily of interest earnings on cash and cash equivalents and interest expense consists primarily of the interest expense and amortization of issuance costs related to the 5³/4% Notes issued in 2000 and the 13.9% Promissory Notes (13.9% Notes) issued in December 2004 and March 2005, as well as interest on certain capital leases and other long-term obligations. The following table sets forth the components of interest expense for the periods indicated.

Interest expense decreased primarily as a result of the conversion of the 10% Senior Convertible Notes (Senior Notes) and a majority of the 5³/4% Notes to shares of Series E preferred stock in July 2004 partially offset by interest related to the 13.9% Notes issued in December 2004.

The provision for income taxes represents the tax on the income generated by certain of our European subsidiaries operations. No current provision or benefit for United States federal or state income taxes has been recorded as we have incurred net operating losses for income tax purposes since our inception. Additionally, no deferred provision or benefit for federal or state income taxes has been recorded as we are in a net deferred tax asset position for which a full valuation allowance has been provided due to uncertainty of realization.

Our Series D preferred stock was originally issued in connection with a financing transaction completed in 2001 from which we received gross cash proceeds of approximately $30.0 million and retired approximately $65.0 million in face value of our outstanding convertible subordinated notes in exchange for shares of our Series D preferred stock. As originally issued, the Series D preferred stock accrued dividends at a rate of 8% per year, compounded on a semi-annual basis. Additionally, the Series D preferred stock was deemed to have an embedded derivative related to the beneficial conversion feature which was limited to the net proceeds allocable to the Series D preferred stock of approximately $42.0 million. The value of the beneficial conversion feature when the Series D preferred stock was originally issued was recorded as a reduction of the carrying amount of the Series D preferred stock and has been accreting over the term of the Series D preferred stock. In July 2004, at a special meeting of shareholders, our shareholders approved proposals to amend and restate the certificate of determination of preferences of Series D preferred stock (the Amended Series D). As part of this amendment, the automatic redemption date was changed to July 2008 and the dividend accrual rate was reduced to 5³/4%. Additionally, we also had to record as a reduction to the carrying value of the Amended Series D, the dividends which had accrued on the old Series D preferred stock totaling approximately $12.2 million. This amount was recorded as a reduction of the carrying amount of the Amended Series D and will accrete over the term of the Amended Series D.

Our Series E preferred stock was issued in connection with the conversion of $45.5 million of principal and accrued interest on our Senior Notes and $32.8 million of our 5³/4% Notes payable into shares of Series E preferred stock as approved by our shareholders at the special meeting in July 2004. The Series E preferred stock has an automatic redemption date of July 2008 and accrues dividends at 5³/4%. At issuance, the Series E preferred stock issued in exchange for the Senior Notes was deemed to have a beneficial conversion feature totaling $16.3 million which was recorded as a reduction of the carrying amount of Series E preferred stock and will accrete over the term of the Series E preferred stock.

The following table sets forth the components of the accretion on mandatorily redeemable preferred stock for the periods indicated.

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

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

In past quarters, we have spent heavily on technology and infrastructure development. We may continue to spend substantial financial and other resources to further develop and introduce new messaging and identity management solutions, and to improve our sales and marketing organizations, strategic relationships and operating infrastructure. We expect that our cost of revenues, sales and marketing expenses, general and administrative expenses, operations, research and customer support expenses and depreciation and amortization expenses could continue to increase in absolute dollars and may increase as a percent of revenues. In addition, in future periods we may incur significant non-cash charges related to stock-based compensation. If revenues do not correspondingly increase, our operating results could decline. If we continue to incur net losses in future periods, we may not be able to retain employees, or fund investments in capital equipment, sales and marketing programs, and research and development to successfully compete against our competitors. We also may never obtain sufficient revenues to exceed our cost structure and achieve profitability. If we do achieve profitability, we may not be able to sustain or increase profitability in the future. This may also, in turn, cause the price of our common stock to demonstrate volatility and/or continue to decline.

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

In the past, our management of operational expenses, including the restructurings of our operations, have placed significant strain on managerial, operational and financial resources and contributed to our history of losses. In addition, we may need to improve or replace our existing operational, customer service and financial systems, procedures and controls and/or incur incremental costs of compliance with legislation, such as the Sarbanes-Oxley Act of 2002. Any failure to properly manage these systems and procedural transitions or these incremental compliance costs could impair our ability to attract and service customers, and could cause us to incur higher operating costs and delays in the execution of our business plan. If we cannot manage restructuring

activities and expenses effectively, our business and operating results could decline. We have recently moved portions of our previously outsourced data operations in-house and to other service providers in order to lower costs and improve service. If we encounter unexpected difficulties in managing our data operations in-house or in working with new service providers, we may fail to fully realize any anticipated cost savings or efficiencies.

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

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

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

Our preferred stock can be converted into common stock at anytime in the discretion of the holder of preferred stock. Having obtained shareholder approval on July 2, 2004, we amended the terms of the Series D preferred stock, including the conversion ratio, to increase the number of shares of common stock issuable upon conversion of the Series D preferred stock. As of March 31, 2005, there were 3,520,537 shares of Series D preferred stock outstanding, which were convertible into approximately 40.9 million shares of common stock. In addition, during the three months ended September 30, 2004, upon conversion of our Senior Notes, the exchange of some of our Series D preferred stock and at the closing of our rights offering, we issued approximately 55.9 million shares of Series E preferred stock, which are convertible as of March 31, 2005, at the option of the holders, into approximately 58.2 million shares of common stock. On May 5, 2005, we filed a Form S-3/A pursuant to a demand from holders of Series E preferred stock to register 28.6 million shares of common stock issuable upon conversion of their shares of Series E preferred stock. Any conversion of our preferred stock into common stock would increase the number of additional shares of common stock that may be sold into the market, which could substantially decrease the price of our common stock.

