Blue Coat Systems (BCSI) 10-Q 2007 Q3 Quarterly report

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 JANUARY 31, 2007

OR

¨ 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 000-28139

BLUE COAT SYSTEMS, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE	91-1715963
(STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)	(IRS EMPLOYER IDENTIFICATION)

420 NORTH MARY AVENUE SUNNYVALE, CALIFORNIA	94085
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)	(ZIP CODE)

REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 220-2200

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. (Check one):

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 of 1934).    Yes  ¨    No  x

Indicate the number of shares outstanding of the issuer’s class of common stock, as of the latest practicable date.

CLASS	OUTSTANDING AT DECEMEBR 31, 2006
Common Stock, par value $.0001	14,885,475

TABLE OF CONTENTS

		PAGE
PART I. FINANCIAL INFORMATION		5
Item 1.	Condensed Consolidated Financial Statements	5
	Condensed Consolidated Balance Sheets as of January 31, 2007 and April 30, 2006	5
	Condensed Consolidated Statements of Operations for the three and nine months ended January 31, 2007 and January 31, 2006 (as restated)	6
	Condensed Consolidated Statements of Cash Flows for the nine months ended January 31, 2007 and January 31, 2006 (as restated)	7
	Notes to Condensed Consolidated Financial Statements (as restated)	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	31
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	56
Item 4.	Controls and Procedures	57
PART II. OTHER INFORMATION		60
Item 1.	Legal Proceedings	60
Item 1A.	Risk Factors	62
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	76
Item 3.	Defaults Upon Senior Securities	76
Item 4.	Submission of Matters to a Vote of Security Holders	76
Item 5.	Other Information	76
Item 6.	Exhibits	76
	Signatures	79

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CAUTIONARY STATEMENT

All statements included in this Quarterly Report on Form 10-Q (“Form 10-Q”), other than statements or characterizations of historical fact, are forward-looking statements. These forward-looking statements are based on our current expectations, estimates, approximations and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. We often use certain words and their derivatives such as “anticipate,” “expect,” “intend,” “plan,” “predict,” “believe,” “estimate,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” and similar expressions in our forward-looking statements. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the section entitled “Risk Factors” under Part II, Item 1A of this Form 10-Q. These forward-looking statements speak only as of the date of this Form 10-Q. We assume no obligation to revise or update any forward-looking statement for any reason, except as otherwise required by law.

Forward-looking statements are not the only statements you should regard with caution. The preparation of our condensed consolidated financial statements required us to make judgments with respect to the methodologies we selected to calculate the adjustments contained in the financial statements, as well as estimates and assumptions regarding the application of those methodologies. These judgments, estimates and assumptions, which are based on factors that we believe to be reasonable under the circumstances, affected, among other things, the amounts of additional deferred stock-based compensation and additional stock-based compensation expense that we recorded. The application of alternative methodologies, estimates and assumptions could have resulted in materially different amounts.

EXPLANATORY NOTE

In this Quarterly Report on Form 10-Q (“Form 10-Q”) for the fiscal quarter ended January 31, 2007, we are restating our condensed consolidated financial statements and related disclosures as of January 31, 2006 and for the three and nine months ended January 31, 2006. The restatement includes adjustments arising from an internal review of our historical financial statements, as well as the determinations of an independent committee of our Board of Directors, assisted by independent legal counsel and accounting experts, formed in July 2006 to conduct an internal investigation into our historical stock option granting practices that concluded that our historical measurement dates could not be relied upon.

In our Annual Report on Form 10-K (“Form 10-K”) for the fiscal year ended April 30, 2006, which was filed with the SEC on March 28, 2007, we restated our consolidated financial statements and related disclosures as of April 30, 2005 and for the years ended April 30, 2005 and 2004. The restatement included adjustments arising from the investigation of our historical practices in granting stock options. We also recorded adjustments affecting our previously-reported financial statements for fiscal years 2000 through 2003, the effects of which are summarized in cumulative adjustments to our additional paid in capital, deferred stock-based compensation and accumulated deficit accounts as of April 30, 2003. The Form 10-K also included the restatement of selected consolidated financial data as of and for the years ended April 30, 2005, 2004, 2003 and 2002, which was included in Item 6, “Selected Financial Data,” of the Form 10-K, and the unaudited quarterly financial data for each of the quarters in the years ended April 30, 2006 and 2005, with the exception of the fourth quarter of fiscal 2006 (which has never been filed), which was included in Item 8, “Financial Statements and Supplementary Data,” of the Form 10-K.

Except as set forth in the previous paragraph, we do not intend to amend any of our other previously filed annual reports on Form 10-K or quarterly reports on Form 10-Q for the periods affected by the restatement or adjustments, other than (i) information as of July 31, 2005 and for the three month period then ended which is included in the Quarterly Report on Form 10-Q for the period ended July 31, 2006, (ii) information as of October 31, 2005 and for the three and six-month periods then ended which is included in the Quarterly Report on Form 10-Q for the period ended October 31, 2006, and (iii) information as of January 31, 2006 and for the three and nine-month periods then ended which is included in this Quarterly Report on Form 10-Q. For this reason, the consolidated financial statements and related financial information contained in our previously filed annual reports on Form 10-K or quarterly reports on Form 10-Q for the periods affected by the restatement or adjustments should no longer be relied upon. Except as otherwise specifically noted in this Quarterly Report on Form 10-Q and except for the sections of this Form 10-Q entitled “Background of the Stock Option Investigation, Findings, Restatement of Condensed Consolidated Financial Statements, Remedial Measures and Related Proceedings” (included in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”), Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements (included in Item 1, “Condensed Consolidated Financial Statements”), and Item 4, “Controls and Procedures,” all of the information in this Quarterly Report on Form 10-Q is as of January 31, 2007 and does not reflect events occurring after January 31, 2007. Accordingly, this Quarterly Report on Form 10-Q should be read in conjunction with our Annual Report on Form 10-K for the year ended April 30, 2006, as well as any Current Reports filed on Form 8-K.

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Additional information on the restatement can be found in this report in:

• Part I, Item 1, Note 2, “Restatement of Condensed Consolidated Financial Statements;”

• Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Background of the Stock Option Investigation, Findings, Restatement of Condensed Consolidated Financial Statements, Remedial Measures and Related Proceedings;”

• Part I, Item 4, “Controls and Procedures;” and

• Part II, Item 1A, “Risk Factors.”

As a result of our failure to file this report and other reports on a timely basis, we will not be eligible to use Form S-3 to register our securities with the SEC until all reports required under the Securities Exchange Act of 1934 have been timely filed for at least 12 months.

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PART I: FINANCIAL INFORMATION

Item 1: Condensed Consolidated Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value and shares)

	January 31, 2007			April 30, 2006
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	42,844		$	46,990
Short-term investments		41,748			10,200
Restricted investments		4,057			996
Accounts receivable, net of allowance of $180 and $145, respectively		29,007			22,285
Inventories		597			435
Prepaid expenses and other current assets		7,235			3,895
Total current assets		125,488			84,801
Property and equipment, net		9,228			8,059
Restricted investments		861			361
Goodwill		92,323			62,462
Identifiable intangible assets, net		7,059			7,758
Other assets		576			723
Total assets	$	235,535		$	164,164
LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	8,503		$	5,437
Accrued payroll and related benefits		7,555			7,451
Deferred revenue		39,242			25,946
Accrued restructuring		339			604
Other accrued liabilities		6,249			4,638
Total current liabilities		61,888			44,076
Deferred rent, less current portion		1,721			1,996
Accrued restructuring, less current portion		—			290
Deferred revenue, less current portion		12,914			7,844
Long-term deferred income taxes		299			—
Commitments and contingencies
Series A redeemable convertible preferred stock; $0.0001 par value
Authorized shares: 10,000,000
Issued and Outstanding: 42,060 at January 31, 2007, none at April 30, 2006 (Aggregate liquidation preference: $42,060)		41,879			—
Stockholders’ equity:
Preferred stock		—			—
Common stock		2			2
Additional paid-in capital		1,025,904			1,014,493
Treasury stock		(903	)		(903	)
Deferred stock compensation		—			(1,901	)
Accumulated deficit		(908,171	)		(901,732	)
Accumulated other comprehensive income (loss)		2			(1	)
Total stockholders’ equity		116,834			109,958
Total liabilities, redeemable convertible preferred stock and stockholders’ equity	$	235,535		$	164,164

See accompanying Notes to Condensed Consolidated Financial Statements.

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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

	Three Months Ended January 31,						Nine Months Ended January 31,
	2007			2006 (as restated) 1			2007			2006 (as restated) 1
Net revenue:
Product	$	35,976		$	28,986		$	93,543		$	87,550
Service		11,132			6,531			29,685			18,037
Total net revenue		47,108			35,517			123,228			105,587
Cost of net revenue:
Product		8,183			7,737			22,429			24,522
Service		4,057			2,605			10,183			6,984
Total cost of net revenue		12,240			10,342			32,612			31,506
Gross profit		34,868			25,175			90,616			74,081
Operating expenses:
Research and development		9,711			6,729			28,429			18,712
Sales and marketing		18,634			13,430			48,497			38,408
General and administrative		6,894			2,627			21,606			11,508
Amortization of intangible assets		112			174			506			522
Restructuring (reversal)		—			—			(19	)		—
Total operating expenses		35,351			22,960			99,019			69,150
Operating income (loss)		(483	)		2,215			(8,403	)		4,931
Interest income		965			620			2,954			1,415
Other expense		(82	)		(124	)		(350	)		(200	)
Income (loss) before income taxes		400			2,711			(5,799	)		6,146
Provision for income taxes		358			9			640			257
Net income (loss)	$	42		$	2,702		$	(6,439	)	$	5,889
Net income (loss) per common share:
Basic	$	0.00		$	0.21		$	(0.44	)	$	0.46
Diluted	$	0.00		$	0.18		$	(0.44	)	$	0.41
Weighted average shares used in computing net income (loss) per common share:
Basic		14,704			12,962			14,523			12,674
Diluted		18,177			14,845			14,523			14,516

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

See accompanying Notes to Condensed Consolidated Financial Statements.

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine Months Ended January 31,
	2007			2006 (as restated) 1
Operating Activities
Net income (loss)	$	(6,439	)	$	5,889
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation		2,825			1,700
Amortization		1,533			1,044
Stock-based compensation		7,610			3,961
Loss (gain) on disposition of equipment		(69	)		206
Restructuring (reversal)		(19	)		—
Changes in operating assets and liabilities:
Accounts receivable, net		(6,722	)		(6,681	)
Inventories		(162	)		(609	)
Prepaid expenses and other current assets		(3,340	)		(390	)
Other assets		13			(61	)
Accounts payable		3,230			1,573
Accrued payroll and related benefits		105			2,568
Other accrued liabilities		802			(278	)
Restructuring accrual		(536	)		(2,028	)
Deferred rent		192			1,465
Deferred revenue		18,366			12,766
Deferred income taxes		299			—
Net cash provided by operating activities		17,688			21,125
Investing Activities
Purchases of investment securities		(95,537	)		(10,000	)
Sales of investment securities		60,431			500
Purchases of property and equipment		(4,159	)		(5,536	)
Sales of property and equipment		70			35
Acquisition of NetCache, net of cash acquired		(24,553	)		—
Net cash used in investing activities		(63,748	)		(15,001	)
Financing Activities
Net proceeds from issuance of common stock		35			7,246
Net proceeds from sales of Series A redeemable convertible preferred stock		41,879			—
Net cash provided by financing activities		41,914			7,246
Net increase (decrease) in cash and cash equivalents		(4,146	)		13,370
Cash and cash equivalents at beginning of period		46,990			47,184
Cash and cash equivalents at end of period	$	42,844		$	60,554

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

See accompanying Notes to Condensed Consolidated Financial Statements.

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Notes to Condensed Consolidated Financial Statements

Note 1. Significant Accounting Policies

Basis of Presentation

The condensed consolidated financial statements include Blue Coat Systems, Inc.’s (also referred to as “we,” or “us,”) accounts and those of our subsidiaries, all of which are wholly owned. All intercompany balances and transactions have been eliminated. We have consolidated the results of Permeo Technologies, Inc., Cerberian, Inc. and Ositis Software, Inc. from their respective acquisition dates of March 3, 2006, November 16, 2004 and November 14, 2003, respectively, in our condensed consolidated financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted as permitted under the Securities and Exchange Commission’s (“SEC’s”) rules and regulations. The accompanying condensed consolidated financial statements and related notes as of January 31, 2007, and for the three and nine month periods ended January 31, 2007 and 2006, are unaudited, but in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of our consolidated financial condition, results of operations and cash flows for the interim date and periods presented. The results of operations for the three and nine month periods ended January 31, 2007 are not necessarily indicative of results for the entire fiscal year or future periods. Our financial results as of and for the three and nine month periods ended January 31, 2006 have been restated. See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements for additional information.

The condensed consolidated balance sheet as of April 30, 2006 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

These condensed consolidated financial statements and notes included herein should be read in conjunction with our audited consolidated financial statements and notes for the year ended April 30, 2006 included in our Annual Report on Form 10-K filed with the SEC on March 28, 2007.

As discussed later in this Note 1, we adopted Statement of Financial Accounting Standards (SFAS) No. 123(R),“Share-Based Payment,”or SFAS No. 123(R), on May 1, 2006 using the modified prospective transition method. Accordingly, our income (loss) from operations for the three and nine months ended January 31, 2007 includes $2.1 million and $7.6 million, respectively, in stock-based compensation expense for employee stock options and our Employee Stock Purchase Plan.

Use of Estimates

The preparation of condensed consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities, at the dates of the condensed consolidated financial statements, and the reported amounts of net revenue and expenses during the reporting periods. Actual results may differ from these estimates, and such differences could be material to the Company’s consolidated financial condition and results of operations. Our critical accounting estimates include (i) Revenue Recognition and Related Receivable Allowances, (ii) Inventories, (iii) Guarantees, Indemnifications and Warranty Obligations, (iv) Valuation of Goodwill, (v) Valuation of Long-Lived and Identifiable Intangible Assets, (vi) Restructuring Liabilities, (vii) Income Taxes, (viii) Contingencies, and (ix) Stock-Based Compensation (x) Impact of judgment and Interpretations on Restatement Amounts and (xi) Payroll and withholding Taxes, Penalties and Interest Related to the Restatement .

Revenue Recognition and Related Receivable Allowances

Our products include software that is essential to the functionality of the appliances. Additionally, we provide unspecified software upgrades and enhancements related to the appliances through our maintenance contracts for most of our products. Accordingly, we account for revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” and all related interpretations.

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We recognize revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Evidence of an arrangement generally consists of customer purchase orders and, in certain instances, sales contracts or agreements. Shipping terms and related documents, or written evidence of customer acceptance, when applicable, are used to verify delivery or performance.

Sales are made through distributors under agreements allowing for certain stock rotation rights. Net revenue, and the related cost of net revenue, resulting from shipments to distributors are deferred until the distributors report that our products have been sold to a customer. Product revenue in China is deferred until the customer registers the proxy appliance.

For sales made direct to end-users and value-added resellers, we recognize product revenue upon transfer of title and risk of loss, which is generally upon shipment. We do not accept orders from these value-added resellers when we are aware that the value-added reseller does not have an order from a customer. For the end-users and value-added resellers, we don’t have significant obligations for future performance such as rights of return or pricing credits.

We assess that the sales price is fixed or determinable based on payment terms and whether the sales price is subject to refund or adjustment.

In an arrangement that includes multiple elements, such as appliances, maintenance, third-party software and/or content filtering subscriptions, we allocate revenue to each element using the residual method based on vendor specific objective evidence of fair value of the undelivered items. Under the residual method, the amount of revenue allocated to delivered elements equals the total arrangement consideration less the aggregate fair value of any undelivered elements. Vendor specific objective evidence of fair value is based on the price charged when the element is sold separately.

We accrue for warranty costs, and other allowances based on historical experience.

Maintenance and subscription revenue is initially deferred and recognized ratably over the life of the contract, with the related expenses recognized as incurred. Maintenance and subscription contracts usually have a term of one year, but can extend to five years. Unearned maintenance and subscription contracts are included in deferred revenue.

When we bill customers for shipping, we record shipping cost in both net revenue and cost of net revenue. If we do not charge customers for shipping, the cost incurred for shipping are reflected in cost of net revenue.

Probability of collection is assessed on a customer-by-customer basis. Our customers are subjected to a credit review process that evaluates the customers’ financial condition and ability to pay for our products and services. If it is determined from the outset of an arrangement that collection is not probable based upon the review process, revenue is not recognized until cash receipt.

We perform ongoing credit evaluations of our customers’ financial condition and maintain an allowance for doubtful accounts. We analyze accounts receivable and historical bad debts, customer concentrations, customer solvency, current economic and geographic trends, and changes in customer payment terms and practices when evaluating the adequacy of such allowance, and any required changes in the allowance are recorded to general and administrative expense.

Cash Equivalents and Short-Term Investments

We consider all highly liquid investments with insignificant interest rate risk and original maturities of three months or less to be cash equivalents.

Short-term investments consist primarily of debt securities with original maturities between three months and one year. We determine the appropriate classification of our investments at the time of purchase and evaluate such designation as of each balance sheet date based on our intent and ability to use such funds for current operations. To date, all of our investments have been classified as available-for-sale and are carried at fair value with unrealized gains and losses, if any, included in accumulated other comprehensive income (loss) in stockholders’ equity. The fair value of these securities is based on quoted market prices. Interest and dividends on all securities are included in interest income.

Inventories

Inventories consist of raw materials, work-in-process and finished goods. Inventories are recorded at the lower of cost or market using the first-in, first-out method, after appropriate consideration has been given to obsolescence and inventory in excess of anticipated future demand. In assessing the ultimate recoverability of inventories, we are required to make estimates regarding future customer demand and market conditions.

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

	As of January 31, 2007		As of April 30, 2006
Raw materials	$	370	$	361
Finished goods		227		74
Total	$	597	$	435

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Valuation of Goodwill

We perform annual goodwill impairment tests in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 142,Goodwill and Other Intangible Assets, (“SFAS No. 142”) during our fourth fiscal quarter, or whenever events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. The first step of the test identifies if potential impairment may have occurred, while the second step of the test measures the amount of the impairment, if any. Impairment is recognized when the carrying amount of goodwill exceeds its fair value. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment. For purposes of the annual impairment test, we consider our market capitalization on the date of the impairment test since we have just one reporting unit. We performed our recurring annual review of goodwill in the fourth quarter of fiscal 2006 and concluded that no impairment existed at April 30, 2006. For the nine months ended January 31, 2007, there have been no significant events or changes in circumstances affecting the valuation of goodwill.

Valuation of Long-Lived and Identifiable Intangible Assets

We periodically evaluate potential impairments of our long-lived assets, including identifiable intangible assets, in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets. We evaluate long-lived assets, including identifiable intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events or changes in circumstances that could result in an impairment review include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for our overall business and significant negative industry or economic trends. Impairment is recognized when the carrying amount of an asset exceeds its fair value as calculated on a discounted cash flow basis.

Restructuring Liabilities

Restructuring activities were initiated prior to December 31, 2002 and were recorded in accordance with Emerging Issues Task Force (“EITF”) Issue No. 94-3,Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). We have accrued through charges to “Restructuring” various restructuring liabilities related to employee severance costs, facilities closure and lease abandonment costs, and contract termination costs in our consolidated financial statements. The restructuring liabilities for facilities closure and lease abandonment costs include various assumptions, such as the time period over which abandoned facilities will be vacant, expected sublease terms, and expected sublease rates. Such assumptions are routinely assessed and any changes in these assumptions may result in a substantial increase or decrease to restructuring expense should different conditions prevail than were anticipated in original estimates.

Guarantees, Indemnifications and Warranty Obligations

Our customer agreements generally include certain provisions for indemnifying such customers against liabilities if our products infringe a third party’s intellectual property rights. To date, we have not incurred any material costs as a result of such indemnification provisions and have not accrued any liabilities related to such obligations in the accompanying consolidated financial statements.

Our Bylaws provide that we shall indemnify our directors and officers to the fullest extent permitted by Delaware law, including in circumstances in which indemnification is otherwise discretionary under Delaware law. We have also entered into indemnification agreements with our officers and directors containing provisions that may require us, among other things, to indemnify such officers and directors against certain liabilities that may arise by reason of their status or service as directors or officers and to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified. We expect to have indemnification obligations to certain current and former officers and directors in connection with matters relating to the stock option investigation (see Note 2 to the Notes to Condensed Consolidated Financial Statements for additional information), as well as with certain of our outstanding litigation matters.

We accrue for warranty expenses in our cost of revenue at the time revenue is recognized and maintain an accrual for estimated future warranty obligations based upon the relationship between historical and

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anticipated warranty costs and revenue volumes. If actual warranty expenses are greater than those projected, additional charges against earnings would be required. If actual warranty expenses are less than projected, obligations would be reduced, providing a positive impact on our reported results. We generally provide a one-year warranty on hardware products and a 90-day warranty on software products.

Changes in our warranty obligations, which are included in “Other accrued liabilities,” for the nine months ended January 31, 2007 and 2006, respectively, were as follows (in thousands):

	Nine Months Ended January 31,
	2007			2006
Beginning balances	$	319		$	262
Warranties issued during the period		1,075			1,023
Settlements made during the period		(967	)		(920	)
Ending balances	$	427		$	365

Income Taxes

We use the liability method to account for income taxes as required by SFAS No. 109,Accounting for Income Taxes, (“SFAS No. 109”). As part of the process of preparing our consolidated financial statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. This process involves determining our income tax expense together with calculating the deferred income tax expense related to temporary differences resulting from the differing treatment of items for tax and accounting purposes, such as deferred revenue or deductibility of certain intangible assets. These temporary differences result in deferred tax assets and liabilities, which are included within the consolidated balance sheets. We must then assess the likelihood that the deferred tax assets will be recovered through carrying back to prior year’s income of through the generation of future taxable income after consideration of tax planning strategies and then record a valuation allowance to reduce deferred tax assets to an amount we believe more likely than not will be realized. As of January 31, 2007, we have a full valuation allowance against our net deferred tax assets because we determined that it is more likely than not that our deferred tax assets will not be realized in the foreseeable future.

The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws. Our estimate for the potential outcome of any uncertain tax issues is highly judgmental. The Company accounts for income tax contingencies in accordance with SFAS No. 5, “Accounting for Contingencies”.

Stock-Based Compensation Prior to Adoption of SFAS No. 123(R)

Prior to May 1, 2006, we accounted for stock-based compensation for options granted to our employees and members of our Board of Directors using Accounting Principles Board (“APB”) Statement No. 25,Accounting for Stock Issued to Employees, and related interpretations, including Financial Accounting Standards Board Interpretation (“FIN”) No. 44,Accounting for Certain Transactions Involving Stock Compensation, An Interpretation of APB Opinion No. 25. In addition, we complied with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123,Accounting for Stock-Based Compensation,as amended by SFAS No. 148, Accountingfor Stock-Based Compensation-Transition and Disclosure Amendment of SFAS No. 123, as if we had applied the fair value-based method in measuring compensation cost for our stock-based compensation plans

Under APB No. 25, compensation expense is measured on the date in which the number of shares and exercise price are known, or fixed. If the number of shares or exercise price of the award is not fixed, the stock option is accounted for as a variable award until such time at which the stock option is exercised, cancelled or expires.

For fixed stock awards, compensation expense is calculated based on its intrinsic value, or the difference between the fair market value of our stock on the date the award is fixed and the award’s exercise price. No compensation expense is recognized if an award’s intrinsic value is zero. Stock compensation expense associated with fixed stock option awards with a positive intrinsic value is recognized over the vesting period using the graded method, which results in greater expense recorded in earlier years than the straight-line method.

For variable awards, the intrinsic value of our stock options is remeasured each period based on the difference between the fair market value of our stock as of the end of the reporting period and the award’s exercise price. As a result, the amount of compensation expense or benefit to be recognized each period fluctuates based on changes in the fair market value of our common stock from the end of the previous reporting period to the end of the current reporting period. Compensation expense in any given period is calculated as the difference between total cumulative earned compensation calculated at the end of the period, less total cumulative earned compensation calculated at the beginning of the period for each such award. Compensation expense for these awards is recognized over the vesting period using an accelerated method of recognition in accordance with FIN No. 28,Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plan, An Interpretation of APB Opinions No. 15 and 25. Variable accounting is applied until the measurement date of the stock option is fixed, or the time at which the stock option is exercised, forfeited or expires.

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We account for modifications to stock options under FIN No. 44, which was effective July 1, 2000. Modifications include, but are not limited to, acceleration of vesting, extension of the exercise period following termination of employment and/or continued vesting while not providing substantive services. Compensation expense is recorded in the period of modification for the intrinsic value of the vested portion of the award, including vesting that occurs while not providing substantive services, on the date of modification.

The following table illustrates the effect on our net income (loss) and net income (loss) per share for the three and nine months ended January 31, 2006 if we had applied the fair value recognition provisions of SFAS 123 to stock-based compensation using the Black-Scholes valuation model (in thousands) in that period.

	Three months ended January 31, 2006 (as restated)1			Nine months ended January 31, 2006 (as restated)1
Net income2	$	2,702		$	5,889
Add: Stock-based employee compensation expense included in reported net income		34			3,961
Deduct: Stock-based employee compensation expense that would have been included in the determination of net income if the fair value method had been applied to all awards3		(3,532	)		(9,309	)
Net income (loss), including stock-based employee compensation expense4	$	(796	)	$	541
Basic net income (loss) per common share:
Reported	$	0.21		$	0.46
Pro forma	$	(0.06	)	$	0.04
Diluted net income (loss) per common share:
Reported	$	0.18		$	0.41
Pro forma	$	(0.06	)	$	0.04

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

(2) Net income and net income per share as reported for periods prior to May 1, 2006 included stock-based compensation for employees calculated in accordance with APB 25 and represented the intrinsic value, but did not include stock-based compensation for our employee stock purchase plan because we did not adopt the recognition provisions of SFAS 123.

(3) Stock-based compensation expense for periods prior to May 1, 2006 was calculated based on the pro forma application of SFAS 123.

(4) Net income and net income per share including stock-based compensation expense for periods prior to May 1, 2006 are based on the pro forma application of SFAS 123.

Stock-Based Compensation Subsequent to Adoption of SFAS No. 123(R)

We adopted SFAS No. 123(R),Share-Based Payment, for our fiscal year beginning May 1, 2006 using the modified prospective transition method. Under that transition method, recognized compensation cost includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of, May 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments granted on or after May 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Further, we have elected to use the straight-line method of amortization for stock-based compensation related to stock options granted after May 1, 2006. We will continue to amortize stock-based compensation using the graded method for stock options granted prior to May 1, 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No. 107, which provides supplemental implementation guidance for SFAS No. 123(R). We have applied the provisions of SAB 107 in our adoption of SFAS No. 123(R). Stock-based compensation expense recognized under SFAS No. 123(R) was approximately $2.1 million and $7.6 million for the three and nine months ended January 31, 2007, respectively.

Concentration and Other Risks

Financial instruments that potentially subject us to credit risk consist of demand deposit accounts, money market accounts, commercial paper, corporate debt securities and trade receivables. We maintain our demand deposit and money market accounts with financial institutions of high credit standing. We invest only in high-quality, investment grade securities and limit investment exposure in any one issue. Investments are classified as cash equivalents or short-term investments, as applicable, on our condensed consolidated balance sheets as of January 31, 2007. We believe the financial risks associated with these financial instruments are minimal. We have not experienced material losses from our investments in these securities.

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We generally do not require collateral for sales to customers. However, we perform on-going credit evaluations of our customers’ financial condition and maintain an allowance for doubtful accounts. As of January 31, 2007 and 2006, no customer accounted for more than 10% of the accounts receivable balance, respectively. For the three and nine months ended January 31, 2007, one customer accounted for 17.1% and 12.7% of net revenue, respectively. For the three and nine months ended January 31, 2006, one customer accounted for 10% and 11.6% of net revenue, respectively.

We currently purchase several key parts and components used in the manufacture of our products from a limited number of suppliers. Generally we have been able to obtain an adequate supply of such parts and components. However, an extended interruption in the supply of parts and components currently obtained from our suppliers could adversely affect our business and consolidated financial statements.

Contingencies

From time to time we are involved in various claims and legal proceedings. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than any other. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary. Litigation is subject to inherent uncertainties, and unfavorable rulings could occur.

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159,The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115. SFAS No. 159 allows measurement at fair value of eligible financial assets and liabilities that are not otherwise measured at fair value. If the fair value option for an eligible item is elected, unrealized gains and losses for that item shall be reported in current earnings at each subsequent reporting date. SFAS No. 159 also establishes presentation and disclosure requirements designed to draw comparison between the different measurement attributes the company elects for similar types of assets and liabilities. This statement is effective for our fiscal year beginning May 1, 2008. We are currently evaluating the effect, if any, that the adoption of SFAS No. 159 will have on our consolidated financial statements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157,Fair Value Measurements. SFAS No. 157 provides a framework for measuring fair value, clarifies the definition of fair value, and expands disclosures regarding fair value measurements. SFAS No. 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. We are required to adopt SFAS No. 157 for our fiscal year beginning May 1, 2008. We are currently evaluating the effect that the adoption of SFAS No. 157 will have on our consolidated results of operations and financial condition, but do not expect it to have a material impact.

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”). Under FIN 48, companies are required to apply the “more likely than not” threshold to the recognition and derecognition of tax positions. FIN 48 also provides guidance on the measurement of tax positions, balance sheet classification, interest and penalties, accounting in interim periods, disclosure and transition rules. We are required to adopt FIN 48 for our fiscal year beginning May 1, 2007. We are currently evaluating the provisions in FIN 48, however, at the present time, we do not anticipate that the adoption of FIN 48 will have a material impact on our consolidated financial statements.

Note 2. Restatement of Condensed Consolidated Financial Statements

In our Form 10-K for the fiscal year ended April 30, 2006, we restated our condensed consolidated financial statements and related disclosures as of April 30, 2005 and for the years ended April 30, 2005 and 2004. The restatement included adjustments arising from an internal review of our historical financial statements, as well as the determinations of an independent committee of our Board of Directors (the “Special Committee”), assisted by independent legal counsel and accounting experts, formed in July 2006 to conduct an internal investigation into our historical stock option granting practices that concluded that our historical measurement dates could not be relied upon. We also recorded adjustments affecting our previously-reported financial statements for fiscal years 2000 through 2003, the effects of which are summarized in cumulative adjustments to our additional paid in capital, deferred stock-based compensation and accumulated deficit accounts as of April 30, 2003 in our Form 10-K for the fiscal year ended April 30, 2006. Our restated interim financial statements for the quarterly and year-to-date periods ended July 31, 2005, October 31, 2005, and January 31, 2006 are included in our quarterly reports on Forms 10-Q for the periods ended July 31, 2006, October 31, 2006 and January 31, 2007, respectively.

