Tumbleweed Communications Corp - Quarterly Report (10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2007

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 000-26223

TUMBLEWEED COMMUNICATIONS CORP.

(Exact name of registrant as specified in its charter)

Delaware

94-3336053

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

700 Saginaw Drive

Redwood City, CA

94063

(Address of principal executive offices)

(Zip Code)

(650) 216-2000

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨

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

The number of shares of common stock outstanding as of October 31, 2007 was 51,123,963.

SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS

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

•

any projections of revenues, earnings, cash balances or cash flow, synergies, or other financial items;

•

any revenue expected to be realized from backlog;

•

any statements of the plans, strategies and objectives of management for future operations;

•

any statements regarding future economic conditions or performance;

•

any statements regarding implementing our business strategy;

•

any statements regarding attracting and retaining customers;

•

any statements regarding obtaining and expanding market acceptance of the products and services we offer;

•

any statements regarding competition in, or size of, our market; and

•

any statements of assumptions underlying any of the foregoing.

These forward-looking statements are only predictions, not historical facts. These forward-looking statements involve certain risks and uncertainties, as well as assumptions. Actual results, levels of activity, performance, achievements and events could differ materially from those stated, anticipated or implied by such forward-looking statements. The factors that could contribute to such differences include those discussed under the caption “Risk Factors” in Part II, Item 1A contained herein, as well as those discussed in our Form 10-K and other filings with the Securities and Exchange Commission. These risks should be considered carefully, among other things, in evaluating our prospects and future financial performance. The occurrence of the events described in the risk factors could harm our business, results of operations and financial condition. These forward-looking statements are made as of the date of this Quarterly Report on Form 10-Q. We disclaim any obligation to update or alter these forward-looking statements, whether as a result of new information, future events or otherwise, or any obligation to explain the reasons why actual results may differ.

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

INDEX


		Page
	Part I

Item 1	Financial Statements (unaudited)	4
	Condensed Consolidated Balance Sheets as of September 30, 2007 and December 31, 2006	4
	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2007 and September 30, 2006	5
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2007 and September 30, 2006	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3	Quantitative and Qualitative Disclosures About Market Risk	20
Item 4	Controls and Procedures	20

	Part II

Item 1	Legal Proceedings	20
Item 1A	Risk Factors	21
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	27
Item 3	Defaults Upon Senior Securities	27
Item 4	Submission of Matters to a Vote of Security Holders	27
Item 5	Other Information	27
Item 6	Exhibits	27
Signatures		28
Certifications

TRADEMARKS

The following are registered trademarks of Tumbleweed Communications Corp. or its subsidiaries in the United States and/or other countries: Tumbleweed ^® , Tumbleweed Communications ^® , the Arrows logo, MailGate ^® , Secure Envelope ^® , Secure Inbox ^® , Tumbleweed Email Firewall ^® , Tumbleweed IME Integrated Messaging Exchange ^® , Messaging Management System (MMS) ^® , Valicert ^® , and Corvigo ^® . The following are other trademarks and service marks of Tumbleweed Communications Corp. or its subsidiaries in the United States and/or other countries: MailGate Appliance ^™ , Secure Messenger ^™ , Tumbleweed Secure Messenger ^™ , Desktop Messenger ^™ , Tumbleweed Desktop Messenger ^™ , Dark Traffic ^™ , Dynamic Anti-Spam Service (DAS) ^™ , Edge Defense ^™ , Tumbleweed Edge Defense ^™ , Intelligent Edge Defense ^™ , SecureTransport ^™ , Tumbleweed SecureTransport ^™ , Validation Authority ^™ , Tumbleweed Validation Authority ^™ , Server Validator ^™ , Desktop Validator ^™ , Tumbleweed FTP Analyzer ^™ , WorldSecure ^™ , and WorldSecure/Mail ^™ . All other trademarks and service marks are the property of their respective owners.

PART I—FINANCIAL INFORMATION

ITEM 1— FINANCIAL STATEMENTS

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in thousands)

(unaudited)


	September 30, 2007			December 31, 2006
Assets
Current assets:
Cash and cash equivalents	$	27,046		$	30,511
Accounts receivable, net of allowance for doubtful accounts of $375 at September 30, 2007 and $431 at December 31, 2006		12,196			12,506
Other current assets		2,520			1,938

Total current assets		41,762			44,955
Goodwill		48,074			48,074
Intangible assets, net		505			1,470
Property and equipment, net		2,038			1,820
Other assets		355			612

Total assets	$	92,734		$	96,931

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	1,727		$	1,808
Accrued liabilities		6,280			7,522
Accrued merger-related and other costs		—			97
Deferred revenue		20,259			20,003

Total current liabilities		28,266			29,430

Deferred revenue, excluding current portion		4,463			4,728
Other long-term liabilities		32			63

Total long-term liabilities		4,495			4,791

Total liabilities		32,761			34,221

Commitments and Contingencies
Stockholders’ equity:
Common stock		52			51
Additional paid-in capital		364,259			359,238
Treasury stock		(796	)		(796	)
Accumulated other comprehensive income		75			29
Accumulated deficit		(303,617	)		(295,812	)

Total stockholders’ equity		59,973			62,710

Total liabilities and stockholders’ equity	$	92,734		$	96,931

See accompanying Notes to Condensed Consolidated Financial Statements

Condensed Consolidated Statements of Operations

(in thousands, except per share data)

(unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
Revenue:
Product revenue	$	5,554		$	7,273		$	16,572		$	19,952
Service revenue		8,305			7,469			25,300			22,067
Intellectual property revenue		191			357			1,323			3,281

Total revenue		14,050			15,099			43,195			45,300

Cost of revenue:
Cost of product revenue		1,158			1,531			4,221			3,224
Provision for excess inventory		—			—			164			—
Cost of service revenue		1,890			1,704			5,719			4,849
Amortization of intangible assets		234			234			702			1,233

Total cost of revenue		3,282			3,469			10,806			9,306

Gross profit		10,768			11,630			32,389			35,994

Operating expenses:
Research and development		3,816			3,783			11,570			11,003
Sales and marketing		7,806			6,937			21,733			19,986
General and administrative		2,545			2,365			7,549			8,314
Amortization of intangible assets		39			204			266			837

Total operating expenses		14,206			13,289			41,118			40,140

Operating loss		(3,438	)		(1,659	)		(8,729	)		(4,146	)
Other income, net		322			278			1,042			843

Net loss before income taxes		(3,116	)		(1,381	)		(7,687	)		(3,303	)
Provision for (benefit from) income taxes		(33	)		(7	)		1			59

Net loss	$	(3,083	)	$	(1,374	)	$	(7,688	)	$	(3,362	)

Net loss per share—basic and diluted	$	(0.06	)	$	(0.03	)	$	(0.15	)	$	(0.07	)

Weighted average shares—basic and diluted		51,092			50,111			50,996			49,905

See accompanying Notes to Condensed Consolidated Financial Statements

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)


	Nine months ended September 30,
	2007			2006
Cash flows from operating activities:
Net loss	$	(7,688	)	$	(3,362	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Stock-based compensation expense		3,617			3,765
Depreciation and amortization expenses		2,075			2,877
Bad debt expense (credit)		(47	)		55
Loss on disposal of property and equipment		40			27
Changes in operating assets and liabilities:
Accounts receivable		357			(944	)
Other current assets and other assets		(325	)		(533	)
Accounts payable, accrued liabilities, and other long-term liabilities		(1,255	)		(49	)
Accrued merger-related and other costs		(97	)		(94	)
Deferred revenue		(9	)		1,887

Net cash provided by (used in) operating activities		(3,332	)		3,629

Cash flows used in investing activities–purchase of property and equipment		(1,584	)		(1,245	)

Cash flows provided by financing activities–proceeds from issuance of common stock		1,405			1,089

Effect of exchange rate on cash and cash equivalents		46			12

Net increase (decrease) in cash and cash equivalents		(3,465	)		3,485
Cash and cash equivalents, beginning of period		30,511			26,952

Cash and cash equivalents, end of period	$	27,046		$	30,437

Supplemental disclosure of cash flow information:
Cash paid during the period for taxes	$	68		$	10

See accompanying Notes to Condensed Consolidated Financial Statements

Notes to Condensed Consolidated Financial Statements

(1) Organization

The condensed consolidated financial statements included herein have been prepared by Tumbleweed Communications Corp. (“Tumbleweed”) without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with Tumbleweed’s audited financial statements and notes thereto included in its Annual Report on Form 10-K for the fiscal year ended December 31, 2006, filed with the SEC on March 14, 2007.

The unaudited condensed consolidated financial statements included herein reflect all adjustments which are, in the opinion of management, necessary to state fairly the financial position of Tumbleweed and its subsidiaries as of September 30, 2007 and December 31, 2006, respectively, the results of operations for the three and nine months ended September 30, 2007 and 2006, respectively, and cash flows for the nine months ended September 30, 2007 and 2006, respectively. Such adjustments are of a normal recurring nature, unless otherwise indicated. The results for the three and nine months ended September 30, 2007 are not necessarily indicative of the results expected for the full fiscal year ending December 31, 2007.

The accompanying condensed consolidated financial statements include the accounts of Tumbleweed and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

(2) Stock-Based Compensation

Tumbleweed’s stock-based compensation program is a broad-based, long-term retention program that is intended to attract and retain employees and align stockholder and employee interests. The stock-based compensation program includes awards of stock options and restricted stock.

