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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED APRIL 30, 2005

OR

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NUMBER: 000-30362

CROSSROADS SYSTEMS, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

8300 NORTH MOPAC EXPRESSWAY

AUSTIN, TEXAS 78759

(Address of Registrant’s principal executive offices, including zip code.)

(512) 349-0300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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.    x  Yes    ¨  No

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

As of June 14, 2005 Registrant had outstanding 26,356,649 shares of common stock, par value $0.001 per share.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

FORM 10-Q

QUARTER ENDED APRIL 30, 2005

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PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

(IN THOUSANDS, EXCEPT SHARE DATA)

See accompanying notes to unaudited condensed consolidated financial statements.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

See accompanying notes to unaudited condensed consolidated financial statements.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(IN THOUSANDS)

See accompanying notes to unaudited condensed consolidated financial statements.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

The accompanying condensed consolidated financial statements include the accounts of Crossroads Systems, Inc. (Crossroads or the Company) and its wholly-owned subsidiaries. Headquartered in Austin, Texas, Crossroads, a Delaware corporation, is a leading global provider of highly secure storage and data management solutions. Crossroads sells and licenses its products and services primarily to leading storage system and server original equipment manufacturers, distributors, system integrators and storage service providers. The Company continues to consolidate the balance sheet, statements of operations and cash flows of NexQL Corporation (NexQL), a variable interest entity (VIE). The Company defines its operations as two distinct businesses: device controllers and network solution appliances.

The accompanying financial data as of April 30, 2005 and for the three and six months ended April 30, 2004 and 2005, have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the SEC’s rules and regulations. These unaudited financial statements should be read in conjunction with the audited financial statements and related notes for the year ended October 31, 2004, included in our Annual Report on Form 10-K.

The preparation of the condensed consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates and such differences may be material to the condensed consolidated financial statements.

Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications include our presentation of auction rate securities. We have made reclassifications to our consolidated statements of cash flows to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents. As a result of these reclassifications, net cash provided by investing activities decreased $3.7 million and increased $2.9 million for the six months ended April 30, 2004 and 2005, respectively. As a result of these reclassifications, cash and cash equivalents decreased $13.9 million and $10.9 million for the period ended October 31, 2004 and April 30, 2005, respectively, and short-term investments increased by these respective amounts. This change in reclassification does not affect previously reported cash flows from operations, cash flows from financing activities, or consolidated statements of operations for any period.

Revenue Recognition

Product revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, collectibility is probable and the risk of loss has passed to the customer. Revenue from product sales to customers that do not have rights of return, including product sales to original equipment manufacturers (OEMs) and certain distributors, Value Added Resellers (VARs) and system integrators, are recognized upon shipment or when title transfers. Sales and cost of sales related to customers that have rights of return are deferred and subsequently recognized upon sell-through to end-users.

Royalty and other revenue includes revenue from the licensing of intellectual property (IP), royalty payments from Hewlett-Packard (HP) and sales of service contracts. IP licensing arrangements can differ, but typically consist of upfront non-refundable fees including payments relating to past and future sales of licensee products. Once a license agreement is signed, delivery of the license has occurred and there are no remaining obligations outstanding, the Company records revenue from upfront nonrefundable IP license arrangements. License arrangements can also include a royalty stream that is recognized quarterly based on reports from the licensee. Revenue from royalty payments from HP is recognized monthly based on reports from HP and quarterly from other IP licensees. Support only includes telephone support and correction of errors. Service revenue is recognized ratably over the service period.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Consolidation of Variable Interest Entities

Financial Accounting Standards Board (FASB) Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46), was issued in January 2003. FIN 46 requires that if an entity is the primary beneficiary of a variable interest entity, the assets, liabilities, and results of operations of the variable interest entity should be included in the consolidated financial statements of the entity. FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (FIN 46(R)), was issued in December 2003. The Company adopted FIN 46(R) effective April 30, 2004, and consolidated NexQL in its reported financial results. For additional information regarding NexQL see Note 6 of our Annual Report on Form 10-K.