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Our management reviewed the information made available to it by the Special Committee and performed its own detailed review of historical stock option grants as part of the effort to establish appropriate measurement dates. In connection with these procedures, our management also conducted certain recertification procedures as part of the process of determining if there was evidence that would prevent our Board of Directors and current management from relying upon the work performed by the accounting, finance and legal personnel as it relates to fiscal years 2004 and 2005, and the extent to which our prior accounting and controls can be relied upon for purposes of the preparation and certification of the restated consolidated financial statements.

As a result of the Special Committee’s investigation and findings, as well as our internal review and recertification procedures, we have recorded additional stock-based compensation expense for numerous stock option grants made from November 1999 through May 2006 to correctly account for stock option grants for which the Special Committee or management determined that the actual measurement date for accounting purposes was different from the stated grant date.

In addition to the deferred stock-based compensation amounts, and related payroll and withholding taxes, penalties, and interest resulting from the revision in measurement dates for historical stock option grants, our internal review also identified certain other errors in accounting determinations and judgments relating to stock-based compensation that have also been corrected in our restated consolidated financial statements. These errors include: (a) incorrect amortization of cheap stock; (b) incorrect accounting for a pre-IPO loan issued to exercise stock options as a fixed award rather than as a variable award in fiscal years 2000 and 2001; (c) incorrect accounting for modifications to equity awards; and (d) incorrect amortization of acquisition-related option grants. These errors in accounting for stock-based compensation expense are described in more detail after the accompanying summary tables below.

Also included in this restatement are certain other non-stock-based compensation items which had not previously been recorded due to their immateriality, but which management was aware of outside of the course of the investigation and the procedures described above. These other non-stock-based compensation items are immaterial both individually and in aggregate, and relate solely to the timing of certain operating expenses between periods such that the net impact to all periods is zero.

The effects of these adjustments as reported in our Form 10-K are summarized as follows (in thousands):

	Year Ended April 30,
	2004 (as restated)			2005 (as restated)			2006			Total
Revised stock option measurement dates	$	4,181		$	9		$	3,271		$	7,461
Corrections of Other Accounting Errors:
Amortization of cheap stock		716			56			—			772
Modifications to equity awards		211			29			19			259
Amortization of acquisition-related option grants		(217	)		(341	)		91			(467	)
Total correction of other accounting errors		710			(256	)		110			564
Total stock-based compensation expense restatement		4,891			(247	)		3,381			8,025
Expense/(benefit) from payroll taxes, penalties and interest		43			837			1,118			1,998
Net adjustments to stock-based compensation expense		4,934			590			4,499			10,023
Non-Stock-Based Compensation Expense/(Benefit):
Adjustments to the timing of certain operating expenses		79			130			(130	)		79
Total non-stock-based compensation expense/(benefit)		79			130			(130	)		79
Net decrease/(increase) in net income due to adjustments	$	5,013		$	720		$	4,369		$	10,102
Cumulative increase to accumulated deficit at April 30, 2003											38,916
Cumulative increase to accumulated deficit at April 30, 2006										$	49,018

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	Year Ended April 30,
	2000		2001			2002			2003		2004		2005		2006			Total
Net restatement of stock-based compensation expense	$	9,502	$	29,823		$	(3,407	)	$	3,020	$	4,934	$	590	$	4,499		$	48,961
Total non-stock-based compensation expense/(benefit)		75		(146	)		—			49		79		130		(130	)		57
Net decrease/(increase) in net income due to adjustments	$	9,577	$	29,677		$	(3,407	)	$	3,069	$	5,013	$	720	$	4,369		$	49,018
Cumulative increase to accumulated deficit	$	9,577	$	39,254		$	35,847		$	38,916	$	43,929	$	44,649	$	49,018

The errors in accounting for stock-based compensation expense are described more fully below:

Correction in the Amortization of Cheap Stock

We analyzed and recalculated the compensation expense associated with our stock options granted before our initial public offering (“IPO”), also known as cheap stock, due to an accounting error in calculating the amount and timing of adjustments to deferred stock-based compensation expense for unvested options upon employee termination. The correction of these accounting errors resulted in the recognition of a benefit in fiscal years 2000 through 2002 and additional expense in fiscal years 2003 through 2005, for a net reduction of stock-based compensation of $8.3 million.

Modifications to Equity Awards

We also identified stock options that had been modified due to the terms of separation agreements and employment agreements. Based on a review of separation agreements and the related employment agreements, we determined that the terms of certain agreements modified certain provisions of the related options, specifically the vesting provisions or the term by providing additional time to exercise. Pursuant to the guidelines set forth in APB 25 and FIN 44, modifications that renew or extend the life of fixed awards, or provide for an extension or renewal if a specified future separation from employment occurs, result in a new measurement date. The modification of the related stock option grants resulted in additional stock-based compensation expense of $0.8 million.

Correction in the Amortization of Acquisition Related Option Grants

We originally adopted the graded method of amortizing stock-based compensation expense. However, we incorrectly used a straight-line amortization method to amortize compensation expense related to an acquisition in fiscal 2006. For stock-based compensation expense related to an acquisition in fiscal 2001, we also incorrectly accounted for the adjustment to stock-based compensation expense for terminated employees to reflect stock-based compensation expense for vested options as if it had been recorded on a straight-line basis. The correction in amortization of acquisition-related stock-based compensation expense resulted in a net reduction in stock-based compensation expense of $7.1 million for the fiscal years 2001 through 2006.

Payroll and Withholding Taxes, Penalties and Interest

Internal Revenue Code Section 421 prohibits the granting of Incentive Stock Options (“ISO’s”) with an exercise price below fair market value of the underlying shares on the date of grant. As described above, nearly all of our stock options granted since November 18, 1999 were subject to revised measurement dates. Therefore, many of the stock options that were granted as ISO’s should have

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been treated as Non-Qualified (“NQ”) stock options for purposes of payroll taxes. We did not withhold Federal Income Taxes, State Income Taxes, FICA or Medicare on the options that were issued as ISO’s that should have been treated as NQ stock options (due to their below-market grant pricing). However, it is our position that in certain circumstances we should have withheld such taxes. As described below, we have accrued payroll and withholding taxes, penalties and interest for these NQ stock options and included these amounts in the restated financial statements.

However, since the statute of limitations has expired for years prior to calendar year 2003, we have reversed expense recorded in prior periods and recognized a benefit in the periods in which the statute of limitations for the respective option exercise expires. In most instances, ISO’s which were exercised as a same-day sale were properly treated as a disqualifying disposition and the income was reported on the individuals Form W-2. In these situations, we accrued payroll taxes, penalties and interest but did not accrue Federal or State Income Taxes as the income from the disqualifying disposition of stock options was included on the employee’s Form W-2 and applicable State and Federal Income Taxes were paid by the employee. For certain ISO’s which subsequently converted to a NQ stock option, we accrued Federal and State Income Taxes, payroll taxes, penalties and interest at the applicable rates, if the income was not reported on the individuals Form W-2.

The combination of taxes, penalties and interest resulted in a net compensation charge of $2.0 million for fiscal years 2000 through 2006.

We believe that the unpaid employee portion of taxes represents joint and several obligations of both us and our employees. However, the change of status of employee options from ISO to NQ was a result of flaws in our stock option granting practices as discussed above. We believe that the employees would likely have a valid claim against us in the event we attempted to recover a portion of the additional taxes, penalties and interest from them. Accordingly, we believe it is appropriate to accrue both the employee and the employer portions of all taxes. In addition, we believe such additional taxes, penalties and interest should be recorded in the respective years in which the underlying in-the-money options were exercised. Since we have fully reserved our deferred tax assets, we did not record any net change to our deferred tax assets associated with this restatement.

The following tables present the impact of the additional stock-based compensation expense-related adjustments, as well as other non-stock-based compensation adjustments which were recorded as part of the restatement, on our condensed consolidated statements of operations, statements of cash flows and pro forma stock-based compensation expense disclosures as provided under SFAS No. 123, as amended by SFAS No. 148, as applicable:

Condensed Consolidated Statements of Operations for the three and nine months ended January 31, 2006 are as follows (in thousands, except per share amounts):

	Three Months Ended January 31, 2006									Nine Months Ended January 31, 2006
	As previously reported			Adjustments			As Restated			As previously reported			Adjustments			As Restated
Net revenue:
Product	$	28,986		$	—		$	28,986		$	87,550		$	—		$	87,550
Service		6,531			—			6,531			18,037			—			18,037
Total net revenue		35,517			—			35,517			105,587			—			105,587
Cost of net revenue:
Product (*)		7,732			5			7,737			24,465			57			24,522
Service (*)		2,587			18			2,605			6,927			57			6,984
Total cost of net revenue		10,319			23			10,342			31,392			114			31,506
Gross profit		25,198			(23	)		25,175			74,195			(114	)		74,081
Operating expenses:
Research and development (*)		6,403			326			6,729			17,696			1,016			18,712
Sales and marketing (*)		13,202			228			13,430			37,808			600			38,408
General and administrative (*)		2,940			(313	)		2,627			8,713			2,795			11,508
Amortization of intangible assets		174			—			174			522			—			522
Total operating expense		22,719			241			22,960			64,739			4,411			69,150
Operating income (loss)		2,479			(264	)		2,215			9,456			(4,525	)		4,931
Interest income		635			(15	)		620			1,460			(45	)		1,415
Other expense		(91	)		(33	)		(124	)		(101	)		(99	)		(200	)
Income (loss) before income taxes		3,023			(312	)		2,711			10,815			(4,669	)		6,146
Provision for income taxes		9			—			9			257			—			257

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	Three Months Ended January 31, 2006								Nine Months Ended January 31, 2006
	As previously reported		Adjustments			As Restated			As previously reported		Adjustments			As Restated
Net income (loss)	$	3,014	$	(312	)	$	2,702		$	10,558	$	(4,669	)	$	5,889
Net income (loss) per common share:
Basic	$	0.23	$	(0.02	)	$	0.21		$	0.83	$	(0.37	)	$	0.46
Diluted	$	0.20	$	(0.02	)	$	0.18		$	0.73	$	(0.32	)	$	0.41
Weighted average shares used in computing net income (loss) per common share:
Basic		12,962		—			12,962			12,674		—			12,674
Diluted		14,845		—			14,845			14,544		(28	)		14,516
(*)    Includes stock-based compensation (reversal) as follows:
Cost of product	$	—	$	(7	)	$	(7	)	$	—	$	19		$	19
Cost of service		—		14			14			—		43			43
Research and development		—		204			204			—		652			652
Sales and marketing		—		151			151			—		497			497
General and administrative		1		(329	)		(328	)		3		2,747			2,750
Total stock-based compensation	$	1	$	33		$	34		$	3	$	3,958		$	3,961

Condensed Consolidated Statements of Cash Flows for the nine months ended January 31, 2006 are as follows (in thousands):

	Nine Months Ended January 31, 2006
	As previously reported			Adjustments			As restated
Operating Activities
Net income (loss)	$	10,558		$	(4,669	)	$	5,889
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation		1,700			—			1,700
Amortization		1,044			—			1,044
Loss (gain) on disposition of equipment		206			—			206
Stock-based compensation		3			3,958			3,961
Changes in operating assets and liabilities:
Accounts receivable		(6,681	)		—			(6,681	)
Inventories		(609	)		—			(609	)
Prepaid expenses and other current assets		(390	)		—			(390	)
Other assets		(61	)		—			(61	)
Accounts payable		1,573			—			1,573
Accrued payroll and related benefits		1,729			839			2,568
Other accrued liabilities		(150	)		(128	)		(278	)
Restructuring accrual		(2,028	)		—			(2,028	)
Deferred rent		1,465			—			1,465
Deferred revenue		12,766			—			12,766
Net cash provided by operating activities		21,125			—			21,125
Investing Activities
Sale of investment securities		500			—			500
Purchases of investment securities		(10,000	)		—			(10,000	)
Purchases of property and equipment		(5,536	)		—			(5,536	)
Sales of property and equipment		35			—			35
Net cash used in investing activities		(15,001	)		—			(15,001	)
Financing Activities
Net proceeds from issuance of common stock		7,246			—			7,246
Net cash provided by financing activities		7,246			—			7,246
Net increase in cash and cash equivalents		13,370			—			13,370
Cash and cash equivalents at beginning of period		47,184			—			47,184
Cash and cash equivalents at end of period	$	60,554		$	—		$	60,554

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We have restated the pro forma information required in accordance with SFAS 123, as amended by SFAS No. 148, to give effect to the revision in measurement dates of certain stock options and adjustments to stock-based compensation expense previously discussed. The effect of these changes for the three and nine months ended January 31, 2006 is presented in the table below (in thousands, except per share amounts):

	Three Months Ended January 31, 2006									Nine Months Ended January 31, 2006
	As previously reported			Adjustments			As Restated			As previously reported			Adjustments			As restated
Net income (loss)	$	3,014		$	(312	)	$	2,702		$	10,558		$	(4,669	)	$	5,889
Stock-based employee compensation expense included in the determination of net income (loss), as reported		1			33			34			3			3,958			3,961
Stock-based employee compensation expense that would have been included in the determination of net income (loss) if the fair value method had been applied to all awards		(2,690	)		(842	)		(3,532	)		(6,646	)		(2,663	)		(9,309	)
Pro forma net income (loss)		325			(1,121	)		(796	)		3,915			(3,374	)		541
Basic net income (loss) per common share:
Reported	$	0.23		$	(0.02	)	$	0.21		$	0.83		$	(0.37	)	$	0.46
Pro forma	$	0.03		$	(0.09	)	$	(0.06	)	$	0.31		$	(0.27	)	$	0.04
Diluted net income (loss) per common share:
Reported	$	0.20		$	(0.02	)	$	0.18		$	0.73		$	(0.32	)	$	0.41
Pro forma	$	0.02		$	(0.08	)	$	(0.06	)	$	0.27		$	(0.23	)	$	0.04

As a result of the restatement, the related disclosures included in the notes to condensed consolidated financial statements have been where indicated as restated.

Note 3. Stock-based Compensation

As of January 31, 2007, we had five stock-based employee compensation plans, which are described below. The employee stock-based compensation cost included in the condensed consolidated statements of operations for the three and nine months ended January 31, 2007 was $2.1 million and $7.6 million, respectively.

1996 Stock Incentive Plan

In 1996, we established the 1996 Stock Option Plan (the “1996 Plan”) under which stock options are granted to employees, directors and consultants. Options granted under the plan expire no later than ten years from the date of grant. After November 18, 1999 no options could be granted under the 1996 plan. As of January 31, 2007, 178,109 shares of common stock remain available for issuance under the plan.

Options that expire and shares issued under the 1996 Plan that are repurchased become available for issuance under the 1999 Stock Incentive Plan, which is discussed further below.

1999 Stock Incentive Plan

In September 1999, our Board of Directors adopted the 1999 Stock Incentive Plan (the “Incentive Plan”), which became effective upon the effective date of our initial public offering. The number of shares reserved under the Incentive Plan automatically increased each year since inception and will increase on an annual basis by the lesser of 5% of the total amount of common stock outstanding or 400,000 shares. Furthermore, any options granted under the 1996 Plan that are cancelled or exercised and subsequently repurchased by us become available for future issuance under the Incentive Plan. Options granted under the plan expire no later than ten years from the date of grant. As of January 31, 2007, 3,279,645 shares of common stock remain available for issuance under the plan. The exercise price for incentive stock options and non-qualified stock options granted under the Incentive Plan may not be less than 100.0% and 85.0%, respectively, of the fair market value of common stock on the option grant date and the stock options are generally subject to a four-year vesting term. However, as discussed in Note 2, “Restatement of Condensed Consolidated Financial Statements,” certain of our historical grants were issued below the fair market value of common stock on the option grant date and stock-based compensation expense has been recorded accordingly.

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1999 Director Option Plan

In September 1999, our Board of Directors adopted the 1999 Director Option Plan (the “Directors Plan”). Under the Directors Plan, each non-employee director joining the Board of Directors following the effective date of our initial public offering automatically receives options to purchase 5,000 shares of common stock. In addition, each non-employee director automatically receives options to purchase 1,000 shares of common stock at each annual meeting of the Board of Directors held in the year 2000 and thereafter. Options granted under the plan expire no later than ten years from the date of grant. Options granted under the Directors Plan will have an exercise price equal to the fair market value of the common stock on the option grant date. The number of shares reserved under the Directors Plan automatically increases by 20,000 shares annually beginning January 1, 2000. As of January 31, 2007, 170,750 shares of common stock remain available for issuance under the plan. Our Board of Directors, at its discretion, may reduce the automatic annual increase in reserved shares.

2000 Supplemental Stock Option Plan

In February 2000, our Board of Directors adopted the 2000 Supplemental Stock Option Plan (the “2000 Plan”), under which 600,000 shares of common stock were reserved for issuance. Non-executive employees and consultants are eligible to participate in the 2000 Plan. The 2000 Plan provides for the grant of non-statutory stock options to purchase shares of our common stock and/or grants of restricted shares of common stock. Options granted under the plan expire no later than ten years from the date of grant. The exercise price for stock options issued under the 2000 Plan may not be less than 25.0% of the fair market value of common stock on the option grant date. As of January 31, 2007, 332,170 shares of common stock remain available for issuance under the plan.

As of January 31, 2007, 499,531 shares of common stock were available for grant and 4,000,685 shares of common stock (including 40,011 shares of common stock from option plans assumed through acquisitions) remain available for future issuance under the aforementioned option plans.

Employee Stock Purchase Plan

In September 1999, our Board of Directors adopted the Employee Stock Purchase Plan (“ESPP”), which became effective upon our initial public offering. Under the ESPP, eligible employees may purchase common stock through payroll deductions, not to exceed 15% of an employee’s compensation, at a price equal to 85% of the closing fair market value of our common stock on the lower of the day prior to the beginning of the offering or the last day of the applicable six-month purchase period. Beginning January 31, 2000, the number of shares reserved under the ESPP is automatically increased by 100,000 shares annually. Effective March 1, 2006, the ESPP was modified to reduce the offering period to six months from a prior maximum of two years. In addition, to provide equitable participation for all employees regardless of compensation, the contribution limit was changed from a percentage of compensation to a fixed dollar limitation of $10,000 per six-month offering period.

As of January 31, 2007, 595,919 shares of common stock remain available for future issuance under the ESPP. Our Board of Directors, at its discretion, may reduce the automatic annual increase in reserved shares.

Impact of the Adoption of SFAS No. 123(R)

See Note 1 for a description of our adoption of SFAS No. 123(R) on May 1, 2006. The following table summarizes the stock-based compensation expense for stock options and our employee stock purchase plan that we recorded in the condensed statements of operations in accordance with SFAS No. 123(R) for the three and nine months ended January 31, 2007 (in thousands).

	Three Months Ended January 31, 2007		Nine Months Ended January 31, 2007
Stock-based compensation expense:
Cost of product	$	108	$	379
Cost of service		105		339
Research and development		810		2,624
Sales and marketing		637		2,529
General and administrative		425		1,739
Total	$	2,085	$	7,610

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Determining Fair Value under SFAS No. 123(R)

Valuation and Amortization Method.We estimate the fair value of stock options granted using the Black-Scholes option valuation model. For options granted before May 1, 2006, we amortize the fair value on a graded basis. For options granted on or after May 1, 2006, we amortize the fair value of stock-based compensation on a straight-line basis for options expected to vest. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods.

Expected Term. The expected term of options granted represents the period of time that they are expected to be outstanding. We estimate the expected term of options granted based on our historical experience of grants, exercises and post-vesting cancellations. Contractual term expirations have not been significant.

Expected Volatility. We estimate the volatility of our stock options at the date of grant using a combination of historical and implied volatilities, consistent with SFAS No. 123(R) and SEC Staff Accounting Bulletin No. 107. Historical volatilities are calculated based on the historical prices of our common stock over a period equal to the expected term of our option grants, while implied volatilities are derived from publicly traded options of our common stock. Prior to the adoption of SFAS No. 123(R), we relied exclusively on the historical prices of our common stock in the calculation of expected volatility.

Expected Forfeitures. Stock-based compensation expense under SFAS No. 123(R) is based on awards ultimately expected to vest, and requires that forfeitures be estimated at the time of grant and revised, if necessary, if actual forfeitures differ from those estimates. We estimated our forfeiture rate at 10% based on an analysis of historical pre-vesting forfeitures, and have reduced stock-based compensation expense accordingly.

Risk-Free Rate.The risk-free interest rate that we use in the Black-Scholes option valuation model is the implied yield in effect at the time of option grant based on U.S. Treasury zero-coupon issues with a remaining term equivalent to the expected term of our option grants.

Dividends.We have never paid any cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model.

Due to the on-going stock option investigation, there were no options granted for the three months ended January 31, 2007, accordingly, no stock options were valued for the period. For the nine months ended January 31, 2007, as well as for the three and nine months ended January 31, 2007, we used the following assumptions to estimate the fair value of stock options granted:

	Three Months Ended January 31, 2006		Nine Months Ended January 31,
Stock Options			2007		2006
Risk-free rate	4.48	%	5.22	%	4.23	%
Expected dividend yield	—		—		—
Expected life (in years)	4.05		4.63		4.00
Expected volatility	0.88		0.76		1.00
Expected forfeitures	—		10	%	—

Due to the on-going stock option investigation, there were no purchases under our ESPP, or amortization of expense related to ESPP shares, for the three and nine ended January 31, 2007. There were no purchases under our ESPP for the three months ended January 31, 2006 as the last day of the applicable six month offering period did not occur in such three month period. Accordingly, no ESPP shares were valued for these periods. For the nine months ended January 31, 2006, we used the following assumptions to estimate the fair value of shares purchased under our ESPP:

	Nine Months Ended January 31, 2006
Risk-free rate	3.72	%
Expected dividend yield	—
Expected life (in years)	1.25
Expected volatility	0.83

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Stock Option Activity

A summary of stock option activity under all stock-based compensation plans during the nine months ended January 31, 2007 is as follows:

	Outstanding Options
	Number of Shares		Weighted-Average Exercise Price Per Share
Balance at May 1, 2006	3,330,399		$	29.45
Options granted	431,220		$	16.89
Options exercised	(7,009	)	$	4.84
Options forfeited	(233,063	)	$	29.53
Options expired	(20,393	)	$	61.05
Outstanding at January 31, 2007	3,501,154		$	27.77
Exercisable at January 31, 2007	2,136,002		$	32.40

The weighted average remaining contractual life for options outstanding and exercisable at January 31, 2007 was 7.04 and 6.15 years, respectively. The aggregate intrinsic value of options exercised during the three and nine months ended January 31, 2007 was $0 and $79,366 respectively. The aggregate intrinsic value of options outstanding and exercisable at January 31, 2007 was $30.3 million and $21.1 million, respectively. The total fair value of options vested during the three and nine months of January 31, 2007 was $2.5 million and $8.4 million, respectively.

There were zero and 17,850 employee stock options under our stock compensation plans granted with exercise prices below the fair market value of our common stock on the date of grant during the three and nine months ended January 31, 2007, respectively. The estimated weighted average fair value of the stock options granted during the three and nine months ended January 31, 2007 was $0 and $10.69 per share, respectively.

As of January 31, 2007, $10.4 million of unrecognized compensation costs related to unvested awards is expected to be recognized over a weighted average period of 2.4 years.

The following table provides segregated ranges of stock options outstanding at January 31, 2007:

Options Outstanding					Options Exercisable
Range of Exercise Prices	Number of Options Outstanding at January 31, 2007	Weighted Average Contractual Life (Years)	Weighted Average Exercise Price		Number of Options Exercisable at January 31, 2007	Weighted Average Exercise Price
$0.05-$0.05	50	3.80	$	0.05	50	$	0.05
$2.25-$2.25	244,982	5.44	$	2.25	244,982	$	2.25
$2.50-$5.44	224,071	6.14	$	4.70	193,666	$	4.69
$5.60-$5.60	217,176	6.38	$	5.60	189,948	$	5.60
$8.04-$13.36	273,365	7.16	$	10.64	167,023	$	10.39
$13.93-$16.70	656,493	8.38	$	15.88	226,974	$	15.39
$16.73-$18.04	170,015	5.60	$	17.01	141,455	$	16.91
$18.08-$18.08	265,613	8.31	$	18.08	107,932	$	18.08
$18.96-$27.80	808,031	7.28	$	21.93	432,380	$	22.37
$30.00-$525.00	641,358	6.35	$	86.77	431,592	$	111.14
$0.05-$525.00	3,501,154	7.04	$	27.77	2,136,002	$	32.40

We received $35,000 and $7.2 million in cash from option exercises under all stock-based compensation plans for the nine months ended January 31, 2007 and 2006, respectively.

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Note 4. Sale of Series A Redeemable Convertible Preferred Stock

On June 22, 2006, we sold an aggregate of $42.1 million of Series A Preferred Redeemable Convertible Stock (“Series A Preferred Stock”). The financing consisted of 42,060 shares of our Series A Preferred Stock.

Significant rights and obligations of the Series A Preferred Stock is as follows:

Conversion feature. The 42,060 shares of Series A Preferred Stock are initially convertible at the option of the holders into 2.4 million shares of our common stock. The conversion price of each share of Series A Preferred Stock is $17.525 per share, such that the conversion rate of the Series A Preferred Stock is approximately 57.06-to-1.0. Each share of Series A Preferred Stock will be automatically converted into shares of Common Stock at the then effective conversion rate for such share upon the approval of the holders of at least a majority of the then-outstanding Series A Preferred Stock.

Redemption features. In the event that we do not complete an acquisition, whether by merger, consolidation, the purchase of assets or otherwise, of another entity or of certain assets of another entity, for at least $18,000,000 in cash within 150 days of June 22, 2006 (the “Closing Date”), the Series A Preferred Stock is redeemable at the option of either the holder or us during a 30 day period thereafter. The Series A Preferred Stock matures six years from the issuance and we will be required to redeem the Series A Preferred Stock at that time. In either of such cases, the redemption price would be the face amount plus an amount equal to declared but unpaid dividends. We completed an acquisition satisfying the criteria above with the acquisition of certain assets of the NetCache™ business from Network Appliance on September 11, 2006.

Liquidation preference. Upon liquidation, Series A Preferred Stock is paid out of our assets an amount equal to the face amount plus an amount equal to declared but unpaid dividends before any distribution to any other class of stock that is junior in ranking.

Voting rights.Each holder of Series A Preferred Stock is entitled to the number of votes equal to the number of shares of Common Stock into which the shares of Series A Preferred Stock held by such holder could be converted as of the record date. The holders of shares of Series A Preferred Stock shall be entitled to vote on all matters on which the Common Stock shall be entitled to vote. In addition, until June 22, 2007, the holders of at least a majority of the then-outstanding Series A Preferred Stock, voting as a separate class, shall be entitled to elect one (1) director to the Board of Directors at each meeting or pursuant to each consent of our stockholders for the election of directors.

Dividends.The Series A Preferred Stock participates equally with the holders of Common Stock in all dividends paid on the Common Stock, when, as and if declared by the Board of Directors, out of funds legally available, as if such shares of Series A Preferred Stock had been converted to shares of Common Stock immediately prior to the record date for the payment of such dividend. No dividends have been declared to date.

Note 5. Acquisition

On September 11, 2006, we completed the acquisition of certain assets of the NetCache™ business from Network Appliance pursuant to an asset purchase agreement executed on June 22, 2006. The final consideration for the transaction consisted of $23.9 million cash consideration, an aggregate of approximately 360,000 shares of our common stock valued at $5.7 million and $1.0 million in estimated direct transaction costs. Of the total purchase price, $0.7 million has been allocated to the intangible assets acquired with the balance of $29.9 million allocated to goodwill.

The NetCache business previously provided solutions to large enterprises to manage internet access and security and control Web content and application acceleration. NetCache was a business unit previously owned by Network Appliance, Inc. Our primary purpose for acquiring certain assets of the NetCache business was to increase our potential customer base through the conversion of existing NetCache customers to our proxy appliances. One employee joined us from Network Appliance as a result of the acquisition. Accordingly, our operating costs were not materially impacted. We do not expect to generate a significant amount of revenue from the sale of NetCache appliances.

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The preliminary allocation of the estimated purchase price, based on the fair value of certain components, consisted of the following at January 31, 2007 (in thousands):

Consideration and direct transaction costs:
Cash	$	23,914
Fair value of Blue Coat common stock		5,668
Estimated direct transaction costs		980
Total purchase price	$	30,562
Allocation of purchase price:
Identifiable intangible assets	$	700
Goodwill		29,862
Total purchase price	$	30,562

To establish the value of the intangible asset, an income approach was used with the assistance of an independent valuation specialist. We utilized a five-step process to value the intangible asset: (i) revenue associated with the intangible assets was projected; (ii) cost of goods sold was then estimated for each period in which revenue was projected; (iii) the resulting net cash flow was tax effected and reduced further by charges for the use of fixed assets, working capital and other assets necessary to generate these cash flows; (iv) the resulting net cash flows were discounted at a rate commensurate with their risk; and (v) we summed the discounted cash flows to estimate their fair market values. We then estimated the tax benefits associated with the intangible asset and this benefit was included in the value of the intangible asset.

As part of the valuation analysis, an understanding of the technology acquired and its future use after the acquisition was necessary. Accordingly, several factors were considered: (i) whether or not the acquired technology had achieved technological feasibility; (ii) the time, costs and risks to complete the development of the technology; (iii) the roadmap for the technology post acquisition; (iv) the existence of any alternative use for the technology; (v) the additional use of any core technology; and (vi) the results of any enhancements or embellishments to the technology.

Using the above guidelines at the time of the acquisition, we identified one intangible asset that was valued separately from goodwill using an income approach as described above. The intangible asset identified was customer relationships. The cash flows were discounted to their present value using a discount rate of approximately 19%. The acquired intangible asset and its estimated useful life is as follows (in thousands):

Identifiable intangible assets	Amortization period	Gross Amount		Accumulated Amortization			Net Carrying Value
Customer relationships	5 years	$	700	$	(52	)	$	648
Total		$	700	$	(52	)	$	648

Note 6. Cash equivalents and investments

The carrying amount of cash and cash equivalents reported on the balance sheet approximates its fair value. Short-term investments consist of marketable debt securities. The fair values of investments are based upon quoted market prices.

The following is a summary of cash, cash equivalents and available-for-sale securities as of January 31, 2007 and April 30, 2006, respectively (in thousands):

	Amortized Cost		As of January 31, 2007
			Unrealized Gain (loss)			Estimated Fair Value
Cash and cash equivalents	$	531	$	—		$	531
Money market funds		39,251		(1	)		39,250
Commercial paper		35,946		1			35,947
Corporate securities		9,778		—			9,778
Government securities		4,003		1			4,004
	$	89,509	$	1		$	89,510
Reported as:
Cash and cash equivalents						$	42,844
Short-term investment							41,748
Short-term restricted investment							4,057
Long-term restricted investment							861
						$	89,510

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	Amortized Cost		As of April 30, 2006
			Unrealized Loss			Estimated Fair Value
Cash	$	832	$	—		$	832
Money market funds		9,183		—			9,183
Commercial paper		33,154		(1	)		33,153
Corporate securities		5,179		—			5,179
Auction rate preferred securities		10,200		—			10,200
	$	58,548	$	(1	)	$	58,547
Reported as:
Cash and cash equivalents						$	46,990
Short-term investments							10,200
Short-term restricted investment							996
Long-term restricted investment							361
						$	58,547

To date we have not recorded any impairment charges on marketable securities related to other-than-temporary declines in market value. We recognize an impairment charge when the decline in the estimated fair value of a marketable security below the amortized cost is determined to be other-than-temporary. We consider various factors in determining whether to recognize an impairment charge, including the duration of time and the severity to which the fair value has been less than our amortized cost, any adverse changes in the investees’ financial condition and our intent and ability to hold the marketable security for a period of time sufficient to allow for any anticipated recovery in market value.