Tumbleweed recognizes stock-based compensation expense for the unvested portion of stock-based compensation awards granted prior to, but not yet vested, as of January 1, 2006 on an accelerated basis over the vesting period of the individual award consistent with its methodology prior to the adoption of Statement of Financial Accounting Standards (“SFAS”) 123 revised (2004), Share-Based Payment (“SFAS 123R”) and consistent with the method described in Financial Accounting Standards Board Interpretation 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans . Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R and compensation cost for these awards is recognized on a straight-line basis over the requisite service period of the award, which is generally the option vesting term.

Tumbleweed estimates the fair value of stock options granted using the Black-Scholes-Merton option-pricing model that uses the assumptions noted in the following table. The expected life of the options is based on the weighted average period of time that options granted are expected to be outstanding, giving consideration to vesting schedules and Tumbleweed’s historical exercise patterns. Tumbleweed’s expected volatility is based on the daily historical volatility of Tumbleweed’s common stock, over the expected life of the option. The risk-free interest rate is based on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term to the expected life of the option. When the expected term of Tumbleweed’s stock-based awards does not correspond with the terms for which interest rates are quoted, Tumbleweed performs a straight-line interpolation to determine the rate from the available term maturities. Tumbleweed has not historically paid dividends, thus the expected dividend yield is zero. Tumbleweed issues new shares of common stock upon the exercise of stock options. The assumptions for the three and nine months ended September 30, 2007 and 2006, respectively, are as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
Stock options:
Weighted average fair value of grants	$	1.39		$	1.91		$	1.83		$	1.86
Expected life		4.5 years			4.5 years			4.5 years			4.5 years
Volatility		72	%		83	%		72	%		83	%
Risk-free interest rate		4.48	%		4.85	%		4.63	%		4.80	%
Dividend yield		0	%		0	%		0	%		0	%

The aggregate intrinsic value of options exercised under Tumbleweed’s stock option plans for the three and nine months ended September 30, 2007 was $45,000 and $677,000, respectively, determined as of the date of option exercise. The aggregate intrinsic value of options exercised under Tumbleweed’s stock option plans for the three and nine months ended September 30, 2006 was $250,000 and $997,000, respectively, determined as of the date of option exercise.

The cost of restricted stock awards is determined using the fair value of Tumbleweed’s common stock on the date of the grant, and compensation expense is recognized over the vesting period. Vesting periods are determined by the Board of Directors. Generally, restricted stock awards are subject to the employee’s continuing service to Tumbleweed. The weighted average grant date fair value of restricted stock granted during the nine months ended September 30, 2007 was $3.28. No restricted stock awards were granted during the nine months ended September 30, 2006.

There is no tax benefit recorded for this expense due to full valuation allowances in the jurisdictions for which these options are deductible for tax purposes. Stock-based compensation expense is included in Tumbleweed’s condensed consolidated statement of operations as follows (in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Cost of product revenue	$	—	$	2	$	—	$	6
Cost of service revenue		40		33		105		106
Research and development		200		442		760		969
Sales and marketing		501		144		1,040		500
General and administrative		575		487		1,712		2,184

Total stock-based compensation expense	$	1,316	$	1,108	$	3,617	$	3,765

(3) Net Loss Per Share

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


	Three Months Ended September 30,		Nine Months Ended September 30,
	2007	2006	2007	2006
Warrants and options excluded from diluted net loss per share	15,146	14,733	14,808	14,500

(4) Concentrations of Credit Risk

Financial instruments, which potentially subject Tumbleweed to concentrations of credit risk, consist primarily of cash equivalents and accounts receivable. Tumbleweed’s cash equivalents generally consist of money market funds with qualified financial institutions. To analyze accounts receivable, Tumbleweed performs periodic evaluations of its customers’ financial condition and, when necessary, records bad debt expense. One customer comprised 12% of Tumbleweed’s accounts receivable balance, net of allowance for doubtful accounts, at September 30, 2007. One customer comprised 27% of Tumbleweed’s accounts receivable balance, net of allowance for doubtful accounts, at December 31, 2006. For the three and nine months ended September 30, 2007, respectively, no single customer comprised 10% or more of Tumbleweed’s revenue. For the three months ended September 30, 2006, one customer comprised 16% of Tumbleweed’s revenue. For the nine months ended September 30, 2006, no single customer comprised 10% or more of Tumbleweed’s revenue.

(5) Intangible Assets and Goodwill

Intangible assets consist of the fair value of core/developed technology, customer base and reseller agreements, maintenance agreements, and trademarks and trade names, all net of accumulated amortization, acquired during the acquisitions of Valicert, Inc. (“Valicert”), Tumbleweed Communications Limited (formerly Incubator Limited), and Corvigo, Inc.

A summary of intangible assets as of September 30, 2007 follows (in thousands):


	Amortization period (in years)	Gross carrying amount		Accumulated amortization			Net
Core/developed technology	3 to 4	$	3,250	$	(2,872	)	$	378
Customer base and reseller agreements	3		450		(399	)		51
Maintenance agreements	3 to 4		500		(443	)		57
Trademarks and trade names	4		150		(131	)		19

		$	4,350	$	(3,845	)	$	505

A summary of intangible assets as of December 31, 2006 is as follows (in thousands):


	Amortization period (in years)	Gross carrying amount		Accumulated amortization			Net
Core/developed technology	3 to 4	$	3,250	$	(2,263	)	$	987
Customer base and reseller agreements	3		2,300		(2,032	)		268
Maintenance agreements	3 to 4		500		(349	)		151
Trademarks and trade names	4		350		(286	)		64

		$	6,400	$	(4,930	)	$	1,470

The estimated amortization of intangible assets for each of the fiscal years subsequent to September 30, 2007, is as follows (in thousands):


Year Ending December 31,
2007 (remaining three months)		273
2008		232

	$	505

Goodwill represents the excess of the purchase price over the fair value of acquired net tangible and identified intangible assets. In accordance with the provisions of SFAS 142, Goodwill and Other Intangible Assets, goodwill is not amortized, but instead, is tested for impairment at least annually and more frequently if certain impairment conditions exist. Tumbleweed completed its annual assessment of goodwill in the three months ended June 30, 2007 and no impairment of goodwill was determined as a result of this assessment. Any future impairment loss related to the goodwill recorded in connection with acquisitions will not be deductible by Tumbleweed for federal income tax purposes.

(6) Comprehensive Loss

Comprehensive loss includes Tumbleweed’s net loss as well as foreign currency translation adjustments. Comprehensive loss for the three months ending September 30, 2007 and 2006, respectively, is as follows (in thousands):


	Three Months Ended September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
Net loss	$	(3,083	)	$	(1,374	)	$	(7,688	)	$	(3,362	)
Other comprehensive income—translation adjustments		35			5			46			12

Comprehensive loss	$	(3,048	)	$	(1,369	)	$	(7,642	)	$	(3,350	)

(7) Segment Information

As defined by SFAS 131, Disclosure About Segments of an Enterprise and Related Information , Tumbleweed’s chief operating decision-maker is its Chief Executive Officer. This officer reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenue by geographic region for purposes of making

operating decisions and assessing financial performance. The consolidated financial information reviewed is the information presented in the accompanying condensed consolidated statement of operations. Tumbleweed operates in a single reporting segment providing messaging security solutions that are developed and sold in similar ways to enterprise and government customers of all sizes.

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


	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
North America	$	12,445	$	14,076	$	38,075	$	42,191
Europe, Middle East, and Africa		1,104		732		3,579		2,219
Asia Pacific		465		226		1,417		696
Other		36		65		124		194

Total	$	14,050	$	15,099	$	43,195	$	45,300

Tumbleweed’s property and equipment, net located in different geographic regions as of September 30, 2007 and December 31, 2006 is as follows (in thousands):


	September 30, 2007		December 31, 2006
North America	$	1,610	$	1,403
Europe		421		410
Other		7		7

Total long-lived assets	$	2,038	$	1,820

(8) Contingencies

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

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

In April 2006, the District Court held a hearing on the proposed settlement but has not yet issued a ruling on the issue. Subsequently, the Court of Appeals for the Second Circuit (the “Court of Appeals”) vacated the class certification of plaintiffs’ claims against the underwriters in six cases designated as focus or test cases. Miles v. Merrill Lynch & Co. (In re Initial Public Offering Securities Litigation , 471 F.3d 24 (2d Cir. 2006). Thereafter, the District Court ordered a stay of all proceedings in all of the lawsuits pending the outcome of plaintiffs’ petition to the Court of Appeals for rehearing en banc and resolution of the class certification issue. On April 6, 2007, the Court of Appeals denied plaintiffs’ petition for rehearing, but clarified that the plaintiffs may seek to certify a more limited class in the District Court.

Accordingly, the stay remains in place and the plaintiffs and issuers have stated that they are prepared to discuss how the settlement might be amended or renegotiated to comply with the ruling of the Court of Appeals. Failure of the District Court to approve the settlement (or an amended or renegotiated settlement) followed by an adverse outcome could harm Tumbleweed’s business and operating results. Moreover, the costs in defending this lawsuit could harm future operating results. The accompanying condensed consolidated financial statements do not include a reserve for any potential loss, as Tumbleweed does not consider a loss to be probable at this time. All costs incurred as a result of this legal proceeding are charged to expense as incurred.