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

In the event of liquidation, dissolution, winding up or change of control of Critical Path, the holders of Series E preferred stock would be entitled to receive $1.50 per share of Series E preferred stock plus all accrued dividends on such share before any proceeds from the liquidation, dissolution or winding up is paid with respect to any other series or class of our capital stock. Accordingly, at March 31, 2005, the approximately 55.9 million shares of Series E preferred stock outstanding currently have an aggregate liquidation preference of approximately $87.3 million. The aggregate amount of the preference will increase as the shares of Series E preferred stock accrue dividends based on simple interest at an annual rate of 5³/4%. After all of the then outstanding shares of Series E preferred stock have received payment of their liquidation preference, the holders of Series D preferred stock would be entitled to receive the greater of $13.75 per share of Series D preferred stock plus all accrued dividends on such share (which, as of March 31, 2005, would result in an aggregate liquidation preference of approximately $61.4 million) or $22 per share (which currently would equal a liquidation preference of $77.5 million) before any proceeds from the liquidation, dissolution, winding up or change in control is paid to holders of our common stock. Holders of our common stock will not receive any proceeds from a liquidation, winding up or dissolution, including from a change of control, until after the liquidation preferences of the our

Series E preferred stock and our Series D preferred stock are paid in full. Consequently, although we would likely be required under applicable law to obtain the separate class approval of the holders of our common stock for a change of control or the sale of all or substantially all of the shares of Critical Path, it is possible that such a transaction could result in all or substantially all of the proceeds of such transaction being distributed to the holders of our Series E preferred stock and Series D preferred stock.

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

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

Currently, shares of Series D preferred stock and shares of Series E preferred stock accrue dividends at a rate of 5³/4% per year. If the maximum amount of dividends accrue on the outstanding shares of Series D preferred stock and Series E preferred stock prior to the automatic call for redemption date, the number of shares of common stock issuable upon conversion will increase by approximately 18 million shares to approximately 117 million shares of common stock.

We may not be able to maintain our listing on the Nasdaq National Market, and if we fail to do so, the price and liquidity of our common stock may decline.

The Nasdaq Stock Market has quantitative maintenance criteria for the continued listing of common stock on the Nasdaq National Market. The current requirements affecting us include (i) having total assets of at least $50 million, (ii) having total revenue of $50 million, (iii) maintaining a minimum market value of our common stock of $15 million, and (iv) maintaining a minimum closing bid price per share of $1.00. On April 12, 2005, The Nasdaq Stock Market Inc. issued us a letter that we were not in compliance with the minimum closing bid price requirement and, therefore, faced delisting proceedings. Even if we are able to regain compliance with the closing bid price requirement for continued listing, as a result of a reverse stock split or otherwise, we may nevertheless be unable to comply with this or the other quantitative maintenance criteria or any of the Nasdaq National Market’s listing requirements or other rules, or other markets listing requirements to the extent our stock is listed elsewhere, in the future. If we fail to maintain continued listing on the Nasdaq National Market and must move to a market with less liquidity, our stock price would likely further decline. If we are delisted, it could have a material adverse effect on the market price of, and the liquidity of the trading market for, our common stock.

We have identified material weaknesses in our disclosure controls and procedures and our internal control over financial reporting, which, if not remedied effectively, could have an adverse effect on the trading price of our common stock and otherwise seriously harm our business.

Management through, in part, the documentation, testing and assessment of our internal control over financial reporting pursuant to the rules promulgated by the SEC under Section 404 of the Sarbanes-Oxley Act of 2002 and Item 308 of Regulation S-K has concluded that our disclosure controls and procedures and our internal control over financial reporting had material weaknesses as of December 31, 2004. We have taken certain actions to begin to address those material weaknesses. Management filed its final report relating to its assessment of the effectiveness of internal control over financial reporting on May 2, 2005. Our inability to remedy our material weaknesses promptly and effectively could have a material adverse effect on our business, results of operations and financial condition, as well as impair our ability to meet our quarterly and annual reporting requirements in a timely manner. These effects could in turn adversely affect the trading price of our common stock. Prior to the remediation of these material weaknesses, there remains risk that the transitional controls on which we currently rely will fail to be sufficiently effective, which could result in a material misstatement of our financial position or results of operations and require a restatement. In addition, even if we are successful in strengthening our controls and procedures, such controls and procedures may not be adequate to prevent or identify irregularities or facilitate the fair presentation of our financial statements or SEC reporting.

Failure or circumvention of our controls and procedures could seriously harm our business.

We are making significant changes in our internal control over financial reporting and our disclosure controls and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, and not absolute, assurances that the objectives of the system are met. In addition, the effectiveness of our remediation efforts and of our internal controls is subject to limitations, including the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, our remediation efforts to improve our internal control over financial reporting may not prevent all improper acts or ensure that all material information will be made known to management in a timely fashion. In addition, because substantial additional costs may be necessary to implement these remedial measures, our limited resources may cause a further delay in remediating all of our material weaknesses. The failure or circumvention of our controls, policies and procedures or of our remediation efforts could have a material adverse effect on our business, results of operations and financial condition.

We face restrictions on our ability to use cash that we currently hold outside of the United States for purposes other than the operation of each of our respective foreign subsidiaries that hold such cash. For example, our ability to use cash held in a given European subsidiary for any reason other than the operation of that subsidiary may result in certain tax liabilities and are subject to local laws that could prevent the transfer of cash from that subsidiary to any other foreign or domestic account. At March 31, 2005, approximately $7.6 million was held outside of the United States. Our inability to utilize this cash could slow our ability to grow our business and reach our business objectives. We may also be forced to incur certain costs, such as tax liabilities, to be able to use this cash for domestic operations, which could cause our expenses to increase and our operating results to decline. In addition, approximately $2.8 million of our cash must be available to support our line of credit with Silicon Valley Bank and related letters of credit by the line of credit and is therefore unavailable for our operating activities.