Note 7. Intangible Assets

Our acquired intangible assets are as follows (in thousands):

January 31, 2007	Amortization period	Gross Amount		Accumulated Amortization			Net Carrying Value
Developed technology	3-7 years	$	6,031	$	(1,947	)	$	4,084
Core technology	5 years		2,929		(1,365	)		1,564
Customer relationships	5-7 years		2,023		(612	)		1,411
Total		$	10,983	$	(3,924	)	$	7,059
April 30, 2006	Amortization period	Gross Amount		Accumulated Amortization			Net Carrying Value
Developed technology	3-7 years	$	6,031	$	(1,221	)	$	4,810
Core technology	5 years		2,929		(924	)		2,005
Customer relationships	5-7 years		1,323		(380	)		943
Total		$	10,283	$	(2,525	)	$	7,758

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Total amortization expense was approximately $0.4 million and $1.4 million in the three and nine months ended January 31, 2007, respectively, and approximately $0.3 million and $0.9 million in the three and nine months ended January 31, 2006, respectively. The amortization of developed technology is charged to cost of goods sold. The amortization of core technology and customer relationships is recorded as an operating expense. As of January 31, 2007, we had no identifiable intangible assets with indefinite lives. The weighted average life of identifiable intangible assets was 6.3 and 4.5 years as of January 31, 2007 and 2006, respectively.

Amortization expense related to intangible assets in future periods is as follows (in thousands):

Year Ended April 30,	Amortization
2007 (remaining 3 months)	$	410
2008		1,639
2009		1,557
2010		1,197
2011		869
2012		780
2013		607
	$	7,059

Goodwill as of January 31, 2007 increased $29.9 million from April 30, 2006 as a result of our acquisition of certain assets of the NetCache™ business from Network Appliance described in Note 5 above.

Note 8. Restructuring Accrual

As of January 31, 2007, substantially all actions under the February 2002, August 2001, and February 2001 restructuring plans were completed, except for payment of future rent obligations of $0.3 million, which are to be paid in cash through fiscal year 2008. We incurred restructuring charges, comprised of employee severance costs, facilities closures and lease abandonment costs, and contract termination costs, to significantly reduce operating expenses and to further align our cost structure with market conditions, future revenue expectations and planned future product direction. Various adjustments to the restructuring accrual have been made to date for abandoned space as a result of changes in market information included in our original estimates. There were no significant changes in estimates on sublease income related to these facilities during the three and nine months period ended January 31, 2007.

The following table summarizes restructuring activity during the three and nine months ended January 31, 2007:

	Abandoned Lease Space Accrual
Balances as of April 30, 2006	$	894
Cash payments		(272	)
Balances as of July 31, 2006		622
Cash payments		(155	)
Reversals		(19	)
Balances as of October 31, 2006		448
Cash payments		(109	)
Balances as of January 31, 2007		339
Less: current portion		339
Long-term restructuring accrual	$	—

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Note 9. Litigation -

eSoft, Inc. V. Blue Coat Systems, Inc.

On March 13, 2006, eSoft, Inc. filed a complaint for patent infringement against us in the U.S. District Court for the District of Colorado. The complaint alleges infringement of eSoft’s U.S. Patent 6,961,773 (the “‘773 Patent”), and seeks unspecified monetary damages as well as an injunction against future infringements. eSoft’s amended complaint, filed on June 9, 2006, identified our ProxySG and ProxyAV products as the alleged infringing products. eSoft has subsequently alleged damages in the form of lost profits and/or a reasonable royalty for use of its patented technology.

We answered the amended complaint denying infringement and contending that eSoft’s patent was invalid. We recently filed several motions for summary judgment on these grounds. In addition, we have requested the United States Patent Office to initiate inter partes reexamination proceedings for the ‘773 Patent in light of a number of prior art references never considered by the patent examiner during the original prosecution of the patent application. The District Court has stayed the litigation pending the outcome of these proceedings.

On October 31, 2006, eSoft filed a complaint for declaratory relief seeking a determination that our U.S. Patent 7,103,794 was invalid and/or that eSoft’s products did not infringe same. We answered this complaint on November 22, 2006, and, in a counterclaim, asserted our ‘794 Patent against eSoft’s InstaGate and ThreatWall Security Gateways. This case is also pending in the U.S. District Court for the District of Colorado and likewise has been stayed pending the outcome of the reexamination of the ‘773 Patent.

IPO Allocation Litigation.

Beginning on May 16, 2001, a series of putative securities class actions were filed in the United States District Court for the Southern District of New York against the firms that underwrote our initial public offering, us, and some of our officers and directors. These cases have been consolidated under the case captionedIn re CacheFlow, Inc. Initial Public Offering Securities Litigation, Civil Action No. 1-01-CV-5143. This is one of a number of actions coordinated for pretrial purposes asIn re Initial Public Offering Securities Litigation, 21 MC 92 with the first action filed on January 12, 2001. Plaintiffs in the coordinated proceeding are bringing claims under the federal securities laws against numerous underwriters, companies, and individuals, alleging generally that defendant underwriters engaged in improper and undisclosed activities concerning the allocation of shares in the IPO’s of more than 300 companies during late 1998 through 2000. Among other things, the plaintiffs allege that the underwriters’ customers had to pay excessive brokerage commissions and purchase additional shares of stock in the aftermarket in order to receive favorable allocations of shares in an IPO.

The consolidated amended complaint in our case seeks unspecified damages on behalf of a purported class of purchasers of our common stock between December 9, 1999 and December 6, 2000. Pursuant to a tolling agreement, the individual defendants were dismissed without prejudice. On February 19, 2003, the court denied our motion to dismiss the claims against us. The litigation is now in discovery. In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us, was submitted to the court for approval. The terms of the settlement, if approved, would dismiss and release all claims against the participating defendants (including us). In exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the plaintiffs from the underwriter defendants of at least $1 billion, and the issuer defendants would agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. On August 31, 2005, the court confirmed preliminary approval of the settlement. On April 24, 2006, the court held a fairness hearing in connection with the motion for final approval of the settlement. The court has yet to issue a ruling on the motion for final approval. The settlement remains subject to a number of conditions, including final court approval. On December 5, 2006, the Court of Appeals for the Second Circuit reversed the lower court’s October 2004 order certifying a class in six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceeding. We are not one of the test cases and it is unclear what impact this will have on the class certified in our case.

Derivative Litigation.

On May 18, 2005, a purported shareholder derivative action was filed in the Superior Court of California, Santa Clara County, alleging that certain of our officers and directors violated their fiduciary duties to the Company by making false or misleading statements about our prospects between February 20, 2004 and May 27, 2004. On July 17, 2006, plaintiffs filed a consolidated amended complaint, adding allegations that certain current and former officers and directors violated their fiduciary duties to us since our initial public offering by granting and failing to account correctly for stock options. The amended complaint seeks various relief on our behalf from the individual defendants. On September 8, 2006, another and substantively identical shareholder derivative action was filed against certain of our current and former officers and directors. Both of these state derivative cases have been consolidated.

On August 8 and September 5, 2006, two purported shareholder derivative actions were filed in the United States District Court for the Northern District of California against certain of our current and former officers and directors. Like the state derivative actions, the federal derivative actions allege that certain of our current and former officers and directors violated their fiduciary duties since our initial public offering by granting and failing to account correctly for stock options and seek various relief on our behalf from the individual defendants. Both of these federal cases have been consolidated.

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Dismissed Class Action Litigation.

Beginning on or about April 11, 2005, several putative class action lawsuits were filed in the United States District Court for the Northern District of California against us and certain of our officers on behalf of purchasers of our stock between February 20, 2004 and May 27, 2004 (the “Class Period”). The complaints alleged that during the Class Period defendants violated the federal securities laws by making false or misleading statements of material fact about our financial prospects. Specifically, the complaints alleged claims under Sections 10(b), 20(a) and 20A of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. All cases were consolidated asIn re Blue Coat Systems, Inc. Securities Litigation, No. C-05-1468 (N.D. Cal.). Following the appointment of a lead plaintiff and lead plaintiffs’ counsel, the lead plaintiff on October 7, 2005 filed a notice of voluntary dismissal without prejudice of the consolidated action. On October 18, 2005, the Court dismissed the case without prejudice.

Although we cannot predict whether the IPO allocation cases will settle as proposed, and cannot predict the outcome of the derivative litigation or the SEC and other regulatory investigations, the costs of defending these matters (including our obligations to indemnify current or former officers, directors, or employees) could have a material adverse effect on our results of operations and financial condition.

Periodically, we review the status of each significant matter and assess potential financial exposure. Because of the uncertainties related to the (i) determination of the probability of an unfavorable outcome

and (ii) amount and range of loss in the event of an unfavorable outcome, we are unable to make a reasonable estimate of the liability that could result from any pending litigation described above and no accrual was recorded in our balance sheet as of April 30, 2006. As additional information becomes available, we will reassess the probability and potential liability related to pending litigation, which could materially impact our results of operations and financial condition.

From time to time and in the ordinary course of business, we may be subject to various other claims and litigation. Such claims could result in the expenditure of significant financial and other resources.

Note 10. Comprehensive Income

We report comprehensive income in accordance with FASB SFAS No. 130, Reporting Comprehensive Income. Included in other comprehensive income are adjustments to record unrealized gains and losses on available-for-sale securities. These adjustments are accumulated in “Accumulated other comprehensive income (loss)” in the stockholders’ equity section of the balance sheet. Significant components of our comprehensive income are as follows (in thousands):

	Three Months Ended January 31,				Nine Months Ended January 31,
	2007		2006 (as restated) 1		2007			2006 (as restated) 1
Net income (loss)	$	42	$	2,702	$	(6,439	)	$	5,889
Unrealized gain on available-for-sale securities		—		7		3			2
Comprehensive income (loss)	$	42	$	2,709	$	(6,436	)	$	5,891

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

Note 11. Per Share Amounts

Basic net income per common share and diluted net income per common share are presented in conformity with FASB SFAS No. 128,Earnings Per Share, for all periods presented. Basic net income per share is computed by dividing net income (loss) by the weighted-average number of shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of shares of common stock outstanding, including dilutive common shares subject to repurchase and potential shares assuming the (i) exercise of dilutive stock options and warrants using the treasury stock method; (ii) issuance of committed but unissued stock awards; and (iii) Shares issuable upon the assumed conversion of outstanding Series A Preferred Stock. For periods for which there is a net loss, the numbers of shares used in the computation of diluted net loss per share are the same as those used for the computation of basic net loss per share as the inclusion of dilutive securities would be anti-dilutive.

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The following table presents the calculation of weighted average common shares used in the computations of basic and diluted per share amounts presented in the accompanying condensed consolidated statements of operations (in thousands, except per share amounts):

	Three Months Ended January 31,				Nine Months Ended January 31,
	2007		2006 (as restated) 1		2007			2006 (as restated) 1
Net income (loss) available to common stockholders	$	42	$	2,702	$	(6,439	)	$	5,889
Basic:
Weighted average common shares used in computing basic net income (loss) per common share		14,704		12,962		14,523			12,674
Basic income (loss) per common share	$	0.00	$	0.21	$	(0.44	)	$	0.46
Diluted:
Weighted average common shares used in computing basic net income (loss) per common share		14,704		12,962		14,523			12,674
Add: Weighted average employee stock options, and warrants		885		1,816		—			1,775
Add: Other weighted average dilutive potential common stock		188		67		—			67
Add: Series A Redeemable Convertible Preferred Stock (as converted)		2,400		—		—			—
Weighted average common shares used in computing diluted net income (loss) per common share		18,177		14,845		14,523			14,516
Diluted income (loss) per common share	$	0.00	$	0.18	$	(0.44	)	$	0.41

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

For the three months ended January 31, 2007 and 2006, approximately 1.5 million and 0.3 million shares, respectively, attributable to outstanding stock options were excluded from the calculation of diluted net income per share because their inclusion would have been anti-dilutive as their exercise prices were greater than or equal to the average market price of the common shares during the respective periods. For the nine months ended January 31, 2007 and 2006, approximately 2.2 million and 0.4 million shares, respectively, attributable to outstanding stock options were excluded from the calculation of diluted net income per share. For the nine months ended January 31, 2007, 2.4 million shares issuable upon the assumed conversion of the Series A Redeemable Convertible Preferred Stock were excluded from the calculation of net income per share.

Under the treasury stock method, outstanding options are assumed to be exercised if their exercise price is below the average fair market value of our common stock for a given period, and the proceeds from the exercise of such options are assumed to be used by us to repurchase shares of our common stock on the open market. Additionally, unearned stock-based compensation, a significant amount of which was recorded as part of our restatement, is added to the proceeds from exercise for purposes of applying the treasury stock method to determine the incremental common shares to be included in diluted net income per share in periods in which we have reported net income. As a result, diluted shares used for purposes of calculating diluted earnings per share will generally be less than the amounts reported in our previously filed Quarterly Report on Form 10-Q.

Note 12. Commitments

Leases

We lease certain equipment and office facilities under non-cancelable operating leases that expire at various dates through 2011. The facility leases generally require us to pay operating costs, including property taxes, insurance and maintenance, and contain scheduled rent increases and certain other rent escalation clauses. Rent expense is recognized in our condensed consolidated financial statements on a straight-line basis over the terms of the respective leases after consideration of rent holidays and improvement allowances, if applicable, with any assets purchased using a lessee improvement allowance capitalized as fixed assets and depreciated over the shorter of their useful lives or the lease term.

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As of January 31, 2007, future minimum lease payments under non-cancelable operating leases with initial or remaining terms in excess of one year are as follows (in thousands):

Year Ending April 30,	Abandoned		In Use		Total
2007 (remaining 3 months)	$	155	$	847	$	1,002
2008		258		3,264		3,522
2009		—		3,000		3,000
2010		—		2,578		2,578
2011		—		973		973
Thereafter		—		554		554
Total minimum lease payments	$	413	$	11,216	$	11,629

Rent expense was $0.9 million and $0.8 million for the three months ended January 31, 2007 and 2006, respectively. Rent expense was $2.6 million and $2.3 million for the nine months ended January 31, 2007 and 2006, respectively. Of the $0.4 million in total operating lease commitments for abandoned facilities, as summarized above, a reserve for $0.3 million has been provided and is included in the captions “Accrued restructuring reserve” in the accompanying condensed consolidated balance sheet at January 31, 2007.

In September 2005, we commenced a five-year operating lease of a building that serves as our headquarters in Sunnyvale, California. As part of this agreement, we are required to maintain a $0.4 million irrevocable standby letter of credit with a major financial institution as a form of security. The letter of credit is secured by deposits and provides for automatic annual extensions, without amendment, through the end of the lease term in August 2010. During the first nine months of fiscal 2007, the letter of credit was increased by $0.5 million due to a leasehold improvement, resulting in a balance of $0.9 million as of January 31, 2007. The letter of credit is classified as “Long-term restricted investments” in the accompanying condensed consolidated balance sheets as of January 31, 2007 and April 30, 2006, respectively.

Other

We have firm purchase and other commitments with various suppliers and contract manufacturers to purchase component inventory and manufacturing material. These agreements are enforceable and legally binding against us in the short-term and all amounts under these arrangements are due in fiscal 2007. Our minimum obligation at January 31, 2007 under these arrangements was $5.4 million.

Note 13. Geographic and Product Category Information Reporting

We conduct business in one operating segment to design, develop, market and support proxy appliances. Our chief operating decision maker, our Chief Executive Officer, allocates resources and makes operating decisions based on financial data consistent with the presentation in the accompanying condensed consolidated financial statements. Our revenue consists of two product categories: product and service. Total international net revenue consists of sales from our U.S. operations to non-affiliated customers in other geographic regions. During the three and nine months ended January 31, 2007 and 2006, there were no intra-company sales, and no material long-lived assets were located in any of our foreign subsidiaries.

Net revenue is attributed to geographic areas based on the location of the customers. The following is a summary of net revenue by geographic area (in thousands):

	Three Months Ended January 31,
	2007				2006
	$		%		$		%
North America	$	21,418	45.5	%	$	17,329	48.8	%
EMEA		20,115	42.7			14,552	41.0
Asia		5,575	11.8			3,636	10.2
Total net revenue	$	47,108	100.0	%	$	35,517	100.0	%

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	Nine Months Ended January 31,
	2007				2006
	$		%		$		%
North America	$	58,886	47.8	%	$	54,188	51.3	%
EMEA		47,671	38.7			39,836	37.7
Asia		16,671	13.5			11,563	11.0
Total net revenue	$	123,228	100.0	%	$	105,587	100.0	%

Note 14. Income Taxes

The provision for income taxes for the three and nine months ended January 31, 2007 was a tax expense of $0.4 million and $0.6 million, respectively. The annual effective tax provision is estimated to be approximately $1.0 million. The provision is primarily foreign corporate income taxes currently due and U.S. taxes related to the acquisition of the NetCache business from Network Appliance, Inc. There is no U.S. tax provision due to current taxable losses.

During the quarter ended October 31, 2006 we acquired the assets of the NetCache business from Network Appliance, Inc. in a taxable asset acquisition. For tax purposes, the goodwill acquired in a taxable asset acquisition is amortized over a period of 15 years. However, for financial reporting goodwill is not amortized but must be analyzed at least annually for impairment. In accordance with SFAS 109,Accounting for Income Taxes,a deferred tax liability must be recorded to account for this taxable temporary difference and such liability may not be used as a source of income to support deferred tax assets. We have therefore recorded a non-cash charge to the provision of $0.2 million during the current quarter ($0.3 million year to date) and a corresponding deferred tax liability on the balance sheet.

Utilization of our net operating loss (“NOL”) and credit carryforwards may be subject to substantial annual limitations in the future due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Such annual limitation could result in the expiration of the NOL’s and tax credit carryforwards before utilization. Historically, several ownership changes have occurred. As a result, approximately $113.0 million of NOL’s and $0.7 million of tax credits have been subject to annual limitation.

In June 2006, we sold shares of Blue Coat Series A Redeemable Convertible Preferred Stock for approximately $42.1 million. It is possible that as a result, we may undergo a change in ownership. We are currently assessing whether this will further limit the usage of our NOLs and credits for federal and state purposes.

At January 31, 2007, we have a full valuation allowance against our deferred tax assets because the determination was made that it is more likely than not that all of the deferred tax assets will not be realized in the foreseeable future due to historical operating losses. The net operating loss and research and development tax credit carryovers that make up the vast majority of the deferred tax assets will expire at various dates through the year 2026. In the future, we will continue to assess the need for the valuation allowance. The future reversal of the valuation allowance will result in amounts being credited to income statement or to additional paid in capital to the extent the losses and credits are attributable to stock options.

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

All statements included in this Quarterly Report on Form 10-Q (“Form 10-Q”), other than statements or characterizations of historical fact, are forward-looking statements. These forward-looking statements are based on our current expectations, estimates, approximations and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. We often use certain words and their derivatives such as “anticipate,” “expect,” “intend,” “plan,” “predict,” “believe,” “estimate,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” and similar expressions in our forward-looking statements. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the section entitled “Risk Factors” under Part II, Item 1A of this Form 10-Q. These forward-looking statements speak only as of the date of this Form 10-Q. We assume no obligation to revise or update any forward-looking statement for any reason, except as otherwise required by law.

Forward-looking statements are not the only statements you should regard with caution. The preparation of our condensed consolidated financial statements required us to make judgments with respect to the methodologies we selected to calculate the adjustments contained in the financial statements, as well as estimates and assumptions regarding the application of those methodologies. These judgments, estimates and assumptions, which are based on factors that we believe to be reasonable under the circumstances, affected, among other things, the amounts of additional deferred stock-based compensation and additional stock-based compensation expense that we recorded. The application of alternative methodologies, estimates and assumptions could have resulted in materially different amounts.

The information below has been adjusted to reflect the restatement of our financial results which is more fully described in the “Explanatory Note” immediately preceding Part I, Item 1 and in Note 2, “Restatement of Condensed Consolidated Financial Statements,” in Notes to Condensed Consolidated Financial Statements of this Form 10-Q. For this reason, the data set forth in this section may not be comparable to discussions and data in our previously filed Quarterly Reports.

Overview

Blue Coat sells a family of appliances and client-based solutions (deployed in branch offices, Internet gateways, end points, and data centers) that provide intelligent points of policy-based control enabling information technology (“IT”) organizations to improve security and accelerate performance for all users and applications. Our products are delivered to customers through a worldwide sales organization that includes direct sales, distributors, and resellers in more than 50 countries worldwide. Blue Coat customers are backed by a worldwide service and support organization that provides a broad range of service options, including 24x7 technical support and product education.

Blue Coat has grown its net revenue and market share in the proxy appliance market in the last few years. However, we see signs of slower growth in the proxy appliance market. In addition, we believe that any further gains in our market share in the proxy appliance market will be more difficult to achieve than earlier gains in market share, and will occur more slowly, if at all.

Background of the Stock Option Investigation, Findings, Restatement of Condensed Consolidated Financial Statements, Remedial Measures and Related Proceedings

Background of the Stock Option Investigation

In May 2006, we were included in a Deutsche Bank report entitled “Infrastructure SW Update: Analyzing Potential for Back Dated Stock Options,” which analyzed the likelihood that various software companies may have back dated historical stock option grants. After reviewing the Deutsche Bank report, our management reviewed various historical documents relating to stock option grants and, on June 1, 2006, informed the Audit Committee of the Board of Directors of potential back dating of stock options. The Audit Committee promptly engaged Pillsbury Winthrop Shaw Pittman LLP (“Pillsbury”) in early June 2006 to assist the Audit Committee in reviewing our historical stock option granting practices. On or about June 9, 2006, Pillsbury engaged Deloitte Financial Advisory Services (“Deloitte”) as a forensic accountant to assist them in the investigation.

On July 12, 2006, our Board of Directors appointed an independent committee of the Board of Directors (the “Special Committee”) to manage the review of our historical practices in granting stock options. The Special Committee was comprised of two members of our Audit Committee, James Barth and Jay Shiveley, and independent board member Timothy Howes; on October 19, 2006, Mr. Shiveley passed away and the Special Committee thereafter consisted of Mr. Barth and Mr. Howes. For purposes of this Quarterly Report on Form 10-Q, the term “Special Committee” also includes the work of the Audit Committee on the stock option investigation between June 1, 2006 and July 12, 2006.

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On July 14, 2006, we announced that we were conducting a voluntary review of our historical practices in granting stock options to management and employees. We also announced that (i) our Board of Directors had appointed a Special Committee of independent directors to conduct this review; (ii) the Special Committee was being assisted by independent legal counsel and accounting experts; (iii) the review covered all option grants since our initial public offering in November 1999; (iv) the Special Committee had also advised our independent registered public accounting firm, Ernst & Young LLP (Ernst & Young”), of its review; (v) the Special Committee had reached a preliminary conclusion that the actual measurement dates for financial accounting purposes of certain stock option grants issued in the past likely differed from the recorded grant dates of such awards; (vi) while the Special Committee had not completed its investigation and was continuing its review, based on their preliminary conclusions we believed we may record additional non-cash charges for stock-based compensation expense, but we were not yet able to determine the amount of such charges or the resulting tax impact of these actions; and (vii) we were not yet able to determine whether any such compensation charges would be material and require us to restate previously issued financial statements.

On July 14, 2006, we also filed a Form 12b-25 with the Securities and Exchange Commission stating that we would be unable to timely file an annual report on Form 10-K for our fiscal year ended April 30, 2006 until the stock option review had been completed. In light of the ongoing review, we also announced that we were withdrawing our previously-issued financial outlook for the first quarter of fiscal 2007 (ending July 31, 2006), and that we expected to incur significant legal and professional fees in the first quarter of fiscal 2007.

On September 11, 2006, we announced that, although the Special Committee’s review was still ongoing, our Board of Directors, with the concurrence of the Special Committee, had determined that, pursuant to the requirements of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), the actual measurement dates for financial accounting purposes of certain stock options granted primarily during fiscal years 2000-2004 differed from the recorded grant dates of such awards. Consequently, new measurement dates for financial accounting purposes would apply to the affected awards, which would result in additional and material non-cash stock-based compensation expense. We also announced that we would restate our financial statements beginning with the fiscal year ended April 30, 2000 through the interim period ended January 31, 2006. Accordingly, we announced that our financial statements and the related reports of our independent registered public accounting firm, Ernst & Young, and all related earnings releases and communications relating to periods after our initial public offering in November 1999, including fiscal years 2000 through 2006 and the interim quarters, as well as the revenue and earnings per share guidance for the first quarter of fiscal 2007 (ended July 31, 2006), should not be relied upon. We indicated, however, that because the review was ongoing, we were not yet able to estimate the extent and timing of adjustments that would be required. We stated that we believed that the majority of the additional non-cash expense would result from revisions to measurement dates for options granted in fiscal years 2000 through 2004 and that the changes in the affected measurement dates would cause non-cash stock-based deferred compensation charges to be amortized in future periods. Finally, we stated that we expected to incur significant legal and professional fees associated with the Special Committee’s review and the restatement process.

On September 12, 2006, December 11, 2006, and March 12, 2007 we filed Form 12b-25 with the Securities and Exchange Commission stating that we would be unable to timely file quarterly reports on Form 10-Q for the fiscal quarters ended July 31, 2006, October 31, 2006, and January 31, 2007, respectively, until the stock option review had been completed.

During the course of its investigation, the Special Committee collected approximately 1,502 gigabytes of electronic data and reviewed more than 100,000 hard copy documents. The electronic data was filtered using a search term glossary, yielding 143 gigabytes (or approximately 7.1 million pages) of unique data for review. The Special Committee conducted 29 substantive interviews of 24 current and former employees and directors. Four former employees declined the Special Committee’s request for an interview.

On December 12, 2006, the Special Committee presented the findings of its stock option investigation to our Board of Directors and proposed various remedial measures. The findings of the Special Committee and the remedial measures proposed by the Special Committee are described below.

Findings

As disclosed above, our Board of Directors appointed a Special Committee to review our past stock option practices. On December 12, 2006, the Special Committee presented its findings to, and recommended certain remedial measures for adoption by, the Board of Directors. The Board of Directors accepted all of the findings of the Special Committee and has adopted, or is in the process of adopting, all of the remedial measures proposed. As a result of the Special Committee’s investigation, as well as our internal review of our historical financial statements, we have determined the following:

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• Between our initial public offering in November 1999 and May 2006, the vast majority of our stock options were granted by the Compensation Committee of the Board of Directors (which consisted of two or three independent directors). In a few instances, the full Board of Directors granted stock options during this period. From June 2005 to May 2006, the Compensation Committee granted a majority of our stock options, awarding stock option grants to individuals pursuant to our annual grant of stock options, as well as to officers, any individual grant covering 20,000 or more underlying shares, and certain individual grants covering less than 20,000 shares, while the Stock Option Committee (which consisted of our Chief Executive Officer) awarded grants to individuals receiving less than 20,000 underlying shares. In the vast majority of cases, the granting body granted the stock options pursuant to an action by unanimous written consent, as opposed to a resolution at a meeting of the granting body. The written consents contained an “effective as of” date, which date we used as the grant date and measurement date of the stock options. However, in a significant number of instances, we had not completed the required actions necessary to grant stock options by the “effective date” of the written consent. Accordingly, 112 of the total of 127 grant dates were established based on a stated “effective date,” or grant date, that differed from the date on which the options appear to have been actually approved after a thorough review of the evidence. In almost every such instance, the price of our Common Stock on the actual approval date for the grant was higher than the price of our Common Stock on the stated grant date. The Special Committee found that, particularly prior to 2005, grant dates were selected by certain members of management with the benefit of hindsight based on perceived historical low points in our stock price. The misdating occurred with respect to grants to all levels of employees. As a result of these activities, we have recorded additional deferred stock-based compensation to reflect the difference in our stock price from the stated grant date to the actual grant date, and amortized the deferred stock-based compensation over the appropriate vesting period of each stock option.

• There was very limited electronic or document evidence available to review in regard to the period from November 1999 to the middle of calendar 2001. Furthermore, several of our former employees who participated in the stock option granting process during this period declined a request to be interviewed by the Special Committee. Therefore, the Special Committee found it difficult to draw conclusions about the roles or actions of employees during this period with regard to the stock option granting practices. However, based on a comparison of grants made during this period to our stock price during this period and forensic evidence relating to the dates unanimous written consents were prepared and stock options were entered into our Equity Edge^® database, the Special Committee found it highly likely that grant dates and prices were selected with the benefit of hindsight during this period.

• For the period from the middle of calendar 2001 to February 2005, the Special Committee found direct evidence that grant dates were selected with the benefit of hindsight. The Special Committee also found that most of the beneficiaries of these stock option grants were new hires, not senior officers, and that there was no evidence that those involved sought to benefit themselves or senior officers exclusively. We believe that the person primarily responsible for our stock option granting practices during this period was our former Chief Financial Officer, Robert Verheecke, who ceased serving as our Chief Financial Officer on May 2, 2005 and whose employment with us terminated on December 31, 2005. Mr. Verheecke declined a request to be interviewed by the Special Committee.

• Beginning in February 2005, we implemented a calendar system, which set forth in advance the dates on which we were to grant stock options. The calendar imposed a more standardized practice for the timing of the grant of stock options. However, the Special Committee found that the calendar served more as a guideline than an established procedure, since even after the calendar was implemented the actual grant dates deviated from the scheduled grant dates for approximately half of the grants. In a majority of the cases, the deviations from the calendar date ranged from one to several days.

• The Special Committee found that our internal controls relating to stock option granting practices were deficient in the following ways:

• We either lacked written stock option procedures or our procedures were generally unresponsive to inherent process risks.

• Our stock option granting practices were haphazard and disorganized. For example, (i) we frequently submitted stock option grant approval documentation to the Compensation Committee weeks after the stated grant date; (ii) the Compensation Committee was asked on several occasions to approve two or three different stock option grants at the same time; and (iii) management frequently added employees to stock option grants after the stated grant date.

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• Management involved in the stock option granting process and interviewed by the Special Committee was generally unaware of the legal requirements associated with the approval of stock option grants; specifically, management uniformly sought board approval of options “as of” a date prior to the date approval was sought.

• Management involved in the stock option granting process and interviewed by the Special Committee was generally unaware of the accounting implications of selecting stock option grant dates retroactively, and did not know that choosing a grant date based on a perceived historical low in the price of our stock should have resulted in a significant negative impact to our income statement. Moreover, such management was generally equally unaware that the accounting implications of such conduct were not properly disclosed in our publicly filed reports.

• The Compensation Committee generally failed to recognize our internal control failures relating to stock option grants. In addition, the Compensation Committee did not have an adequate knowledge base to appreciate the accounting and legal implications of the above-described practices. Specifically, the Compensation Committee routinely approved stock option grants on an “as of” basis and did not inquire into the propriety of retroactively selecting grant dates.