Tumbleweed indemnifies its customers from third party claims of intellectual property infringement relating to the use of its products. Historically, costs related to these guarantees have not been significant. Tumbleweed is unable to estimate the potential impact of these guarantees on its future results of operations.

Tumbleweed is engaged in other legal actions arising in the ordinary course of business. Although there can be no assurance as to the outcome of such litigation, Tumbleweed believes it has adequate legal defenses and it believes that the ultimate outcome of any of these actions will not have a material effect on its consolidated financial positions or results of operations.

(9) Recent Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS 109, Accounting for Income Taxes and requires a two-step approach to evaluate tax positions and determine if they should be recognized in the financial statements. The two-step approach involves recognizing any tax positions that are “more likely than not” to occur and then measuring those positions to determine if they are recognizable in the financial statements. The interpretation is effective for fiscal years beginning after December 15, 2006. Tumbleweed adopted FIN 48 on January 1, 2007. The impact of FIN 48 did not have a material effect on Tumbleweed’s consolidated financial position, results of operations, or cash flows.

As of January 1, 2007, Tumbleweed did not have any federal, state, and foreign unrecognized tax benefits. Upon adoption of FIN 48, Tumbleweed adopted an accounting policy to classify interest and penalties on unrecognized tax benefits as income tax expense. For the years prior to adoption of FIN 48, Tumbleweed did not have interest or penalties on unrecognized tax benefits and therefore, had no established accounting policy. As of January 1, 2007, Tumbleweed had no interest or penalties accrued on unrecognized tax benefits. Tumbleweed files income tax returns in the U.S. federal jurisdiction, various states, and foreign jurisdictions. Tumbleweed is subject to U.S. federal and state income tax examinations by tax authorities for all periods since inception due to net operating losses. As of September 30, 2007, Tumbleweed did not have and does not expect to have any material changes to unrecognized tax benefits within the next twelve months.

In June 2006, the FASB ratified the Emerging Issues Task Force (“EITF”) consensus on Issue 06-03, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement” (“EITF 06-03”). EITF 06-03 provides guidance on an entity’s disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-03 are those that are imposed on and concurrent with a specific revenue-producing transaction. The guidance is effective for interim and annual periods beginning after December 15, 2006. Tumbleweed did not have and does not expect to have any material impact of EITF 06-03 on its financial position and results of operations.

In June 2006, the FASB ratified the EITF consensus on Issue 06-02, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, Accounting for Compensated Absences” (“EITF 06-02”). EITF 06-02 requires that the costs associated with unrestricted sabbaticals and other similar benefit arrangements be recognized over the service period during which the employee earns the benefit. The provisions of EITF 06-02 are effective for fiscal years beginning after December 15, 2006. The provisions of EITF 06-02 were applied by Tumbleweed through a cumulative effect adjustment to its accumulated deficit that resulted in increases of $117,000 each to its accumulated deficit and accrued liabilities balances, respectively. The changes in accumulated deficit for the nine months ended September 30, 2007 are as follows:


	(In thousands)
Balance as of December 31, 2006	$	(295,812	)
Net loss		(7,688	)
Adoption effect of EITF 06-02		(117	)

Balance as of September 30, 2007	$	(303,617	)

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the condensed consolidated financial statements and the accompanying notes to this Quarterly Report on Form 10-Q and Tumbleweed’s Annual Report on Form 10-K for 2006 filed with the Securities and Exchange Commission (“SEC”), as well as Management’s Discussion and Analysis of Financial Condition and Results of Operations included therein. The following discussion contains forward-looking statements that reflect Tumbleweed’s plans, estimates and beliefs. Tumbleweed’s actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and at Part II, Item 1A, “Risk Factors” to this Quarterly Report.

Overview

Tumbleweed Communications Corp. (“Tumbleweed” or “we”) is a recognized expert in providing messaging and content security solutions for enterprise and government customers of all sizes. With our products, organizations can block security threats, protect information, confidently conduct business online, and reduce their cost of doing business. We provide comprehensive solutions for secure file transfer, email threat protection, email encryption, and identity validation that allow organizations to safely and confidently conduct business over the Internet. We offer these solutions in four comprehensive product suites: SecureTransport, Secure Messenger, MailGate, and Validation Authority. SecureTransport enables customers to safely exchange large files and transactions without having to change their internal infrastructure. Secure Messenger is a policy-based secure message delivery solution that enables the inspection of incoming and outgoing mail and dynamically applies user-defined encryption and routing preferences. MailGate provides protection against spam and viruses, and enables policy-based message filtering, encryption, and routing. Validation Authority is a leading solution for determining the validity of digital certificates.

We are trusted by more than 3,000 enterprise and government customers who use our products to connect with over 10,000 corporations and millions of end-users. While our solutions apply to many industry sectors, our traditional market focus has been in the financial services, healthcare, and government markets. Security-conscious organizations use our products to block security threats, protect information assets, and enable the safe exchange of messages, files, and transactions.

Backlog

Our backlog consists of deferred revenue as well as contractual commitments that are not due and payable as of the balance sheet date, or for which the product or service has not yet been delivered, and/or for which collectibility is not considered probable. Our backlog excludes all items relating to consulting and training services. Backlog was $23.9 million at September 30, 2007. We believe that $18.3 million of the backlog at September 30, 2007 will be recognized as revenue in the next 12 months in accordance with our revenue recognition policy, with the balance to be recognized thereafter.

Outlook

We believe that our success in the remainder of 2007 will depend on our ability to build on our core competency in messaging and content security as we:

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expand our reseller channel by having our sales organization and channel partners work cooperatively to increase our revenue base;

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expand the pipeline of sales opportunities and then close those opportunities in a timely manner;

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expand our customer base in email and file transfer by solving a larger number of our customers’ problems in messaging and content security;

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differentiate our products on ease of use, business communications enablement, and security effectiveness; and

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increase our brand awareness including building greater mindshare among buyers of email, file transfer, and validation technologies.

We believe that key risks include overall economic conditions and the overall level of information technology spending; economic and business conditions within our target customer sectors; timing of the closure of customer contracts; integration of the new members of our sales management, and competitive factors in our rapidly changing industry. Our prospects must be considered in light of the risks, expenses and difficulties encountered by companies at our stage of development, particularly given that we operate in rapidly evolving markets. We may not be successful in addressing such risks and difficulties. Please refer to the “Risk Factors” section at Part II, Item 1A for additional information.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of operations are 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 us to make estimates and judgments in determining the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We regularly evaluate our estimates, including those related to revenue recognition, customer arrangements, collectibility of accounts receivable, valuation of assets, and contingencies and litigation. When making estimates, we consider our historical experience, our knowledge of economic and market factors and various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

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

Revenue Recognition

We derive our revenue from three sources: (i) product revenue, which includes license fees and appliance fees (for products that are either sold as a standalone software solution or pre-loaded on an appliance platform), and subscription-based license fees; (ii) service revenue, which consists of support and maintenance fees, consulting fees, and training fees; and (iii) intellectual property revenue, which consists of patent license agreement fees. As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period based on the judgments and estimates made by our management.

We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, Software Revenue Recognition (“SOP 97-2”), as amended by SOP 98-9, Modification of SOP 97-2 , “Software Revenue Recognition” With Respect to Certain Transactions (“SOP 98-9”). We make significant judgments related to revenue recognition. Specifically, as set forth in paragraph 8 of SOP 97-2 in connection with each transaction involving our products, we must evaluate whether: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, and (iv) collectibility is probable. We apply these criteria as discussed below.

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Persuasive evidence of an arrangement exists. We require a written contract, signed by both the customer and us, or a purchase order from those customers that have previously negotiated a standard license arrangement or volume purchase agreement with us prior to recognizing revenue on an arrangement.

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Delivery has occurred. We deliver software to our customers physically or electronically. For physical deliveries, our transfer terms are typically free on board, or FOB, shipping point. For electronic deliveries, delivery occurs when we provide the customer access codes or “keys” that allow the customer to take immediate possession of the software.

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The fee is fixed or determinable. Our determination that an arrangement fee is fixed or determinable depends principally on the arrangement’s payment terms. Our standard payment terms require the arrangement fee to be due within a maximum of 90 days. Where these terms apply, we regard the fee as fixed or determinable, and we recognize revenue upon delivery pursuant to the terms of the arrangement, assuming all other revenue recognition criteria are met. If the payment terms do not meet this standard, which we refer to as “extended payment terms,” we do not consider the fee to be fixed or determinable and generally recognize revenue when customer installments are due and payable.

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Collectibility is probable. To recognize revenue, we must judge collectibility of the arrangement fees, which we do on a customer-by-customer basis pursuant to our credit review policy. We typically sell to customers with whom we have a history of successful collection. For new customers, we evaluate the customer’s financial position and ability to pay. If we determined that collectibility is not probable based upon our credit review process or the customer’s payment history, we recognize revenue when payment is received.