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

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

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

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

We cannot accurately forecast our revenues as a result of our evolving business strategy and the

emerging nature of the consumer messaging and directory infrastructure market. Forecasting is further complicated by recent strategic and operational restructurings, as well as fluctuations in license revenues as a percentage of total revenues from 40% in 2002 to 31% in 2003 to 27% in 2004 and most recently, 26% in the three months ended March 31, 2005. Our revenues in some past quarters fell and could continue to fall short of expectations if we experience delays or cancellations of even a small number of orders. We often offer volume-based pricing, which may affect our operating margins. A number of factors are likely to cause fluctuations in operating results, including, but not limited to:

In addition to the factors set forth above, our GAAP financial results have been and will continue to be impacted by the extent to which we incur non-cash charges associated with stock-based arrangements with employees and non-employees. In particular, during the year ended December 31, 2004, we incurred stock-based compensation expense of $1.9 million and $0.3 million for the three months ended March 31, 2005 relating to the issuance of common stock and the grant of options and warrants to employees and non-employees. Grants of options and warrants also may be dilutive to existing shareholders.

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

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

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

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

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

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

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

We depend on strategic relationships to expand distribution channels and opportunities and to undertake joint product development and marketing efforts. Our ability to increase revenues depends upon aggressively marketing our services through new and existing strategic relationships. For example, we depend on a broad acceptance of our software and outsourced messaging services on the part of potential resellers and partners. We also depend on joint marketing and product development through

strategic relationships to achieve further market acceptance and brand recognition. Our agreements with strategic partners typically do not restrict them from introducing competing services. These agreements typically are for terms of one to three years, and automatically renew for additional one-year periods unless either party gives prior notice of its intention to terminate the agreement. In addition, these agreements are terminable by our partners without cause, and some agreements are terminable by us. Most of our hosted customer agreements also provide for the partial refund of fees paid or other monetary penalties in the event that our services fail to meet defined minimum performance standards. Distribution partners may choose not to renew existing arrangements on commercially acceptable terms, or at all.

In addition to strategic relationships, we also depend on the ability of our customers aggressively to sell and market our services to their end-users. If we lose any strategic relationships, fail to renew these agreements or relationships, fail to fully exploit our relationships, or fail to develop new strategic relationships, we could encounter increased difficulty in selling our products and services.

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

We expect that sales of our products and services to a limited number of customers will continue to account for a high percentage of our revenue for the foreseeable future. For example, for the three months ended March 31, 2005, our top ten customers accounted for approximately 44% of our total revenues and for the years ended December 31, 2002, 2003 and 2004, our top 10 customers accounted for approximately 31%, 27% and 34%, respectively, of our total revenues. Our future success depends on our ability to retain our current customers, and to attract new customers, in our target markets. The loss of one or several major customers, whether through termination of agreements, acquisitions or bankruptcy, could significantly reduce our revenues. Our agreements with our customers typically have terms of one to three years often with automatic one-year renewals and can be terminated without cause upon certain notice periods that vary among our agreements and range from a period of 30 to 120 days notice.

In addition, a number of our customers, particularly for our hosted services business and in the technology industry, have also suffered from falling revenue. For example, the telecommunications industry during the three months ended March 31, 2005, accounted for approximately 72% of the revenues from our top ten customers whereas for the fiscal years ended December 31, 2002, 2003 and 2004 it accounted for approximately 44%, 52% and 57%, respectively, of the revenues from our top ten customers. The relative financial performance of our customers will continue to impact our sales cycles and our ability to attract new business. Worldwide technology spending has also decreased in recent quarters across all industries. If our customers terminate their agreements for any reason before the end of the contract term, the loss of the customer would reduce our current and future revenues. Also, if we are unable to enter into agreements with new customers and develop business with our existing customers, our business will not grow and we will not generate additional revenues.

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

Because we have a variety of messaging and directory infrastructure products and services, we encounter different competitors at each level of our products and services. Our primary competitors of our messaging solutions include Sun Microsystems’ iPlanet, OpenWave Systems, Inc., Mirapoint, Inc., IronPort Systems, Inc. and Microsoft Corporation. In the identity management market, we compete primarily with Sun Microsystems’ iPlanet, Microsoft Corporation, IBM Corporation, Siemens Corporation, Computer Associates and Novell Corporation. Our competitors for customers seeking outsourced hosted messaging solutions include Outblaze Limited and BlueTie, Inc. If we are unable to successfully compete in our product market, our ability to retain our customers and attract new customers could decline.

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

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

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

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

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

Because we sell complex and sophisticated technology, our sales cycle, in particular with respect to our software solutions, can be long and unpredictable, often taking between four to 18 months. Because of the nature of our product and service offerings it can take many months of customer education and product evaluation before a purchase decision is made. In addition, many factors can influence the decision to purchase our product and service offerings including budgetary restraints and decreases in capital expenditures, quarterly fluctuations in operating results of customers and potential customers, the emerging and evolving nature of the internet-based services and wireless services markets. Furthermore,

general global economic conditions, and weakness in global securities markets, continuing recessionary spending levels, and a protracted slowdown in technology spending in particular, have further lengthened and affected our sales cycle. Such factors have led to and could continue to lead to delays and postponements in purchasing decisions and in many cases cancellations of anticipated orders. Any delay or cancellation in sales of our products or services could cause our operating results to be lower than those projected and cause our stock price to decline.

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

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

Under California law, in connection with our charter documents and indemnification agreements we entered into with our executive officers and directors, we must indemnify our current and former officers and directors to the fullest extent permitted by law. The indemnification covers any expenses and liabilities reasonably incurred in connection with the investigation, defense, settlement or appeal of legal proceedings. We have made payments and may continue to make payments in connection with the indemnification of officers and directors in connection with lawsuits and possibly pending investigations. However, it is unlikely that our director and officer liability insurance will be available to cover such payments.