Deferred Revenue

NexQL entered into a Master Reseller Agreement (Agreement) on July 30, 2004 with a reseller in Europe. Subject to the terms of the Agreement, NexQL has assigned specific customer accounts exclusively to the reseller for an initial fee of $50,000. In August 2004, NexQL delivered product simulators to the reseller and has collected $950,000 for the simulators and $50,000 for the Agreement. Crossroads will recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred and the fee is fixed or determinable. Securities and Exchange Commission Staff Accounting Bulletin No. 104-”Revenue Recognition” requires the Company to be able to estimate returns and warranty expenses prior to recognizing revenue. Since NexQL has no history selling their products, we are not able to estimate returns and warranty expense at this time. Revenue from sales of products prior to the time we are able to estimate returns and warranty expense will be deferred. As of April 30, 2005 the entire $1.0 million remained deferred.

Purchased Intangible Assets

Purchased intangible assets are amortized over their useful economic life and periodically tested for impairment in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” The Company performs impairment tests on an annual basis.

The Company intends to evaluate the useful economic life of this intangible annually and will record an impairment charge as necessary. When an evaluation is required, the estimated future undiscounted cash flows associated with this asset will be compared to the carrying amount to determine if a write-down to fair market value or discounted cash flow value is required.

Stock-Based Compensation

As of April 30, 2005, the Company has one employee stock-based compensation plan, which is described more fully in Note 12 of our Annual Report on Form 10-K. Stock-based compensation is recognized using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair value of the Company’s stock at the date of grant over the amount an employee must pay to acquire the stock amortized over the vesting period.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The Company allocates stock-based compensation to specific line items within the condensed consolidated statements of operations based on the classification of the employees who receive the benefit. Stock-based compensation was recorded as follows (in thousands):

The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” to employee stock-based compensation (in thousands, except share data):

2. INVENTORIES

Inventories, net consist of the following (in thousands):

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

3. CONCENTRATIONS

Financial instruments that potentially expose the Company to concentrations of credit risk consist primarily of cash and cash equivalents, short-term investments and accounts receivable. The Company invests only in high credit quality short-term debt instruments.

The Company’s sales are primarily concentrated in the United States and are primarily derived from sales to OEMs in the computer storage and server industry. Revenue is concentrated with several major customers. The loss of a major customer, a change of suppliers or a significant technological change in the industry could affect operating results adversely. The Company performs credit evaluations of its customers and generally does not require collateral on accounts receivable balances and provides allowances for potential credit losses, product sales returns and other allowances. The Company has not experienced material credit losses in any of the periods presented.

The Company relies on a limited number of contract manufacturers to provide manufacturing services for its products. The inability of any contract manufacturer or supplier to fulfill supply requirements could materially impact future operating results. Additionally, the Company’s supplier arrangement for the production of certain vital components of its storage routers is concentrated with a small number of key suppliers.

The percentage of sales to significant customers was as follows:

The level of sales to any customer may vary from quarter to quarter. However, the Company expects that significant customer concentration, particularly to our three major customers, will continue for the foreseeable future. The loss of any one of these customers, or a decrease in the level of sales to any one of these customers, could have a material adverse impact on the Company’s financial condition or results of operations.

4. BUSINESS COMBINATIONS

Purchase Acquisition

During the fourth quarter of fiscal 2004, the Company completed an asset acquisition of Teracruz, Inc. (Teracruz), to add application acceleration and monitoring technology. The acquisition was accounted for as a purchase transaction. For additional information regarding the asset acquisition of Teracruz, Inc. see Note 6 of our Annual Report on Form 10-K.

The purchase price of the transaction was allocated to the acquired assets based on their estimated fair values as of the date of the acquisition, including identifiable intangible assets. The allocation is subject to change as additional information is received.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The following table presents details of the purchased intangible assets acquired during fiscal 2004 as part of the Teracruz asset acquisition and represents the balance at April 30, 2005 (in thousands, except number of years):

The future amortization expense for the next three years is as follows (in thousands):

NEXQL

During the first fiscal quarter of 2004, the Company entered into a strategic relationship with NexQL, a privately-held development stage company. Pursuant to certain agreements with NexQL, the Company has invested $1.0 million to purchase NexQL common stock and has provided NexQL with an additional $2.1 million under a loan facility. In February 2005, the Company amended its existing agreements with NexQL. See Note 8 Commitments and Contingencies – NexQL Commitment. The investment in NexQL has inherent risk as the markets for the technologies or products of NexQL are in the early stages of development and may never materialize.

In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” which addresses consolidation by business enterprises of VIEs either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46 (Revised Interpretations) resulting in multiple effective dates based on the nature as well as the creation date of the VIE. VIEs created after January 31, 2003, but prior to January 1, 2004, may be accounted for either based on the original interpretation or the Revised Interpretations. However, the Revised Interpretations must be applied no later than the second quarter of fiscal year 2004. VIEs created after January 1, 2004 must be accounted for under the Revised Interpretations.