We allocate revenue on software transactions (referred to as “arrangements” in the accounting literature) involving multiple elements to each undelivered element based on their respective fair values. Specifically, in a multi-element arrangement we allocate revenue first to undelivered elements such as support and maintenance, consulting services, and training based on each element’s fair value and the residual is allocated to the product license as product revenue. The fair value of support and maintenance fees is recognized ratably over the contractual term of the maintenance, typically one year. The fair value of services not considered essential to the functionality of the product or technology delivered is initially deferred and recognized as revenue as the services are performed. Our determination of the fair value of each element in multiple element arrangements is based on vendor-specific objective evidence (“VSOE”). We limit our assessment of the VSOE of fair value for each element to the price charged when that element is sold separately.

Arrangements that include consulting services are evaluated to determine whether those services are essential to the functionality of the other elements of the arrangement. When services are not considered essential, the revenue allocable to the services is recognized separately from the software, provided VSOE of the fair value of these services exists. If we provide consulting services that are considered essential to the functionality of the software products, both the product revenue and service revenue are recognized under contract accounting in accordance with the provisions of SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts . Revenue from these arrangements is recognized under the percentage of completion method based on the ratio of direct labor hours incurred to date to total projected labor hours except in limited circumstances where completion status cannot be reasonably estimated, in which case the completed contract method is used.

Our software products are typically fully functional upon delivery and do not require significant modification or alteration. For arrangements where services are not essential to the functionality of the software, customers typically purchase consulting services to facilitate the adoption of our technology, but they may also decide to use their own resources or appoint other professional service organizations to perform these services. Software products and related support and maintenance services may be billed separately and independently from professional services, which are typically billed on either a time-and-materials basis or a fixed fee basis. For time-and-materials contracts, we recognize revenue as the services are performed. For fixed fee engagements with milestones or acceptance provisions, revenue is recognized upon completion of a milestone or acceptance, if applicable.

We recognize revenue from patent license agreements when (i) the patent license agreement is executed, (ii) the amounts due are fixed, determinable, and billable, and (iii) collection of the resulting receivable is probable.

We recognize revenue from indirect channels such as resellers using the same criteria as is used for arrangements obtained through our direct sales team.

We typically grant our customers a warranty which guarantees that our products will substantially conform to our current specifications for 90 days from the delivery date pursuant to the terms of the arrangement. We account for the estimated cost of product and service warranties in accordance with Statement of Financial Accounting Standards (“SFAS”) 5, Accounting for Contingencies , provided that it is probable that a liability exists, and provided the cost to repair or otherwise satisfy the claim can be reasonably estimated. The amount of the accrual recorded is equal to the costs to repair or otherwise satisfy the claim. Costs related to warranty claims for the three months ended September 30, 2007 and 2006 were $86,000 and $107,000, respectively. Costs related to warranty claims for the nine months ended September 30, 2007 and 2006 were $207,000 and $132,000, respectively.

Stock-based Compensation Expense

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123 revised (2004), Share-Based Payment (“SFAS 123R”), using the modified prospective transition method. Under this transition method, stock-based compensation expense includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, Accounting for Stock-Based Compensation (“SFAS 123”). We recognize stock-based compensation expense for the unvested portion of stock-based compensation awards granted prior to, but not yet vested, as of January 1, 2006 on an accelerated basis over the vesting period of the individual award consistent with our methodology prior to the adoption of SFAS 123R and consistent with the method described in Financial Accounting Standards Board Interpretation 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans . Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R and compensation cost for these awards is recognized on a straight-line basis over the requisite service period of the award, which is generally the option vesting term. In accordance with the provisions of SFAS 123R, we recognize stock-based compensation expense net of an estimated forfeiture rate and recognize the compensation expense for only those shares expected to vest over the requisite service period of the award, which is generally the option vesting term. We estimate the forfeiture rate based on our historical experience during the preceding term that equals the expected life of the options. The expected life of the options is based on the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns. Our expected volatility is based on the daily historical volatility of our common stock, over the expected life of the option. The risk-free rate is based on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term to the expected life of the option. Where the expected term of our stock-based awards does not correspond with the terms for which interest rates are quoted, we perform a straight-line interpolation to determine the rate from the available term maturities. Determining the fair value of stock based awards at the grant date requires judgment, including estimating the expected life of stock options, the expected volatility of our stock and the amount of stock options expected to be forfeited. To the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. Actual results, and future changes in estimates, may differ substantially from our current estimates and our results of operations could be materially impacted.

Valuation of Allowance for Doubtful Accounts

We must make estimates of the collectibility of our accounts receivable. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. A considerable amount of judgment is required when we assess the realization of receivables, including assessing the probability of collection and the current credit-worthiness of each customer. We specifically analyze accounts receivable, including review of historical bad debts, customer credit-worthiness, current economic trends, aging of the balance, estimated collectibility percentages for different aging ranges, and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. If the financial condition of certain of our customers were to deteriorate, resulting in an impairment of their ability to make payments, we may record a specific allowance against amounts owed to us by those customers, and thereby reduce the value of the receivable to the amount we reasonably believe will be collected. If all collection efforts have been exhausted, we would write off the receivable against the allowance.

Valuation of Long-Lived Assets and Goodwill

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

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significant underperformance relative to historical or projected future operating results;

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significant changes in the manner or our use of the acquired assets or the strategy for our overall business;

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significant negative industry or economic trends;

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significant decline in our stock price for a sustained period; and

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our market capitalization relative to our net book value.

We evaluate whether goodwill is impaired on at least an annual basis in accordance with SFAS 142, Goodwill and Other Intangible Assets (“SFAS 142”) or more frequently if certain indicators are present. If this evaluation indicates that the value of the goodwill may be impaired, we make an assessment of the impairment of the goodwill using the two-step method prescribed by SFAS 142. Any such impairment charge could be significant and have a material adverse effect on our reported financial statements. We did not record any impairment charges on our goodwill during the three months ended September 30, 2007 and 2006, respectively.

Any future impairment loss related to the goodwill recorded in connection with acquisitions will not be deductible by us for federal income tax purposes. As of September 30, 2007 we had goodwill of $48.1 million.

RESULTS OF OPERATIONS

Three and Nine Months Ended September 30, 2007 and 2006

Revenue for the three and nine months ended September 30, 2007 was $14.1 million and $43.2 million, respectively, as compared to $15.1 million and $45.3 million, respectively, for the same three and nine months in 2006. Net loss for the three and nine months ended September 30, 2007 was $3.1 million and $7.7 million, respectively, as compared to $1.4 million and $3.4 million, respectively, for the same three and nine months in 2006.

Net loss for both the three and nine month periods increased partially due to decreases in revenue. In addition, the net loss for the three month period also increased due to an increase in operating expenses, and the net loss for the nine month period also increased due to increases in cost of revenue and operating expenses. The decrease in total revenue for the three month period was primarily due to a decrease in product revenue, partially offset by an increase in service revenue. The decrease in total revenue for the nine month period was due to decreases in intellectual property revenue and in product revenue, partially offset by an increase in service revenue.

Total cost of revenue decreased to $3.3 million for the three months ended September 30, 2007 from $3.5 million for the same three months in 2006 primarily due to a decrease in appliance costs, which resulted from a decline in the number of appliance units shipped to our customers. Total cost of revenue increased to $10.8 million for the nine months ended September 30, 2007 from $9.3 million for the same nine months in 2006 primarily due to increases in product costs, service costs, and provision for excess inventory, partially offset by a decrease in the amortization of intangible assets. Product costs increased primarily due to an increase in appliance and royalty costs. Appliance costs increased due to an increase in the

number of appliances shipped to our customers as customer adoption of our appliance products increased during the nine month period. Royalty costs increased due to an increase in revenue from our anti-virus products and the increase in the number of appliance units shipped to our customers, both of which require third-party licenses for which we pay royalties. Total operating expenses increased to $14.2 million for the three months ended September 30, 2007 from $13.3 million for the same three months in 2006. Total operating expenses increased to $41.1 million for the nine months ended September 30, 2007 from $40.1 million for the same nine months in 2006. The increase in total operating expenses for both three and nine months were primarily due to increases in sales and marketing expenses driven by increases in employee and employee-related costs.

Revenue. Revenue, which consists of product revenue, service revenue and intellectual property revenue, results from new contracts and backlog. We define backlog as deferred revenue, contractual commitments that are not due and payable as of the balance sheet date, or for which collectibility is not considered probable, or for which the product or service has not yet been delivered. Product revenue consists of license fees and appliance fees (for products that are either sold as a standalone software solution or are pre-loaded on an appliance platform), and subscription-based license fees. Service revenue includes support and maintenance fees, consulting fees, and training fees. Intellectual property revenue consists of patent license agreement fees. Total revenue for the three months ended September 30, 2007 was $14.1 million as compared to $15.1 million for the same three months in 2006. The decrease in total revenue was primarily due to a $1.7 million decrease in product revenue and a $166,000 decrease in intellectual property revenue, partially offset by an $836,000 increase in service revenue. Total revenue for the nine months ended September 30, 2007 decreased to $43.2 million from $45.3 million for the same nine months in 2006. The decrease in total revenue was due to a $3.4 million decrease in product revenue and a $2.0 million decrease in intellectual property revenue, partially offset by a $3.2 million increase in service revenue.