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

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

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

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

In 2002, we incurred a number of restructuring charges related to the resizing of our business. These efforts included additional facilities and equipment lease terminations, continuing expense management and headcount reductions. In 2003, we continued to restructure our operations including consolidating some office locations and reducing our global workforce by approximately 175 positions, or approximately 30% of the workforce. In 2004, we expanded our restructuring activities in an effort to reduce both short-term and long-term cash requirements. These activities included the reduction of fixed costs through the restructuring of contracts, consolidation of certain activities to offices in Toronto, Canada and Dublin, Ireland from higher cost areas such as the San Francisco Bay area and the elimination of approximately

20% of employee positions and reduced use of third party contractors. We expect to continue to make determinations about the strategic future of our business and operations, and our ability to execute on such plans effectively and to make such determinations prudently could affect our future operations. A failure to execute successfully on such plans and to plan appropriately could cause or expenses to continue to outpace our revenues and our financial condition could significantly decline.

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

Economic growth has slowed significantly in the United States and internationally. In addition, terrorist attacks across the world and turmoil and war in the Middle East have increased the uncertainty in the global economy and may further add to the decline in the international business environment. A substantial portion of our business is derived from international sales, and the continued decline in the global economy could have a more severe impact on our financial results than on the results of some of our competitors. The effects of terrorist attacks and other similar events and the war in Iraq could contribute further to the slowdown of the already slumping market demand for goods and services, including digital communications software and services. If the global economy continues to decline as a result of the recent economic, political and social turmoil, or if there are further terrorist attacks in the United States or elsewhere, or as a result of war in the Middle East and elsewhere, we may experience decreases in the demand for our products and services, which may cause our operating results to decline.

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

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

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

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

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

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

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

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

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

Finally, the Sarbanes-Oxley Act of 2002 and new rules subsequently implemented by the Securities and Exchange Commission have required changes in corporate governance practices of public companies. In addition to final rules and rule proposals already made by the Securities and Exchange Commission, the Nasdaq Stock Market has adopted revisions to its requirements for listed companies. We are currently reviewing all of our accounting policies and practices, legal disclosure and corporate governance policies under the new legislation, including those related to our relationships with our independent registered public accounting firm, enhanced financial disclosures, internal controls, board and board committee practices, corporate responsibility and loan practices, and intend fully to comply with such laws. We expect these new rules and regulations to make it more difficult for us to attract and retain qualified executive officers and qualified members of our board of directors, particularly to serve on our various committees of the Board including, in particular, the audit committee.

We may have liability for Internet content and we may not have adequate liability insurance.

As a provider of messaging and directory services, we face potential liability for defamation, negligence, copyright, patent or trademark infringement and other claims based on the nature and content of the materials transmitted via our services. We do not and cannot screen all of the content generated by our users, and we could be exposed to liability with respect to this content. Furthermore, some foreign governments, such as Germany, have enforced laws and regulations related to content distributed over the Internet that are more strict than those currently in place in the United States. In some instances, we may be subject to criminal liability in connection with Internet content transmission.

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

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

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

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

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

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

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

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

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

Revenues from international sales accounted for 77% of our revenues in the three months ended March 31, 2005 and 54%, 62% and 68% of our revenues in 2002, 2003 and 2004, respectively. We intend to continue to operate in international markets and to spend significant financial and managerial resources to do so. In particular, in 2002 we purchased the remaining interests of our joint venture partners for our operations in Japan. We hope to expend revenues and plan to increase resources to grow our operations in the Asian market. If revenues from international operations do not exceed the expense of establishing and maintaining these operations, our business and our ability to increase revenue and improve our operating results could suffer. We have limited experience in international operations and may not be able to compete or operate effectively in international markets. We face certain risks inherent in conducting business internationally, including:

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

The significant equity ownership by the General Atlantic Investors and the Cheung Kong Investors may limit the ability of our other shareholders to influence significant corporate decisions which could delay or prevent a change of control or depress our stock price.

Following the conversion of the notes held by the General Atlantic Investors and the Cheung Kong Investors into Series E preferred stock and the amendment of the terms of our Series D preferred stock, as of March 31, 2005, the General Atlantic Investors beneficially own approximately 28.8% of our outstanding securities (which represents approximately 17.7% of the voting power) and the Cheung Kong Investors beneficially own approximately 20.4% of our outstanding securities (which represents approximately 19.2% of the voting power). In addition, the holders of our Series D preferred stock, which is controlled by the General Atlantic Investors, are entitled to elect one director and the Cheung Kong Investors have the right to nominate one director. Currently, one of our directors is affiliated with General Atlantic Investors and one of our directors is affiliated with the Cheung Kong Investors. As a result, the General Atlantic Investors and the Cheung Kong Investors, although not affiliated, will have the ability, acting together, to control the outcome of shareholder votes, including votes concerning the election of a majority of our directors, approval of merger transactions involving us and the sale of all or substantially all of our assets or other business combination transactions, charter and bylaw amendments and other significant corporate actions, which could delay or prevent a change in control or depress our stock price.

The significant equity ownership by the General Atlantic Investors and the Cheung Kong Investors may result in potential conflicts of interests, which could adversely affect the holders of our common stock, delay a change in control and depress our stock price.

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

The use of our net operating losses could be limited if an ownership change occurred during the preceding three-year period.