As a result of the Revised Interpretations, under FIN 46R rules, the operating results of NexQL were accounted for on the equity method for the three months ended January 31, 2004 and the six months ended April 30, 2004. The company began consolidating the statements of operations and cash flows of NexQL beginning May 1, 2004, the beginning of the Company’s third fiscal quarter of 2004.

Management believes that recognition of additional liabilities as a result of consolidating NexQL does not result in any incremental increase in the level of claims on the general assets of the Company and its other subsidiaries, rather, the additional liabilities represent claims against the additional assets recognized by the Company as a result of the consolidation. Conversely, the additional assets recognized as a result of consolidating NexQL do not represent additional assets of the Company that could be used to satisfy claims by the creditors of the Company and its other subsidiaries.

Crossroads did not record any amounts as revenue related to NexQL for the three or six months ended April 30,

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

2004 or 2005. Net operating expenses and net loss attributable to NexQL for the three months ended April 30, 2004 and 2005 were approximately $0.5 million and $1.0 million, respectively. Net operating expenses and net loss attributable to NexQL for the six months ended April 30, 2004 and 2005 were approximately $0.7 million and $1.7 million, respectively. Overall results were significantly impacted as a result of our investment in NexQL and adoption of FIN 46R.

5. SEGMENT INFORMATION

Under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” the Company operates in two reportable industry segments: device controllers and network solution appliances. The Chief Executive Officer is the Company’s Chief Operating Decision Maker (CODM), as defined by SFAS No. 131. The CODM evaluates resource allocation decisions and operational performance based upon product type. For the six months ended 2005, the network solution appliances segment is comprised of NexQL and the assets acquired from Teracruz. The Company did not operate in reportable industry segments during the six months ended April 30, 2004.

The following presents selected financial information for the six months ended April 30, 2005 by product type (in thousands):

6. BUSINESS RESTRUCTURING EXPENSES AND ASSET IMPAIRMENT

In March 2005 the Company’s board of directors approved a restructuring plan to reduce its workforce by approximately 20 percent, or 23 people, to streamline operations and re-align resources with the company’s current strategy in targeted growth areas. For the three and six months ended April 30, 2005, the Company recorded $0.6 million in restructuring charges. Components of the restructuring charge and the remaining restructuring accrual as of April 30, 2005 are as follows (in thousands):

As of April 30, 2005, remaining cash expenditures resulting from the restructuring are estimated to be $0.3 million and relate primarily to facility lease losses. The Company estimates that these costs will be substantially incurred within one year of the restructuring. The Company has substantially implemented its restructuring efforts initiated in conjunction with the restructuring announcement made during the three months ended April 30,2005; however, there can be no assurance future restructuring efforts will not be necessary.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Consolidation of Excess Facilities

Facility lease losses relate to lease obligations for excess office space the Company has vacated as a result of the restructuring plan. The Company recorded $0.6 million in restructuring expense in relation to a site consolidation during the three and six months ended April 30, 2005. Total lease commitments include the remaining lease liabilities, and do not include any leasehold improvements required to sublease the vacated space or brokerage commissions. Of the $0.6 million charge recorded during the three and six months ended April 30, 2005, approximately $0.3 million relates to the base rent and fixed operating expenses of the vacated space through the lease term of April 15, 2006.

Asset Impairments

Asset impairments recorded pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets To Be Disposed Of”, relate to computer equipment that was impaired as a direct result of the Company’s restructuring plan, reducing its workforce by 20%, and decision to vacate certain office space, resulting in an impairment of $18,000 during the three and six months ended April 30, 2005.

Employee Separation and Other Costs

Employee separation and other costs, which include severance, related taxes, outplacement and other benefits, payable to approximately 23 terminated employees, totaled $0.3 million during the three and six months ended April 30, 2005. Employee groups impacted by the restructuring efforts include personnel in positions throughout the Company.

Previous Restructuring Plan

In May 2002, the Company completed a restructuring plan that reduced its workforce by approximately 25%, or 40 people (primarily in the sales, marketing and general and administrative areas), to scale down its infrastructure and to consolidate operations. The remaining accrual related to the May 2002 restructuring plan was $0.1 million as of April 30, 2005. The entire remaining accrual amount relates to remaining payments to be made for lease abandonment losses. In March 2003, the Company entered into an agreement to sublease a portion of its abandoned facilities. The anticipated rent payments from this sublease are approximately $0.5 million through January 2006. A second agreement to sublease a portion of its abandoned properties was signed in May 2003. The anticipated rent payments from the second sublease are approximately $0.3 million through January 2006.