Product revenue decreased to $5.6 million for the three months ended September 30, 2007 from $7.3 million for the same three months in 2006. The decrease in product revenue was due to a reduction in revenue from our Validation Authority product due to a large customer transaction involving this product line during the three months ended September 30, 2006 with no comparable transactions during the three months period ended September 30, 2007. The decrease in product revenue from our Validation Authority product was partially offset by an increase in product revenue from our SecureTransport and MailGate products. Product revenue decreased to $16.6 million for the nine months ended September 30, 2007 from $20.0 million for the same nine months in 2006. The decrease in product revenue was due to three large transactions during the nine months ended September 30, 2006 that accounted for 37% of our product revenue during that period, with no comparable transactions recorded during the nine months ended September 30, 2007. This was partially offset by increases in the volume of our license transactions, reflecting an expansion of our customer base.

Service revenue increased to $8.3 million for the three months ended September 30, 2007 from $7.5 million for the same three months in 2006. Service revenue increased to $25.3 million for the nine months ended September 30, 2007 from $22.1 million for the same nine months in 2006. The increases in service revenue were primarily due to increases in support and maintenance revenue of $475,000 and $2.2 million for the three and nine months ended September 30, 2007, respectively. The increases in service revenue were also due to increases in consulting revenue of $347,000 and $831,000 for the three and nine months ended September 30, 2007, respectively. The increases in support and maintenance revenue were due to the increased number of customers covered by support agreements due to the expansion of our customer base. The increases in consulting revenue were due to increased customer demand for consulting services related to our SecureTransport product line. We expect service revenue to increase on a year-over-year basis during 2007 due to the expansion of our customer base.

Intellectual property revenue decreased to $191,000 for the three months ended September 30, 2007 from $357,000 for the same three months in 2006. The decrease in intellectual property revenue for the three months ended September 30, 2007 was due to a decrease in patent license revenue. Intellectual property revenue decreased to $1.3 million for the nine months ended September 30, 2007 from $3.3 million for the same nine months in 2006. The decrease in intellectual property revenue for the nine months ended September 30, 2007 was due to a large patent license agreement during the three months ended June 30, 2006, with no comparable transactions in 2007.

Cost of revenue. Cost of revenue is comprised of product costs, service costs, provision for excess inventory, and the amortization of intangible assets for core/developed technology and maintenance agreements relating to the acquisitions of Valicert, Inc. (“Valicert”), Incubator Limited (now named Tumbleweed Communications Limited), and Corvigo, Inc. (“Corvigo”). Product costs are primarily comprised of royalties paid to third parties for software licensed by us for inclusion in our products, the cost of our products sold on appliances including related shipping and warranty costs, and employee and employee-related costs, including stock-based compensation expense. Service costs are comprised primarily of employee and employee-related costs, including stock-based compensation expense, for customer support, consulting, and training, and contract development projects with third parties. Provision for excess inventory is comprised of costs associated with excess inventory resulting from our transition to a new appliance manufacturer. Total cost of revenue decreased to $3.3 million, or 23% of total revenue, for the three months ended September 30, 2007 from $3.5 million, or 23% of total revenue, for the same three months in 2006. The decrease in total cost of revenue was due to a $373,000 decrease in product costs, partially offset by a $186,000 increase in service costs. Total cost of revenue increased to $10.8 million, or 25% of total revenue, for

the nine months ended September 30, 2007 from $9.3 million, or 21% of total revenue, for the same nine months in 2006. The increase in total cost of revenue was due to a $1.0 million increase in product costs, an $870,000 increase in service costs, and a $164,000 increase in provision for excess inventory, partially offset by a $531,000 decrease in the amortization of intangible assets.

Cost of product revenue decreased to $1.2 million, or 8% of total revenue, for the three months ended September 30, 2007 from $1.5 million, or 10% of total revenue, for the same three months in 2006. The decrease in product cost was primarily due to a decrease in the number of appliances shipped to our customers as our revenues decreased in the three months ended September 30, 2007 as compared to the same three months in 2006. Cost of product revenue increased to $4.2 million, or 10% of total revenue, for the nine months ended September 30, 2007 from $3.2 million, or 7% of total revenue, for the same nine months in 2006. The increase in product cost was primarily due to an increase of $766,000 for the nine months ended September 30, 2007 in appliance costs due to an increase in the number of appliances shipped to our customers as customer adoption of our appliance products increased relative to the same nine months in 2006. In addition, royalty costs increased by $421,000 for the nine months ended September 30, 2007, due to an increase in revenue from our anti-virus appliance products and the increase in the number of appliance units shipped to our customers, both of which require third-party licenses for which we pay royalties.

Provision for excess inventory of $164,000 for the nine months ended September 30, 2007 is the estimated loss for excess inventory associated with transitioning our hardware products to a new appliance manufacturer and from a proprietary design to a standard product offering. This $164,000 expense was recognized during the three months ended March 31, 2007. There was no comparable expense during the three months ended September 30, 2007 or during the three and nine months ended September 30, 2006.

Service costs increased to $1.9 million, or 13% of total revenue, for the three months ended September 30, 2007 from $1.7 million, or 11% of total revenue, for the same three months in 2006. Service costs increased to $5.7 million, or 13% of total revenue, for the nine months ended September 30, 2007 from $4.8 million, or 11% of total revenue, for the same nine months in 2006. The increases in service costs for the three and nine month periods ended September 30, 2007 were due to increases in employee and employee-related costs and increases in travel expenses. Employee and employee-related costs increased by $190,000 and $772,000, respectively, for the three and nine months ended September 30, 2007 due to increases in average services headcount. Average services headcount increased to 78 and 79, respectively, for the three and nine months ended September 30, 2007, from 70 and 60, respectively, for the same three and nine months in 2006 primarily due to transitioning from a partial utilization of third parties in our support function towards a full employee-based support model and due to the need for greater personnel resources to fulfill our customer service requirements due to our increased service revenues. In addition, travel expenses for the nine months ended September 30, 2007 increased by $155,000 due to increased travel related to customer projects. We expect cost of service revenue to increase on a year-over-year basis during 2007 due to an anticipated increase in employee and employee-related costs driven by increased headcount necessary to meet our expected higher service revenue.

Amortization of intangible assets included in cost of revenue was $234,000, or 2% of total revenue, for both the three months ended September 30, 2007 and 2006, respectively. Amortization of intangible assets included in cost of revenue decreased to $702,000, or 2% of total revenue, for the nine months ended September 30, 2007 from $1.2 million, or 3% of total revenue, for the same nine months in 2006. The decreases in the amortization of intangible assets were due to the amortization in full during the three months ended June 30, 2006 of the intangible assets for core/developed technology and maintenance agreements acquired during the acquisition of Valicert.

Research and development expenses. Research and development expenses are primarily comprised of employee and employee-related costs, including stock-based compensation expense and other costs required for the development and quality assurance of our products. Research and development expenses for both the three months ended September 30, 2007 and the three months ended September 30, 2006 were $3.8 million, or 27% and 25% of total revenue, respectively. Research and development expenses for the nine months ended September 30, 2007 increased to $11.6 million, or 27% of total revenue, from $11.0 million, or 24% of total revenue, for the same nine months in 2006. The increase in research and development expenses was primarily due to an increase in employee and employee-related costs and in consulting costs. Employee and employee-related costs increased by $374,000 primarily due to salary increases. The increase in average engineering headcount was primarily driven by our efforts to broaden and upgrade our products. Consulting costs increased by $142,000 due to a greater utilization of third-parties to assist in our research and development processes.

Sales and marketing expenses. Sales and marketing expenses are primarily comprised of employee and employee-related costs, including stock-based compensation expense, travel expenses, and costs associated with marketing program costs. Sales and marketing expenses increased to $7.8 million, or 56% of total revenue, for the three months ended September 30, 2007 from $6.9 million, or 46% of total revenue, for the same three months in 2006. The increase in sales and

marketing expense was primarily due to increases in stock-based compensation expense, severance expense, travel expense, and marketing program expense. Stock-based compensation expense increased by $357,000 primarily due to stock-based compensation expense associated with the terminations of certain employees and due to a greater number of stock options vesting over the three month period ended September 30, 2007 as compared to the same period in 2006. Severance expense increased by $154,000 due to the terminations of certain employees. Travel expense increased by $100,000 due to an increase in airfares and an expansion of our international sales headcount. Marketing program expense increased by $97,000 due to our efforts to expand the awareness of our products and company.

Sales and marketing expenses for the nine months ended September 30, 2007 increased to $21.7 million, or 50% of total revenue, from $20.0 million, or 44% of total revenue, for the same nine months in 2006. The increase in sales and marketing expense was primarily due to increases in marketing program expense, stock-based compensation expense, and severance expense. The increases of $811,000 in marketing programs expense was due to our efforts to expand the awareness of our products and company. Stock-based compensation expense increased by $540,000 primarily due to stock-based compensation expense associated with the terminations of certain employees and due to a greater number of stock options vesting over the nine month period ended September 30, 2007 as compared to the same period in 2006. Severance expense increased by $125,000 due to the terminations of certain employees.