• In May 2001, we hired Robert Verheecke as our Chief Financial Officer. We granted Mr. Verheecke options to purchase 100,000 shares of Common Stock on a stated effective date of July 31, 2001, at an exercise price of $16.75 per share. During the option investigation, however, the Special Committee discovered evidence that the Compensation Committee had originally granted the 100,000 options to Mr. Verheecke pursuant to a unanimous written consent on May 1, 2001, at an exercise price of $30.50. The Special Committee concluded that the option grant to Mr. Verheecke was improperly disclosed and improperly accounted for in our financial records. We have determined that a grant was made on May 1, 2001 and then re-priced on July 31, 2001, and, as a result, the grant should have been accounted for under the variable method of accounting. Mr. Verheecke realized a gain of $875,717 associated with the change in value from May 1, 2001 to the new option price date of July 31, 2001. Mr. Verheecke remained an employee until December 31, 2005, although he ceased serving as our Chief Financial Officer on May 2, 2005.

• We use the Equity Edge software system to track stock option activity. When a grant is made, our accounting department prints the stock option grant notice agreement from the Equity Edge system. During the period from about May 2005 to May 2006, two non-officer members of the accounting department downloaded the Equity Edge stock option grants to Word files. The print date of the grant notice agreements sent to employees was then manually changed to match the date that stock administration was notified that the grants were approved by the Compensation Committee or the Stock Option Committee. This was apparently done to make it appear that employees were being notified of their grants soon after the grant approvals were received. The more senior of the two non-officer employees authorized this practice after learning from our auditors of a possible change in the accounting rules that would require employees to be notified of grants soon after they were approved in order to support the measurement date as the date of grant approval. The date changes to the print dates did not impact the grant date or measurement date of the stock options. The Special Committee determined that only these two non-officer employees were aware of this practice. On December 12, 2006, as recommended by the Special Committee, we requested and received the immediate resignation of the more senior of the two non-officer employees.

• On November 18, 1999, the day before our initial public offering, our Board of Directors granted options at a board meeting to a large group of individuals at an exercise price of $120.00 per share. During the course of the investigation, we concluded that ten individuals who were granted stock options at that board meeting were not our employees as of the stated grant date but rather became our employees after the initial public offering. The latest measurement date for the stock options granted to these ten individuals was January 24, 2000. Since our stock option plans authorize us to grant stock options only to employees and other service providers, the grant date of an option award to each individual could not be earlier than such individual’s date of employment with us. Accordingly, the appropriate measurement date for each of the ten options is the date on which the employee began his or her employment with us. These individuals provided no services to us prior to the beginning of their employment.

• The Special Committee reviewed the conduct of various current and former employees in connection with its investigation. A summary of the findings of the Special Committee with respect to certain individuals follows:

• Brian NeSmith (our current President and Chief Executive Officer and a director): The Special Committee concluded that Mr. NeSmith participated in the stock option granting process and was aware of the fact that

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certain grant dates were selected with the benefit of hindsight. However, the Special Committee concluded that Mr. NeSmith did not appreciate the accounting or legal implications of these actions. The Special Committee noted that Mr. NeSmith did not benefit monetarily from any stock option grants for which the measurement dates have changed as a result of the investigation of historical stock option grants. Further, the Special Committee noted that Mr. NeSmith has not received any bonuses that were tied to our financial performance during the period in which our stock option granting processes were flawed. The Special Committee reviewed with our Board of Directors Mr. NeSmith’s unrealized gains on those of our stock options that were the subject of changed measurement dates, including the portion of such gains associated with back dating. Based on the closing price of our Common Stock on December 12, 2006, Mr. NeSmith held unexercised stock options that were subject to changed measurement dates with a combined in-the-money value of $2.6 million, of which $91,980 is attributable to improper measurement dates. Mr. NeSmith voluntarily agreed to amend the exercise price of his stock option grants to eliminate any gains associated with improper measurement dates. As recommended by the Special Committee, our Board of Directors (i) will institute continuing education for Mr. NeSmith with respect to legal and accounting matters important to our ongoing efforts to comply with current regulations, minimize risks and improve corporate governance, and (ii) has directed Mr. NeSmith to develop a plan to elevate the knowledge and experience among his direct reports, and to develop cross-functional education for all who are involved in the equity grant process.

• Kevin Royal (our current Chief Financial Officer and Principal Accounting Officer):The Special Committee concluded that there was no evidence that Mr. Royal was aware of improper actions relating to our stock option granting practices. Furthermore, the Special Committee noted that Mr. Royal did not benefit from our improper stock option granting practices. Mr. Royal did not join Blue Coat until May 2, 2005, and was not actively involved in stock administration.

• David Hanna (our current Chairman of the Board, a director, a member of the Compensation Committee, a member of the Audit Committee and a member of the Nominating/Corporate Governance Committee):The Special Committee concluded that Mr. Hanna was sent several e-mails that indicated that stock option grant dates and prices were being selected with the benefit of hindsight. However, since it was unclear whether Mr. Hanna received and reviewed all of the emails in question, the Special Committee could not conclude with substantial certainty that Mr. Hanna was aware of our improper stock option dating practices. Irrespective of this uncertainty, the Special Committee concluded that Mr. Hanna did not appreciate the accounting or legal implications of these matters. The Special Committee also concluded that while it would have been better if members of the Compensation Committee had focused more on the prices at, and dates on, which stock options were granted, the directors were entitled to presume that matters brought before them for action were procedurally proper and consistent with applicable legal and accounting standards. The Special Committee noted that Mr. Hanna did not benefit monetarily from any stock option grants for which the measurement dates have changed as a result of the investigation of historical stock option grants. Further, the Special Committee noted that Mr. Hanna has not received any bonuses that were tied to our financial performance during the period in which our stock option granting processes were flawed. The Special Committee reviewed with our Board of Directors Mr. Hanna’s unrealized gains on those of our stock options that were the subject of changed measurement dates, including the portion of such gains associated with back dating. Based on the closing price of our Common Stock on December 12, 2006, Mr. Hanna held unexercised stock options that were the subject of changed measurement dates with a combined in-the-money value of $162,520, of which $158,610 is attributable to improper measurement dates. Mr. Hanna voluntarily agreed to amend the exercise price of his stock options to eliminate any holding gains associated with improper measurement dates.

• Cameron Laughlin (our current General Counsel):The Special Committee concluded that Ms. Laughlin was aware of the fact that grant dates were selected with the benefit of hindsight and should have appreciated the legal significance of these actions. The Special Committee noted that Ms. Laughlin had limited public company securities and corporate governance experience prior to joining us. The Special Committee concluded that while Ms. Laughlin was partially responsible for some of the improvements in our stock option granting process, these improvements were not the result of her appreciation of the fundamental failure of the process to properly select or record option grant dates. The Special Committee noted that Ms. Laughlin has been forthcoming with the Special Committee, and that it believed that she is credible and trustworthy. The Special Committee recommended that we open a search for a new General Counsel, with more experience in public company securities and corporate governance matters. The Special Committee also recommended that outside counsel take responsibility for financial reporting and SEC-related matters in the interim period. The Special Committee was not opposed to Ms. Laughlin’s remaining an employee of Blue Coat, provided that she is not responsible for financial reporting and SEC-related matters. The Special Committee reviewed with our Board

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of Directors Ms. Laughlin’s realized and unrealized gains on her exercised stock options and outstanding options that were the subject of changed measurement dates, including the portion of such gains associated with back dating. Based on the closing price of our Common Stock on December 12, 2006, Ms. Laughlin held unexercised stock options that were the subject of changed measurement dates with a combined in-the-money value of $134,362, of which $23,091 is attributable to improper measurement dates. Ms. Laughlin has also realized gains in the amount of $215,764 from the sale of our Common Stock associated with stock options that were the subject of changed measurement dates, of which $36,182 is attributable to improper measurement dates. Ms. Laughlin voluntarily agreed to amend the exercise price of her stock option grants to eliminate any gains associated with improper measurement dates.

• Robert Verheecke (our former Chief financial Officer):The Special Committee concluded that Mr. Verheecke was aware of the fact that stock option grant dates and prices were selected with the benefit of hindsight. The Special Committee also concluded that Mr. Verheecke’s actions in connection with the improper authorization, recording and reporting of stock option pricing raise serious concerns. The Special Committee noted that because Mr. Verheecke declined a request to be interviewed by the Special Committee to explain his actions, the Special Committee was unable to determine his actual mental state with respect to this practice. Nevertheless, the Special Committee determined that he should have appreciated the accounting and disclosure implications of such actions. Mr. Verheecke realized gains in the amount of $5.0 million from the sale of our Common Stock associated with stock options that were the subject of changed measurement dates, of which (i) $30,000 is attributable to improper measurement dates, and (ii) $875,717 represented gains associated with the aforementioned repricing of his original stock option grant. As recommended by the Special Committee, we are reviewing with outside counsel whether we should pursue disgorgement against Mr. Verheecke.

• Non-officer Member of our Accounting Staff:As noted above, the Special Committee concluded that a non-officer member of the accounting department intentionally altered certain stock option grant notifications, although this had no effect on the selection of grant dates or on the actual measurement dates. The Special Committee concluded that the non-officer employee was also aware of the fact that grant dates and prices were selected with the benefit of hindsight and should have appreciated the accounting and disclosure implications of these actions. As recommended by the Special Committee, we requested and received the non-officer employee’s immediate resignation on December 12, 2006. The Special Committee reviewed with our Board of Directors the non-officer employee’s realized and unrealized gains on his or her exercised stock options and outstanding options that were the subject of changed measurement dates, including the portion of such gains associated with back dating. Based on the closing price of our Common Stock on December 12, 2006, the non-officer employee held unexercised stock options that were the subject of changed measurement dates with a combined in-the-money value of $175,173, of which $37,278 is attributable to improper measurement dates. The non-officer employee has also realized gains in the amount of $882,156 from the sale of our Common Stock associated with stock options that were the subject of changed measurement dates, of which $160,548 is attributable to improper measurement dates. The non-officer employee voluntarily agreed to amend the exercise price of his or her stock option grants to eliminate any gains associated with improper measurement dates.

• Other Current Employees: The Special Committee determined that several other lower level employees in human resources and stock administration were also involved in the stock option granting process and were aware to varying degrees that option grant dates and prices were being selected with the benefit of hindsight. As recommended by the Special Committee, our Board of Directors will require that these employees undergo training to educate them on the legal, accounting and other issues surrounding stock option granting.

• Other Former Employees:The Special Committee reviewed with our Board of Directors the realized and unrealized gains on our stock of several former officers and employees, including the portion of such gains derived from improper measurement dates associated with stock options. As recommended by the Special Committee, we are reviewing with outside counsel whether we should pursue disgorgement against such persons.

Restatement of Condensed Consolidated Financial Statements

Our management reviewed the information made available to it by the Special Committee and performed its own detailed review of historical stock option grants as part of the effort to establish appropriate measurement dates. In connection with these procedures, our management also conducted certain recertification procedures as part of the process of determining if there was evidence that would prevent our Board of Directors and current management from relying upon the

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work performed by the accounting, finance and legal personnel as it relates to fiscal years 2004 and 2005, and the extent to which our prior accounting and controls can be relied upon for purposes of the preparation and certification of the restated consolidated financial statements.

As a result of the Special Committee’s investigation and findings, as well as our internal review and recertification procedures, we have recorded additional stock-based compensation expense for numerous stock option grants made from November 1999 through May 2006 to correctly account for stock option grants for which the Special Committee or management determined that the actual measurement date for accounting purposes was different from the stated grant date. Further, since Section 421 of the Internal Revenue Code precludes granting Incentive Stock Options (“ISO’s”) with exercise prices below the fair market value of our common stock on the date of grant, and the majority of our stock options were found to have been granted below fair market value, we have also recorded liabilities for payroll and withholding taxes, and associated penalties and interest in each of the four fiscal years ending April 30, 2006 in connection with the disqualification of ISO tax treatment for certain stock options. However, since we have fully reserved our deferred tax assets, we did not record any net change to our deferred tax assets associated with this restatement.

In addition to the deferred stock-based compensation amounts, and related payroll and withholding taxes, penalties, and interest resulting from the revision in measurement dates for historical stock option grants, our internal review also identified certain other errors in accounting determinations and judgments relating to stock-based compensation that have also been corrected in our restated consolidated financial statements. These adjustments are described in more detail below. Also included in this restatement are certain other non-stock-based compensation items which had not previously been recorded due to their immateriality, but which management was aware of outside of the course of the investigation and the procedures described above. These other non-stock-based compensation items are immaterial both individually and in aggregate, and relate solely to the timing of certain operating expenses between periods such that the net impact to all periods is zero.

As a result of the findings of the stock option investigation and our recertification procedures described above, our consolidated financial statements and related disclosures as of April 30, 2005 and for the years ended April 30, 2005 and 2004 have been restated in our Annual Report on Form 10-K for the period ended April 30, 2006. We have also restated our selected consolidated financial data as of and for the years ended April 30, 2005, 2004, 2003 and 2002, which is included in Item 6, “Selected Consolidated Financial Data,” and the unaudited quarterly financial data for each of the quarters in the years ended April 30, 2006 and 2005, with the exception of the fourth quarter of fiscal 2006 (which has never been filed), which is included in Item 8, “Financial Statements and Supplementary Data,” all of which is included in our Annual Report on Form 10-K for the period ended April 30, 2006. Our restated interim financial statements for the quarterly and year-to-date periods ended July 31, 2005, October 31, 2005, and January 31, 2006 are included in our quarterly reports on Forms 10-Q for the periods ended July 31, 2006, October 31, 2006 and January 31, 2007, respectively. We also recorded adjustments affecting our previously-reported financial statements for fiscal years 2000 and 2001. Adjustments are also reported in our consolidated statements of operations in subsequent periods based on the accounting treatment for exercises, modifications and expenses recognized over the remaining option vesting periods.

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The following table summarizes the total adjustments related to this restatement for fiscal years 2000 through 2006, and the related tax expense, which includes payroll and withholding taxes, penalties and interest:

The effects of the adjustments were summarized as follows in our Form 10-K for the year ended April 30, 2006 (in thousands):

	Year Ended April 30,
	2000 (as restated)			2001 (as restated)			2002 (as restated)			2003 (as restated)			2004 (as restated)			2005 (as restated)			2006			Total
Revised stock option measurement dates	$	8,094		$	43,034		$	3,659		$	2,133		$	4,181		$	9		$	3,271		$	64,381
Corrections of Other Accounting Errors:
Amortization of cheap stock		(5,653	)		(3,141	)		(2,637	)		2,405			716			56			—			(8,254	)
Variable accounting for a pre-IPO loan		6,738			(9,580	)		—			—			—			—			—			(2,842	)
Modifications to equity awards		323			255			(35	)		(40	)		211			29			19			762
Amortization of acquisition-related option grants		—			(755	)		(4,395	)		(1,479	)		(217	)		(341	)		91			(7,096	)
Total correction of other accounting errors		1,408			(13,221	)		(7,067	)		886			710			(256	)		110			(17,430	)
Total stock-based compensation expense restatement		9,502			29,813			(3,408	)		3,019			4,891			(247	)		3,381			46,951
Expense/(benefit) from payroll taxes, penalties and interest		—			10			1			1			43			837			1,118			2,010
Net adjustment to stock-based compensation expense		9,502			29,823			(3,407	)		3,020			4,934			590			4,499			48,961
Non-Stock-Based Compensation Expense/(Benefit):
Adjustments to the timing of certain operating expenses		—			(128	)		—			49			79			130			(130	)		—
Interest expense/(benefit) related to notes receivable		75			(18	)		—			—			—			—			—			57
Total non-stock-based compensation expense/(benefit)		75			(146	)		—			49			79			130			(130	)		57
Net decrease/(increase) in net income due to adjustments	$	9,577		$	29,677		$	(3,407	)	$	3,069		$	5,013		$	720		$	4,369		$	49,018
	Year Ended April 30,
	2000 (as restated)			2001 (as restated)			2002 (as restated)			2003 (as restated)			2004 (as restated)			2005 (as restated)			2006			Total
Net restatement of stock-based compensation expense	$	9,502		$	29,823		$	(3,407	)	$	3,020		$	4,934		$	590		$	4,499		$	48,961
Total non-stock-based compensation expense/(benefit)		75			(146	)		—			49			79			130			(130	)		57
Net decrease/(increase) in net income due to adjustments	$	9,577		$	29,677		$	(3,407	)	$	3,069		$	5,013		$	720		$	4,369		$	49,018
Cumulative increase to accumulated deficit	$	9,577		$	39,254		$	35,847		$	38,916		$	43,929		$	44,649		$	49,018

As mentioned above, our internal review and recertification procedures also identified certain other errors in accounting determinations and judgments relating to stock-based compensation statements. These errors include: (a) incorrect amortization of cheap stock; (b) incorrect accounting for a pre-IPO loan issued to exercise stock options as a fixed award rather than as a variable award; (c) incorrect accounting for modifications to equity awards; and (d) incorrect amortization of acquisition-related option grants. The errors in accounting for stock-based compensation expense are described more fully below.

Correction in the Amortization of Cheap Stock

We analyzed and recalculated the compensation expense associated with our stock options granted before our initial public offering (“IPO”), also known as cheap stock, due to an accounting error in calculating the amount and timing of adjustments to deferred stock-based compensation expense for unvested options upon employee termination. The correction of these accounting errors resulted in the recognition of a benefit in fiscal years 2000 through 2002 and additional expense in fiscal years 2003 through 2005, for a net reduction of stock-based compensation of $8.3 million.

Variable Accounting for a Pre-IPO Loan

We historically accounted for all options exercised with interest-bearing loans as fixed awards. In reviewing stock options exercised with loans, we identified one non-recourse loan with a fixed interest rate related to the exercise of pre-IPO stock options. In this case, the option price should not have been determined until the options were exercised as the pre-IPO loan did not meet the requirements for fixed accounting. Specifically, depending on when the non-recourse loan was repaid (i.e., when the option was exercised), the amount of non-recourse interest calculated as part of the exercise price would differ, resulting in a variable exercise price. We had previously concluded that compensation expense for stock options exercised with this loan was fixed on the date of grant. The change in accounting for the stock options exercised with this loan from fixed accounting to the variable method of accounting resulted in the net reversal of $2.8 million in stock-based compensation expense for the fiscal years 2000 and 2001. The reduction of $9.6 million in fiscal 2001 relates to stock-based compensation expense recorded in prior periods that was reversed in fiscal 2001 to appropriately adjust the value of the stock options exercised with the pre-IPO loan in accordance with the variable method of accounting.

Modifications to Equity Awards

We also identified stock options that had been modified due to the terms of separation agreements and employment agreements. Based on a review of separation agreements and the related employment agreements, we determined that the

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terms of certain agreements modified certain provisions of the related options, specifically the vesting provisions or the term by providing additional time to exercise. Pursuant to the guidelines set forth in APB 25 and FIN 44, modifications that renew or extend the life of fixed awards, or provide for an extension or renewal if a specified future separation from employment occurs, result in a new measurement date. The modification of the related stock option grants resulted in additional stock-based compensation expense of approximately $0.8 million.

Correction in the Amortization of Acquisition Related Option Grants

We originally adopted the graded method of amortizing stock-based compensation expense. However, we incorrectly used a straight-line amortization method to amortize compensation expense related to an acquisition in fiscal 2006. For stock-based compensation expense related to an acquisition in fiscal 2001, we also incorrectly accounted for the adjustment to stock-based compensation expense for terminated employees to reflect stock-based compensation expense for vested options as if it had been recorded on a straight-line basis. The correction in amortization of acquisition-related stock-based compensation expense resulted in a net reduction in stock-based compensation expense of $7.1 million for the fiscal years 2001 through 2006.

Payroll and Withholding Taxes, Penalties and Interest

Internal Revenue Code Section 421 prohibits the granting of Incentive Stock Options (“ISO’s”) with an exercise price below fair market value of the underlying shares on the date of grant. As described above, nearly all of our stock options granted since November 18, 1999 were subject to revised measurement dates. Therefore, many of the stock options that were granted as ISO’s should have been treated as Non-Qualified (“NQ”) stock options for purposes of tax with payroll taxes. We did not withhold Federal Income Taxes, State Income Taxes, FICA or Medicare on the options that were issued as ISO’s that should have been treated as NQ stock options (due to their below-market grant pricing). However, it is our position that in certain circumstances we should have withheld such taxes. As described below, we have accrued payroll and withholding taxes, penalties and interest for these NQ stock options and included these amounts in the restated financial statements.

However, since the statute of limitations has expired for years prior to calendar year 2003, we have reversed expense recorded in prior periods and recognized a benefit in the periods in which the statute of limitations for the respective option exercise expires. In most instances, ISO’s which were exercised as a same-day sale were properly treated as a disqualifying disposition and the income was reported on the individuals Form W-2. In these situations, we accrued payroll taxes, penalties and interest but did not accrue Federal or State Income Taxes as the income from the disqualifying disposition of stock options was included on the employee’s Form W-2 and applicable State and Federal Income Taxes were paid by the employee. For certain ISO’s which subsequently converted to a NQ stock option, we accrued Federal and State Income Taxes, payroll taxes, penalties and interest at the applicable rates, if the income was not reported on the individuals Form W-2.

The combination of taxes, penalties and interest resulted in a net compensation charge of $2.0 million for fiscal years 2000 through 2006.

We believe that the unpaid employee portion of taxes represents joint and several obligations of both us and our employees. However, the change of status of employee options from ISO to NQ was a result of flaws in our stock option granting practices as discussed above. We believe that the employees would likely have a valid claim against us in the event we attempted to recover a portion of the additional taxes, penalties and interest from them. Accordingly, we believe it is appropriate to accrue both the employee and the employer portions of all taxes. In addition, we believe such additional taxes, penalties and interest should be recorded in the respective years in which the underlying in-the-money options were exercised. Since we have fully reserved our deferred tax assets, we did not record any net change to our deferred tax assets associated with this restatement.

Methodology Used for Assessing Measurement Dates in Restated Consolidated Financial Statements

In determining the appropriate measurement date for historical stock option grants, we used the guidance set forth in the letter dated September 19, 2006 from the Office of the Chief Accountant (“Chief Accountant’s Letter”) and in Accounting Principles Board (“APB”) Statement No. 25,Accounting for Stock Issued to Employees, which defines the measurement date as “the first date on which are known both (1) the number of shares that an individual employee is entitled to receive and (2) the option or purchase price, if any.” Therefore, to establish a measurement date, our methodology required that appropriate approvals had occurred and both criteria (1) and (2) were met.

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Our methodology resulted in the selection of a measurement date that coincided with the date on which there was the strongest evidence that all required granting actions related to the approval of the stock option grant had occurred and the terms of the option were determined with finality. We believe that the last granting action signifies the date upon which the required approvals and both criteria were met to establish a determinable measurement date. The hierarchy of the categories of evidence is explained below.

Categories of Evidence

We established categories of evidence to determine measurement dates and ranked the categories from strongest to weakest, and selected the strongest evidence available for each grant as the measurement date. Evidence categorized as type “A” is generally considered to be more persuasive than evidence categorized as type “B,” which in turn is considered to be more persuasive than type “C.” Our methodology incorporated the review of all evidence identified, as well as a thorough consideration of the facts and circumstances related to each grant date as well as the individual grants, including whether administrative delays were reasonable or whether back-dating occurred.

Category A evidence consists of definitive evidence supporting the fact that all required granting actions had occurred on the indicated date. Category A evidence is comprised of the following: 1) Minutes of a regular meeting of the Compensation Committee at which both members were physically present and which minutes were signed by the Secretary for the meeting. The date of the meeting is used as the measurement date; 2) Fax dates on signature pages for Unanimous Written Consents (“UWCs”) from both Compensation Committee members. The latest fax receipt date is used as the measurement date; 3) Emails from the legal department communicating conclusively that signatures and/or approvals have been obtained from all Compensation Committee members, or the Stock Option Committee for individual grants of less than 20,000 shares to non-officer employees. The email date is used as the measurement date; and 4) One fax date signature page for the UWC from one Compensation Committee member. The associated fax date is used as the measurement date.

Category B evidence consists of evidence that, while not providing definitive support for the selected grant as is the case with Category A, provides a reasonable basis to form a conclusion as to the measurement date for stock options in consideration of the guidance set forth in the Chief Accountant’s Letter. Category B evidence is comprised of the following: 1) Date of the next board meeting, in cases in which the required Compensation Committee or board member signatures are all on one page of the UWC; 2) Email evidence from others involved in the stock option granting process (such as the finance and human resource departments) indicating that the grant had been approved by the Compensation Committee; 3) Option notice date (Equity Edge date stamp on option notice) indicating the date the notice was printed. We note that this type of evidence was not utilized in the period in which there was evidence of manual edits to date stamps on the grant notifications, as described above under “Findings;” 4) Option notice date (date of employee’s signature, postmark, or fax) for periods when the date stamp on the option notice is not available; 5) Other forms of evidence indicating that a grant occurred at a prior date such as the date of SEC filings (Forms 3, 4, or 5), same-day-sale for vested options, or the Summary of Stock Purchase (annual statement listing an employee’s activity in Blue Coat securities); and 6) Option exercise date (used for 1 grant).

Category C evidence is comprised only of the Equity Edge entry date. The Equity Edge entry date is used as the measurement date when other forms of evidence for determining measurement dates are not available or are not as persuasive. We relied on the Equity Edge input date as the measurement date in 10 instances. We recognize, however, that while grants are typically entered into Equity Edge after approval, the entry of data into Equity Edge for 4 grant dates, representing 809 individual grants, occurred prior to either the UWC date or the metadata indicating when that grant was prepared. We did not use the Equity Edge entry date for these 4 grants. In the few instances when Equity Edge was pre-populated, it was typically when the population was known in advance, such as our option exchange program that occurred in September 2001 or our annual year-end grants for current employees. In these situations, we reasonably assumed that the pre-population of grant data into Equity Edge occurred for administrative convenience rather than to price the grant at a lower value. Therefore, we did not rule out altogether the use of Equity Edge entry dates, but used the Equity Edge entry date as the measurement date only in the absence of stronger evidence and only when we could reasonably conclude that the terms of the awards were not known with certainty until the Equity Edge input date.

Impact of Judgments and Interpretations on Restatement Amounts

As stated above, we considered the guidance provided in the Chief Accountant’s Letter in determining the grant dates for our historical stock option grants and in calculating the associated amount of incremental stock-based compensation expense

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to record. Specifically, we used all reasonably available relevant information to form reasonable conclusions as to the most likely option granting actions that occurred and the dates on which such actions occurred in determining the parameters of the restatement. This process required us to make certain interpretations and assumptions in order to form the resulting conclusions. There is the risk that the interpretations and assumptions we made could be disputed by others, or that we did not draw the correct conclusions. Further, there is risk that the information considered was inaccurate or incomplete. All of these risks are particularly acute where there was incomplete documentation.

We prepared a sensitivity analysis for certain categories of evidence where the specific approval of a grant cannot be defined with certainty within a range of likely dates. The sensitivity analysis is formulated to provide the reader of the financial statements with the potential expense impact of a change in measurement dates. We summarized the categories of measurement date evidence into three groups for purposes of the sensitivity analysis.

First, we identified the evidence categories that provide a high level of assurance that the approval of the grant happened on the indicated date. Group 1 consists of all evidence listed above in Category A, as well as evidence from the “next board meeting” from Category B, since such evidence, as a group, is considered to produce the most definitive evidence that approval of the related grant occurred on the revised measurement date. For these categories of evidence, we do not believe it necessary to prepare a sensitivity analysis.

Next, we grouped all remaining evidence from Category B into Group 2. While we believe this evidence represents the most likely dates that the terms of the awards were first fixed and approved, we do not believe that the evidence is as strong as Group 1. For this second group, we applied an expense sensitivity methodology to examine the largest possible variation in stock-based compensation expense within a range of possible approval dates for each grant. We developed a range using the later of the grant date specified in the UWC as the beginning of the range or, in instances where we had the UWC data file, we used the last modified date of the file as the beginning of the range as we believe the electronic evidence is a much stronger indicator of the date the UWC was prepared. We then used the later of the revised measurement date or the Equity Edge input date for each grant as the end of the range. While we believe the evidence used to determine the revised measurement dates in these categories to be the best available, we also believe that illustrating differences in stock-based compensation expense using differing methodologies provides the reader of the financial statements insight into the potential fluctuations in stock-based compensation expense within these evidence categories.

After developing the range for the grant dates within the second group, we selected the highest and lowest closing price of our stock within the range for each grant and calculated the difference in stock-based compensation expense for the grants in Group 2 using the highest and the lowest stock price within the range, and compared the aggregate results to the stock-based compensation expense that resulted from using this group’s “best available evidence.” Had we used the highest closing price of our stock within the range resulting from the above methodology for each grant in Group 2, our total restated stock-based compensation adjustment relating to the revision in measurement dates would have increased by $13.8 million. Had we used the lowest closing price of our stock within the range resulting from the above methodology for each grant, our total restated stock-based compensation adjustment relating to the revision in measurement dates would have decreased by $15.6 million.

Group 3 consisted of the evidence from Category C. Similar to the expense sensitivity methodology used for Group 2, we developed a range for each grant using the later of the grant date specified in the UWC as the beginning of the range or, in instances where we had the UWC data file, we used the last modified date of the file as the beginning of the range as we believe the electronic evidence is a much stronger indicator of the date the UWC was prepared. We used the Equity Edge input date for each grant as the end of the range. Within the identified range we selected the highest and lowest closing price of our stock within the range for each grant and calculated the difference in stock-based compensation expense for the grants in Group 3 using the highest and the lowest stock price within the range and compared the aggregate results to the stock-based compensation expense that resulted from using this group’s “best available evidence.” Had we used the highest closing price of our stock within the range resulting from the above methodology for each grant in Group 3, our total restated stock-based compensation adjustment relating to the revision in measurement dates would have increased by $1.7 million. Had we used the lowest closing price of our stock within the range resulting from the above methodology for each grant, our total restated stock-based compensation adjustment relating to the revision in measurement dates would have decreased by $3.3 million.

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The overall results of the sensitivity analysis are presented below (in thousands):

	Remeasurement Methodology		High		Change from Remeasurement Methodology		Low			Change from Remeasurement Methodology
2000	$	8,094	$	8,359	$	265	$	8,094		$	—
2001		43,034		48,467		5,433		39,737			(3,297	)
2002		3,659		11,522		7,863		(9,612	)		(13,271	)
2003		2,133		3,254		1,121		751			(1,382	)
2004		4,181		4,705		524		3,719			(462	)
2005		9		269		260		(365	)		(374	)
2006		3,271		3,308		37		3,184			(87	)
	$	64,381	$	79,884	$	15,503	$	45,508		$	(18,873	)

Remedial Measures

Management is committed to correcting the weaknesses identified above by implementing changes to our internal controls over financial reporting. Management along with our Board of Directors has implemented, or is in the process of implementing, the following changes to our internal control systems and procedures:

• We have adopted a policy requiring all option grants, whether to board members, officers or employees, be made on a predetermined schedule. Specifically, grants to new employees or to recently promoted employees will be approved by the Compensation Committee or the Stock Option Committee, as applicable, after the employee’s first day of employment or the date of the employee’s promotion. Annual grants to existing employees will be approved by the Compensation Committee at a meeting scheduled prior to the beginning of a fiscal year for a specified date in that fiscal year. Option grants to new hires and existing employees will be effective on the “date of grant,” which will be the third Thursday of a calendar month following the date of approval. As a result, grants to new and promoted employees will be limited to one specific date each month.