In total, the Company has reduced its restructuring accrual related to the May 2002 restructuring plan by approximately $0.1 million during the six months ended April 30, 2005, principally for rent payments to be received over the next twelve months of the remaining sublease terms. As the Company has entered into the last twelve months of these subleases, the Company will no longer reduce the restructuring accrual for rent payments to be received, though the Company continues to assess recoverability of these sublease payments on a quarterly basis.

The following table details the changes in both the May 2002 and the March 2005 restructuring accruals during the six months ended April 30, 2005 (in thousands):

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

7. LINE OF CREDIT

The Company carries a line of credit with its bank. The committed revolving line provides for an advance of up to $3.0 million with a borrowing base of 80% of eligible accounts receivable. The line of credit will mature on June 14, 2005. The Company intends to continue to carry the line of credit. As of October 31, 2004 and April 30, 2005, there were no borrowings outstanding under this revolving line of credit.

8. COMMITMENTS AND CONTINGENCIES

OPERATING LEASES

The Company leases office space and equipment under long-term operating lease agreements that expire on various dates through July 31, 2007. In conjunction with entering into a lease agreement for its headquarters, the Company signed an unconditional, irrevocable letter of credit with a bank for $0.1 million, which is secured by the $3.0 million line of credit. Future minimum lease payments under all non-cancelable operating leases as of April 30, 2005 were approximately $2.9 million. In addition to base rent on its facilities lease, many of the operating lease agreements require that the Company pay a proportional share of the respective facilities’ operating expenses.

GUARANTEES AND PRODUCT WARRANTIES

FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee.

The disclosure requirements of FIN 45 are applicable to the Company’s product warranty liability and certain guarantees issued before December 31, 2002. The Company’s guarantees issued before December 31, 2002, which would have been disclosed in accordance with the disclosure requirements of FIN 45, were not material.

It is the Company’s policy to repair or replace products that have been authorized for repair or replacement by the Company’s customers. The Company maintains a reserve for the estimated costs of such repairs or replacements and adjusts the reserve based on historical sales volumes as well as actual costs incurred. The Company warrants products for a period from 12 to 39 months following the sale of its products.

Activity in the accrued warranty costs during the six months ended April 30, 2004 and 2005 was as follows (in thousands):

LEGAL PROCEEDINGS

Intellectual Property Litigation

On October 17, 2003, the Company filed a lawsuit against Dot Hill Systems, Inc. (Dot Hill) alleging that Dot Hill has infringed two of the Company’s patents, U.S. Patent No. 5,941,972 (the ’972 Patent) and U.S. Patent No. 6,425,035 (the ‘035 Patent), with some of Dot Hill’s products. Subsequently, Dot Hill filed an answer denying infringement and alleging the ‘972 and ‘035 Patents are invalid and unenforceable. Dot Hill had filed a third-party

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

complaint against FalconStor, Inc. (FalconStor), seeking indemnification for certain of Dot Hill’s products at issue in the litigation. In response, FalconStor had also denied infringement and alleged the ‘972 and ‘035 Patents are invalid and unenforceable. On August 18, 2004, FalconStor and Crossroads settled their claims against one another. The settlement included an upfront license fee from FalconStor to Crossroads and a cross-license of patents between the parties. By Order dated March 22, 2005, the Court stayed the case for 90 days to provide the United States Patent Office with time to attempt to resolve the currently pending reexamination of the patents-in-suit. The stay is scheduled to expire on July 7, 2005 regardless of whether the reexamination is completed by that date. In the continuing litigation against Dot Hill, Crossroads plans to vigorously defend its patents against all counterclaims.