General and administrative expenses. General and administrative expenses consist primarily of employee and employee-related costs, including stock-based compensation expense, for our administrative, finance, legal, and human resources departments, as well as public reporting costs and professional fees including intellectual property enforcement and protection costs. General and administrative expenses for the three months ended September 30, 2007 increased to $2.5 million, or 18% of total revenue, from $2.4 million, or 16% of total revenue, for the same three months in 2006. The increase in general and administrative expenses was primarily due to a $109,000 increase in employee and employee-related costs and an $88,000 increase in stock-based compensation expense. Employee and employee-related costs increased due to salary increases and growth in average general and administrative headcount. General and administrative headcount increased to 41 for the three months ended September 30, 2007 from 39 for the same three months in 2006. The increase in average general and administrative headcount was primarily driven by our efforts to expand our corporate training capabilities. Stock-based compensation expense increased due to a greater number of stock options vesting over the three month period ended September 30, 2007 as compared to the same period in 2006.

General and administrative expenses for the nine months ended September 30, 2007 decreased to $7.5 million, or 17% of total revenue, from $8.3 million, or 18% of total revenue, for the same nine months in 2006. The decrease in general and administrative expenses was primarily due to a decrease of $472,000 in stock-based compensation expense due to the acceleration of vesting, during the three months ended March 31, 2006, of certain stock options granted to our Chief Executive Officer with no comparable activity during 2007. In addition, intellectual property incentive compensation expense decreased by $348,000 as our intellectual property revenue decreased in the nine months ended September 30, 2007 as compared to the same nine months in 2006.

Amortization of intangible assets. Amortization of intangible assets included in operating expenses consists of the amortization of intangible assets for customer base and reseller agreements and trademarks and trade names recorded as a result of the Valicert, Incubator Limited, and Corvigo acquisitions. Amortization of intangible assets included in operating expenses decreased to $39,000 for the three months ended September 30, 2007 from $204,000, or 1% of total revenue, for the same three months in 2006. Amortization of intangible assets included in operating expenses for the nine months ended September 30, 2007 decreased to $266,000, or 1% of total revenue, from $837,000, or 2% of total revenue, for the same nine months in 2006. The decreases in the amortization of intangible assets included in operating expenses were due to completing the amortization of the customer base and reseller agreements acquired during the Valicert acquisition during the three months ended June 30, 2006.

Other income, net. Other income, net, is generally comprised of interest income earned on investment securities. Other income, net, increased to $322,000 for the three months ended September 30, 2007 from $278,000 for the same three months in 2006. Other income, net for the nine months ended September 30, 2007 increased to $1.0 million from $843,000 for the same nine months in 2006. The increases in other income, net were primarily due to increases in interest income driven by an increase in interest rates.

LIQUIDITY AND CAPITAL RESOURCES

Since inception, we have financed our operations primarily through the issuance of equity securities. As of September 30, 2007, we had approximately $27.0 million in cash and cash equivalents.

Net cash used in operating activities for the nine months ended September 30, 2007 was $3.3 million, which was primarily the result of our net loss of $7.7 million and a decrease in our accounts payable, accrued liabilities, and other long-term liabilities balance of $1.3 million, the impact of which was partially offset by non-cash charges of $3.6 million for stock-based compensation expense and $2.1 million for depreciation and amortization expenses.

Net cash used in operating activities for the nine months ended September 30, 2007 was $3.3 million compared to net cash provided by operating activities for the nine months ended September 30, 2006 of $3.6 million. This was primarily the result of a $4.3 million increase in our net loss and an $802,000 decrease in depreciation and amortization expense for the nine months ended September 30, 2007 compared to the same nine months in 2006. In addition, the change was due to a $9,000 decrease in deferred revenue during the nine months ended September 30, 2007 as compared to a $1.9 million increase in deferred revenue during the same nine months in 2006.

Net cash used in investing activities for the nine months ended September 30, 2007 increased to $1.6 million from $1.2 million for the same nine months in 2006. Net cash used in investing activities for both the nine months ended September 30, 2007 and September 30, 2006 was comprised of purchases of property and equipment. Purchases of property and equipment for the nine months ended September 30, 2007 increased as compared to the nine months ended September 30, 2006 due to investments made to strengthen our information technology infrastructure as well as additional computer equipment purchased for our employees.

Net cash provided by financing activities for the nine months ended September 30, 2007 increased to $1.4 million from $1.1 million for the same nine months in 2006. Net cash provided by financing activities for both the nine months ended September 30, 2007 and September 30, 2006 was due to the proceeds from the issuance of common stock as a result of the exercises of stock options. The increase in net cash provided by financing activities was due to an increase in the number of stock option exercises.

As of September 30, 2007, our principal commitments consisted of obligations related to outstanding operating leases and unconditional purchase obligations. We do not anticipate a substantial increase in operating lease obligations in the immediate future.

In June 1999, we entered into an operating lease covering approximately 40,000 square feet of office space in Redwood City, California and renewed that lease in 2003. The renewed lease expires in July 2008 with current monthly rent payments of approximately $77,000.

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

OFF-BALANCE SHEET ARRANGEMENTS

At September 30, 2007, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements.

TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

Future cash payments for contractual obligations and commercial commitments as of September 30, 2007, are as follows (in thousands):


	Less Than 1 Year		1 – 2 Years		More Than 2 Years		Total
Operating leases	$	357	$	654	$	37	$	1,048
Unconditional purchase obligations		72		254		—		326

Total	$	429	$	908	$	37	$	1,374

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We currently do not use financial instruments to hedge operating expenses in Australia, Bulgaria, Japan, the Netherlands, Singapore, Switzerland, or the United Kingdom denominated in the respective local currency. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.

We do not use derivative financial instruments for speculative trading purposes, nor do we hedge our foreign currency exposure in a manner that entirely offsets the effects of changes in foreign exchange rates. We regularly review our hedging program and may as part of this review determine at any time to change our hedging program.

Interest Rate Sensitivity

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the fair value of the investment to fluctuate. For example, if we hold a security that was issued with a fixed rate equal to the then-prevailing interest rate and the prevailing interest rate later rises, the fair value of our investment will decline. To minimize this risk, we maintain our portfolio of cash equivalents in commercial paper and money market funds. In general, our investments are not subject to market risk because the interest paid on these funds fluctuates with the prevailing interest rate. As of September 30, 2007, none of our cash equivalents were subject to market risk.

ITEM 4.

CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2007. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2007, our disclosure controls and procedures are effective.

(b) Changes in internal controls.

During the three months ended September 30, 2007, we expanded the deployment of our financial accounting system to our subsidiaries in Bulgaria and the United Kingdom. This expansion was designed to enhance our financial reporting by providing more timely and accurate financial and accounting information, and by eliminating the need to transfer financial data from one financial system to another.

Other than the change mentioned above, no other changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the thee months ended September 30, 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II—OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

In April 2006, the District Court held a hearing on the proposed settlement but has not yet issued a ruling on the issue. Subsequently, the Court of Appeals for the Second Circuit (the “Court of Appeals”) vacated the class certification of plaintiffs’ claims against the underwriters in six cases designated as focus or test cases. Miles v. Merrill Lynch & Co. (In re Initial Public Offering Securities Litigation , 471 F.3d 24 (2d Cir. 2006). Thereafter, the District Court ordered a stay of all proceedings in all of the lawsuits pending the outcome of plaintiffs’ petition to the Court of Appeals for rehearing en banc and resolution of the class certification issue. On April 6, 2007, the Court of Appeals Circuit denied plaintiffs’ petition for rehearing, but clarified that the plaintiffs may seek to certify a more limited class in the District Court.

Accordingly, the stay remains in place and the plaintiffs and issuers have stated that they are prepared to discuss how the settlement might be amended or renegotiated to comply with the ruling of the Court of Appeals. Failure of the District Court to approve the settlement (or an amended or renegotiated settlement) followed by an adverse outcome could harm our business and operating results. Moreover, the costs in defending this lawsuit could harm future operating results. The accompanying condensed consolidated financial statements do not include a reserve for any potential loss, as we do not consider a loss to be probable at this time.

All costs incurred as a result of this legal proceeding are charged to expense as incurred. We indemnify our customers from third party claims of intellectual property infringement relating to the use of our products. Historically, costs related to these guarantees have not been significant and we are unable to estimate the potential impact of these guarantees on our future results of operations.

We are engaged in other legal actions arising in the ordinary course of business. Although there can be no assurance as to the outcome of such litigation, we believe we have adequate legal defenses and we believe that the ultimate outcome of any of these actions will not have a material effect on our consolidated financial positions or results of operations.

ITEM 1A.

RISK FACTORS

We have a history of losses and may experience losses in the future.

We have a history of losses and may experience losses in the future. Our prospects must be considered in light of the risks, expenses, delays and difficulties frequently encountered by companies engaged in rapidly evolving technology markets like ours. We incurred net losses of $4.9 million, $3.9 million, and $7.5 million in 2006, 2005, and 2004, respectively. As of September 30, 2007, we had incurred cumulative net losses of $303.6 million.

Our success may depend in large part upon the adoption and use of our products and technology, as well as our ability to effectively maintain existing relationships and develop new relationships with customers, both in new vertical markets and new segments, and via direct sales, channel sales partners, and strategic partners. In particular, we intend to expend significant financial and management resources on product development, sales and marketing, strategic relationships, technology, and operating infrastructure. As a result, we may incur additional losses and continued negative cash flow from operations for the foreseeable future and may not achieve or maintain profitability.

Fluctuations in our quarterly operating results may not be predictable and may result in significant volatility in our stock price.