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

Due to the fact that a full valuation allowance has been provided for the net deferred tax asset relating to our net operating losses, we have never analyzed whether events such as the issuance of Series E preferred stock upon conversion of the 10% notes, the amendment to the terms of the Series D preferred stock and/or the exercise of the subscription rights in the rights offering caused us to undergo an

ownership change for federal income tax purposes. If such an ownership change were considered to have occurred, our use of our pre-change net operating losses would generally be limited annually to the product of the long-term tax-exempt rate as of the time the ownership change occurred and the value of our stock immediately before the ownership change. (The current long-term tax-exempt rate is 4.72%.) This could increase our federal income tax liability if we generate taxable income in the future. There can be no assurance that the Internal Revenue Service would not be able to successfully assert that we have undergone one or more ownership changes in the preceding three-year period.

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

The trading price of our common stock has been and may continue to experience volatility, wide fluctuations and declines. For example, during the three months ended March 31, 2005, the closing sale prices of our common stock on the Nasdaq National Market ranged from $1.69 on January 12, 2005 to $0.66 on March 29, 2005. Our stock price may further decline or fluctuate in response to any number of factors and events, such as announcements related to technological innovations, intense regulatory scrutiny and new corporate and securities and other legislation, strategic and sales relationships, new product and service offerings by us or our competitors, litigation outcomes, changes in senior management, changes in financial estimates and recommendations of securities analysts, the operating and stock price performance of other companies that investors may deem comparable, news reports relating to trends in our markets and the market for our stock, media interest in accounting scandals and corporate governance questions, overall market conditions and domestic and international economic factors unrelated to our performance. In addition, the stock market in general, particularly with respect to technology stocks, has experienced extreme volatility and a significant cumulative decline in recent quarters. This volatility and decline has affected many companies, including our company, irrespective of the specific operating performance of such companies. These broad market influences and fluctuations may adversely affect the price of our stock, and our ability to remain listed on the Nasdaq National Market, regardless of our operating performance or other factors.

A decline in our stock price could result in securities class action litigation against us that could divert management’s attention and harm our business.

We have been in the past and may in the future be subject to shareholder lawsuits, including securities class action lawsuits. In the past, securities class action litigation has often been brought against a company after periods of volatility in the market price of securities. In the future, we may be a target of similar litigation. Securities litigation could result in substantial costs and divert our management’s attention and resources, which in turn could harm our ability to execute our business plan.

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

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

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

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

Changes in accounting rules for employee stock options could significantly impact our GAAP financial results.

Accounting policies affecting many aspects of our business, including rules relating to employee stock option grants, have recently been revised or are under review. The FASB and other agencies have finalized changes to U.S. generally accepted accounting principles that will require us, starting in the first quarter of 2006, to record a charge to earnings for employee stock option grants and other equity incentives although we may elect to become subject to these accounting principles before we are required to. We may have significant and ongoing accounting charges resulting from option grant and other equity incentive expensing that could reduce our overall net income. In addition, since we historically have used equity-related compensation as a component of our total employee compensation program, the accounting change could make the use of equity-related compensation less attractive to us and therefore make it more difficult to attract and retain employees.

The following table presents the hypothetical changes in fair value in the 5³/4% Notes and 13.9% Notes at March 31, 2005. The value of the instrument is sensitive to changes in interest rates. The modeling technique used measures the change in fair values arising from hypothetical parallel shifts in the yield curve of plus or minus 50 basis points (bps), 100 bps and 150 bps over a twelve-month time horizon. The base value represents the estimated traded fair market value of the notes.

As of March 31, 2005, we had cash and cash equivalents of $27.2 million and no investments in marketable securities and our long-term obligations consisted of our $5.7 million five-year, 5³/4% Notes which were due and paid on April 1, 2005, our $18.0 million three year, 13.9% Notes due December 2008 and certain fixed rate capital leases. Accordingly, an immediate 10% change in interest rates would not affect our long-term obligations or our results of operations.

A significant portion of our international operations has a functional currency other than the United States dollar. Accordingly, we are exposed to foreign currency exchange rate risk inherent in our sales commitments, anticipated sales, and assets and liabilities of these operations. Fluctuations in exchange rates may harm our results of operations and could also result in exchange losses. The impact of future exchange rate fluctuations cannot be predicted with any certainty; however, our exposure to foreign

currency exchange rate risk is primarily associated with fluctuations in the Euro. We realized a net gain on foreign exchange of $47,000 during the three months ended March 31, 2005. To date, we have not sought to hedge the risks associated with fluctuations in exchange rates.

We maintain “disclosure controls and procedures,” as such term is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in United States Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our disclosure committee and management, including the chief executive officer and the chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(b) and 15d-15(b). Based upon, and as of the date of this evaluation, the chief executive officer and the chief financial officer concluded that our disclosure controls and procedures were not effective because of the material weaknesses discussed in our Annual Report on Form 10-K/A as filed on May 2, 2005 for the year ended December 31, 2004 specifically because we did not maintain effective controls over (i) lack of expertise and resources to analyze and apply generally accepted accounting principles to significant non-routine transactions, (ii) inadequate controls over period-end financial reporting processes, (iii) inadequate segregation of duties and (iv) inadequate controls over access to financial applications and data, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In light of these material weaknesses described more fully in our Form 10-K/A, we performed additional analysis and other post-closing procedures to ensure our consolidated financial statements are prepared in accordance with generally accepted accounting principles (GAAP). Accordingly, management believes that the financial statements included in this report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.

The certifications of our principal executive officer and principal financial officer required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this Quarterly Report on Form 10-Q. The disclosures set forth in this Item 4 contain information concerning the evaluation of our disclosure controls and procedures, internal control over financial reporting and changes in internal control over financial reporting referred to in those certifications. Those certifications should be read in conjunction with this Item 4 for a more complete understanding of the matters covered by the certifications.