• We have adopted a policy limiting the granting authority of the different groups that grant stock options. The Stock Option Committee’s authority is limited to the ability to make option grants that (i) are to individuals who are neither (a) executive officers of Blue Coat or members of our Board of Directors, nor (b) direct reports to a member of the Stock Option Committee, (ii) as to any individual grant, consist of 20,000 or fewer underlying shares, and (iii) have an exercise price equal to or not less than 100% of the fair market value of a share of Common Stock on the date of the grant. The policy further requires that any grants to individuals subject to Section 16 of the Securities Exchange Act of 1934, as amended, be made by the Compensation Committee after recommendation from the Board of Directors. The Compensation Committee of the Board of Directors has the authority to make all other grants permitted under our stock option plans.

• We have expanded the size of the Stock Option Committee from one to two directors. The Stock Option Committee previously consisted of our Chief Executive Officer, Brian NeSmith. In the future, the Stock Option Committee will consist of our Chief Executive Officer and an independent director.

• We have adopted a policy requiring that all option grants by the Compensation Committee be approved at a meeting of the Compensation Committee, and that the actions of such body be documented in minutes of the meeting. The policy prohibits the Compensation Committee from granting options by written consent. The policy allows the Stock Option Committee to document the grant of options by unanimous written consent, provided that the written consent is signed by both members of the Stock Option Committee on or prior to the effective date of the written consent.

• The Special Committee has recommended, and we are in the process of implementing, a series of improvements in our internal controls. We intend to revise documentation and to create appropriate controls for annual, new hire and promotion grant preparation, presentation for approval, entry into Equity Edge, and notification to employees. We

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have already adopted a specific internal control that all internal approvals of stock option grants must be obtained prior to presentation for any Stock Option Committee or Compensation Committee action. We plan to develop an annual plan or budget for issuance of options, together with guidelines for the number and types of awards that are offered to the different salary grades, which shall be reviewed and approved annually by the Compensation Committee after or in connection with the Board of Directors’ approval of the annual business plan.

• Under the direction of our Chief Executive Officer, we will establish cross-functional training for personnel in all areas associated with the stock option granting process. The training will cover (i) the stock option and other equity award programs and related improvements to equity compensation controls, processes and procedures, (ii) the accounting implications of equity award grants, and (iii) the legal and tax implications of equity award grants. We will also require all personnel responsible for stock option administration, including (i) the Chief Executive Officer and all direct reports, (ii) finance department members, (iii) legal department members, (iv) human resource department members, (v) stock administration department members, and (vi) all new employees involved in the above-listed functions or roles, be trained at least annually. Finally, we will be formalizing our procedures for the use of Equity Audit, a module that interfaces directly with Equity Edge and enables auditing functionality of our stock option database.

• We have established a search for an experienced General Counsel with particular strength in public company securities disclosure, financial reporting matters and corporate governance. When hired, the new General Counsel will report directly to our Chief Executive Officer.

• We plan to expand the size of our Board of Directors, focusing in particular on the relative degree to which each candidate has the ability to devote substantial attention to Blue Coat matters, their expertise in areas that complement the strengths of other board members, and their experience with good corporate governance. Our Board of Directors has tasked our Nominating/Corporate Governance Committee with reviewing current committee assignments, with a goal of changing such assignments to the extent deemed appropriate to even out the demands placed upon the members of the board, utilizing the particular strengths of the individual board members, and ensuring that important matters are monitored sufficiently. Finally, we have established a Board of Directors’ policy that at least one member (on a rotating basis) of the Board of Directors should attend “directors’ college” or the equivalent each year. The Board of Directors has also approved resolutions stating that specialized update training by board members in matters of corporate governance, executive and incentive compensation, and financial reporting are highly encouraged.

Additionally, management is investing in ongoing efforts to continuously improve the control environment and has committed considerable resources to the continuous improvement of the design, implementation, documentation, testing and monitoring of our internal controls.

Related Proceedings

Regulatory Inquiries. In July 2006, we were advised that the SEC was conducting an informal inquiry into our historical stock option grants and accounting practices, In the Matter of Blue Coat Systems, Inc., SF-3165. We are cooperating with the investigation. The Company is also voluntarily cooperating with requests for information from the U.S. Attorney’s Office for the Northern District of California.

Derivative Lawsuits. On May 18, 2005, a purported shareholder derivative action was filed in the Superior Court of California, Santa Clara County, alleging that certain of our officers and directors violated their fiduciary duties to us by making false or misleading statements about our prospects between February 20, 2004 and May 27, 2004. On July 17, 2006, plaintiffs filed a consolidated amended complaint, adding allegations that certain current and former officers and directors violated their fiduciary duties to us since our initial public offering by granting and failing to account correctly for stock options. The amended complaint seeks various relief on our behalf from the individual defendants. On September 8, 2006, another and substantively identical purported shareholder derivative action was filed against certain of our current and former officers and directors. Both of these state derivative cases have been consolidated.

On August 8 and September 5, 2006, two purported shareholder derivative actions were filed in the United States District Court for the Northern District of California against certain of our current and former officers and directors. Like the state derivative actions, the federal derivative actions allege that certain of our current and former officers and directors violated their fiduciary duties since our initial public offering by granting and failing to account correctly for stock options and seek various relief on our behalf from the individual defendants. Both of these federal cases have been consolidated.

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Nasdaq. In August 2006, we failed to timely file our Form 10-K for the year ended April 30, 2006, and in September 2006, December 2006 and March 2007, we failed to timely file our Form 10-Q’s for the quarters ended July 31, 2006, October 31, 2006 and January 31, 2007, respectively, all as a result of the ongoing Special Committee investigation. Nasdaq promptly notified us that these failures to file periodic reports caused us to violate the requirements for continued listing as set forth in Marketplace Rule 4310(c)(14). We requested a hearing before a Nasdaq Listing Qualifications Panel (the “Panel”) to petition for continued listing on the Nasdaq Stock Market. The hearing was held on September 14, 2006. On November 13, 2006, the Panel informed us that we would have until January 29, 2007 to file our Form 10-K for the year ended April 30, 2006, our Form 10-Q for the quarters ended July 31, 2006 and October 31, 2006, and any required restatements. On January 18, 2007, we informed the Nasdaq Stock Market that we would not meet the January 29, 2007 deadline, because we had determined to seek pre-clearance from the Office of the Chief Accountant (the “OCA”) of the Division of Corporate Finance, U.S. Securities and Exchange Commission, of our proposed accounting treatment and related disclosures. On January 24, 2007, the Panel denied our request for additional time to comply with our filing obligations and determined to delist our shares effective as of the open of business on Tuesday, January 30, 2007, as the Panel had no additional authority to extend the filing deadlines. We promptly appealed the Panel’s decision to the Nasdaq Listing and Hearing Review Council (the “Listing Council”). On January 26, 2007, the Listing Council called for review the earlier decision of the Panel requiring us to file all required restatements and delinquent periodic reports by January 29, 2007, and stayed any suspension of trading of our securities pending further action by the Listing Council. We may submit additional information to the Listing Council by March 30, 2007. The Listing Council will then review the Panel’s decision on the written record. We have filed our Form 10-K for the year ended April 30, 2006, our Form 10-Q for the quarters ended July 31, 2006, October 31, 2006 and January 31, 2007, and what we believe to be all required restatements with the SEC. With these filings, we believe that we have remedied our non-compliance with Marketplace Rule 4310(c)(14), subject to Nasdaq’s affirmative completion of its compliance protocols and its notification of us accordingly. However, if the SEC disagrees with the manner in which we have accounted for and reported the financial impact of past stock option grants, there could be further delays in filing subsequent SEC reports that might result in delisting of our common stock from the Nasdaq Stock Market.

Costs of Restatement and Legal Activities. We have incurred substantial expenses for legal, accounting, tax and other professional services in connection with the Special Committee’s investigation, our internal review and recertification procedures, the preparation of the April 30, 2006 consolidated financial statements and the restated consolidated financial statements, the SEC investigation and the derivative litigation. These expenses were approximately $10.5 million in aggregate through the quarter ended January 31, 2007. We expect to continue to incur significant expense in connection with the derivative litigation, the ongoing SEC investigation of our historical stock option practices, and our indemnity obligations related thereto, and other stock option investigation-related matters. There can be no assurance that our directors’ and officers’ liability insurance will be sufficient to cover these costs. In addition, we expect to incur significant payment obligations to employees relating to adverse tax consequences as a result of granting options with exercise prices below the fair market value of our Common Stock on the actual measurement dates.

Critical Accounting Policies

Our discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, net revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to Revenue Recognition and Related Receivable Allowances, Inventories, Guarantees, Indemnifications and Warranty Obligations, Valuation of Goodwill, Valuation of Long-Lived and Identifiable Intangible Assets, Restructuring Liabilities, Income Taxes, Contingencies, Stock-Based Compensation, Impact of Judgments and Interpretations on Restatement Amounts, and Payroll and Withholding Taxes, Penalties and Interest Related to the Restatement. Estimates related to the restatement, due to their nature, are not evaluated on an ongoing basis. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and such differences could be material. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

We have discussed the development and selection of critical accounting policies and estimates with our audit committee. We believe the accounting policies described below, among others, are the ones that most frequently require us to make estimates and judgments, and therefore are critical to the understanding of our financial condition and results of operations:

• Revenue Recognition and Related Receivable Allowances;

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• Inventories;

• Guarantees, Indemnifications and Warranty Obligations;

• Valuation of Goodwill;

• Valuation of Long-Lived and Identifiable Intangible Assets;

• Restructuring Liabilities;

• Income Taxes;

• Contingencies;

• Stock-Based Compensation;

• Impact of Judgments and Interpretations on Restatement Amounts; and

• Payroll and Withholding Taxes, Penalties and Interest Related to the Restatement.

Revenue Recognition and Related Receivable Allowances

Our products include software that is essential to the functionality of the appliances. Additionally, we provide unspecified software upgrades and enhancements related to the appliances through our maintenance contracts for most of our products. Accordingly, we account for revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” and all related interpretations.

We recognize revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Evidence of an arrangement generally consists of customer purchase orders and, in certain instances, sales contracts or agreements. Shipping terms and related documents, or written evidence of customer acceptance, when applicable, are used to verify delivery or performance.

Sales are made through distributors under agreements allowing for certain stock rotation rights. Net revenue, and the related cost of net revenue, resulting from shipments to distributors are deferred until the distributors report that our products have been sold to a customer. Product revenue in China is deferred until the customer registers the proxy appliance.

For sales made direct to end-users and value-added resellers, we recognize product revenue upon transfer of title and risk of loss, which is generally upon shipment. We do not accept orders from these value-added resellers when we are aware that the value-added reseller does not have an order from a customer. For the end-users and value-added resellers, we don’t have significant obligations for future performance such as rights of return or pricing credits.

We assess that the sales price is fixed or determinable based on payment terms and whether the sales price is subject to refund or adjustment.

In an arrangement that includes multiple elements, such as appliances, maintenance, third-party software and/or content filtering subscriptions, we allocate revenue to each element using the residual method based on vendor specific objective evidence of fair value of the undelivered items. Under the residual method, the amount of revenue allocated to delivered elements equals the total arrangement consideration less the aggregate fair value of any undelivered elements. Vendor specific objective evidence of fair value is based on the price charged when the element is sold separately.

We accrue for warranty costs, and other allowances based on historical experience.

Maintenance and subscription revenue is initially deferred and recognized ratably over the life of the contract, with the related expenses recognized as incurred. Maintenance and subscription contracts usually have a term of one year, but can extend to three years. Unearned maintenance and subscription contracts are included in deferred revenue.

When we bill customers for shipping, we record shipping cost in both net revenue and cost of net revenue. If we do not charge customers for shipping, the cost incurred for shipping are reflected in cost of net revenue.

Probability of collection is assessed on a customer-by-customer basis. Our customers are subjected to a credit review process that evaluates the customers’ financial condition and ability to pay for our products and services. If it is determined from the outset of an arrangement that collection is not probable based upon the review process, revenue is not recognized until cash receipt.

We perform ongoing credit evaluations of our customers’ financial condition and maintain an allowance for doubtful accounts. We analyze accounts receivable and historical bad debts, customer concentrations, customer solvency, current economic and geographic trends, and changes in customer payment terms and practices when evaluating the adequacy of such allowance, and any required changes in the allowance are recorded to general and administrative expense.

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Inventories

Inventories consist of raw materials, work-in-process and finished goods. Inventories are recorded at the lower of cost or market using the first-in, first-out method, after appropriate consideration has been given to obsolescence and inventory in excess of anticipated future demand. In assessing the ultimate recoverability of inventories, we are required to make estimates regarding future customer demand and market conditions. If actual market conditions are less favorable than those projected, additional write-offs and other charges against earnings may be required.

Guarantees, Indemnifications and Warranty Obligations

We accrue for warranty expenses as part of our cost of revenue at the time revenue is recognized and maintain an accrual for estimated future warranty obligations based upon the relationship between historical and anticipated warranty costs and revenue volumes. If actual warranty expenses are greater than those projected, additional charges against earnings may be required. If actual warranty expenses are less than projected, obligations could be reduced providing a positive impact on our reported results. We generally provide a one-year warranty on hardware products and a 90-day warranty on software products.

Our Bylaws provide that we shall indemnify our directors and officers to the fullest extent permitted by Delaware law, including in circumstances in which indemnification is otherwise discretionary under Delaware law. We have also entered into indemnification agreements with our officers and directors containing provisions that may require us, among other things, to indemnify such officers and directors against certain liabilities that may arise by reason of their status or service as directors or officers and to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified. We expect to have indemnification obligations to certain current and former officers and directors in connection with matters relating to the stock option investigation, as well as with certain of our outstanding litigation matters. See Part 1 - Item 1, Note 2 of the Notes to Condensed Consolidated Financial Statements, Part II - Item 1, “Legal Proceedings,” and Part II - Item 4, “Controls and Procedures.”

Valuation of Goodwill

We perform our annual goodwill impairment tests in our fourth fiscal quarter or whenever indicators of impairment are present. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment. For purposes of our annual impairment test, we considered our market capitalization on the date of our impairment test (since we have only one reporting unit). We performed our recurring annual review of goodwill in the fourth quarter of fiscal 2006 and concluded that no impairment existed at April 30, 2006. For the three and nine months ended January 31, 2007, there have been no significant events or changes in circumstances affecting the valuation of goodwill.

Valuation of Long-Lived and Identifiable Intangible Assets

We evaluate our long-lived and identifiable intangible assets in accordance with FASB SFAS No. 144,Accounting for Impairment or Disposal of Long-Lived Assets. We review our long-lived assets, including property and equipment and identifiable intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Events or changes in circumstances that could result in an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of acquired assets or the strategy for our business and significant negative industry or economic trends. Impairment is recognized when the carrying amount of an asset exceeds its fair value as calculated on a discounted cash flow basis.

Restructuring Liabilities

We have accrued through charges to “Restructuring” in our consolidated financial statements various restructuring liabilities, related to employee severance costs, facilities closure and lease abandonment costs, and contract termination costs. Our restructuring liabilities for facilities closure and lease abandonment costs include various assumptions, such as the time period over which abandoned facilities will be vacant, costs required to restore leased facilities to the condition stipulated in the related lease agreements, expected sublease terms, and expected sublease rates. We constantly monitor these assumptions and any changes in these assumptions may result in a substantial increase or decrease to restructuring expense should different conditions prevail than were anticipated in original management estimates.

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Income Taxes

We use the liability method to account for income taxes as required by the FASB SFAS No. 109,Accounting for Income Taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves determining our income tax expense together with calculating the deferred income tax expense related to temporary differences resulting from the differing treatment of items for tax and accounting purposes, such as deferred revenue or deductibility of certain intangible assets. These temporary differences result in deferred tax assets and liabilities, which are included in the consolidated balance sheets. We must then assess the likelihood that the deferred tax assets will be recovered through carry back to prior year’s income or through the generation of future taxable income and after consideration of tax planning strategies record a valuation allowance to reduce deferred tax assets to an amount we believe more likely than not will be realized. As of January 31, 2007, we have a full valuation allowance against our deferred tax assets because the determination was made that it is more likely than not that all of the deferred tax assets may not be realized in the foreseeable future due to historical operating losses.

The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws. Our estimate for the potential outcome of any uncertain tax issues is highly judgmental. The Company accounts for income tax contingencies in accordance with SFAS No. 5, “Accounting for Contingencies”.

Contingencies

From time to time we are involved in various claims and legal proceedings. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we record the amount of the loss or the minimum estimated liability when the loss is estimated using a range and no point within the range is more probable than any other. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary. Litigation is subject to inherent uncertainties, and unfavorable rulings could occur.

Stock-Based Compensation Prior to Adoption of SFAS No. 123(R)

Prior to May 1, 2006, we accounted for stock-based compensation for options granted to our employees and members of our Board of Directors using Accounting Principles Board (“APB”) Statement No. 25,Accounting for Stock Issued to Employees, and related interpretations, including Financial Accounting Standards Board Interpretation (“FIN”) No. 44,Accounting for Certain Transactions Involving Stock Compensation, An Interpretation of APB Opinion No. 25. In addition, we complied with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123,Accounting for Stock-Based Compensation,as amended by SFAS No. 148, Accountingfor Stock-Based Compensation-Transition and Disclosure Amendment of SFAS No. 123, as if we had applied the fair value-based method in measuring compensation cost for our stock-based compensation plans

Under APB No. 25, compensation expense is measured on the date in which the number of shares and exercise price are known, or fixed. If the number of shares or exercise price of the award is not fixed, the stock option is accounted for as a variable award until such time at which stock option is exercised, cancelled or expires.

For fixed stock awards, compensation expense is calculated based on its intrinsic value, or the difference between the fair market value of our stock on the date the award is fixed and the award’s exercise price. No compensation expense is recognized if an award’s intrinsic value is zero. Stock compensation expense associated with fixed stock option awards with a positive intrinsic value is recognized over the vesting period using the graded method, which results in greater expense recorded in earlier years than the straight-line method.

For variable awards, the intrinsic value of our stock options is remeasured each period based on the difference between the fair market value of our stock as of the end of the reporting period and the award’s exercise price. As a result, the amount of compensation expense or benefit to be recognized each period fluctuates based on changes in the fair market value of our common stock from the end of the previous reporting period to the end of the current reporting period. Compensation expense in any given period is calculated as the difference between total earned compensation calculated at the end of the period, less total earned compensation calculated at the beginning of the period. Compensation expense for these awards is recognized over the vesting period using an accelerated method of recognition in accordance with FIN No. 28,Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plan, An Interpretation of APB Opinions No. 15 and 25. Variable accounting is applied until the stock option is fixed, or the time at which the stock option is exercised, forfeited or expires.

We account for modifications to stock options under FIN No. 44, which was effective July 1, 2000. Modifications include, but are not limited to, acceleration of vesting, extension of the exercise period following termination of employment and/or continued vesting while not providing substantive services. Compensation expense is recorded in the period of modification for the intrinsic value of the vested portion of the award, including vesting that occurs while not providing substantive services, on the date of modification.

Impact of Judgments and Interpretations on Restatement Amounts

As previously stated, we considered the guidance provided in the Chief Accountant’s Letter in determining the grant dates for our historical stock option grants and in calculating the associated amount of incremental stock-based compensation

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expense to record. Specifically, we used all reasonably available relevant information to form reasonable conclusions as to the most likely option granting actions that occurred and the dates on which such actions occurred in determining the parameters of the restatement. This process required us to make certain interpretations and assumptions in order to form the resulting conclusions. There is the risk that the interpretations and assumptions we made could be disputed by others, or that we did not draw the correct conclusions. Further, there is risk that the information considered was inaccurate or incomplete. All of these risks are particularly acute where there was incomplete documentation.

We prepared a sensitivity analysis for certain categories of evidence where the specific approval of a grant cannot be defined with certainty within a range of likely dates. The sensitivity analysis is formulated to provide the reader of the financial statements with the potential expense impact of a change in measurement dates. We summarized the categories of measurement date evidence into three groups for purposes of the sensitivity analysis. For a description of the difference categories of evidence that we identified, please see “Methodology Used for Assessing Measurement Dates in Restated Consolidated Financial Statements – Categories of Evidence” within the “Restatement of Condensed Consolidated Financial Statements” section of Item 2, “Managements Discussion and Analysis of Financial Condition and Results of Operations.”

First, we identified the evidence categories that provide a high level of assurance that the approval of the grant happened on the indicated date. Group 1 consists of all evidence listed in Category A, as well as evidence from the “next board meeting” from Category B, since such evidence, as a group, is considered to produce the most definitive evidence that approval of the related grant occurred on the revised measurement date. For these categories of evidence, we do not believe it necessary to prepare a sensitivity analysis.

Next, we grouped all remaining evidence from Category B into Group 2. While we believe this evidence represents the most likely dates that the terms of the awards were first fixed and approved, we do not believe that the evidence is as strong as Group 1. For this second group, we applied an expense sensitivity methodology to examine the largest possible variation in stock-based compensation expense within a range of possible approval dates for each grant. We developed a range using the later of the grant date specified in the UWC as the beginning of the range or, in instances where we had the UWC data file, we used the last modified date of the file as the beginning of the range as we believe the electronic evidence is a much stronger indicator of the date the UWC was prepared. We then used the later of the revised measurement date or the Equity Edge input date for each grant as the end of the range. While we believe the evidence used to determine the revised measurement dates in these categories to be the best available, we also believe that illustrating differences in stock-based compensation expense using differing methodologies provides the reader of the financial statements insight into the potential fluctuations in stock-based compensation expense within these evidence categories.

After developing the range for the grant dates within the second group, we selected the highest and lowest closing price of our stock within the range for each grant and calculated the difference in stock-based compensation expense for the grants in Group 2 using the highest and the lowest stock price within the range, and compared the aggregate results to the stock-based compensation expense that resulted from using this group’s “best available evidence.” Had we used the highest closing price of our stock within the range resulting from the above methodology for each grant in Group 2, our total restated stock-based compensation adjustment relating to the revision in measurement dates would have increased by $13.8 million. Had we used the lowest closing price of our stock within the range resulting from the above methodology for each grant, our total restated stock-based compensation adjustment relating to the revision in measurement dates would have decreased by $15.6 million.

Group 3 consisted of the evidence from Category C. Similar to the expense sensitivity methodology used for Group 2, we developed a range for each grant using the later of the grant date specified in the UWC as the beginning of the range or, in instances where we had the UWC data file, we used the last modified date of the file as the beginning of the range as we believe the electronic evidence is a much stronger indicator of the date the UWC was prepared. We used the Equity Edge input date for each grant as the end of the range. Within the identified range we selected the highest and lowest closing price of our stock within the range for each grant and calculated the difference in stock-based compensation expense for the grants in Group 3 using the highest and the lowest stock price within the range and compared the aggregate results to the stock-based compensation expense that resulted from using this group’s “best available evidence.” Had we used the highest closing price of our stock within the range resulting from the above methodology for each grant in Group 3, our total restated stock-based compensation adjustment relating to the revision in measurement dates would have increased by $1.7 million. Had we used the lowest closing price of our stock within the range resulting from the above methodology for each grant, our total restated stock-based compensation adjustment relating to the revision in measurement dates would have decreased by $3.3 million.

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The overall results of the sensitivity analysis are presented below:

	Remeasurement Methodology		High		Change from Remeasurement Methodology		Low			Change from Remeasurement Methodology
2000	$	8,094	$	8,359	$	265	$	8,094		$	—
2001		43,034		48,467		5,433		39,737			(3,297	)
2002		3,659		11,522		7,863		(9,612	)		(13,271	)
2003		2,133		3,254		1,121		751			(1,382	)
2004		4,181		4,705		524		3,719			(462	)
2005		9		269		260		(365	)		(374	)
2006		3,271		3,308		37		3,184			(87	)
	$	64,381	$	79,884	$	15,503	$	45,508		$	(18,873	)

Payroll and Withholding Taxes, Penalties and Interest Related to the Restatement

Internal Revenue Code Section 421 prohibits the granting of Incentive Stock Options (“ISO’s”) with an exercise price below fair market value of the underlying shares on the date of grant. As described above, nearly all of our stock options granted since November 18, 1999 were subject to revised measurement dates. Therefore, many of the stock options that were granted as ISO’s should have been treated as Non-Qualified (“NQ”) stock options for purposes of payroll taxes. We did not withhold Federal Income Taxes, State Income Taxes, FICA or Medicare on the options that were issued as ISO’s that should have been treated as NQ stock options (due to their below-market grant pricing). However, it is our position that in certain circumstances we should have withheld such taxes. As described below, we have accrued payroll and withholding taxes, penalties and interest for these NQ stock options and included these amounts in the restated financial statements.

However, since the statute of limitations has expired for years prior to calendar year 2003, we have reversed expense recorded in prior periods and recognized a benefit in the periods in which the statute of limitations for the respective option exercise expires. In most instances, ISO’s which were exercised as a same-day sale were properly treated as a disqualifying disposition and the income was reported on the individuals Form W-2. In these situations, we accrued payroll taxes, penalties and interest but did not accrue Federal or State Income Taxes as the income from the disqualifying disposition of stock options was included on the employee’s Form W-2 and applicable State and Federal Income Taxes were paid by the employee. For certain ISO’s which subsequently converted to a NQ stock option, we accrued Federal and State Income Taxes, payroll taxes, penalties and interest at the applicable rates, if the income was not reported on the individuals Form W-2.

The combination of taxes, penalties and interest resulted in a net compensation charge of $2.0 million for fiscal years 2000 through 2006.

We believe that the unpaid employee portion of taxes represents joint and several obligations of both us and our employees. However, the change of status of employee options from ISO to NQ was a result of flaws in our stock option granting practices as discussed above. We believe that the employees would likely have a valid claim against us in the event we attempted to recover a portion of the additional taxes, penalties and interest from them. Accordingly, we believe it is appropriate to accrue both the employee and the employer portions of all taxes. In addition, we believe such additional taxes, penalties and interest should be recorded in the respective years in which the underlying in-the-money options were exercised. Since we have fully reserved our deferred tax assets, we did not record any net change to our deferred tax assets associated with this restatement.

Stock-Based Compensation Subsequent to Adoption of SFAS No. 123(R)

We adopted SFAS No. 123(R),Share-Based Payment, for our fiscal year beginning May 1, 2006 using the modified prospective transition method. Under that transition method, recognized compensation cost includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of, May 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments granted on or after May 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R).

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For options granted on or after May 1, 2006, we amortize the fair value of stock-based compensation on a straight-line basis for options expected to vest. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods.

Under SFAS No. 123(R), the fair value of each employee stock option and employee stock purchase right is estimated on the date of grant using an option pricing model that meets certain requirements. We use the Black-Scholes option pricing model to estimate the fair value of our share-based payments. The Black-Scholes model meets the requirements of SFAS No. 123(R), but the fair values generated by the model may not be indicative of the actual fair values of our stock-based awards as the model does not consider certain factors important to stock-based awards, such as continued employment, periodic vesting requirements and limited transferability. The determination of the fair value of share based payment awards utilizing the Black-Scholes model is affected by our stock price and a number of assumptions, including expected term, expected volatility, risk-free interest rate and expected dividends. A description of our assumptions is included below:

Expected Term. The expected term of options granted represents the period of time that they are expected to be outstanding. We estimate the expected term of options granted based on our historical experience of grants, exercises and post-vesting cancellations. Contractual term expirations have not been significant.

Expected Volatility. We estimate the volatility of our stock options at the date of grant using a combination of historical and implied volatilities, consistent with SFAS No. 123(R) and SEC Staff Accounting Bulletin No. 107. Historical volatilities are calculated based on the historical prices of our common stock over a period equal to the expected term of our option grants, while implied volatilities are derived from publicly traded options of our common stock. Prior to the adoption of SFAS No. 123(R), we relied exclusively on the historical prices of our common stock in the calculation of expected volatility.

Expected Forfeitures. Stock-based compensation expense under FAS 123(R) is based on awards ultimately expected to vest, and requires that forfeitures be estimated at the time of grant and revised, if necessary, if actual forfeitures differ from those estimates. We estimated our forfeiture rate at 10% based on an analysis of historical pre-vesting forfeitures, and have reduced stock-based compensation expense accordingly.

Risk-Free Rate.The risk-free interest rate that we use in the Black-Scholes option valuation model is the implied yield in effect at the time of option grant based on U.S. Treasury zero-coupon issues with a remaining term equivalent to the expected term of our option grants.

Dividends.We have never paid any cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model.

Stock-based compensation expense recorded in our financial statements in fiscal 2007 and thereafter will be based on awards that are ultimately expected to vest. Stock-based compensation expense under FAS 123(R) is based on awards ultimately expected to vest, and requires that forfeitures be estimated at the time of grant and revised, if necessary, if actual forfeitures differ from those estimates. The amount of stock-based compensation expense in fiscal 2007 and thereafter will be reduced for estimated forfeitures.

We evaluate the assumptions used to value stock awards on a quarterly basis. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. To the extent that we grant additional equity securities to employees or we assume unvested securities in connection with any acquisitions, our stock-based compensation expense will be increased by the additional unearned compensation resulting from those additional grants or acquisitions. Stock-based compensation expense recognized under SFAS No. 123(R) was approximately $2.1 million and $7.6 million for the three and nine months ended January 31, 2007, respectively. Had we adopted SFAS No. 123(R) in prior periods, the magnitude of the impact of that standard on our results of operations would have approximated the pro forma amount under SFAS 123 described in Note 1 of our Notes to Condensed Consolidated Financial Statements.