Our revenue and our operating results have fluctuated and may continue to fluctuate based on, among other things, the timing of the execution and termination of customer agreements in a given quarter. We have experienced, and expect to continue to experience, fluctuations in revenue and operating results from quarter to quarter for other reasons, including the timing of our target customers’ election to adopt and implement our products and services, the election of our customers to delay their purchase commitments or purchase in smaller amounts, and the timing of and our ability to continue to license our patents. Further, we have experienced and may continue to experience difficulty in managing the amount and timing of

operating costs and capital expenditures relating to our business, operations and infrastructure as well as collecting fees owed by customers. Finally, any acquisitions or divestitures we complete as well as the announcement or introduction of new or enhanced products and services may create additional volatility in our results.

As a result of these factors, we believe that quarter-to-quarter comparisons of our revenue and operating results are not necessarily meaningful, and that these comparisons may not be accurate indicators of future performance. Because our staffing and operating expenses are based on anticipated revenue levels, and because a high percentage of our costs are fixed, small variations in the timing of the recognition of specific revenue could cause significant variations in our operating results from quarter to quarter. In addition, many of our customers delay purchases of our products until the end of each quarter. If we are unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall, any significant revenue shortfall would likely have an immediate negative effect on our operating results. Moreover, we believe the challenges and difficulties that we face, as outlined above with respect to financial forecasts, also apply to securities analysts that may publish estimates of our financial results. Our operating results in the past have, and in future quarters may, fail to meet our expectations or those of securities analysts or our investors due to any of a wide variety of factors, including fluctuations in financial ratios or other metrics used to measure our performance. If this occurs, we would expect to experience an immediate and significant decline in the trading price of our stock.

Competitive pricing, sales volume, mix and product costs could materially adversely affect our revenue and gross margins.

Our gross margins are impacted by a variety of factors, including competitive pricing, product costs (including in-licensed software), and both the volume and relative mixture of our product and service revenue streams. Increased product costs, increased pricing pressures, the relative and varying rates of increases or decreases in product costs and product prices, changes in product and services revenue mixture or decreased volume could each have a material adverse effect on our revenues, gross margins or ability to make a profit.

The costs of third-party components comprise a significant portion of our product costs. While we generally have been able to manage our component costs, we may have difficulty managing such costs if supplies of certain components become limited or component prices increase. Any such limitation could result in an increase in our component costs, and an increase in product costs relative to our product prices could have a material adverse effect on our gross margins and earnings.

We may have difficulty in executing our business operations.

Our future operating results will depend on our overall ability to manage operations, which includes, among other things:

•

retaining and hiring, as required, the appropriate number of qualified employees;

•

transitioning from our historical distribution model, which emphasized direct sales, to a distribution model that emphasizes sales through channel partners such as value added resellers and system integrators;

•

building an adequate pipeline of prospective sales;

•

accurately forecasting revenues;

•

training our sales force, particularly its newer members, to sell more products and services;

•

developing products with strong market appeal;

•

managing inventory levels, including minimizing excess and obsolete inventory, while maintaining sufficient inventory to meet customer demands;

•

controlling expenses;

•

managing, protecting and enhancing, as appropriate, our infrastructure, including but not limited to, our information systems and internal controls; and

•

otherwise executing on our plans.

An unexpected decline in revenues without a corresponding and timely reduction in expenses or a failure to manage other aspects of our operations could have a material adverse effect on our business, results of operations or financial condition.

If we lose the services of executive officers or other key employees, or our new employees, our ability to develop our business and secure customer relationships will suffer.

We are substantially dependent on the continued services and performance of our executive officers and other key personnel and do not have long-term employment agreements with any of our key personnel. In this regard, during 2006 we

appointed a new Chief Executive Officer and Chief Technology Officer and during the nine months ended September 30, 2007 we appointed new members of our sales management, including our Executive Vice President, Worldwide Field Operations. These new appointments subject us to heightened risks as these executive officers assume their roles, work together as a team, and make changes to our business and operations. The loss of the services of any of our executive officers or other key employees, including members of our sales force, could significantly delay or prevent the achievement of the goals of our strategic and operating plan.

If we have elected an ineffective strategy, or do not execute our strategy well, our business could be harmed.

We have developed a strategic and operating plan with four key initiatives: expanding our reseller channel, expanding our international sales, increasing our brand awareness, and delivering a broader product portfolio. If the company strategy we have elected to pursue turns out to be ineffective, it could significantly limit our ability to compete successfully against current and future competitors.

If on the other hand we have elected to pursue an effective strategy, but we do not execute our strategy well by optimizing our methods of producing, marketing, and selling our products, it could significantly limit our ability to compete successfully against current and future competitors.

If we do not develop our products, marketing and distribution channels more successfully than our competitors, our business could be harmed.

Larger companies, such as Microsoft, Cisco Systems, Google, Symantec, Websense, and Secure Computing, are concentrating an increasing amount of their substantially greater financial and other resources on the markets in which we participate, which represents a serious competitive threat to Tumbleweed.

The markets in which we compete are intensely competitive and rapidly changing, through consolidation and otherwise. Vendors in our markets use different methods of marketing and distribution in order to meet expected customer demand. For example, our competitors include multiple software-only vendors, appliance-only vendors, and service providers, as well as vendors that offer a combination of some or all of the foregoing. Moreover, our competitors’ offerings range from single-function point products and services to more sophisticated and scalable multi-functional offerings. In addition, pricing and other terms and conditions of sales contracts also vary considerably among our competition. Because it is difficult to predict demand in our rapidly changing markets, we may not be able to manage our product development, marketing, and sales efforts in an optimal way, which may disadvantage our business in comparison to competitors.

Competitors may develop new technologies or products in advance of us or establish business models or technologies disruptive to us. Our business may be materially adversely affected by the announcement or introduction of new products, including hardware and software products and services by our competitors, and the implementation of effective marketing or sales strategies by our competitors. The material adverse effect to our business could include a decrease in demand for our products and services and an increase in the length of our sales cycle due to customers taking longer to compare products and services and to complete their purchases.

Competitive factors in our industry include customer-driven requirements such as high quality, additional functionality, improved product performance, ease of use, integration capacity, platform coverage, and the quality of each vendor’s global technical support. Some of our competitors have greater financial, technical, sales, marketing and other resources than we do, as well as greater name recognition and a larger installed customer base. Additionally, some of these competitors have research and development capabilities that may allow them to develop new or improved products that may compete with product lines we market and distribute. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any of which could harm our business.

We expect that the market for messaging security products will continue to become more consolidated with larger companies being better positioned to compete in such an environment in the long term. As this market has continued to develop, a number of companies with greater resources than ours have increased their presence in this market and others could attempt to increase their presence in this market by acquiring or forming strategic alliances with our competitors or business partners.

Our success will depend on our ability to adapt our strategy to these competing forces, to develop and successfully launch more effective products more rapidly and less expensively than our competitors, and to educate potential customers as to the benefits of licensing our products rather than developing their own products or licensing our competitors’ products. In particular our product development team is transitioning to an agile software development process, a transition that may cause delays, attrition, and near-term inefficiencies with respect to product development.

In particular, our success depends on our ability to grow and develop our indirect distribution channels, both in the United States and internationally, and the inability to do so could adversely affect future operating results. We must continue to increase the number of strategic and other third-party relationships with vendors of Internet-related systems and application software, resellers and systems integrators. Our existing or future channel partners may choose to devote greater resources to marketing and supporting the products of other companies, which could have a negative impact on our company.

In addition, our success depends in part on our ability to sell our appliance-based products. In comparison to several of our leading competitors, we have less experience in managing the product development, marketing, and sales of appliance-based products. Historically most of our revenue has been derived from software-based products, not appliance-based products, and our business could be harmed if we do not successfully execute our plans with respect to our appliance-based products.

We may be unable to keep pace with rapid industry, technological and market changes.

The markets in which we compete are characterized by rapid technological change, frequent new product introductions, evolving industry standards and changing needs of customers. There can be no assurance that our existing products will be properly positioned in the market or that we will be able to introduce new or enhanced products into the market on a timely basis, or at all. We spend a considerable amount of money on research and development and introduce new products from time to time. There can be no assurance that enhancements to existing products and solutions or new products and solutions will receive customer acceptance. As competition in the information technology industry increases, it may become increasingly difficult for us to maintain a technological advantage and to leverage that advantage toward increased revenues and profits.

Risks associated with the development and introduction of new products include delays in development and changes in information security and operating system technologies that could require us to modify existing products.

Risks inherent in the transition to new products include:

•

the difficulty in forecasting customer preferences or demand accurately;

•

the inability to expand production capacity to meet demand for new products;

•

the impact of customers’ demand for new products on the products being replaced, thereby causing a decline in sales of existing products and an excessive, obsolete supply of inventory; and

•

delays in initial shipments of new products.

Further risks inherent in new product introductions include the uncertainty of price-performance relative to products of competitors, competitors’ responses to the introductions and the desire by customers to evaluate new products for extended periods of time. Our failure to introduce new or enhanced products on a timely basis, keep pace with rapid industry, technological or market changes or effectively manage the transitions to new products or new technologies could have a material adverse effect on our business, results of operations, or financial condition.

Contractual issues may arise during the negotiation of license agreements that may delay the anticipated closure of a transaction and our ability to recognize revenue as anticipated.