Our management has discussed the material weaknesses as previously disclosed in Item 9A in our Annual Report on Form 10-K/A for the year ended December 31, 2004 and other deficiencies with our audit committee. In an effort to remediate the identified material weaknesses and other deficiencies, we intend to implement remedial measures, including, but not limited to the following:

During the first quarter of 2005, we began requiring passwords, which are changed every 90 days, to access critical systems and financial applications. However, there was no significant change in our internal control over financial reporting that occurred during the first quarter of 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. While we believe that the remedial actions will result in correcting the material weaknesses in our internal controls, the exact timing of when the conditions will be corrected is dependent upon future events, which may or may not occur.

From time to time, we have been subject to litigation including the pending litigation described below. Our current estimated range of liability related to some of the pending litigation below is based on claims for which we can estimate the amount and range of loss. We have recorded the minimum estimated liability related to those claims, where there is a range of loss. Because of the uncertainties related to both the amount and range of loss on the remaining pending litigation, we are unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, we will assess our potential liability and revise our estimates.

Action in the Superior Court of San Diego. In December 2003, we were named in a lawsuit filed by former shareholders of Remedy Corporation against current and former officers and directors of Peregrine Systems, Inc., Peregrine’s former accountants, some of Peregrine’s customers, including us, and various other unnamed defendants. The operative complaint alleges that we, as Peregrine’s customer, engaged in a fraudulent transaction with Peregrine that was not accounted for by Peregrine in conformity with generally accepted accounting principles (GAAP) and that this substantially inflated the value of Peregrine securities issued as consideration in Remedy’s merger with Peregrine approximately one year later in August 2001. The operative complaint alleges causes of action against us for fraud and deceit, violations of California Corporations Code provisions regarding aiding and abetting securities fraud, common law conspiracy to commit fraud, and common law aiding and abetting the commission of fraud. The complaint seeks an unspecified amount of compensatory and punitive damages, along with rescission of the Peregrine securities purchased in the Remedy merger, interest and attorneys fees. Effective as of January 2005, the Company entered into a settlement agreement providing that the claims against us would be dismissed immediately without prejudice. Thereafter, upon our satisfaction of certain conditions, the plaintiffs are obligated to dismiss the claims with prejudice. Such conditions consist principally of informal discovery such as, for example, providing access to employees and consultants who may have knowledge relevant to the plaintiff’s continuing case against the remaining defendants and providing documents which may be relevant to such case. The settlement involved no cash or other financial consideration. We had not recorded a liability against this claim as of March 31, 2005.

On March 29, 2005, we received aggregate proceeds of $7.0 million from certain accredited investors in exchange for the issuance of unsecured promissory notes having an aggregate principal balance of $7.0 million, together with warrants to purchase an aggregate of 149,998 shares of Series F redeemable convertible preferred stock (Series F preferred stock) at a per share price of $14.00 (equivalent to $1.40 per share on a common equivalent basis). The warrants to purchase shares of Series F preferred stock entitle the holders thereof to purchase shares of our Series F preferred stock at anytime until July 9, 2007 at an exercise price of $14.00 per share (equivalent to $1.40 per share on a common equivalent basis). The exercise price and the number of shares of Series F preferred stock issuable upon exercise of these warrants to purchase Series F preferred stock is subject to adjustment upon certain events such as any dividend or distribution on the outstanding shares of Series F preferred stock or our common stock or any subdivision, combination or reclassification of the Series F preferred stock. At any time, holders of Series F preferred stock may elect to convert their Series F preferred stock into common stock. The Series F preferred stock will accrue dividends at a simple annual rate of 5³/4% of the purchase price of $14.00 (equivalent to $1.40 per share on a common equivalent basis), whether or not declared by our board of directors. Dividends in respect of the Series F preferred stock will not be paid in cash but will be added to the value of the Series F preferred stock and will be taken into account for purposes of determining the conversion rate into common stock as well as the liquidation and change in control preference and voting rights of the Series F preferred stock. As of March 31, 2005, each share of Series F preferred stock was convertible into ten shares of common stock.

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

On May 5, 2005, the Compensation Committee of the Board of Directors approved the establishment of a bonus pool of up to an aggregate total amount of $75,000 to be paid to certain members of our Finance Department, including James Clark, our Chief Financial Officer, based on the achievement of certain operating cash management targets in 2005. Individual awards made under the bonus pool, and to whom they are made within the Finance Department, will be in the discretion of the CEO and the Compensation Committee.

On May 5, 2005, we entered into a Second Amendment to Lease with PPF Off 345 Spear Street, L.P., to amend the Lease dated as of November 16 2001, as amended, under which we lease our headquarters facilities in San Francisco, California. Under the terms of the second amendment, we will be moving into new office space provided for us at 2 Harrison Street, San Francisco, California and vacating our current headquarters no later than June 29, 2005. The new office space to which we will relocate consists of approximately 22,881 square feet and will be leased for a term of five years commencing on the date we move into the new facility (which is no later than June 29, 2005). In connection with the second amendment, we are required to make a lease termination payment totaling approximately $1.3 million on May 30, 2005; however, the annual rent, on a cash basis, for our new headquarters facility will decline from approximately $2.5 million per year to less than approximately $0.7 million per year on average over the term of the lease. Additionally, we will incur costs related to the physical move and build out of the new facility which we currently estimate will cost approximately $0.2 million.

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


CRITICAL PATH, INC.