Securities Class Action Litigation

The Company and several of its current and former officers and directors were named as defendants in several class action lawsuits filed in the United States District Court for the Western District of Texas. The plaintiffs in the actions purport to represent purchasers of the Company’s common stock during various periods ranging from January 25, 2000 through August 24, 2000. On February 24, 2003, the Court entered a final judgment in the defendants’ favor. Plaintiff’s appealed to the United States Court of Appeals for the Fifth Circuit. On April 14, 2004, the Fifth Circuit issued an opinion, which affirmed in part and vacated in part the district court’s ruling. The remaining claims were remanded to the district court. On May 12, 2004, the Fifth Circuit denied plaintiff’s request for panel rehearing. In December 2004, the Company reached an agreement in principle to settle this litigation. The shareholder class will receive a total payment of $4.35 million. Of that amount, the Company’s directors-and-officers insurance carriers agreed to pay $3.35 million and the Company has paid $1.0 million. On February 14, 2005, the Court entered into an order preliminarily approving the settlement, certifying the class for settlement purposes and providing for notice. The Court has set a hearing on the settlement on July 11, 2005. Any changes in threatened or pending litigation could result in revisions to the Company’s estimates of the potential liability and could materially impact the results of operations and financial position.

Other

From time to time, the Company may be involved in litigation relating to claims arising out of its ordinary course of business. Management believes that, other than the matters described above, there are no claims or actions pending or threatened against the Company, the ultimate disposition of which would have a material impact on the Company’s financial position, results of operations or cash flows.

EMPLOYMENT CONTRACTS

The Company has entered into an Employment Agreement with its President and Chief Executive Officer (CEO). The CEO is employed on an “at will” basis and may be terminated at any time, with or without cause, subject to the Severance Benefit Plans described below.

The Company also entered into Severance Benefit Plans with each of its executive officers. Pursuant to the terms of these plans, to the extent these executive officers are terminated prior to a change of control involving the Company they will receive a cash payment equal to either (i) one month of salary for each quarter of service they have provided to the Company, up to a maximum of twelve months salary or (ii) twelve months of salary and (ii) the vesting of all options held by such executive officer will accelerate by a period of one year.

NEXQL COMMITMENT

During the first fiscal quarter of 2004, the Company entered into a strategic relationship with NexQL, a privately-held development stage company. Pursuant to certain agreements with NexQL, the Company has invested $2.5 million to purchase NexQL common stock and has provided NexQL with an additional $0.6 million under a loan facility. In February 2005, the Company amended its existing agreements with NexQL. The material terms of the amended agreement are:

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

9. NET LOSS PER SHARE

In accordance with SFAS No. 128, “Earnings Per Share,” basic and diluted net loss per share is computed by dividing the loss to common stockholders by the weighted average number of common shares outstanding for the period, less shares subject to repurchase. Diluted loss per share is equivalent to basic loss per share because all common stock equivalents are antidilutive for all periods presented.

Common stock equivalents consist of outstanding stock options. The total number of outstanding stock options excluded from the calculations of diluted net loss per common share was 5,084,627 and 4,096,090 as of April 30, 2004 and 2005, respectively.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

10. SUBSEQUENT EVENTS

On May 1, 2005, the Company appointed Valerie H. Savage, 49, as its Chief Financial Officer after serving as the Company’s Interim Chief Financial Officer and the Company’s principal financial officer and principal accounting officer since February 15, 2005.

On April 29^, 2005, NexQL’s board of directors approved a restructuring plan to reduce NexQL’s workforce to streamline operations and re-align resources with NexQL’s current strategy effective May 2, 2005. NexQL will recognize a charge in its third fiscal quarter as a result of this restructuring plan.

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

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than historical or current facts, including, without limitation, statements about our business strategy, plans and objectives of management and our future prospects, are forward-looking statements. Although we believe that the expectations reflected in such forward-looking statements are reasonable, such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from these expectations. Such risks and uncertainties include, without limitation, the following:

These risks and uncertainties are beyond our control and, in many cases, we cannot predict the risks and uncertainties that could cause our actual results to differ materially from those indicated by the forward-looking statements. When used in this document, the words “believes,” “plans,” “expects,” “anticipates,” “intends,” “continue,” “may,” “will,” “could,” “should,” “future,” “potential,” “estimate,” or the negative of such terms and similar expressions as they relate to us or our management are intended to identify forward-looking statements.

The following discussion should be read in conjunction with, and is qualified in its entirety by, the condensed consolidated financial statements and notes thereto included above in Item 1 of this Quarterly Report and the condensed consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Form 10-K filed with the SEC on January 26, 2005. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods.