Because we focus on selling enterprise-wide software products to enterprises and government entities, the process of contractual negotiation is critical and may be lengthy. Additionally, many factors may require us to defer recognition of license revenue for a significant period of time after entering into a license agreement.

Many customers negotiate software licenses near the end of each quarter. In part, this is because customers are able, or believe that they are able, to negotiate lower prices and more favorable terms at that time. Our reliance on a large portion of software license revenue occurring at the end of the quarter and the increase in the dollar value of transactions that occur at the end of a quarter can result in increased uncertainty relating to quarterly revenues. Due to end of period variances, forecasts may not be achieved, either because expected sales do not occur or because they occur at lower prices or on terms that are less favorable to us.

A limited number of customers have accounted for a high percentage of our revenue, and the failure to maintain or expand these relationships could adversely affect our future revenue.

The loss of one or more of our major customers, the failure to attract new customers on a timely basis, or a reduction in revenue associated with existing or proposed customers would harm our future revenue and prospects. No single customer comprised 10% or more of our revenue for the three and nine months ended September 30, 2007. One customer comprised 12% of Tumbleweed’s accounts receivable balance, net of allowance for doubtful accounts, at September 30, 2007. For the three months ended September 30, 2006, one customer comprised 16% of Tumbleweed’s revenue. For the nine months ended September 30, 2006, no single customer comprised 10% or more of Tumbleweed’s revenue. For the three months ended September 30, 2007 and 2006, five customers comprised approximately 15% and 24% of our revenue, respectively. For the nine months ended September 30, 2007 and 2006, five customers comprised approximately 11% and 28% of our revenue, respectively.

Our appliance products may not be adopted in the market and expose us to hardware costs and supply chain issues.

Over time, we have expanded our portfolio of products sold on appliances, which are manufactured by a third party. The inclusion of these hardware appliances in our product portfolio subjects us to additional risks, including, but not limited to:

•

increased marginal costs relative to software-only transactions which may reduce our gross profits, particularly with respect to lower priced appliances, which may represent a greater percentage of our sales than in the past;

•

the inability of the manufacturer to perform in accordance with our expectations, including our expectations regarding the hardware appliances’ compliance with any applicable regulations;

•

the inability to deliver appliance products to customers in a timely manner, harming our ability to win time-sensitive customer contracts and/or recognize revenue;

•

product shortages that could result in increased product costs;

•

price increases from suppliers that may not be able to be passed on to customers;

•

oversupply or obsolescence of inventory, which may result in the need to reduce our prices and/or write down inventory; and

•

product quality issues.

The occurrence of any of these events could adversely affect our business and operating results.

Economic conditions that result in a decrease in information technology spending could adversely affect our business.

An important factor affecting our ability to generate revenue is the impact of general economic conditions on our customers’ willingness to spend on information technology. Variability in employment, corporate profit growth, interest rates, energy prices and other factors in specific markets could impact customers’ willingness to spend on information technology in the near term. In addition, country-to-country variability in economic conditions could significantly impact our business as our reliance on international sales as a percentage of our overall revenue increases.

We may be unable to adequately protect our intellectual property rights or may be subject to claims of patent infringement, either of which could result in substantial costs to us.

We currently rely on a combination of patents, trade secrets, copyrights, trademarks and licenses, together with non-disclosure and confidentiality agreements, to establish and protect our proprietary rights in our products. We hold certain patent rights with respect to some of our products. Our existing patents or trademarks, as well as any future patents or trademarks obtained by us, may be challenged, invalidated or circumvented, or our competitors may independently develop or patent technologies that are substantially equivalent or superior to our technology. We also rely on unpatented trade secrets and other unpatented proprietary information. Although we take precautionary measures to maintain our unpatented proprietary information, others may acquire equivalent information or otherwise gain access to or disclose our proprietary information, and we may be unable to meaningfully protect our rights to our proprietary information. As a result, our operating results could suffer.

Third parties could assert patent or other intellectual property infringement claims against us and the cost of responding to such assertions, regardless of their validity, could be significant. We may increasingly be subject to claims of intellectual property infringement as the number of our competitors grows and the functionality of their products and services increasingly overlap with ours. In addition, we may infringe upon patents that may be issued to third parties in the future. It may be time consuming and costly to defend ourselves against any of these claims and we may not prevail. Furthermore,

parties making such claims may be able to obtain injunctive or other equitable relief that could block our ability to further develop or commercialize some or all of our products in the United States and abroad. In the event of a claim of infringement, we may be required to obtain one or more licenses from or pay royalties to third parties. We may be unable to obtain any such licenses at a reasonable cost, if at all. Defense of any lawsuit or failure to obtain such license could harm our business.

The enforcement of our intellectual property rights, especially through patent infringement lawsuits we may initiate, could result in substantial litigation costs and ultimately may not result in additional revenue to us or a favorable judicial determination.

Since 1999 we have aggressively pursued cases of potential infringement by third parties of our patents and other intellectual property rights. The enforcement process is costly and requires significant management attention. These costs are expensed during the period incurred, and the costs of pursuing the litigation may not be directly matched with the related patent license agreement revenue, if any. In addition, our enforcement of our rights may increase the risk of adverse claims, with or without merit, which could be time consuming to defend, result in costly litigation, divert management’s attention and our resources, limit the use of our services, or require us to enter into royalty or license agreements. In addition, such counter-claims asserted by these third parties may be found to be valid and could result in an injunction or damages against us. Our ability to prevail in this litigation is inherently uncertain, and if we were subject to an adverse judicial determination, our ability to protect our products and to secure related licensing or settlement revenue could be lost.

Failure to license necessary third party software incorporated in our products could cause delays or reductions in our sales.

We license third party software that we incorporate into our products. These licenses may not continue to be available on commercially reasonable terms, or at all. Some of this technology would be difficult to replace. The loss of any such license could result in delays or reductions of our applications until we identify, license and integrate, or develop equivalent software. If we are required to enter into license agreements with third parties for replacement technology, we could face higher royalty payments and our products may lose certain attributes or features. In the future, we might need to license other software to enhance our products and meet evolving customer needs. If we are unable to do this, we could experience reduced demand for our products.

Our international business exposes us to additional risks that may result in future additional costs or limit the market for product sales.

Products and services provided to our international customers accounted for 10% and 7% of our revenues for the three months ended September 30, 2007 and September 30, 2006, respectively, and for 12% and 8% of our revenues for the nine months ended September 30, 2007 and September 30, 2006, respectively. Conducting business outside of the United States subjects us to additional risks, including:

•

changes in regulatory requirements and any resulting costs of compliance, for example, the introduction by the European Union of its Restrictions on Hazardous Substances;

•

reduced protection of intellectual property rights; evolving privacy laws; tariffs and other trade barriers;

•

difficulties in staffing and managing foreign operations;

•

increased income tax expenses;

•

problems in collecting accounts receivable; and

•

difficulties in authenticating customer information.

Managing these risks may subject us to additional costs that may not be justified in light of the market opportunity, and the inability to comply with or manage foreign laws and related risks may preclude or limit sales in foreign jurisdictions.

We rely on public key cryptography and other security techniques that could be breached, resulting in reduced demand for our products and services.

A requirement for the continued growth of electronic commerce is the secure transmission of confidential information over public networks. We rely on public key cryptography, an encryption method that utilizes two keys, a public and a private key, for encoding and decoding data, and on digital certificate technology, to provide the security and authentication necessary for secure transmission of confidential information. Regulatory and export restrictions may prohibit us from using the strongest and most secure cryptographic protection available, and thereby may expose us or our customers to a risk of data interception. A party who is able to circumvent our security measures could misappropriate proprietary information or interrupt our or our customers’ operations. Any compromise or elimination of our security could result in risk of loss or litigation and possible liability and reduce demand for our products and services.

Our stock price could be adversely affected if we are unable to continue to favorably assess the effectiveness of our internal control over financial reporting.

In the future, we may encounter problems or delays in completing the implementation of any changes necessary to make a favorable assessment of our internal controls over financial reporting. If we cannot favorably assess the effectiveness of our internal controls over financial reporting, investor confidence and our stock price could be adversely affected.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

ITEM 5.

OTHER INFORMATION

Not applicable.

ITEM 6.

EXHIBITS

a. Exhibits are incorporated herein by reference or are filed with this report as indicated below (numbered in accordance with Item 601 of Regulation S-K):


Exhibit Number		Description

3.1(1)		Amended and Restated Certificate of Incorporation of Registrant

3.2(1)		Amended and Restated Bylaws of Registrant

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

31.2		Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 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

(1)	Incorporated by reference to our Registration Statement on Form S-4 (File No. 333-92589), filed December 10, 1999.

SIGNATURES

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, hereunto duly authorized:


	TUMBLEWEED COMMUNICATIONS CORP.

Date: November 9, 2007	By:	/s/ J AMES P. S CULLION
		James P. Scullion
		*Chairman and Chief Executive Officer*
		*(Principal Executive Officer)*


Date: November 9, 2007	By:	/s/ T IMOTHY G. C ONLEY
		Timothy G. Conley
		Senior Vice President of Finance and Chief Financial Officer
		(Principal Financial Officer and Principal Accounting Officer)

INDEX TO EXHIBITS


Exhibit Number		Description

3.1(1)		Amended and Restated Certificate of Incorporation of Registrant

3.2(1)		Amended and Restated Bylaws of Registrant

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

31.2		Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 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