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Results of Operations

The following table sets forth, as a percentage of net revenue, condensed consolidated statements of operations data for the periods indicated:

	Three Months Ended January 31,				Nine Months Ended January 31,
	2007		2006 (as restated) 1		2007		2006 (as restated) 1
Net revenue:
Product	76.4	%	81.6	%	75.9	%	82.9	%
Service	23.6		18.4		24.1		17.1
Total net revenue	100.0		100.0		100.0		100.0
Cost of net revenue
Product	17.4		21.8		18.2		23.2
Service	8.6		7.3		8.3		6.6
Total cost of net revenue	26.0		29.1		26.5		29.8
Gross profit	74.0		70.9		73.5		70.2
Operating expenses:
Research and development	20.6		19.0		23.1		17.7
Sales and marketing	39.6		37.8		39.3		36.4
General and administrative	14.6		7.4		17.5		10.9
Amortization of intangible assets	0.2		0.5		0.4		0.5
Total operating expenses	75.0		64.7		80.3		65.5
Operating income (loss)	(1.0	)	6.2		(6.8	)	4.7
Interest income	2.1		1.8		2.4		1.3
Other expense	(0.2	)	(0.4	)	(0.3	)	(0.2	)
Income (loss) before income taxes	0.9		7.6		(4.7	)	5.8
Provision for income taxes	0.8		—		0.5		0.2
Net income (loss)	0.1	%	7.6	%	(5.2	)%	5.6	%

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

Net Revenue

The following is a summary of net revenue and the changes in net revenue (in thousands):

	Three Months Ended January 31,						Nine Months Ended January 31,
	2007			2006			2007			2006
Total net revenue	$	47,108		$	35,517		$	123,228		$	105,587
Change from same period prior year ($)	$	11,591		$	10,768		$	17,641		$	37,786
Change from same period prior year (%)		32.6	%		43.5	%		16.7	%		55.7	%

For the three and nine months ended January 31, 2007, we continued to drive revenue growth across our product portfolio. Net revenue increased by 32.6% to $47.1 million in the third quarter of fiscal 2007, from $35.5 million in the third quarter of fiscal 2006. In the nine months ended January 31, 2007, net revenue increased 16.7% to $123.2 million from $105.6 million in the nine months ended January 31, 2006. The growth in net revenue from prior periods was primarily attributable to continued market acceptance of our products, coupled with increased sales and marketing efforts to broaden our market presence and expand our distribution channels. Service revenue increased 70.4% and 64.6% for the three and nine months ended January 31, 2007, respectively, primarily due to an increase in service renewals.

The following table illustrates the geographic makeup of our net revenue for the periods stated (in thousands):

	Three Months Ended January 31,
	2007				2006
	$		%		$		%
North America	$	21,418	45.5	%	$	17,329	48.8	%
EMEA		20,115	42.7			14,552	41.0
Asia		5,575	11.8			3,636	10.2
Total net revenue	$	47,108	100.0	%	$	35,517	100.0	%

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	Nine Months Ended January 31,
	2007				2006
	$		%		$		%
North America	$	58,886	47.8	%	$	54,188	51.3	%
EMEA		47,671	38.7			39,836	37.7
Asia		16,671	13.5			11,563	11.0
Total net revenue	$	123,228	100.0	%	$	105,587	100.0	%

Net revenues grew in all geographies in the three and nine months ended January 31, 2007, compared to the same periods of fiscal 2006. For the three months ended January 31, 2007, as compared to the same quarter in the prior year, net revenue in North America increased $4.1 million, or 23.6%, net revenue in EMEA increased $5.6 million, or 38.2%, and net revenue in Asia increased $1.9 million, or 53.3%. For the nine months ended January 31, 2007, as compared to the same period in the prior year, net revenue in North America increased $4.7 million, or 8.7%, net revenue in EMEA increased $7.8 million, or 19.7%, and net revenue in Asia increased $5.1 million, or 44.2%.

Gross Profit

The following is a summary of gross profit (in thousands):

	Three Months Ended January 31,						Nine Months Ended January 31,
	2007			2006 (as restated) 1			2007			2006 (as restated) 1
Gross profit	$	34,868		$	25,175		$	90,616		$	74,081
Gross profit as a percentage of net revenue		74.0	%		70.9	%		73.5	%		70.2	%

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

Gross profit was $34.9 million in the third quarter of fiscal 2007 compared to $25.2 million for the third quarter of fiscal 2006. As a percentage of net revenue, gross profit for the third quarter of fiscal 2007 and 2006 was 74.0% and 70.9%, respectively. Gross profit was $90.6 million for the first nine months of fiscal 2007 compared to $74.1 million for the first nine months of fiscal 2006. As a percentage of net revenue, gross profit for the first nine months of fiscal 2007 and 2006 was 73.5% and 70.2%, respectively. The increases in gross profit were due primarily to increases in net revenue. The improvement in gross profit as a percentage of sales for the three and nine month periods ended January 31, 2007, as compared to the comparable prior year periods, was primarily due to more favorable product pricing and higher overall revenue resulting in more effective leverage on fixed product costs, partially offset by continued investments in our service infrastructure to support our increasing customer base.

Research and Development

The following is a summary of research and development expense (in thousands):

	Three Months Ended January 31,						Nine Months Ended January 31,
	2007			2006 (as restated) 1			2007			2006 (as restated) 1
Research and development	$	9,711		$	6,729		$	28,429		$	18,712
Research and development as a percentage of net revenue		20.6	%		19.0	%		23.1	%		17.7	%

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

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Research and development expense consists primarily of salaries and benefits, prototype costs, and testing equipment costs.

Research and development expense increased $3.0 million to $9.7 million in the third quarter of fiscal 2007 from $6.7 million for the third quarter of fiscal 2006. These amounts represented 20.6% and 19.0% of net revenue for the third quarters of fiscal 2007 and 2006, respectively. Research and development expense increased $9.7 million to $28.4 million for the first nine months of fiscal 2007 from $18.7 million for the first nine months of fiscal 2006. These amounts represented 23.1% and 17.7% of net revenue for the first nine months of fiscal 2007 and 2006, respectively. The increase in research and development expense was primarily a result of higher employee costs from increased headcount, as well as increased spending on engineering materials, in order to enhance existing applications and address new product development. The increase was also attributable to stock-based compensation expense of $0.8 million and $2.6 million related to research and development under SFAS No. 123(R) in the three and nine months ended January 31, 2007, as compared to $0.2 million and $0.7 million related to research and development under APB 25 in the three and nine months ended January 31, 2006.

We believe that continued investment in product enhancements and new product development is critical to achieving our strategic objectives. As a result, as our net revenue allows, we expect research and development expense to continue to increase in absolute dollars.

Sales and Marketing

The following is a summary of sales and marketing expense (in thousands):

	Three Months Ended January 31,						Nine Months Ended January 31,
	2007			2006 (as restated) 1			2007			2006 (as restated) 1
Sales and marketing	$	18,634		$	13,430		$	48,497		$	38,408
Sales and marketing as a percentage of net revenue		39.6	%		37.8	%		39.3	%		36.4	%

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

Sales and marketing expense consists primarily of salaries and benefits, commissions, travel, advertising and promotional expenses.

Sales and marketing expense increased $5.2 million to $18.6 million for the third quarter of fiscal 2007 from $13.4 million for the third quarter of fiscal 2006. These amounts represented 39.6% and 37.8% of net revenue for the third quarters of fiscal 2007 and 2006, respectively. Sales and marketing expense increased $10.1 million to $48.5 million for the first nine months of fiscal 2007 from $38.4 million for the first nine months of fiscal 2006. These amounts represented 39.3% and 36.4% of net revenue for the first nine months of fiscal 2007 and 2006, respectively. The increase in sales and marketing expense was primarily due to higher commissions resulting from the outsourcing of service contract renewals, increases in sales headcount and related expenses, marketing programs and travel costs and an increase in commission expense associated with higher net revenue. The increase was also attributable to stock-based compensation expense of $0.6 million and $2.5 million related to sales and marketing under SFAS No. 123(R) in the three and nine months ended January 31, 2007, as compared to $0.2 million and $0.5 million related to sales and marketing under APB 25 in the three and nine months ended January 31, 2006.

We expect sales and marketing expense to increase in absolute dollars in an effort to expand domestic and international markets, establish and expand new distribution channels, and introduce new products.

General and Administrative

The following is a summary of general and administrative expense (in thousands):

	Three Months Ended January 31,						Nine Months Ended January 31,
	2007			2006 (as restated) 1			2007			2006 (as restated) 1
General and administrative	$	6,894		$	2,627		$	21,606		$	11,508
General and administrative as a percentage of net revenue		14.6	%		7.4	%		17.5	%		10.9	%

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

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General and administrative expense consists primarily of salaries and benefits, legal services, accounting and audit services, and other general corporate expenses.

General and administrative expense increased $4.3 million to $6.9 million for the third quarter of fiscal 2007 from $2.6 million for the third quarter of fiscal 2006. These amounts represented 14.6% and 7.4% of net revenue for the third quarters of fiscal 2007 and 2006, respectively. General and administrative expense increased $10.1 million to $21.6 million for the first nine months of fiscal 2007 from $11.5 million for the first nine months of fiscal 2006. These amounts represented 17.5% and 10.9% of net revenue for the first nine months of fiscal 2007 and 2006, respectively. The increase in general and administrative expense was primarily due to increased headcount, and substantially higher legal, auditing and other professional fees in connection with the investigation into our historical stock option granting practices. For the three months ended January 31, 2007, stock-based compensation expense increased $0.7 million to $0.4 million under SFAS No. 123(R) as compared to $(0.3) million in the three months ended January 31, 2006 under APB 25. For the nine months ended January 31, 2007, the increase in general and administrative expense was offset by a $1.1 million decrease in stock-based compensation expense to $1.7 million under SFAS No. 123(R) as compared to $2.8 million related to general and administrative under APB 25 in the nine months ended January 31, 2006.

We expect that general and administrative expense will increase in absolute dollars as we increase headcount and infrastructure to manage an anticipated increase in business volume.

Amortization of Intangible Assets

Amortization of intangible assets reflects the amortization of developed technology, core technology, and customer relationships, all related to our September 11, 2006 acquisition of certain assets of the NetCache business, March 3, 2006 acquisition of Permeo, November 16, 2004 acquisition of Cerberian and November 14, 2003 acquisition of Ositis. The amortization of developed technology is charged to cost of goods sold. The amortization of core technology and customer relationships is recorded as an operating expense. Total amortization expense was $0.4 million and $1.4 million in the three and nine months ended January 31, 2007, respectively, and $0.3 million and $0.9 million in the three and nine months ended January 31, 2006, respectively.

Interest Income and Other Income

The following summarizes interest income and other expense (in thousands):

	Three Months Ended January 31,						Nine Months Ended January 31,
	2007			2006 (as restated) 1			2007			2006 (as restated) 1
Interest income, net	$	965		$	620		$	2,9544		$	1,415
Other expense	$	(82	)	$	(124	)	$	(350	)	$	(200	)

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

For the three and nine months ended January 31, 2007, as compared with the comparable prior year periods, interest income increased as a result of increased cash, cash equivalents and short-term investment balances earning interest at higher rates. The fluctuation in other expense over the periods presented is the result of changes in exchange rates between the currencies of our international locations and the U.S. dollar.

Provision for Income Taxes

The provision for income taxes for the three and nine months ended January 31, 2007 was a tax expense of $0.4 million and $0.6 million, respectively, as compared to a tax expense of $0.01 million and $0.3 million, respectively, for the three and nine months ended January 31, 2006. The provision for income taxes for the three and nine months ended January 31, 2007 is primarily foreign corporate income taxes currently due and U.S. taxes related to the acquisition of the NetCache business from Network Appliance, Inc. (see Note 5 for more detail discussion). The tax provision for the three and nine months ended January 31, 2006 is primarily foreign corporate income taxes currently due.

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Sale of Series A Redeemable Convertible Preferred Stock

On June 22, 2006, we sold an aggregate of $42.1 million of Series A Redeemable Convertible Preferred Stock (“Series A Preferred Stock”). The financing consisted of 42,060 shares of our Series A Preferred Stock.

Significant rights and obligations of the Series A Preferred Stock is as follows:

Conversion feature.The 42,060 shares of Series A Preferred Stock are initially convertible at the option of the holders into 2.4 million shares of our common stock. The conversion price of each share of Series A Preferred Stock is $17.525 per share, such that the conversion rate of the Series A Preferred Stock is approximately 57.06-to-1.0. Each share of Series A Preferred Stock will be automatically converted into shares of Common Stock at the then effective conversion rate for such share upon the approval of the holders of at least a majority of the then-outstanding Series A Preferred Stock.

Redemption features. In the event that we do not complete an acquisition, whether by merger, consolidation, the purchase of assets or otherwise, of another entity or of certain assets of another entity, for at least $18,000,000 in cash within 150 days of June 22, 2006 (the “Closing Date”), the Series A Preferred Stock is redeemable at the option of either the holder or us during a 30 day period thereafter. The Series A Preferred Stock matures six years from the issuance and we will be required to redeem the Series A Preferred Stock at that time. In either of such cases, the redemption price would be the face amount plus an amount equal to declared but unpaid dividends. We completed an acquisition satisfying the criteria above with the acquisition of certain assets of the NetCache™ business from Network Appliance on September 11, 2006.

Liquidation preference.Upon liquidation, Series A Preferred Stock is paid out of our assets at an amount equal to the face amount plus an amount equal to declared but unpaid dividends before any distribution to any other class of stock that is junior in ranking.

Voting rights.Each holder of Series A Preferred Stock is entitled to the number of votes equal to the number of shares of Common Stock into which the shares of Series A Preferred Stock held by such holder could be converted as of the record date. The holders of shares of Series A Preferred Stock shall be entitled to vote on all matters on which the Common Stock shall be entitled to vote. In addition, until June 22, 2007, the holders of at least a majority of the then-outstanding Series A Preferred Stock, voting as a separate class, shall be entitled to elect one (1) director to the Board of Directors at each meeting or pursuant to each consent of our stockholders for the election of directors.

Dividends.The Series A Preferred Stock participates equally with the holders of Common Stock in all dividends paid on the Common Stock, when, as and if declared by the Board of Directors, out of funds legally available, as if such shares of Series A Preferred Stock had been converted to shares of Common Stock immediately prior to the record date for the payment of such dividend.No dividends have been declared to date.

Acquisition

On September 11, 2006, we completed the acquisition of certain assets of the NetCache™ business from Network Appliance pursuant to an asset purchase agreement executed on June 22, 2006. The final consideration for the transaction consisted of $23.9 million cash consideration, an aggregate of approximately 360,000 shares of our common stock valued at $5.7 million and $1.0 million in estimated direct transaction costs. Of the total purchase price, $0.7 million has been allocated to the intangible assets acquired with the balance of $29.9 million allocated to goodwill.

The NetCache business previously provided solutions to large enterprises to manage internet access and security and control Web content and application acceleration. NetCache was a business unit previously owned by Network Appliance, Inc. Our primary purpose for acquiring certain assets of the NetCache business was to increase our potential customer base through the conversion of existing NetCache customers to our proxy appliances. Only one employee joined us from Network Appliance as a result of the acquisition. Accordingly, our operating costs were not materially impacted. We do not expect to generate a significant amount of revenue from the sale of NetCache appliances.

Liquidity and Capital Resources

We believe the existing cash and cash equivalents, short-term investments and cash generated from operations, if any, will be sufficient to meet our operating requirements for at least the next 12 months, including working capital requirements and capital expenditures. We may choose at any time to raise additional capital to strengthen our financial condition, facilitate expansion and pursue strategic investments or to take advantage of business opportunities as they arise.

	As of January 31,
(In thousands)	2007			2006 (as restated) 1
Cash and cash equivalents	$	42,844		$	60,554
Short-term investment		41,748			10,080
Restricted investments		4,918			1,357
Subtotal		89,510			71,991
Total assets	$	235,535		$	130,855
Percentage of Total assets		38.0	%		55.0	%

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

	Nine Months Ended January 31,
(In thousands)	2007			2006 (as restated) 1
Cash provided by operating activities	$	17,688		$	21,125
Cash used in investing activities		(63,748	)		(15,001	)
Cash provided by financing activities		41,914			7,246
Net increase (decrease) in cash and cash equivalents	$	(4,146	)	$	13,370

(1) See Note 2, “Restatement of Condensed Consolidated Financial Statements,” of the Notes to Condensed Consolidated Financial Statements.

Since our inception, we have financed our operations and capital expenditures through cash provided by operating activities, private sales of preferred and common stock, bank loans, equipment leases, and an initial public offering of our common stock.

Net cash provided by operating activities was $17.7 million for the first nine months ended January 31, 2007 compared to $21.1 million in the comparable prior year period. The decrease in cash provided by operating activities was largely attributable to slower growth in the proxy appliance market, as well as an increase in operating expenses from 65.5% of net revenue in the first nine months of fiscal 2006 to 80.3% of net revenue in the first nine months of fiscal 2007.

Working capital sources of cash for the first nine months of fiscal 2007 mainly included increases in deferred revenue of $18.4 million, account payable of $3.2 million and other accrued liabilities of $0.8 million. Deferred revenue increased as a result of increased shipments of Blue Coat WebFilter as well as increased service revenue, both of which are recognized ratably over the service period. Accounts payable increased as a result of the significant growth in business volume. Other accrued liabilities increased as a result of substantially higher legal, accounting and other professional fees in connection with the investigation into our historical stock option granting practices.

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Working capital uses of cash for the first nine months of fiscal 2007 included increases in accounts receivable of $6.7 million and prepaid expenses and other current assets of $3.3 million. Accounts receivable increased as a result of higher net revenue during the first nine months of fiscal 2007, coupled with an increase in our days of sales outstanding from 47 days at January 31, 2006 to 57 days at January 31, 2007. Prepaid expenses and other current assets increased primarily due to prepaid royalties.

Net cash used in investing activities was $63.7 million for the first nine months of fiscal 2007, compared to $15.0 million used in the comparable prior year period. The increase in net cash used in investing activities for the first nine months of fiscal 2007 was primarily due to net purchase of investment securities of $35.1 million and cash consideration and direct costs related to the NetCache acquisition of $24.6 million. We also used cash of $4.2 million to purchase property and equipment, primarily consisting of purchases of computer equipment, software, furniture and leasehold improvements.

Net cash provided by financing activities was $41.9 million for the first nine months of fiscal 2007, compared to $7.2 million used in the comparable prior year period. The net cash provided by our financing activities for the first nine months of fiscal 2007 primarily related to the proceeds received from the sale of Series A Preferred Stock. The net cash provided by our financing activities for the first nine months of fiscal 2006 was primarily due to the issuance of common stock from the exercise of employee stock options.

Off-Balance Sheet Arrangements

At January 31, 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 or for other contractually narrow or limited purposes. Further, we have not guaranteed any obligations of unconsolidated entities, nor do we have any commitment or intent to provide additional funding to any such entities. As such, we are not materially exposed to any market, credit, liquidity or financing risk that could arise if we had engaged in such relationships.

We do not maintain any off-balance sheet transactions, arrangements, or obligations that are reasonably likely to have a material current or future effect on our financial condition, results of operations, liquidity, or capital resources.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are subject to certain market risks, including changes in exchange rates and interest rates. We do not undertake any specific actions to cover our exposures to exchange and interest rate risks, and we are not a party to any risk management transactions. We do not purchase or hold any derivative financial instruments for speculative or trading purposes.

Interest Rate Risk

We are subject to certain market risks, including changes in exchange rates and interest rates. We do not undertake any specific actions to cover our exposures to exchange and interest rate risks, and we are not a party to any risk management transactions. We also do not purchase or hold any derivative financial instruments for speculative or trading purposes.

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. At January 31, 2007, we had $84.6 million invested primarily in money market funds, commercial paper, corporate securities and government securities, which are included in cash, cash equivalents and short-term investments in our consolidated balance sheets. We maintain a strict investment policy, which is intended to ensure the safety and preservation of our invested funds by limiting default risk, market risk and reinvestment risk. The fair value of our investment portfolio would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the short-term nature of the majority of our investment portfolio.

Foreign Currency Exchange Rate Risk

We develop products in the United States (“U.S.”) and sell them throughout the world. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Because all of our sales are currently made in U.S. dollars, a strengthening of the dollar could make our products less price-competitive in foreign markets. If the events described above were to occur, our net revenue and earnings could be seriously impacted, since a significant portion of our net revenue and earnings is derived from international operations. Net revenue derived from customers outside of North America represented 54.5% and 52.2% of total net revenue for the three and nine months ended January 31, 2007, respectively. Net revenue derived from customers outside of North America represented 51.2% and 48.7% of total net revenue for the three and nine months ended January 31, 2006, respectively.

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In contrast, substantially all of the expenses of operating our foreign subsidiaries are incurred in foreign currencies. As a result, our U.S. dollar earnings and net cash flows from international operations may be affected by changes in foreign currency exchange rates. However, we do not consider the market risk associated with our international operations to be material. We do not currently use derivative financial instruments for hedging or speculative purposes.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified by the SEC. Disclosure controls and procedures include, without limitation, controls and procedures that are designed to ensure that such information is accumulated and communicated to our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate to allow timely decisions regarding required disclosure.

The evaluation of our disclosure controls included a review of their objectives and design, our implementation of the controls and the effect of the controls on the information generated for use in this Quarterly Report on Form 10-Q. In the course of the controls evaluation, we reviewed identified data errors or control problems and sought to confirm that appropriate corrective actions, including process improvements, were being undertaken. This type of evaluation is performed on a quarterly basis so that the conclusions of management, including the CEO and CFO, concerning the effectiveness of the disclosure controls can be reported in our periodic reports on Form 10-Q and Form 10-K. Many of the components of our disclosure controls are also evaluated on an ongoing basis by our internal finance organization. The overall goals of these various evaluation activities are to monitor our disclosure controls and to modify them as necessary. We intend to maintain the disclosure controls as dynamic systems that we adjust as circumstances merit.

Our management, under the supervision and with the participation of our CEO and CFO, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were not effective as of January 31, 2007, because of the material weakness in internal control over financial reporting described in Management’s Report on Internal Control Over Financial Reporting in Item 9A, “Controls and Procedures,” in our Annual Report on Form 10-K for the fiscal year ended April 30, 2006. In that section we described a material weakness in internal control over financial reporting with regard to our accounting for, and disclosure of, stock-based compensation and related payroll taxes. Specifically, we lacked adequate controls to ensure that all actions necessary for the grant of stock options had been completed as of the stated grant date. As discussed below, certain changes to our internal controls have been implemented as of the date of this filing. In addition, we have not granted stock options subsequent to July 13, 2006 pending the results of our investigation into historical stock option granting practices.

Changes in Internal Control Over Financial Reporting

Beginning in calendar year 2005, we implemented improvements to procedures, processes, and systems to provide additional safeguards and greater internal control over the stock option granting and administration function in compliance with the Sarbanes-Oxley Act of 2002 (“SOX”) and evolving accounting guidance. These improvements included:

• The implementation of a calendar system in February 2005 set forth in advance the dates on which we were to grant stock options. The calendar imposed a more standardized practice for the timing of the grant of stock options. However, the calendar served more as a guideline than an established procedure and did not adequately mitigate the material weakness discussed above; and

• Hiring additional personnel, segregating responsibilities, adding reviews and reconciliations, and redefining roles and responsibilities.

There were no changes in our internal control over financial reporting during the fiscal quarter ended January 31, 2007 in connection with the aforementioned evaluation that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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To remediate the material weakness identified by our management, we have made the following changes to our internal controls subsequent to January 31, 2007 and prior to the date of this filing:

• We have adopted a policy requiring all option grants, whether to board members, officers or employees, be made on a predetermined schedule. Specifically, grants to new employees or to recently promoted employees will be approved by the Compensation Committee or the Stock Option Committee, as applicable, after the employee’s first day of employment or the date of the employee’s promotion. Annual grants to existing employees will be approved by the Compensation Committee at a meeting scheduled prior to the beginning of a fiscal year for a specified date in that fiscal year. Option grants to new hires and existing employees will be effective on the “date of grant,” which will be the third Thursday of a calendar month following the date of approval. As a result, grants to new and promoted employees will be limited to one specific date each month.

• We have adopted a policy limiting the granting authority of the different groups that grant stock options. The Stock Option Committee’s authority is limited to the ability to make option grants that (i) are to individuals who are neither (a) executive officers of Blue Coat or members of our Board of Directors, nor (b) direct reports to a member of the Stock Option Committee, (ii) as to any individual grant, consist of 20,000 or fewer underlying shares, and (iii) have an exercise price equal to or not less than 100% of the fair market value of a share of Common Stock on the date of the grant. The policy further requires that any grants to individuals subject to Section 16 of the Securities Exchange Act of 1934, as amended, be made by the Compensation Committee after recommendation from the Board of Directors. The Compensation Committee of the Board of Directors has the authority to make all other grants permitted under our stock option plans.

• We have expanded the size of the Stock Option Committee from one to two directors. The Stock Option Committee previously consisted of our Chief Executive Officer, Brian NeSmith. In the future, the Stock Option Committee will consist of our Chief Executive Officer and an independent director.

• We have adopted a policy requiring that all option grants by the Compensation Committee be approved at a meeting of the Compensation Committee, and that the actions of such body be documented in minutes of the meeting. The policy prohibits the Compensation Committee from granting options by written consent. The policy allows the Stock Option Committee to document the grant of options by unanimous written consent, provided that the written consent is signed by both members of the Stock Option Committee on or prior to the effective date of the written consent.

Additionally, management is investing in ongoing efforts to continuously improve the control environment and has committed considerable resources to the continuous improvement of the design, implementation, documentation, testing and monitoring of our internal controls. Specifically, in addition to the controls identified above that have been implemented as of the date of this filing, we will be implementing the following measures for our fiscal year ending April 30, 2007:

• The Special Committee has recommended, and we are in the process of implementing, a series of improvements in our internal controls. We intend to revise documentation and to create appropriate controls for annual, new hire and promotion grant preparation, presentation for approval, entry into Equity Edge, and notification to employees. We have already adopted a specific internal control that all internal approvals of stock option grants must be obtained prior to presentation for any Stock Option Committee or Compensation Committee action. We plan to develop an annual plan or budget for issuance of options, together with guidelines for the number and types of awards that are offered to the different salary grades, which shall be reviewed and approved annually by the Compensation Committee after or in connection with the Board of Directors’ approval of the annual business plan.

• Under the direction of our Chief Executive Officer, we will establish cross-functional training for personnel in all areas associated with the stock option granting process. The training will cover (i) the stock option and other equity award programs and related improvements to equity compensation controls, processes and procedures, (ii) the accounting implications of equity award grants, and (iii) the legal and tax implications of equity award grants. We will also require all personnel responsible for stock option administration, including (i) the Chief Executive Officer and all direct reports, (ii) finance department members, (iii) legal department members, (iv) human resource department members, (v) stock administration department members, and (vi) all new employees involved in the above-listed functions or roles, be trained at least annually. Finally, we will be formalizing our procedures for the use of Equity Audit, a module that interfaces directly with Equity Edge and enables auditing functionality of our stock option database.

• We have established a search for an experienced General Counsel with particular strength in public company securities disclosure, financial reporting matters and corporate governance. When hired, the new General Counsel will report directly to our Chief Executive Officer.

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• We plan to expand the size of our Board of Directors, focusing in particular on the relative degree to which each candidate has the ability to devote substantial attention to Blue Coat matters, their expertise in areas that complement the strengths of other board members, and their experience with good corporate governance. Our Board of Directors has tasked our Nominating/Corporate Governance Committee with reviewing current committee assignments, with a goal of changing such assignments to the extent deemed appropriate to even out the demands placed upon the members of the board, utilizing the particular strengths of the individual board members, and ensuring that important matters are monitored sufficiently. Finally, we have established a Board of Directors’ policy that at least one member (on a rotating basis) of the Board of Directors should attend “directors’ college” or the equivalent each year. The Board of Directors has also approved resolutions stating that specialized update training by board members in matters of corporate governance, executive and incentive compensation, and financial reporting are highly encouraged.

Limitations on Effectiveness of Controls

Our management, including the CEO and the CFO, do not expect that our disclosure controls or our internal controls over financial reporting will prevent all errors and fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to errors or fraud may occur and not be detected.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

eSoft, Inc. V. Blue Coat Systems, Inc.

On March 13, 2006, eSoft, Inc. filed a complaint for patent infringement against us in the U.S. District Court for the District of Colorado. The complaint alleges infringement of eSoft’s U.S. Patent 6,961,773 (the “‘773 Patent”), and seeks unspecified monetary damages as well as an injunction against future infringements. eSoft’s amended complaint, filed on June 9, 2006, identified our ProxySG and ProxyAV products as the alleged infringing products. eSoft has subsequently alleged damages in the form of lost profits and/or a reasonable royalty for use of its patented technology.

We answered the amended complaint denying infringement and contending that eSoft’s patent was invalid. We recently filed several motions for summary judgment on these grounds. In addition, we have requested the United States Patent Office to initiate inter partes reexamination proceedings for the ‘773 Patent in light of a number of prior art references never considered by the patent examiner during the original prosecution of the patent application. The District Court has stayed the litigation pending the outcome of these proceedings.

On October 31, 2006, eSoft filed a complaint for declaratory relief seeking a determination that our U.S. Patent 7,103,794 was invalid and/or that eSoft’s products did not infringe same. We answered this complaint on November 22, 2006, and, in a counterclaim, asserted our ‘794 Patent against eSoft’s InstaGate and ThreatWall Security Gateways. This case is also pending in the U.S. District Court for the District of Colorado and likewise has been stayed pending the outcome of the reexamination of the ‘773 Patent.

IPO Allocation Litigation.

Beginning on May 16, 2001, a series of putative securities class actions were filed in the United States District Court for the Southern District of New York against the firms that underwrote our initial public offering, us, and some of our officers and directors. These cases have been consolidated under the case captionedIn re CacheFlow, Inc. Initial Public Offering Securities Litigation, Civil Action No. 1-01-CV-5143. This is one of a number of actions coordinated for pretrial purposes asIn re Initial Public Offering Securities Litigation, 21 MC 92 with the first action filed on January 12, 2001. Plaintiffs in the coordinated proceeding are bringing claims under the federal securities laws against numerous underwriters, companies, and individuals, alleging generally that defendant underwriters engaged in improper and undisclosed activities concerning the allocation of shares in the IPO’s of more than 300 companies during late 1998 through 2000. Among other things, the plaintiffs allege that the underwriters’ customers had to pay excessive brokerage commissions and purchase additional shares of stock in the aftermarket in order to receive favorable allocations of shares in an IPO.

The consolidated amended complaint in our case seeks unspecified damages on behalf of a purported class of purchasers of our common stock between December 9, 1999 and December 6, 2000. Pursuant to a tolling agreement, the individual defendants were dismissed without prejudice. On February 19, 2003, the court denied our motion to dismiss the claims against us. The litigation is now in discovery. In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us, was submitted to the court for approval. The terms of the settlement, if approved, would dismiss and release all claims against the participating defendants (including us). In exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the plaintiffs from the underwriter defendants of at least $1 billion, and the issuer defendants would agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. On August 31, 2005, the court confirmed preliminary approval of the settlement. On April 24, 2006, the court held a fairness hearing in connection with the motion for final approval of the settlement. The court has yet to issue a ruling on the motion for final approval. The settlement remains subject to a number of conditions, including final court approval. On December 5, 2006, the Court of Appeals for the Second Circuit reversed the court’s October 2004 order certifying a class in six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceeding. We are not one of the test cases and it is unclear what impact this will have on the class certified in our case.

Derivative Litigation.

On May 18, 2005, a purported shareholder derivative action was filed in the Superior Court of California, Santa Clara County, alleging that certain of our officers and directors violated their fiduciary duties to the Company by making false or misleading statements about our prospects between February 20, 2004 and May 27, 2004. On July 17, 2006, plaintiffs filed a consolidated amended complaint, adding allegations that certain current and former officers and directors violated their

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fiduciary duties to us since our initial public offering by granting and failing to account correctly for stock options. The amended complaint seeks various relief on our behalf from the individual defendants. On September 8, 2006, another and substantively identical purported shareholder derivative action was filed against certain of our current and former officers and directors. Both of these state derivative cases have been consolidated.