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


	December 31, 2004			March 31, 2005
	(In thousands; unaudited)
ASSETS
Current assets
Cash and cash equivalents	$	23,239		$	27,196
Accounts receivable, net		19,667			18,817
Prepaid and other current assets		4,567			3,696

Total current assets		47,473			49,709
Property and equipment, net		11,379			8,829
Goodwill		6,613			6,613
Restricted cash		2,702			2,783
Other assets		1,032			993

Total assets	$	69,199		$	68,927

LIABILITIES, MANDATORILY REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS’ DEFICIT
Current liabilities
Accounts payable	$	4,973		$	3,986
Accrued liabilities		23,207			24,524
Deferred revenue		9,978			11,451
Capital lease and other obligations, current		1,067			695
Notes payable, current		5,565			5,565

Total current liabilities		44,790			46,221
Deferred revenue		173			136
Embedded derivative liability		5,173			3,660
Notes payable, net of current portion		8,875			15,847

Total liabilities		59,011			65,864

Commitments and contingencies (Note 8)
Mandatorily redeemable preferred stock, par value $0.001		122,377			117,569

Shareholders’ deficit
Common stock and paid-in-capital, par value $0.001
Shares authorized: 200,000
Shares issued and outstanding: 21,182 and 29,744		2,174,496			2,179,710
Common stock warrants		5,947			5,947
Unearned compensation		(1,353	)		(1,053	)
Accumulated deficit		(2,290,725	)		(2,298,094	)
Accumulated other comprehensive loss		(554	)		(1,016	)

Total shareholders’ deficit		(112,189	)		(114,506	)

Total liabilities, mandatorily redeemable preferred stock and shareholders’ deficit	$	69,199		$	68,927


	Three Months Ended March 31,
	2004			2005
	(In thousands, except per share amounts; unaudited)
Net revenues
Software license	$	4,251		$	4,445
Hosted messaging		4,343			5,211
Professional services		2,659			3,084
Maintenance and support		5,825			4,700

Total net revenues		17,078			17,440

Cost of net revenues
Software license		911			1,208
Hosted messaging		6,381			5,124
Professional services		3,094			2,404
Maintenance and support		1,449			1,550
Stock-based expense — Hosted messaging		5			—
Stock-based expense — Professional services		—			22
Stock-based expense — Maintenance and support		—			42

Total cost of net revenues		11,840			10,350

Gross profit		5,238			7,090

Operating expenses
Sales and marketing		6,939			4,647
Research and development		5,779			4,893
General and administrative		3,122			3,914
Stock-based expense — Sales and marketing		14			10
Stock-based expense — Research and development		18			18
Stock-based expense — General and administrative		9			216
Restructuring expenses		1,065			1,639

Total operating expenses		16,946			15,337

Loss from operations		(11,708	)		(8,247	)
Other income (expense), net		3,517			1,846
Interest income (expense)		(1,430	)		(660	)

Loss before income taxes		(9,621	)		(7,061	)
Provision for income taxes		(366	)		(308	)

Net loss		(9,987	)		(7,369	)
Accretion on mandatorily redeemable preferred stock		(3,147	)		(5,277	)

Net loss attributable to common shares	$	(13,134	)	$	(12,646	)

Net loss per share attributable to common shares — basic and diluted	$	(0.63	)	$	(0.46	)

Weighted average shares — basic and diluted		21,014			27,256


	Three months ended March 31,
	2004			2005
	(in thousands; unaudited)
Cash flow from operating activities:
Net loss	$	(9,987	)	$	(7,369	)
Provision (credit) for allowance for doubtful accounts		(93	)		3
Depreciation		2,610			2,903
Stock-based costs and expenses		46			307
Change in fair value of embedded derivative liabilities		(3,160	)		(1,666	)
Amortization of debt discount		60			164
Amortization of start up costs		48			330
Restructuring charges — non-cash		—			1,453
Change in assets and liabilities:
Accounts receivable		(448	)		(43	)
Other assets		(362	)		354
Accounts payable		(798	)		(497	)
Accrued liabilities		1,475			511
Deferred revenue		1,295			1,930

Net cash used in operating activities		(9,314	)		(1,620	)

Cash flow from investing activities:
Notes receivable from officers		3			—
Property and equipment purchases		(1,090	)		(439	)

Net cash used in investing activities		(1,087	)		(439	)

Cash flow from financing activities:
Proceeds from issuance of convertible notes, net		31,156			7,000
Proceeds from issuance of common stock, net		163			—
Payments on line of credit facility		(2,298	)		—
Principal payments on note and lease obligations		(287	)		(361	)

Net cash provided by financing activities		28,734			6,639

Net change in cash and cash equivalents		18,333			4,580
Effect of exchange rates on cash and cash equivalents		(186	)		(623	)
Cash and cash equivalents at beginning of period		18,984			23,239

Cash and cash equivalents at end of period	$	37,131		$	27,196


	Mandatorily redeemable preferred stock						Shareholders’ equity (deficit)
							Common stock and additional paid in capital			Common stock warrants		Unearned compensation			Accumulated deficit and other comprehensive income (loss)			Total

	Amended Series D			Series E
	(in thousands; unaudited)
Balance at December 31, 2004	$	59,575		$	62,802		$	2,174,496		$	5,947	$	(1,353	)	$	(2,291,279	)	$	(112,189	)
Accretion of dividend on mandatorily redeemable preferred stock		856			1,183			(2,039	)		—		—			—			(2,039	)
Accretion to redemption value for mandatorily redeemable preferred stock		2,197			1,041			(3,238	)		—		—			—			(3,238	)
Conversion of preferred stock to common stock		(10,055	)		(30	)		10,518			—		—			—			10,518
Issuance of restricted stock		—			—			7			—		—			—			7
Payment of taxes on vested restricted stock		—			—			(34	)		—		—			—			(34	)
Amortization of unearned compensation		—			—			—			—		300			—			300
Foreign currency translation adjustments		—			—			—			—		—			(462	)		(462	)
Net loss		—			—			—			—		—			(7,369	)		(7,369	)

Balance at March 31, 2005	$	52,573		$	64,996		$	2,179,710		$	5,947	$	(1,053	)	$	(2,299,110	)	$	(114,506	)