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OVERVIEW

We are a leading provider of enterprise data routing solutions for open system storage area networks, or SANs, based on our market share of storage routers shipped. By using our storage routers to serve as the interconnect between SANs and the other devices in a computer network, organizations are able to more effectively and efficiently store, manage and ensure the integrity and availability of their data. Specifically, when used in SANs our storage routers:

Our objective is to maintain our position as a leading provider of highly secure storage and data management solutions while also expanding into new markets. Our vision is to bring intelligent, focused solutions to the marketplace that solve specific customer problems in the area of data access, use and storage. By providing special purposed network controllers and network solutions appliances, we believe that we can achieve our vision of delivering solutions that provide “Intelligence At The Edge.” “Intelligence At The Edge” defines our approach to maximizing storage resource understanding, utilization and management through the delivery of value-add software features and functionality between storage devices and the network through specifically purposed devices that reside within the network and have a complete view of the application servers and the storage systems. This vision will require us to transform ourself from a tape device networking interface provider focusing primarily on hardware to a networking solutions company that incorporates software on specifically purposed hardware solutions.

To date, we have sold our storage products primarily to original equipment manufacturers, or OEMs, of servers and storage systems. These computer equipment manufacturers sell our storage routers to end-user organizations for use in their SANs. We also sell our storage routers through companies that distribute, resell or integrate our storage routers as part of a complete SAN solution.

On a product basis, sales have shifted to our fifth generation of products, the 6000 and 10000, and to our embedded line of products. Additionally, as storage networking continues to mature as an industry, we have seen a trend towards simplification of networking components and management. The impact of this trend on our business has been the push for, and subsequent ramp up of, embedded routers being shipped with tape libraries.

In March 2005, we introduced our StrongBox^™ family of products that deliver a set of intelligent appliances designed to operate together supporting enterprise-wide auditing, security, and analysis as well as performance monitoring, with no impact on network or application performance. To date, we have appliances installed for evaluation purposes only and have not recognized revenue from our StrongBox^™ family of products. At the present time, we are considering multiple options to sell and distribute these products including OEM’s, distributors, systems integrators and direct sales.

Our financial results depend on our ability and the ability of our OEM partners to predict and to respond to industry-wide trends. While the quantity of online data continues to grow, the price of storage and storage networking hardware continues to decline. Data growth is outpacing information technology, or IT, spending growth. Companies are migrating towards modular, scalable systems rather than large, fixed frame systems. Companies are looking for storage systems with data management software to help simplify data storage and reduce the total cost of ownership. Due to these changes, we believe the basic protocol to protocol conversion bridge business on which our historical operations are based is declining due to:

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With this challenge in mind, we began focusing on an “Intelligence At The Edge” strategy in early 2004. This strategy is designed to translate our technology leadership in fibre channel to SCSI (FC-SCSI) connectivity and expand it by developing solutions targeted at the fibre channel to SAN (FC-SAN), internet protocol to SAN (IP-SAN), and local area network (LAN) environments.

Another trend significant to our business and financial results is the decline of our bridge product business through our distribution channel. We recognize that bridge products have a short life cycle. Eventually, customers will either adopt the bridge into its central solution, which we are seeing in our OEM opportunities, or products will evolve such that the bridging function is no longer required. We are approaching the end of the bridging product life cycle. As such, we have sought to offset the impact of this waning revenue stream by transforming the basic bridge into a storage controller for tape much like a disk/RAID controller does for disk.

Our reliance on OEMs, as opposed to sales through distributors or VARs, poses a challenge in visibility for revenue growth as we are subject to their product delivery schedules. This limited visibility is the primary reason it was important to restructure our storage business. In March 2005, our board of directors approved a restructuring plan to reduce our workforce by approximately 20 percent, or 23 people throughout the company, to scale down our infrastructure and to reduce the size of our storage device controllers operations. We recognized a charge in the second fiscal quarter of approximately $0.6 million as a result of this restructuring plan.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, deferred taxes, investment in privately-held company and consolidation, warranty obligations, excess and obsolete inventories, allowance for doubtful accounts, facility lease abandonment losses associated with our restructuring, valuation of intangibles and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

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Revenue recognition. With respect to sales of our products to OEMs, we recognize product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, collectibility is probable and risk of loss has passed to the OEM. Product sales to distributors, VARs and system integrators who do not have return rights are recognized upon shipment. To the extent that we sell products to distributors, VARs and system integrators that have rights of return, we defer revenue and the related cost of revenue associated with such sales and recognize these amounts when that customer sells our products to its customers. Judgments and estimates must be made and used in connection with the revenue recognized in any given accounting period. Material differences may result in the amount and timing of our revenue, in any given accounting period, if our management alters the method by which they derive such judgments or estimates.