On August 8 and September 5, 2006, two purported shareholder derivative actions were filed in the United States District Court for the Northern District of California against certain of our current and former officers and directors. Like the state derivative actions, the federal derivative actions allege that certain of our current and former officers and directors violated their fiduciary duties since our initial public offering by granting and failing to account correctly for stock options and seek various relief on our behalf from the individual defendants. Both of these federal cases have been consolidated.

Regulatory Investigations.

In July 2006, we were advised that the SEC was conducting an informal inquiry into our historical stock option grants and accounting practices,In the Matter of Blue Coat Systems, Inc.,SF-3165. We are cooperating with the investigation. We are also voluntarily cooperating with requests for information from the U.S. Attorney’s Office for the Northern District of California.

In late 2005, the SEC informed us of its formal investigation into trading in certain securities,In the Matter of Trading in Certain Securities, H0-9818, including trading in our securities, prior to our public announcement on May 27, 2004 of our financial results for the fourth quarter and fiscal year 2004. The SEC also informed us that we are the subject of a formal order of private investigation,In the Matter of Blue Coat Systems, Inc., HO-10096, concerning whether certain present or former officers, directors, employees, affiliates or others made intentional or non-intentional selective disclosures of material nonpublic information in connection with our May 27, 2004 announcement, traded in our stock while in possession of such information, or communicated such information to others who thereafter traded in our stock. The SEC subpoenaed information from us and took testimony from certain current and former officers in the summer of 2005.

On February 27, 2006, the NASD informed us that it is reviewing trading in our common stock surrounding our February 6, 2006 announcement of net income and revenue for the third quarter of fiscal year 2006. We are cooperating with the investigation.

On March 9, 2006, the Chicago Board Options Exchange (“CBOE”) informed us that it is reviewing option activity surrounding our January 3, 2006 announcement that we will acquire Permeo Technologies, Inc. We are cooperating with the investigation.

On December 21, 2006, Blue Coat entered into an Assurance of Discontinuance (“AOD”) with the Attorney General of the State of New York, Internet Bureau (“OAG”), resolving an inquiry by the OAG into certain business practices of Blue Coat. Pursuant to the AOD, and without admitting the OAG’s findings or any violation of law, Blue Coat agreed that (1) for any Blue Coat product or service that will or may be distributed to a New York consumer or used in New York, Blue Coat will not include in its licensing agreement a “Restriction Clause” preventing the purchaser from publishing the results of any comparative test of Blue Coat’s products or services without Blue Coat’s express written consent; and (2) Blue Coat will not enforce, attempt to enforce or threaten to enforce any Restriction Clause contained in a previously distributed License Agreement against any New York party. In connection with the AOD, Blue Coat agreed to pay $30,000 to the OAG.

Dismissed Class Action Litigation.

Beginning on or about April 11, 2005, several putative class action lawsuits were filed in the United States District Court for the Northern District of California against us and certain of our officers on behalf of purchasers of our stock between February 20, 2004 and May 27, 2004 (the “Class Period”). The complaints alleged that during the Class Period defendants violated the federal securities laws by making false or misleading statements of material fact about our financial prospects. Specifically, the complaints alleged claims under Sections 10(b), 20(a) and 20A of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. All cases were consolidated asIn re Blue Coat Systems, Inc. Securities Litigation, No. C-05-1468 (N.D. Cal.). Following the appointment of a lead plaintiff and lead plaintiffs’ counsel, the lead plaintiff on October 7, 2005 filed a notice of voluntary dismissal without prejudice of the consolidated action. On October 18, 2005, the Court dismissed the case without prejudice.

Although we cannot predict whether the IPO allocation cases will settle as proposed, and cannot predict the outcome of the derivative litigation or the SEC and other regulatory investigations, the costs of defending these matters (including our obligations to indemnify current or former officers, directors, or employees) could have a material adverse effect on our results of operations and financial condition.

Periodically, we review the status of each significant matter and assess potential financial exposure. Because of the uncertainties related to the (i) determination of the probability of an unfavorable outcome and (ii) amount and range of loss in

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the event of an unfavorable outcome, we are unable to make a reasonable estimate of the liability that could result from any pending litigation described above and no accrual was recorded in our balance sheet as of April 30, 2006. As additional information becomes available, we will reassess the probability and potential liability related to pending litigation, which could materially impact our results of operations and financial condition.

From time to time and in the ordinary course of business, we may be subject to various other claims and litigation. Such claims could result in the expenditure of significant financial and other resources.

Item 1A. Risk Factors

FACTORS AFFECTING FUTURE OPERATING RESULTS

All statements included in this Quarterly Report on Form 10-Q (“Form 10-Q”), other than statements or characterizations of historical fact, are forward-looking statements. These forward-looking statements are based on our current expectations, estimates, approximations and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. We often use certain words and their derivatives such as “anticipate,” “expect,” “intend,” “plan,” “predict,” “believe,” “estimate,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” and similar expressions in our forward-looking statements. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the section entitled “Risk Factors” under Part II, Item 1A of this Form 10-Q. These forward-looking statements speak only as of the date of this Form 10-Q. We assume no obligation to revise or update any forward-looking statement for any reason, except as otherwise required by law.

Forward-looking statements are not the only statements you should regard with caution. The preparation of our condensed consolidated financial statements required us to make judgments with respect to the methodologies we selected to calculate the adjustments contained in the financial statements, as well as estimates and assumptions regarding the application of those methodologies. These judgments, estimates and assumptions, which are based on factors that we believe to be reasonable under the circumstances, affected, among other things, the amounts of additional deferred stock-based compensation and additional stock-based compensation expense that we recorded. The application of alternative methodologies, estimates and assumptions could have resulted in materially different amounts.

Our business, financial condition and results of operations could be seriously harmed by any of the following risks. In addition, the trading price of our common stock could decline due to any of the following risks.

The matters relating to the investigation by the Special Committee of the Board of Directors and the restatement of our consolidated financial statements may result in additional litigation and governmental enforcement actions.

On July 14, 2006, we announced that we were conducting a voluntary review of our historical practices in granting stock options and that our Board of Directors had appointed a special committee of independent directors (the “Special Committee”) to conduct this review. On September 11, 2006, we announced that we had determined that the actual measurement dates for financial accounting purposes of certain stock options granted primarily during fiscal years 2000-2004 differed from the recorded grant dates of such awards. Consequently, new measurement dates for financial accounting purposes would apply to the affected awards, which would result in additional and material non-cash stock-based compensation expense. We also announced that we would restate our financial statements beginning with the fiscal year ended April 30, 2000 through the interim period ended January 31, 2006. On December 12, 2006, the Special Committee presented the findings of its stock option investigation to our Board of Directors and proposed various remedial measures. The Board of Directors accepted all of the findings of the Special Committee and has adopted, or is in the process of adopting, all of the remedial measures proposed. As a result of the Special Committee’s investigation, as well as our internal review of our historical financial statements, we have recorded additional stock-based compensation expense for numerous stock option grants made from November 1999 through May 2006. We have restated our consolidated financial statements as of and for the years ended April 30, 2005, 2004, 2003, 2002, 2001 and 2000 to correctly account for stock option grants for which the Special Committee or management determined that the measurement date for accounting purposes was different from the stated grant date. For more information on these matters, see Part I Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Background of the Stock Option Investigation, Findings, Restatement of Condensed Consolidated Financial Statements, Remedial Measures and Related Proceedings,” Part 1, Item 1, Note 2 of the Notes to Condensed Consolidated Financial Statements, and Part I, Item 4, “Controls and Procedures.”

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The internal review, the independent investigation, and related activities have required us to incur substantial expenses for legal, accounting, tax and other professional services, and have diverted management’s attention from our business.

While we believe we have made appropriate judgments in determining the correct measurement dates for our stock option grants, the SEC may disagree with the manner in which we have accounted for and reported the financial impact. Accordingly, there is a risk we may have to further restate our prior financial statements, amend prior filings with the SEC, or take other actions not currently contemplated.

Our past stock option granting practices and the restatement of prior financial statements have exposed us to greater risks associated with litigation, regulatory proceedings and government enforcement actions. As described in Part II, Item 1, “Legal Proceedings,” several derivative complaints have been filed in state and federal courts against our directors and certain of our executive officers pertaining to allegations relating to stock option grants. We have provided the results of our internal review and independent investigation to the SEC, and in that regard we have responded to informal requests for documents and additional information. The Company is also voluntarily cooperating with requests for information from the U.S. Attorney’s Office for the Northern District of California. We intend to continue full cooperation with both the SEC and the U.S. Attorney’s Office. We may become the subject of, or otherwise required to incur legal fees and costs in connection with, additional private litigation, regulatory proceedings, or government enforcement actions. No assurance can be given regarding the outcomes from such activities. The resolution of these matters will be time consuming, expensive, and will distract management from the conduct of our business. Our available directors’ and officers’ liability insurance may not be sufficient to cover our legal expenses or those of persons we are obligated to indemnify. Furthermore, if we are subject to adverse findings in litigation, regulatory proceedings or government enforcement actions, we could be required to pay damages or penalties or have other remedies imposed, which could harm our business, financial condition, results of operations and cash flows. Furthermore, the restatements of our financial results, the derivative litigation, the ongoing SEC investigation and any negative outcome that may occur from the investigation, or the requests for information from the U.S. Attorney’s Office and any negative outcome that may occur from such requests, could impact our relationships with customers and our ability to generate revenue.

In July 2006, we failed to timely file our Form 10-K for the year ended April 30, 2006, and in September 2006, December 2006, and March 2007 we failed to timely file our Forms 10-Q for the quarters ended July 31, 2006, October 31, 2006 and January 31, 2007, respectively, all as a result of the ongoing Special Committee investigation. Nasdaq promptly notified us that these failures to file periodic reports caused us to violate the requirements for continued listing as set forth in Marketplace Rule 4310(c)(14). We requested a hearing before a Nasdaq Listing Qualifications Panel (the “Panel”) to petition for continued listing on the Nasdaq Stock Market. The hearing was held on September 14, 2006. On November 13, 2006, the Panel informed us that we would have until January 29, 2007 to file our Form 10-K for the year ended April 30, 2006, our Forms 10-Q for the quarters ended July 31, 2006 and October 31, 2006, and any required restatements. On January 18, 2007, we informed the Nasdaq Stock Market that we would not meet the January 29, 2007 deadline because we had determined to seek pre-clearance from the Office of the Chief Accountant (the “OCA”) of the Division of Corporate Finance, U.S. Securities and Exchange Commission, of our proposed accounting treatment and related disclosures. On January 24, 2007, the Panel denied our request for additional time to comply with our filing obligations and determined to delist our shares effective as of the open of business on Tuesday, January 30, 2007, as the Panel had no additional authority to extend the filing deadlines. We promptly appealed the Panel’s decision to the Nasdaq Listing and Hearing Review Council (the “Listing Council”), and on January 26, 2007, the Listing Council called for review the earlier decision of the Panel requiring us to file all required restatements and delinquent periodic reports by January 29, 2007, and stayed any suspension of trading of our securities pending further action by the Listing Council. We may submit additional information to the Listing Council by March 30, 2007. The Listing Council will then review the Panel’s decision on the written record. We have now filed our Form 10-K for the year ended April 30, 2006, our Forms 10-Q for the quarters ended July 31, 2006, October 31, 2006 and January 31, 2007, and what we believe to be all required restatements with the SEC. With these filings, we believe that we have remedied our non-compliance with Marketplace Rule 4310(c)(14), subject to Nasdaq’s affirmative completion of its compliance protocols and its notification to us accordingly. However, if the SEC disagrees with the manner in which we have accounted for and reported, or not reported, the financial impact of past stock option grants, there could be further delays in filing subsequent SEC reports that might result in the delisting of our common stock from the Nasdaq Stock Market.

Our ability to forecast our quarterly operating results is limited, and if our quarterly operating results are below the expectations of analysts or investors, the market price of our common stock will likely decline.

Our net sales and operating results are likely to continue to vary significantly from quarter to quarter. We believe that quarter-to-quarter comparisons of our operating results should not be relied upon as indicators of future performance. It is likely that in some future quarter or quarters, our operating results will be below the expectations of public market analysts or

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investors. If this occurs our stock price will likely decline, and may decline significantly. For example, in February 2006 we announced financial results for our third quarter ended January 31, 2006. The net revenue, net income and net income per diluted share reported were below our expectations, as well as below the expectations of public market analysts and investors, and below the guidance provided by us on November 15, 2005. As a result of these earnings announcements and guidance provided by us for our fourth quarter ending April 30, 2006, our stock price fell dramatically. A number of factors are likely to cause variations in our sales and operating results, including factors described elsewhere in this “Risk Factors” section.

We cannot reliably forecast our future quarterly sales for several reasons, including:

• Fluctuations in demand for our products and services;

• The market in which we compete is relatively new and rapidly evolving;

• Variability in the rate of growth, if any, of the proxy appliance market, which is difficult to predict;

• Our ability to continue to increase our market share, as our market share has increased;

• Our sales cycle varies substantially from customer to customer;

• Variations in the mix of products sold;

• The timing, size, and mix of orders from customers;

• Our sales cycle may lengthen as the complexity of proxy appliance solutions continues to increase;

• The level of competition in our target product markets;

• Market acceptance of new products and product enhancements;

• Announcements, introductions and transitions of new products or product enhancements by us or our competitors;

• Deferrals of customer orders in anticipation of new products or product enhancements introduced by us or our competitors;

• Technological changes in our target product markets;

• The percentage of our sales related to subscription-based products;

• Future accounting pronouncements and changes in accounting policies; and

• Our inability to predict future macro-economic conditions.

A high percentage of our expenses, including those related to manufacturing overhead, technical support, research and development, sales and marketing, general and administrative functions, amortization of intangible assets and amortization of deferred compensation, are essentially fixed in the short term. As a result, if our net sales are less than forecasted, our quarterly operating results are likely to be seriously harmed and our stock price would likely decline. For example, a substantial portion of our shortfall in net income and net income per diluted share in our third quarter ended January 31, 2006 was attributable to our shortfall in net revenue in that quarter.

If we fail to create additional sales through our sales channel partners, our business will be seriously harmed.

A significant amount of our revenue is generated through sales by our sales channel partners, which include distributors, resellers and system integrators. We increasingly depend upon these partners to generate sales opportunities and to independently manage the entire sales process. In order to increase our net revenue, we will need to maintain our existing sales channel partners and add new sales channel partners. If we cannot do so, our business will not grow and our operating results will be adversely affected.

We provide our sales channel partners with specific programs to assist them in selling our products, but there can be no assurance that these programs will be effective. In addition, our sales channel partners may be unsuccessful in marketing, selling and supporting our products and services. They may also market, sell and support products and services that are competitive with ours, or may devote more resources to the marketing, sales and support of products competitive to ours. They may cease selling our products and services altogether. We cannot assure you that we will retain these indirect channel partners or that we will be able to secure additional or replacement partners. The loss of one or more of our key indirect channel partners or the failure to obtain and ship a number of large orders each quarter through them could harm our operating results. Any new sales channel partner will require extensive training and typically take several months to achieve productivity. Many of our sales channel partners do not have minimum purchase or resale requirements and carry products that are competitive with our products. If we fail to manage existing sales channels, our business will be seriously harmed.

In addition, a limited number of sales channel partners have accounted for a large part of our net revenue to date. Since our expense levels are based on our expectations as to future revenue and to a large extent are fixed in the short term, if there

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is a significant reduction or delay in sales of our products to any significant indirect channel partner, individually or in the aggregate, or if any significant indirect sales channel partner fails to maintain its current levels of marketing, sales and support of our products and services, our operating results could be adversely affected. End users can stop purchasing and indirect channel partners can stop marketing our products at any time.

If we are unable to establish fair value for any undelivered element of a customer order, revenue relating to the entire order will be deferred until the revenue recognition criteria for all elements of the customer order are met. This could lower our net revenue in one period and increase it in future periods resulting in greater variability in net revenue and earnings period to period.

In the course of our selling efforts, we often enter into arrangements with our customers that require us to deliver a combination of different appliances, software products or services. We refer to each individual appliance, software product or service as an “element” of the overall arrangement with our customer. In some cases, these arrangements require us to deliver particular elements in a future period. We do not recognize revenue on any undelivered elements until we can determine the fair value for the undelivered elements or such elements have been delivered to our customer. In the event we are unable to determine the fair value of any undelivered elements, we defer the revenue from the entire arrangement rather than just the undelivered elements. As a result, a portion of the net revenue we recognize in each quarter could relate to previously delivered products. As such, an increase in the number of multiple element arrangements for which we cannot determine the fair value of any undelivered elements would negatively impact our net revenue in the current period, while increasing net revenue in future periods. In addition, we may be unable to timely adjust our cost structure to reflect this reduction in net revenue recognized in the current period, which would reduce our income for the current period. In addition, if sales related to multiple element arrangements for which we cannot determine the fair value of any undelivered elements increase significantly, sequential growth in our net revenue may decline since revenue associated with such arrangements will be recognized in future periods.

Because we depend on several third-party manufacturers to build our products, we are susceptible to manufacturing delays and sudden price increases, which could prevent us from shipping customer orders on time, if at all, and may result in the loss of sales and customers.

We currently purchase base assemblies or final assemblies for all of our current appliances. Our reliance on our third-party manufacturers reduces our control over the manufacturing process, exposing us to risks, including reduced control over quality assurance, product costs and product supply. Any manufacturing disruption by our third-party manufacturers could impair our ability to fulfill orders. We also rely on several other third-party manufacturers to build portions of our products. If we, or our suppliers, are unable to manage the relationships with these third-party manufacturers effectively, or if these third-party manufacturers experience delays, disruptions, capacity constraints or quality control problems in their manufacturing operations, or fail to meet our future requirements for timely delivery, our ability to ship products to our customers could be impaired and our business would be seriously harmed.

These manufacturers fulfill our supply requirements on the basis of individual purchase orders or agreements with us. Accordingly, these third-party manufacturers are not obligated to continue to fulfill our supply requirements, and the prices we are charged for these components could be increased on short notice. If there is any interruption in the operations of any one of these third-party manufacturers, or if we are required to change third-party manufacturers, this would adversely affect our ability to meet our scheduled product deliveries to our customers, which could cause the loss of existing or potential customers, or could increase our costs, which could adversely affect our gross margins.

In addition, the products that these third-party manufacturers build for us may not be sufficient in quality or in quantity to meet our needs. Our delivery requirements could be higher than the capacity of these third-party manufacturers, which would likely result in manufacturing delays, which could result in lost sales and the loss of existing and potential customers. We cannot be certain that these third-party manufacturers will be able to meet the technological or delivery requirements of our current products or any future products that we may develop and introduce. The inability of these third-party manufacturers in the future to provide us with adequate supplies of high-quality products, or the loss of any of our third-party manufacturers in the future would cause a delay in our ability to fulfill customer orders while we attempt to obtain a replacement manufacturer. Delays associated with our attempting to replace or our inability to replace one of our third-party manufacturers would seriously harm our business by increasing our costs and affecting our gross margins.

We have no long-term contracts or arrangements with any of our third-party manufacturers that guarantee product availability, the continuation of particular payment terms or the extension of credit limits. We have experienced in the past, and may experience in the future, problems with our third-party manufacturers, such as inferior quality, insufficient quantities and late delivery of product. To date, these problems have not materially adversely affected us. We may not be able to obtain additional volume purchase or manufacturing arrangements on terms that we consider acceptable, if at all. If we enter into a high-volume or long-term supply arrangement and subsequently decide that we cannot use the products or services provided for in the agreement, our business will be harmed. Any of these difficulties could harm our relationships with customers and cause us to lose orders.

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In the future, we may seek to use additional third-party manufacturers. We may experience difficulty in locating and qualifying suitable manufacturing candidates capable of satisfying our product specifications or quantity requirements.

Because some of the key components in our products come from limited sources of supply, we are susceptible to supply shortages or supply changes, which could disrupt or delay our scheduled product deliveries to our customers and may result in the loss of sales and customers.

We currently purchase several key parts and components used in the manufacture of our products from limited sources of supply. The introduction by these suppliers of new versions of their hardware, particularly if not anticipated by us, could require us to expend significant resources to incorporate this new hardware into our products. In addition, if these suppliers were to discontinue production of a necessary part or component, we would be required to expend significant resources in locating and integrating replacement parts or components from another vendor.

In addition, our reliance on a limited number of suppliers involves several risks, including:

• a potential inability to obtain an adequate supply of required parts or components;

• supplier capacity restraints;

• financial or other difficulties faced by our suppliers;

• price increases;

• timely delivery; and

• component quality.

Qualifying additional suppliers for limited source components can be time-consuming and expensive. Any of these events would be disruptive to us and could seriously harm our business. Any interruption or delay in the supply of any of these parts or components, or the inability to obtain these parts or components from alternate sources at acceptable prices and within a reasonable amount of time, would seriously harm our ability to meet our scheduled product deliveries to our customers.

We must maintain a competitive position in the proxy appliance market by developing and introducing new products while enhancing existing products to match the needs of our customers or we will lose market share and our operating results will be adversely affected.

To maintain our competitive position in a market characterized by rapid rates of technological advancement, we must continue to invest significant resources in research and development. We need to develop and introduce new products and enhancements to existing products on a timely basis that keep pace with technological developments and emerging industry standards and address the increasingly sophisticated needs of our customers. The introduction of new products by others, market acceptance of products based on new or alternative technologies, or the emergence of new industry standards, could render our existing products obsolete or make it easier for other products to compete with our products. Our future success will depend in part upon our ability to:

• develop and maintain competitive products;

• enhance our products by adding innovative features that differentiate our products from those of our competitors;

• bring products to market on a timely basis at competitive prices;

• identify and respond to emerging technological trends in the market; and

• respond effectively to new technological changes or new product announcements by others.

Primary competitive factors that have typically affected our market include product characteristics such as reliability, scalability and ease of use, as well as price and customer support. The intensity of competition is expected to increase in the future. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any one of which could seriously harm our business. We may not be able to compete successfully against current or future competitors and we cannot be certain that competitive pressures we face will not seriously harm our business.

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Our business will not grow unless we can continue to extend our product offerings through the introduction of new products and enhancements that accurately predict the needs of our target market.

We intend to extend the offerings under our product families in the future, both by introducing new products and by introducing enhancements to our existing products. However, we may experience difficulties in doing so, and our inability to timely and cost-effectively introduce new products and product enhancements, or the failure of these new products or enhancements to achieve market acceptance, could seriously harm our business. Further, the introduction of new products and product enhancements could result in the obsolescence of inventory which we have bought, or committed to buy, potentially requiring the recording of material charges, which would reduce net income. The process of developing new technologies is complex and uncertain, and if we fail to accurately predict our target customers’ changing needs and emerging technological trends, our business could be harmed. This process requires commitment of significant resources to develop new products before knowing whether our investments will result in products the market will accept. Furthermore, we may not be able to execute on new product initiatives because of errors in product planning or timing, technical hurdles that we fail to overcome in a timely fashion, or a lack of appropriate resources. This could result in competitors providing those solutions before we do and a decrease in our market share and net revenue.

In addition, life cycles of our products are difficult to predict because the market for our products is new and evolving and characterized by rapid technological change, frequent enhancements to existing products and new product introductions, changing customer needs and evolving industry standards. The emergence of new industry standards might require us to redesign our products. If our products are not in compliance with industry standards, our customers and potential customers will not purchase our products. There is no guarantee that we will accurately predict the direction in which the proxy appliance market will evolve. Failure on our part to anticipate the direction of the market and develop products that meet those emerging needs will significantly impair our business, financial condition and results of operations.

The market for proxy appliance solutions is relatively new, unknown and evolving, and subject to rapid technological changes. If this market does not develop as we anticipate, our sales may not grow and may decline. We need to continue to develop market awareness of our company and our products.

Sales of our products depend on increased demand for proxy appliances. The market for proxy appliances is a new and rapidly evolving market. If the market for proxy appliances fails to grow as we anticipate, or grows more slowly than we anticipate, our business will be seriously harmed. We see signs of slower growth in the proxy appliance market. In addition, we believe that any further gains in our market share in the proxy appliance market will be more difficult to achieve than earlier gains in market share, and will occur more slowly, if at all. In addition, our business will be harmed if the market for proxy appliances continues to be negatively impacted by uncertainty surrounding macroeconomic growth.

Market awareness of our products is essential to the growth and success of our company. One of our goals is to increasingly market and advertise our company and our products. If our advertising and marketing programs are not successful in creating market awareness of our company and products, our net revenue and results of operations could be substantially impacted.

Our sales may not grow because our proxy appliances only protect Web-based applications and content, and our target customers may not wish to purchase our network security device without protection for non-Web based applications and content. Any failure of this product to satisfy customer demands could harm our business.

Our proxy appliances are specially designed to secure only Web-based protocols, such as http, https, ftp and streaming. While we believe that the majority of traffic traveling over the networks of our target customers is Web-based, a significant amount of our target customers’ network traffic may not be Web-based. Our products do not protect non-Web protocols. If our target customers do not wish to purchase a security device that only handles network traffic that is Web protocol-based, our target customers may not purchase our products and our growth could be limited. We may not be successful in achieving market acceptance of any new products that we develop if they do not contain non-Web based applications and content.

Some of our competitors have greater financial, technical, sales, marketing and other resources than we do. In addition, acquisitions of or other strategic transactions by our competitors could weaken our competitive position or reduce our revenue.

The market for proxy appliances is intensely competitive, evolving and subject to rapid technological change. The intensity of this competition is expected to increase in the future. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any one of which could seriously harm our business. We may not be able to compete successfully against current or future competitors and we cannot be certain that competitive pressures we face will not seriously harm our business. Our competitors vary in size and in the scope and breadth of the products and services they offer. We encounter competition from a variety of companies, including Cisco Systems, Network Appliance (prior to our

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acquisition of certain assets of their NetCache™ business in September 2006), Microsoft, and various others. In addition, we expect additional competition from other established and emerging companies as the market for proxy appliances continues to develop and expand. Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed base of customers than we do. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our industry. As a result, our competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, marketing, promotion and sale of their products than we can. The products of our competitors may have features and functionality that our products do not have. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the market acceptance of their products. In addition, our competitors may be able to replicate our products, make more attractive offers to existing and potential employees and strategic partners, develop new products or enhance existing products and services more quickly, or bundle proxy appliances in a manner that we cannot provide. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We also expect that competition will increase as a result of industry consolidation.

We have been informed of SEC and other investigations, which could result in substantial costs and divert management attention and resources.

In July 2006, we were advised that the SEC was conducting an informal inquiry into our historical stock option grants and accounting practices,In the Matter of Blue Coat Systems, Inc.,SF-3165. We are cooperating with the investigation. We are also voluntarily cooperating with requests for information from the U.S. Attorney’s Office for the Northern District of California.

In late 2005, the SEC informed us of its formal investigation into trading in certain securities,In the Matter of Trading in Certain Securities, H0-9818, including trading in our securities, prior to our public announcement on May 27, 2004 of our financial results for the fourth quarter and fiscal year 2004. The SEC also informed us that we are the subject of a formal order of private investigation,In the Matter of Blue Coat Systems, Inc., HO-10096, concerning whether certain present or former officers, directors, employees, affiliates or others made intentional or non-intentional selective disclosures of material nonpublic information in connection with our May 27, 2004 announcement, traded in our stock while in possession of such information, or communicated such information to others who thereafter traded in our stock. The SEC subpoenaed information from us and took testimony from certain current and former officers in the summer of 2005.

On February 27, 2006, the NASD informed us that it is reviewing trading in our common stock surrounding our February 6, 2006 announcement of net income and revenue for the third quarter of fiscal year 2006. We are cooperating with the investigation.

On March 9, 2006, the Chicago Board Options Exchange (“CBOE”) informed us that it is reviewing option activity surrounding our January 3, 2006 announcement that we would acquire Permeo Technologies, Inc. We are cooperating with the investigation.

An unfavorable outcome in, or resolution of, any of these matters may be costly, and result in damage to our reputation among our customers and investors, cause a drop in the price of our common stock, or both.

Our gross margin percentage may be below our expectations or the expectations of investors and analysts due to a variety of factors, which would adversely affect our operating results and could result in a decline in the market price of our common stock.

Our gross margin percentage has been and will continue to be affected by a variety of factors, including:

• market acceptance of our products and fluctuations in demand;

• the timing and size of customer orders and product implementations;

• the mix of direct and indirect sales;

• the mix and average selling prices of products;

• new product introductions and enhancements;

• manufacturing and component costs;

• availability of sufficient inventory to meet demand;

• purchase of inventory in excess of demand

• increased price competition and pressures and changes in product pricing;

• actions taken by our competitors;

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• how well we execute on our strategy and operating plans; and

• revenue recognition rules.

For example, we have in the past entered into large revenue transactions with certain customers that, because of the product mix and volume discount, have decreased our total gross margin percentage. We may, in the future, enter into similar transactions. Our lower end appliances have poorer margins than our higher end appliances, and if our customers submit a large order or orders for our lower end appliances, the combination of smaller margins and volume discount provided to those customers would result in a negative impact to our gross margin percentage.

Factors that could cause demand to be different from our expectations can include changes in customer order patterns, including order cancellations, and changes in business and economic conditions. Even if we achieve our revenue and operating expense objectives, if our gross margins are below expectations we may fail to meet our net income objectives and our operating results may be below our expectations and the expectations of investors and analysts, which might cause our stock price to decline.

We have a history of losses and profitability could be difficult to sustain.

While we have been profitable in certain quarters, we have not been able to maintain profitability on a quarterly basis. Furthermore, our level of profitability (loss) has fluctuated from quarter to quarter, such that we have not been able to demonstrate consistency in our financial results. We may not be profitable on a quarterly or annual basis in the future. Our ability to achieve, sustain or increase profitability on a quarterly or annual basis will be affected by changes in our business and the demand for our products and services. We expect our operating expenses to increase as our business grows, and we anticipate that we will make investments in our business. As a result, our results of operations will be harmed if our sales do not increase at a rate commensurate with the rate of increase in our expenses. If our sales are less than anticipated or if operating expenditures exceed our expectations or cannot be adjusted accordingly, we may experience losses on a quarterly and annual basis.

We rely on technology that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions.

We rely on technology that we license from third parties, including software that is used in our products to perform key functions. If we are unable to continue to license any of this software on commercially reasonable terms, we will face delays in releases of our software or we will be required to drop this functionality from our software until equivalent technology can be identified, licensed or developed, and integrated into our current product. In addition, the inability to obtain certain licenses or other rights might require us to engage in litigation regarding these matters, which could have a material adverse effect on our financial condition. Any of these delays could seriously harm our business.

We may not be able to continue to generate a significant level of sales from the international markets in which we currently operate.

We expect international customers to continue to account for a significant percentage of net sales in the future, but we may fail to maintain or increase international market demand for our products. Also, because our international sales are currently denominated in United States dollars, an increase in the value of the United States dollar relative to foreign currencies could make our products more expensive and, therefore, potentially less competitive in international markets, and this would decrease our international sales. Our ability to generate international sales depends on our ability to maintain our international operations (including efficient use of existing resources and effective channel management), and to recruit additional international resellers.