	Three months ended March 31,
	2004			2005
	(In thousands, except per share amounts)
Net loss attributable to common shares — as reported	$	(13,134	)	$	(12,646	)
Add:
Stock-based employee compensation expense included in reported net loss attributable to common shares, net of related tax effects		46			307
Deduct:
Total stock-based employee compensation expense determined under a fair value based method for all grants, net of related tax effects		(2,426	)		(1,403	)

Net loss attributable to common shareholders — pro forma	$	(15,514	)	$	(13,742	)

Basic and diluted net loss per share attributable to common shareholders — as reported	$	(0.63	)	$	(0.46	)

Basic and diluted net loss per share attributable to common shareholders — pro forma	$	(0.74	)	$	(0.50	)


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


	Workforce reductions			Facility and operations consolidation and other charges			Total
	(in millions)
Beginning accrual balance at December 31, 2004	$	201		$	553		$	754
Restructure charge		247			1,392			1,639
Cash payments		(413	)		(223	)		(636	)
Non-cash credits		(187	)		—			(187	)

Ending balance at March 31, 2005	$	(152	)	$	1,722			1,570


	December 31, 2004
Proceeds from issuance of 13.9% Notes	$	18,000
Less: Fair value of Series F preferred stock warrant derivative instrument		(2,711	)
Add: accretion of fair value of Series F preferred stock warrant derivative instrument		164
Add: accrued interest		394

Carrying value of 13.9% Notes	$	15,847


	December 31, 2004		March 31, 2005
	(in thousands)
Series D preferred stock — Amended Series D	$	56,355	$	59,575
Add amortization and accretion		3,220		3,053
Less value of Series D preferred stock converted to common stock		—		(10,055	)

Carrying value of Amended Series D preferred stock		59,575		52,573

Liquidation value of Amended Series D preferred stock, as accreted	$	70,568	$	61,371

Liquidation value of Amended Series D preferred stock	$	90,252	$	77,452


	Capital Leases			Operating Leases
	(In thousands)
Year Ending December 31
2005 (remaining nine months ending December 31, 2005)	$	605		$	3,879
2006		93			2,957
2007		19			2,316
2008		—			1,936
2009		—			1,751
2010 and beyond					4,991

Total minimum lease payments	$	717		$	17,830

Less: Amount representing interest		(17	)

Present value of capital lease obligations	$	700


	Three months ended March 31,						Change
	2004			2005			$		%
	(in thousands)
Net loss attributable to common shareholders	$	(13,134	)	$	(12,646	)	$	488	-4	%
Net cash used by operating activities		(9,314	)	$	(1,620	)		7,694	-83	%


Beginning balance at December 31, 2004	$	23,239

Net cash used by operating activities		(1,620	)
Net cash used by investing activities		(439	)
Net cash provided by financing activities		6,639

Net increase in cash and cash equivalents		4,580
Effect of exchange rates on cash and cash equivalents		(623	)

Ending balance at March 31, 2005	$	27,196


	December 31, 2004		March 31, 2005		Change
	December 31, 2004		March 31, 2005		$			%
	(in thousands, except DSOs)
Accounts receivable, net	$	19,667	$	18,817	$	(850	)	-4	%
DSOs(a)		91		97		6		7	%


			9 months ended December 31, 2005			Fiscal year ended December 31,
	Total		9 months ended December 31, 2005			2006		2007		2008		2009		Thereafter
	(in thousands)
Convertible subordinated notes, including interest (a)	$	5,725	$	5,725		$	—	$	—	$	—	$	—	$	—
Mandatorily redeemable preferred stock		175,551		—			—		—		175,551		—		—
13.9% Notes (b)		26,785		—			—		26,785		—		—		—
Operating lease obligations		17,830		3,879	(d)		2,957		2,316		1,936		1,751		4,991
Capital lease obligations		717		605			93		19		—		—		—
Other purchase obligations (c)		3,937		2,612			1,135		190		—		—		—

	$	230,545	$	12,821		$	4,185	$	29,310	$	177,487	$	1,751	$	4,991


	Three months ended March 31,								Change
	2004				2005				$			%
	(in thousands)
North America	$	6,225	36	%	$	4,081	23	%	$	(2,144	)	-34	%

Europe		9,841	58	%		12,608	72	%		2,767		28	%
Latin America		398	2	%		253	1	%		(145	)	-36	%
Asia pacific		614	4	%		499	3	%		(115	)	-19	%

Subtotal international		10,853	64	%		13,360	77	%		2,507		23	%

	$	17,078	100	%	$	17,440	100	%	$	362		2	%


	Three months ended March 31,
	2004		2005
Risk free interest rate	3.0	%	4.1	%
Expected lives (in years)	4.0		4.0
Dividend yield	0.0	%	0.0	%
Expected volatility	111.0	%	142.0	%


	Valuation of borrowing given an interest rate decrease of X basis points						No change in interest rate		Valuation of borrowing given an interest rate increase of X basis points
	150 bps		100 bps		50 bps		No change in interest rate		50 bps		100 bps		150 bps
	(in thousands)
5³/4% Notes	$	6,089	$	5,914	$	5,739	$	5,565	$	5,392	$	5,219	$	5,047
13.9% Notes		4,063		4,059		4,054		4,050		4,046		4,041		4,037

	$	10,152	$	9,973	$	9,793	$	9,615	$	9,438	$	9,260	$	9,084


4.1		Form of Note dated as of December 30, 2004 (Incorporated by reference to Exhibit 4.1 of Registrant’s Current Report on Form 8-K filed on January 3, 2005)

4.2		Form of Warrant to Purchase Series F Redeemable Convertible Preferred Stock of the Company dated as of December 30, 2004 (Incorporated by reference to Exhibit 4.2 of Registrant’s Current Report on Form 8-K filed on January 3, 2005)

10.1		Second Amendment to Lease dated May 5, 2005 by and between Critical Path, Inc. and PPF Off 345 Spear Street, LP.

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

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

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

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