Royalty and other revenue includes licensing of intellectual property (IP), royalty payments and sales of service contracts. IP licensing arrangements typically consist of upfront nonrefundable fees, including payments related to past sales of licensed products or payments related to a paid-up license in which the licensee makes a single payment for a lifetime patent license. Once a license agreement is signed, delivery of the license has occurred and there are no remaining obligations outstanding, we record revenue from upfront nonrefundable IP license fees. License arrangements can also include a royalty stream that is recognized quarterly based on reports from the licensee. Revenue from royalty payments from HP is recognized monthly based on reports from HP and quarterly from other IP licensees. Service revenue is recognized ratably over the service period.

Deferred taxes. In preparing our financial statements, we are required to estimate our income tax obligations. This process involves estimating our actual tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. If we change this valuation allowance in a period, we must include an expense or benefit within the tax provision in our statement of operations.

Judgment is required in determining our deferred tax assets and liabilities and our valuation allowance recorded against our net deferred tax assets. In assessing the potential realization of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon us attaining future taxable income during the period in which our deferred tax assets are recoverable. Due to uncertainty surrounding our ability to generate taxable income in the future, we have determined that it is more likely than not that we will not be able to utilize any of the benefits of our deferred tax assets, including net operating loss carry forwards, before they expire. Therefore, we have provided a 100% valuation allowance on our deferred tax assets, and our net deferred tax assets as of April 30, 2005 is zero.

Investment in privately-held company and consolidation. We assess the impairment of investments whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered important which could trigger an impairment review include: (i) inherent risk of investment due to stage of development, (ii) underperformance relative to projected future operating results, and (iii) changes in the strategy of business. When we determine that the carrying value of an investment may not be recoverable, an impairment charge is recorded.

As of April 30, 2005, we had a minority equity interest in NexQL of approximately 45% and we held one of four of NexQL’s board of director seats. Currently, NexQL has a negative equity position. If we are required to consolidate our financial results with NexQL in the future, any additional losses will impact our consolidated statement of operations. The factors used to determine how we will account for our interest in NexQL in the future makes it difficult for us to assess the impact of NexQL on our financial results in future periods.

Warranty obligations. We provide for the estimated cost of product warranties at the time revenue is recognized. These estimates are developed based on historical information. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required.

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Excess and obsolete inventory. We write-down our inventory for estimated obsolescence or unmarketable inventory based on the difference between the cost of inventory and the estimated market value derived by assumptions about future demand and market conditions. If actual demand and/or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Allowance for doubtful accounts. We assess the collectibility of outstanding customer invoices and in doing such, we maintain an allowance for estimated losses resulting from the non-collection of customer receivables. In estimating this allowance, we consider factors such as:

Actual customer collections could differ from our estimates. For example, if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Facility lease abandonment losses. We vacated excess leased facilities as a result of restructuring plans we completed during the second quarter of 2005 as well as fiscal 2002. We estimated costs of vacating these leased facilities, including estimated costs to sublease, based on market information and trend analysis. Any sublease payments received by us are recorded as a reduction to this accrual based on the specified sublease terms. Actual results may differ from these estimates in the near term, and such differences could be material to our financial statements.

Valuation of purchased intangible assets. We record intangible assets when we acquire companies. The cost of the acquisition is allocated to the assets and liabilities acquired, including identifiable intangible assets, with the remaining amount being classified as goodwill, if applicable. Identifiable intangible assets are amortized over time, while in-process research and development is recorded as a charge on the date of acquisition and goodwill is capitalized, subject to periodic review for impairment. The allocation of the acquisition cost to identifiable intangible assets requires extensive use of estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets. Should conditions be different than management’s current assessment, material write-downs of the fair value of intangible assets may be required. We periodically review the estimated remaining useful lives of our intangible assets. A reduction in the estimate of remaining useful life could result in accelerated amortization expense or a write-down in future periods. As such, any future write-downs of the assets would adversely affect our gross and operating margins.

Litigation. We evaluate contingent liabilities, including pending or threatened litigation in accordance with SFAS No. 5, “Accounting for Contingencies” and record accruals when the outcome of these matters is deemed probable and the liability is reasonably estimable. We make these assessments based upon the facts and circumstances, and in some instances based in part upon the advice of outside legal counsel. As of April 30, 2005, we have not accrued any material costs associated with any pending or threatened litigation, as no amounts have been deemed probable or reasonably estimable. However, any changes in the pending or threatened litigation could result in revisions to our estimates of the potential liability and could materially impact our results of operations and financial position.