Our international operations are subject to certain inherent risks including:

• technical difficulties and costs associated with product localization;

• challenges associated with coordinating product development efforts among geographically dispersed areas;

• potential loss of proprietary information due to piracy, misappropriation, or laws that may be less protective of our intellectual property rights;

• lack of experience in certain geographic markets;

• longer payment cycles for sales in certain foreign countries;

• seasonal reductions in business activity in the summer months in Europe and certain other countries;

• the significant presence of some of our competitors in some international markets;

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• potentially adverse tax consequences;

• import and export restrictions and tariffs;

• foreign laws and other government controls, such as trade and employment restrictions;

• management, staffing, legal and other costs of operating an enterprise spread over various countries;

• political instability in the countries where we are doing business; and

• fears concerning travel or health risks that may adversely affect our ability to sell our products and services in any country in which the business sales culture encourages face-to-face interactions.

To the extent we are unable to manage these risks effectively, our growth, if any, in international sales will be limited and our business could be seriously harmed.

Unpredictable macroeconomic conditions could adversely impact our existing and potential customers’ ability and willingness to purchase our products, which would cause a decline in our sales.

There is uncertainty relating to the prospects for near-term U.S. economic growth and growth within the international markets. This uncertainty has in the past and may in the future contribute to delays in decision-making by our existing and potential customers and a resulting decline in our sales. Continued uncertainty or a decrease in corporate spending could result in a decline to our sales and our operating results could be below our expectations and the expectations of public market analysts and investors.

Our variable sales cycle makes it difficult to predict the timing of a sale or whether a sale will be made, which makes our quarterly operating results less predictable.

Because customers have differing views on the strategic importance of implementing proxy appliances, the time required to educate customers and sell our products can vary widely. As a result, the evaluation, testing, implementation and acceptance procedures undertaken by customers can vary, resulting in a variable sales cycle, which typically ranges from one to nine months. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing expenses and expend significant management efforts. In addition, purchases of our products are frequently subject to unplanned processing and other delays, particularly with respect to larger customers for whom our products represent a very small percentage of their overall purchase activity. Large customers typically require approvals at a number of management levels within their organizations, and, therefore, frequently have longer sales cycles. Since one of our strategies is to focus on mid-to-large size enterprises, we may experience a lengthening of our sales cycle. In addition, as we compete for larger orders, competition is likely to increase causing customers to extend their decision making process. As a result of these factors, it is difficult to predict the timing of a sale or whether a sale will be made, which makes our quarterly operating results less predictable. For example, we anticipated closing several large orders toward the end of our third quarter ended January 31, 2006. We learned very late in the third quarter that these deals would not close in the quarter. Based in part on these deals not closing as anticipated, our net revenue, net income and net income per diluted share for our third quarter was below our expectations. It is difficult to determine the timing of closing of any particular transactions, which makes predicting our quarterly operating results very difficult.

We are subject to evolving and expensive corporate governance regulations and requirements. Our failure to adequately adhere to these requirements or the failure or circumvention of our controls and procedures could seriously harm our business.

Because we are a publicly-traded company, we are subject to certain federal, state and other rules and regulations, including rules and regulations recently adopted in response to laws adopted by Congress, such as the Sarbanes-Oxley Act of 2002. Compliance with these evolving regulations is costly and requires significant management time and attention, particularly with regard to our disclosure controls and procedures and our internal control over financial reporting.

We had a material weakness in internal control over financial reporting and cannot assure you that additional material weaknesses will not be identified in the future. If our internal control over financial reporting or disclosure controls and procedures are not effective, there may be errors in our financial statements that could require a restatement or our filings may not be timely and investors may lose confidence in our reported financial information, which could lead to a decline in our stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal control over financial reporting as of the end of each year, and to include a management report assessing the effectiveness of our internal control over financial reporting in each Annual Report on Form 10-K. Section 404 also requires our independent registered public accounting firm to attest to, and report on, management’s assessment of our internal control over financial reporting.

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In assessing the results of the Special Committee’s investigation and findings, as well as the internal review and recertification procedures performed for purposes of the preparation and certification of the restated consolidated financial statements, our management concluded that as of April 30, 2006 there was a material weakness in our internal control over financial reporting with regard to our accounting for, and disclosure of, stock-based compensation and related payroll taxes. A description of the material weakness related to our inadequate controls over the accounting for, and disclosure of, stock-based compensation and related payroll taxes is set forth in Part II, Item 9A “Controls and Procedures” of our Annual Report on Form 10-K for the fiscal year ended April 30, 2006. Our management also evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered under this Quarterly Report on Form 10-Q and concluded that our disclosure controls and procedures were not effective as of that date, because of the material weakness in our internal control over financial reporting.

We have adopted, or are in the process of adopting, various remedial measures that are designed to improve our internal controls over the accounting for and disclosure of stock-based compensation. We cannot assure you, however, that these remedial measures will be effective. We also cannot assure you that significant deficiencies or material weaknesses in our internal control over financial reporting will not exist in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, or result in material misstatements in our financial statements. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding disclosure controls and the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder. The existence of a material weakness could result in errors in our financial statements that could result in a restatement of financial statements, cause us to fail to timely meet our reporting obligations and cause investors to lose confidence in our reported financial information, leading to a decline in our stock price.

Undetected product errors, or failures found in new products may result in a loss of or delay in market acceptance of our products, which could cause us to incur significant costs and reduce our sales.

Our products may contain undetected operating errors when first introduced or as new versions are released. Despite testing by us and by current and potential customers, errors may not be found in new products or new versions until after commencement of commercial shipments, resulting in loss of or delay in market acceptance, which could materially adversely affect our operating results. These errors may cause us to incur significant warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems. In addition, all of our products operate on our internally developed operating system. As a result, any error in the operating system will affect all of our products. We have experienced minor errors in the past in connection with new products. We expect that errors will be found from time to time in new or enhanced products after commencement of commercial shipments, which could seriously harm our business.

We develop products in the United States and sell them throughout the world. As a result, changes in foreign currency exchange rates and/or weak economic conditions in foreign markets could negatively impact our financial results.

Because we develop products in the United States and sell them throughout the world, our financial results could be negatively affected by factors such as changes in foreign currency exchange rates and weak economic conditions in foreign markets. All of our sales are currently made in United States dollars and a strengthening of the dollar could make our products less competitive in foreign countries. Should the U.S. dollar’s strength increase in foreign markets, and/or weak economic conditions prevail in these markets, our net sales could be seriously impacted, since a significant portion of our nets sales are derived from international operations.

All of our foreign subsidiaries operating expenses are incurred in foreign currencies. As a result, should the dollar strengthen our foreign operating expenses would decrease and should the dollar weaken our foreign operating expenses would increase. Should foreign currency exchange rates fluctuate, our earnings and net cash flows from international operations may be adversely affected.

We are dependent upon key personnel and we must attract, assimilate and retain other highly qualified personnel or our ability to execute our business strategy and generate sales could be harmed.

Our business could be seriously disrupted if we do not maintain the continued service of our senior management, research and development and sales personnel. We have experienced and may continue to experience transition in our management team. The majority of our employees are employed on an “at-will” basis. Our ability to conduct our business also depends on our continuing ability to attract, hire, train and retain a number of highly skilled managerial, technical, sales, marketing and customer support personnel. New hires frequently require extensive training before they achieve desired levels of productivity, so a high employee turnover rate could seriously impair our ability to operate and manage our business.

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We are the target of a Class Action Lawsuit and Derivative Litigation and regulatory proceedings, which could result in substantial costs, divert management attention and resources, and have a material adverse effect on our results of operations or financial condition.

IPO Allocation Litigation. Beginning on May 16, 2001, a series of putative securities class actions were filed in the United States District Court for the Southern District of New York against the firms that underwrote our initial public offering, us, and some of our officers and directors. These cases have been consolidated under the case captionedIn re CacheFlow, Inc. Initial Public Offering Securities Litigation, Civil Action No. 1-01-CV-5143. This is one of a number of actions coordinated for pretrial purposes asIn re Initial Public Offering Securities Litigation, 21 MC 92 with the first action filed on January 12, 2001. Plaintiffs in the coordinated proceeding are bringing claims under the federal securities laws against numerous underwriters, companies, and individuals, alleging generally that defendant underwriters engaged in improper and undisclosed activities concerning the allocation of shares in the IPO’s of more than 300 companies during late 1998 through 2000. Among other things, the plaintiffs allege that the underwriters’ customers had to pay excessive brokerage commissions and purchase additional shares of stock in the aftermarket in order to receive favorable allocations of shares in an IPO.

The consolidated amended complaint in our case seeks unspecified damages on behalf of a purported class of purchasers of our common stock between December 9, 1999 and December 6, 2000. Pursuant to a tolling agreement, the individual defendants were dismissed without prejudice. On February 19, 2003, the court denied our motion to dismiss the claims against us. The litigation is now in discovery.

In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us, was submitted to the court for approval. The terms of the settlement, if approved, would dismiss and release all claims against the participating defendants (including us). In exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the plaintiffs from the underwriter defendants of at least $1 billion, and the issuer defendants would agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. On August 31, 2005, the court confirmed preliminary approval of the settlement. On April 24, 2006, the court held a fairness hearing in connection with the motion for final approval of the settlement. The court has yet to issue a ruling on the motion for final approval. The settlement remains subject to a number of conditions, including final court approval. On December 5, 2006, the Court of Appeals for the Second Circuit reversed the court’s October 2004 order certifying a class in six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceeding. We are not one of the test cases and it is unclear what impact this will have on the class certified in our case.

Dismissed Class Action. Beginning on or about April 11, 2005, several putative class action lawsuits were filed in the United States District Court for the Northern District of California against us and certain of our officers on behalf of purchasers of our stock between February 20, 2004 and May 27, 2004 (the “Class Period”). The complaints alleged that during the Class Period defendants violated the federal securities laws by making false or misleading statements of material fact about our financial prospects. Specifically, the complaints alleged claims under Sections 10(b), 20(a) and 20A of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. All cases were consolidated asIn re Blue Coat Systems, Inc. Securities Litigation, No. C-05-1468 (N.D. Cal.). Following the appointment of a lead plaintiff and lead plaintiffs’ counsel, the lead plaintiff on October 7, 2005 filed a notice of voluntary dismissal without prejudice of the consolidated action. On October 18, 2005, the Court dismissed the case without prejudice.

Derivative Lawsuits. On May 18, 2005, a purported shareholder derivative action was filed in the Superior Court of California, Santa Clara County, alleging that certain of our officers and directors violated their fiduciary duties to us by making false or misleading statements about our prospects between February 20, 2004 and May 27, 2004. On July 17, 2006, plaintiffs filed a consolidated amended complaint, adding allegations that certain current and former officers and directors violated their fiduciary duties to us since our initial public offering by granting and failing to account correctly for stock options. The amended complaint seeks various relief on our behalf from the individual defendants. On September 8, 2006, another and substantively identical purported shareholder derivative action was filed against certain of our current and former officers and directors. Both of these state derivative cases have been consolidated.

On August 8 and September 5, 2006, two purported shareholder derivative actions were filed in the United States District Court for the Northern District of California against certain of our current and former officers and directors. Like the state derivative actions, the federal derivative actions allege that certain of our current and former officers and directors violated their fiduciary duties since our initial public offering by granting and failing to account correctly for stock options and seek various relief on our behalf from the individual defendants. Both of these federal cases have been consolidated.

Regulatory Proceedings. In July 2006, we were advised that the SEC was conducting an informal inquiry into our historical stock option grants and accounting practices,In the Matter of Blue Coat Systems, Inc.,SF-3165. We are cooperating with the investigation. We are also voluntarily cooperating with requests for information from the U.S. Attorney’s Office for the Northern District of California.

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In late 2005, the SEC informed us of its formal investigation into trading in certain securities,In the Matter of Trading in Certain Securities, H0-9818, including trading in our securities, prior to our public announcement on May 27, 2004 of our financial results for the fourth quarter and fiscal year 2004. The SEC also informed us that we are the subject of a formal order of private investigation,In the Matter of Blue Coat Systems, Inc., HO-10096, concerning whether certain present or former officers, directors, employees, affiliates or others made intentional or non-intentional selective disclosures of material nonpublic information in connection with our May 27, 2004 announcement, traded in our stock while in possession of such information, or communicated such information to others who thereafter traded in our stock. The SEC subpoenaed information from us and took testimony from certain current and former officers in the summer of 2005.

On February 27, 2006, the NASD informed us that it is reviewing trading in our common stock surrounding our February 6, 2006 announcement of net income and revenue for the third quarter of fiscal year 2006. We are cooperating with the investigation.

On March 9, 2006, the Chicago Board Options Exchange (“CBOE”) informed us that it is reviewing option activity surrounding our January 3, 2006 announcement that we will acquire Permeo Technologies, Inc. We are cooperating with the investigation.

Although we cannot predict whether the IPO allocation cases will settle as proposed, and cannot predict the outcome of the derivative litigation or the SEC and other regulatory investigations, the costs of defending these matters (including our obligations to indemnify current or former officers, directors, or employees), an adverse result, or the diversion of management’s attention and resources could have a material adverse effect on our results of operations and financial condition.

In addition, from time to time and in the ordinary course of business, we may be subject to various other claims and litigation. Such claims could result in the expenditure of significant financial and other resources.

If the protection of our proprietary technology is inadequate, our competitors may gain access to our technology, and our market share could decline.

We depend significantly on our ability to develop and maintain the proprietary aspects of our technology. To protect our proprietary technology, we rely primarily on a combination of contractual provisions, confidentiality procedures, trade secrets, copyright and trademark laws and patents. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Our means of protecting our proprietary rights may not be adequate and our competitors may independently develop similar technology, duplicate our products or design around patents that may be issued to us or our other intellectual property.

We presently have several issued patents and pending United States patent applications. We cannot assure that any U.S. patent will be issued from these applications. Even with issued patents, we cannot assure that we will be able to detect any infringement or, if infringement is detected, that patents issued will be enforceable or that any damages awarded to us will be sufficient to adequately compensate us.

We currently operate in foreign locations and may increase the amount of research and development that is done internationally. The laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Should we be unable to defend our existing or developed intellectual property, or should the existing laws protecting intellectual property and its development deteriorate, our business and our results of operations would be adversely affected.

There can be no assurance or guarantee that any products, services or technologies that we are presently developing, or will develop in the future, will result in intellectual property that is protectable under law, whether in the United States or a foreign jurisdiction, that this intellectual property will produce competitive advantage for us or that the intellectual property of competitors will not restrict our freedom to operate, or put us at a competitive disadvantage.

There has been a substantial amount of litigation in the technology industry regarding intellectual property rights. In November 2003, we entered into a legal settlement with Network Caching Technology L.L.C., which had alleged, among other things, that we infringed certain of their patent rights. On March 13, 2006, eSoft, Inc. (“eSoft”) filed a complaint for patent infringement against us in the U.S. District Court for the District of Colorado. The complaint alleges infringement of eSoft’s U.S. Patent 6,961,773, (the “‘773 Patent”) and seeks unspecified monetary damages, as well as an injunction against future infringements. eSoft’s amended complaint, filed on June 9, 2006, identified our ProxySG and ProxyAV products as the alleged infringing products. eSoft has subsequently alleged damages in the form of lost profits and/or a reasonable royalty for use of its patented technology.

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We answered the amended complaint denying infringement and contending that eSoft’s patent was invalid. We recently filed several motions for summary judgment on these grounds. Discovery is progressing and we intend to contest the case vigorously. As part of our defense, we have requested the United States Patent Office to initiate inter partes reexamination proceedings for the ‘773 Patent in light of a number of prior art references never considered by the patent examiner during the original prosecution of the patent application. The District Court has stayed the litigation pending the outcome of these proceedings.

On October 31, 2006, eSoft filed a complaint for declaratory relief seeking a determination that our U.S. Patent 7,103,794 was invalid and/or that eSoft’s products did not infringe same. We answered this complaint on November 22, 2006, and, in a counterclaim, asserted our ‘794 Patent against eSoft’s InstaGate and ThreatWall Security Gateways. This case is also pending in the U.S. District Court for the District of Colorado and likewise has been stayed pending the outcome of the reexamination of the ‘773 Patent. We expect that companies in the Internet and networking industries will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any claims, including the eSoft claim, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could seriously harm our business.

If we are unable to raise additional capital, our business could be harmed.

As of January 31, 2007, we had $84.6 million in cash, cash equivalents and short-term investments. We believe that these amounts will enable us to meet our capital requirements for at least the next 12 months. However, if cash is used for unanticipated needs, we may need additional capital during that period. The development and marketing of new products will require a significant commitment of resources. In addition, if the market for proxy appliances develops at a slower pace than anticipated or if we fail to establish significant market share and achieve a meaningful level of sales, we could be required to raise substantial additional capital. We cannot be certain that additional capital will be available to us on favorable terms, or at all. If we were unable to raise additional capital when we require it, our business would be seriously harmed.

The legal environment in which we operate is uncertain and claims against us could cause our business to suffer.

Our products operate in part by storing material available on the Internet and making this material available to end users from our appliance. This creates the potential for claims to be made against us, either directly or through contractual indemnification provisions with customers, for defamation, negligence, copyright or trademark infringement, personal injury, invasion of privacy or other legal theories based on the nature, content or copying of these materials. As of January 31, 2007, we have not accrued any liabilities relating to indemnification provisions with our customers. It is also possible that if any information provided through any of our products contains errors, third parties could make claims against us for losses incurred in reliance on this information. Our insurance may not cover potential claims of this type or be adequate to protect us from all liability that may be imposed.

Potential new accounting pronouncements may impact our future financial condition or results of operations.

Future changes in financial accounting standards, including new changes in accounting for employee stock-based awards, may cause adverse, unexpected fluctuations in the timing of the recognition of net revenue or expenses and may affect our financial condition or results of operations. New pronouncements and varying interpretations of pronouncements have occurred and expected to continue to occur frequently, and we may make changes in our accounting policies in the future. As a result, we intend to invest significant resources to comply with evolving standards, and this investment may result in increased general and administrative expenses.

In particular, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No.123(R), which requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in our consolidated statements of income. The accounting provisions of SFAS No.123(R) are effective for annual periods beginning after June 15, 2005. We adopted SFAS No.123(R) in our first quarter of fiscal year 2007. The adoption of the SFAS No.123(R) fair value method will have a significant adverse impact on our reported results of operations, currently estimated at approximately $2.5 million to $3.5 million per quarter, although it will have no impact on our overall financial condition.

We may make acquisitions in the future, which could affect our operations.

We may make acquisitions in the future. Acquisitions of companies, products or technologies entail numerous risks, including:

• our inability to successfully integrate the operations, technologies, products and personnel of the acquired companies;

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• diversion of management’s attention from normal daily operations of the business;

• loss of key employees of acquired companies; and

• substantial transaction costs.

We completed the acquisition of Permeo Technologies, Inc. (“Permeo”), on March 3, 2006. On September 11, 2006, we completed the acquisition of certain assets of the NetCache™ business from Network Appliance, pursuant to an asset purchase agreement executed on June 22, 2006. Our acquisitions of Permeo and of certain assets from Network Appliance may or may not be successful and are subject to all of the risks described above.

Acquisitions may also cause us to:

• issue equity securities that would dilute our current stockholders’ percentage ownership;

• assume certain liabilities;

• incur additional debt;

• make large and immediate one-time write-offs and restructuring and other related expenses;

• become subject to intellectual property or other litigation; and

• create goodwill or other intangible assets that could result in significant amortization expense.

Any of these problems or factors could seriously harm our business. We issued a combination of stock and cash in the Permeo and NetCache transactions, and in the private placement of preferred stock from which we funded a portion of the NetCache transaction. The issuance of stock in these transactions diluted our existing stockholders. We also used $14.9 million and $23.9 in cash as consideration in the Permeo and NetCache transactions, respectively.

We could be subject to product liability claims, which are time-consuming and costly to defend.

Our customers install our proxy appliance products directly into their network infrastructures. Any errors, defects or other performance problems with our products could negatively impact the networks of our customers or other Internet users, resulting in financial or other damages to these groups. These groups may then seek damages from us for their losses. If a claim were brought against us, we may not have sufficient protection from statutory limitations or license or contract terms with our customers, and any unfavorable judicial decisions could seriously harm our business. A product liability claim brought against us, even if not successful, would likely be time-consuming and costly. A product liability claim could also seriously harm our business reputation.

Our operations could be significantly hindered by the occurrence of a natural disaster, terrorist attack or other catastrophic event.

Our operations are susceptible to outages due to fire, floods, power loss, telecommunications failures, terrorist attacks and other events beyond our control. In addition, a substantial portion of our facilities, including our headquarters, are located in Northern California, an area susceptible to earthquakes. We do not carry earthquake insurance for earthquake-related losses. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any of these events. Any such event could have a material adverse effect on our business, operating results and financial condition.

Our stock price is volatile and, as a result, you may have difficulty evaluating the value of our stock, and the market price of our stock may decline.

Since our initial public offering, the market price of our common stock has fluctuated significantly. The market price of our common stock may fluctuate significantly in response to the following factors, among others:

• variations in our quarterly operating results;

• changes in financial estimates or investment recommendations by securities analysts;

• changes in macro-economic conditions;

• the introduction of new products by our competitors;

• our ability to keep pace with changing technological requirements;

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• changes in market valuations of Internet-related and networking companies;

• announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments;

• loss of a major customer;

• additions or departures of key personnel;

• fluctuations in stock market volumes;

• speculation in the press or investment communication about our strategic position, financial condition, results of operations, business; and

• significant transactions.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults upon Senior Securities

None

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

None

Item 5. Other Information

None

Item 6. Exhibits

Number	Description
2.1	Agreement and Plan of Merger and Reorganization, dated as of October 28, 2003, by and among Blue Coat Systems, Inc., Riga Corp., Ositis Software, Inc., Vilis Ositis and Liana Abele (which is incorporated herein by reference to Exhibit 2.1 of Form 8-K filed by the Registrant with the Commission on November 28, 2003)
2.2	Agreement and Plan of Merger and Reorganization, dated as of July 16, 2004, by and among Blue Coat Systems, Inc., Utah Merger Corporation, Cerberian, Inc., and Scott Petty, as Stockholders’ Representative (which is incorporated herein by reference to Exhibit 2.1 of Form 8-K filed by the Registrant with the Commission on November 23, 2004)
2.3	Amendment Number 1 to Agreement and Plan of Merger and Reorganization, dated as of October 5, 2004, by and among Blue Coat Systems, Inc., Utah Merger Corporation, Cerberian, Inc., and Scott Petty, as Stockholders’ Representative (which is incorporated herein by reference to Exhibit 2.2 of Form 8-K filed by the Registrant with the Commission on November 23, 2004)
2.4	Agreement and Plan of Merger and Reorganization, dated as of December 30, 2005, by and among Blue Coat Systems, Inc., Permeo Technologies, Inc., Pivot Acquisition Corp. and Chris Pacitti, as Stockholders’ Representative (which is incorporated herein by reference to Exhibit 2.1 of Form 8-K filed by the Registrant with the Commission on January 4, 2006)
2.5	Asset Purchase Agreement, dated as of June 22, 2006, between Blue Coat Systems, Inc. and Network Appliance, Inc. (which is incorporated herein by reference to Exhibit 2.1 of Form 8-K filed by the Registrant with the Commission on June 23, 2006)
2.6	Amendment to Asset Purchase Agreement , dated as of September 8, 2006, between Blue Coat Systems, Inc. and Network Appliance, Inc. (which is incorporated herein by reference to Exhibit 2.1 of Form 8-K filed by the Registrant with he Commission on September 11, 2006)
3.1	Amended and Restated Certificate of Incorporation of the Registrant (which is incorporated herein by reference to Exhibit 3.2 to the Registrant’s Registration Statement on Form S-1 No. 333-87997)
3.2	Amended and Restated Bylaws of the Registrant (which is incorporated herein by reference to Exhibit 3.4 to the Registrant’s Registration Statement on Form S-1 No. 333-87997)

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3.3	Certificate of Ownership and Merger of Blue Coat Systems, Inc. with and into Cacheflow Inc. (which is incorporated herein by reference to Exhibit 3.3 of Form 10-Q filed by the Registrant with the Commission on December 16, 2002)
3.4	Certificate of Amendment to Amended and Restated Certificate of Incorporation of Blue Coat Systems, Inc. dated September 12, 2002 (which is incorporated herein by reference to Exhibit 3.4 of Form 10-Q filed by the Registrant with the Commission on December 16, 2002)
3.5	Certificate of Designation, Preferences, and Rights of Series A Preferred Stock (which is incorporated herein by reference to Exhibit 4.1 of Form 8-K filed by the Registrant with the Commission on June 23, 2006)
4.1	Reference is made to Exhibits 3.1, 3.2, 3.3, 3.4 and 3.5
4.2	Specimen Certificate of the Registrant’s Common Stock (which is incorporated herein by reference to Exhibit 4.3 of Form 10-K filed by the Registrant with the Commission on July 29, 2003)
10.1	Form of Indemnification Agreement (which is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Registration Statement on Form S-1/A No. 333-87997)
10.2	1996 Stock Option Plan (which is incorporated herein by reference to Exhibit 10.2 to the Registrant’s Registration Statement on Form S-1 No. 333-87997)
10.3	1999 Stock Incentive Plan (which is incorporated herein by reference to Exhibit 10.3 to the Registrant’s Registration Statement on Form S-1 No. 333-87997)
10.4	1999 Director Option Plan (which is incorporated herein by reference to Exhibit 10.4 to the Registrant’s Registration Statement on Form S-1 No. 333-87997)
10.5	1999 Employee Stock Purchase Plan (which is incorporated herein by reference to Exhibit 10.5 to the Registrant’s Registration Statement on Form S-1 No. 333-87997)
10.6	Commercial lease agreement between Registrant, the Arrillaga Foundation and the Perry Foundation, dated July 14, 1998 (which is incorporated herein by reference to Exhibit 10.6 to the Registrant’s Registration Statement on Form S-1 No. 333-87997)
10.7	Commercial lease agreement between Registrant and Zetron Properties, Inc., dated April 20, 2000 (which is incorporated herein by reference to Exhibit 10.7 of Form 10-K filed by the Registrant with the Commission on July 16, 2001)
10.8	Commercial lease agreement between CacheFlow Canada and Wiebe Property Corporation Ltd., dated May 1, 1999 (which is incorporated herein by reference to Exhibit 10.8 to the Registrant’s Registration Statement on Form S-1 No. 333-87997)
10.9	Offer Letter with Brian NeSmith (which is incorporated herein by reference to Exhibit 10.9 to the Registrant’s Registration Statement on Form S-1/A No. 333-87997)
10.10	2000 Supplemental Stock Option Plan (which is incorporated herein by reference to Exhibit 99.1 of Form S-8 filed by the Registrant with the Commission on April 11, 2000)
10.11	SpringBank Networks, Inc. 2000 Stock Incentive Plan (which is incorporated herein by reference to Exhibit 99.2 of Form S-8 filed by the Registrant with the Commission on September 8, 2000)
10.12	Entera, Inc. 1999 Equity Incentive Plan (which is incorporated herein by reference to Exhibit 99.1 of Form S-8 filed by the Registrant with the Commission on December 18, 2000)
10.13	Entera, Inc. 2000 Equity Incentive Plan (which is incorporated herein by reference to Exhibit 99.2 of Form S-8 filed by the Registrant with the Commission on December 18, 2000)
10.14	Offer Letter with David de Simone (which is incorporated herein by reference to Exhibit 10.24 of Form 10-Q filed by the Registrant with the Commission on December 12, 2003)
10.15	Common Stock Purchase Agreement dated September 18, 2003 (which is incorporated herein by reference to Exhibit 10.1 of Form 8-K filed by the Registrant with the Commission on September 22, 2003)
10.16	Registration Rights Agreement dated September 18, 2003 (which is incorporated herein by reference to Exhibit 10.2 of Form 8-K filed by the Registrant with the Commission on September 22, 2003)

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10.17	Technology License And Settlement Agreement dated October 29, 2003 by and between Network Caching Technology L.L.C and Blue Coat Systems, Inc. (which is incorporated herein by reference to Exhibit 10.27 of Form 10-Q filed by the Registrant with the Commission on December 12, 2003)
10.18	Source Code License & Services Agreement, effective August 12, 2004, by and between Blue Coat Systems, Inc. and Flowerfire, Inc. (which is incorporated herein by reference to Exhibit 10.1 of Form 10-Q filed by the Registrant with the Commission on September 9, 2004)
10.19	Form of Notice of Grant of Stock Option and Stock Option Agreement used to evidence options granted under the Blue Coat Systems, Inc. 1999 Stock Incentive Plan (which is incorporated herein by reference to Exhibit 10.2 of Form 10-Q filed by the Registrant with the Commission on December 9, 2004)
10.20	Employment Agreement between Blue Coat Systems, Inc. and Kevin Royal dated as of March 31, 2005 (which is incorporated herein by reference to Exhibit 10.32 of Form 10-K filed by the Registrant with the Commission on July 14, 2005)
10.21	Separation Agreement between Blue Coat Systems, Inc. and Robert Verheecke dated as of April 29, 2005 (which is incorporated herein by reference to Exhibit 10.33 of Form 10-K filed by the Registrant with the Commission on July 14, 2005)
10.22	Cerberian, Inc. 2000 Stock Option Plan (which is incorporated herein by reference to Exhibit 10.22 of Form 10-K filed by the Registrant with the Commission on March 28, 2007)
10.23	Permeo Technologies, Inc. 2001 Stock Option Plan (which is incorporated herein by reference to Exhibit 10.22 of Form 10-K filed by the Registrant with the Commission on March 28, 2007)
10.24	Series A Preferred Stock Purchase Agreement dated as of June 22, 2006, by and among Blue Coat Systems, Inc., Francisco Partners II, L.P., Francisco Partners Parallel Fund II, L.P., Sequoia Capital Growth Fund III, Sequoia Capital Growth Partners III and Sequoia Capital Growth III Principals Fund (which is incorporated herein by reference to Exhibit 10.1 of Form 8-K filed by the Registrant with the Commission on June 23, 2006)
10.25	Investors’ Rights Agreement dated as of June 22, 2006, by and among Blue Coat Systems, Inc., Francisco Partners II, L.P., Francisco Partners Parallel Fund II, L.P., Sequoia Capital Growth Fund III, Sequoia Capital Growth Partners III and Sequoia Capital Growth III Principals Fund (which is incorporated herein by reference to Exhibit 10.2 of Form 8-K filed by the Registrant with the Commission on June 23, 2006)
10.27	Separation Agreement between Blue Coat Systems, Inc. and Tom Ayers dated as of November 20, 2006
10.28	2006 Profit Sharing Plan
10.29	Offer letter with Kevin Biggs, dated as of December 3, 2006 (amended as of March 2007)
31.1	Chief Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Chief Executive Officer and Chief Financial Officer Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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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 thereunto duly authorized.

BLUE COAT SYSTEMS, INC.

/s/ Kevin S. Royal

Kevin S. Royal

Senior Vice President and Chief Financial Officer

(Principal Financial and Accounting Officer)

Dated: March 28, 2007

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