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RESULTS OF OPERATIONS

Our net loss for the three and six months ended April 30, 2005 was $3.7 million and $6.7 million, respectively. Our net loss for the three and six months ended April 30, 2004 was $0.7 million and $1.8 million, respectively. A decrease in sales to EMC during the three and six months ended April 30, 2005 contributed to an increase in our current net loss. In addition, our investment in NexQL had a significant impact on our current net loss. Net operating expenses and net loss attributable to NexQL for the three months ended April 30, 2004 and 2005 were approximately $0.5 million and $1.0 million, respectively. Net operating expenses and net loss attributable to NexQL for the six months ended April 30, 2004 and 2005 were approximately $0.7 million and $1.7 million, respectively.

The following table sets forth, for the periods indicated, a year-over-year comparison of the key components of our revenue, costs of revenue and gross profit:

TOTAL REVENUE

Total revenue consists of product revenue and royalty revenue. Compared to the three and six months ended April 30, 2004, royalty and other revenue remained relatively flat; however, product revenue decreased approximately 63% and 56%, respectively.

A significant portion of our revenue is concentrated among a limited number of OEM customers. For the three months ended April 30, 2005, two customers represented 66% and 22%, respectively, of total revenue for a combined total of 88% of total revenue. We expect that a significant portion of our future revenue will continue to come from sales of products to a limited number of customers. Therefore, the loss of, or a decrease in the level of sales to, any one of these customers could seriously harm our financial condition and results of operations.

Product Revenue

Product revenue consists of sales of our storage router and ServerAttach lines of products. Our product revenue is primarily generated from sales to our OEM partners who then sell our products to end-user customers. During the three and six months ended April 30, 2005, the decrease in product revenue is primarily due to a significant reduction in revenue from our OEM customers due to what we believe is a shift in the industry toward more comprehensive storage solutions. We do not anticipate that product revenue will increase until we are able to introduce new solutions to our OEMs and gain market acceptance of our new StrongBox^™ family of products.

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Royalty and Other Revenue

Royalty and other revenue consists of revenue from the licensing of IP, royalty payments from HP and sales of service contracts. IP licensing arrangements typically consist of upfront nonrefundable fees. These fees are collected as consideration for either past or future sales of licensee products. When a license agreement is signed, delivery of the license has occurred and there are no remaining obligations outstanding, we record revenue from upfront nonrefundable IP licensing arrangements. License arrangements can also include a royalty stream that is recognized quarterly based on reports from the licensee. Revenue from royalty payments from HP is recognized monthly based on reports from HP and quarterly from other IP licensees. Service revenue is recognized ratably over the service period.

Royalty and other revenue for the three and six months ended April 30, 2005 remained relatively flat as compared to the comparable period in fiscal 2004 as we did not generate additional license revenue or release any new royalty based products with HP. We are currently developing new royalty based products with HP to be released in the latter half of fiscal 2005.

Given the nature of patent license agreements, the timing of license revenue is difficult to forecast and therefore is expected to cause fluctuations in royalty and other revenue. Our potential to generate patent license revenue in the future will be largely dependent upon our ability to identify and successfully pursue additional, potential licensees.

Gross Profit

Gross profit is total revenue less total cost of revenue. Total gross profit decreased for the three and six months ended April 30, 2005 as compared to the same period in fiscal 2004 mainly due to lower product revenue. Gross profit percentage was relatively flat for both periods as a result of product mix, including the positive effect of royalty revenue, and the absence of license revenue in both periods.

Cost of product revenue consists primarily of contract manufacturing costs, material costs, manufacturing overhead, third party software licenses and warranty costs. Cost of product revenue decreased for the three and six months ended April 30, 2005 as compared to the comparable periods in fiscal 2004 mainly due to lower product revenue resulting from decreases in demand from our OEMs. We expect cost of product revenue to fluctuate based on the introduction of new products, changes in product mix and other fluctuations in the components of cost of product revenue.

We expect to introduce new products throughout fiscal 2005. As new or enhanced products are introduced, we must successfully manage the transition from older products to avoid excessive levels of older product inventories, and ensure that sufficient supplies of new products can be delivered to meet customer demands. Our revenue and gross profit margin will be adversely affected if we fail to successfully manage the introductions of these new products.

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OPERATING EXPENSES

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries, commissions, travel, tradeshow and advertising programs, and other promotional activities. The following table sets forth, for the periods indicated, a year-over-year comparison of the key components of our sales and marketing expenses: