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WEBSENSE INC
10-Q, 2000-11-14
BUSINESS SERVICES, NEC

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-Q

(Mark One)

/x/	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended September 30, 2000.
/ /	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 000-30093

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Websense, Inc.
(Exact Name of Registrant as Specified in Its Charter)

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    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.  (1) Yes   X    No        (2) Yes   X    No       

    The number of shares of the Registrant's common stock, $0.01 par value, outstanding as of November 1, 2000 was 19,611,390.

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Websense, Inc.
Table of Contents

						Page
Part I.  Financial Information
		Item 1.		Financial Statements (unaudited)
				Balance Sheets as of September 30, 2000 and December 31, 1999		3
				Statements of Operations for the three and nine months ended September 30, 2000 and 1999		4
				Statement of Stockholders' Equity for the nine months ended September 30, 2000		5
				Statements of Cash Flows for the nine months ended September 30, 2000 and 1999		6
				Notes to Financial Statements		7
		Item 2.		Management's Discussion and Analysis of Financial Condition and Results of Operations		9
				Risks and Uncertainties		17
		Item 3.		Quantitative and Qualitative Disclosures About Market Risk		27
Part II.  Other Information
		Item 1.		Legal Proceedings		28
		Item 2.		Changes in Securities and Use of Proceeds		28
		Item 3.		Defaults upon Senior Securities		28
		Item 4.		Submission of Matters to a Vote of Security Holders		28
		Item 5.		Other Information		28
		Item 6.		Exhibits and Reports on Form 8-K		28
Signatures						29

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Part I—Financial Information

Item 1.  Financial Statements (unaudited)

Websense, Inc.

Balance Sheets

(in thousands)

				September 30, 2000			December 31, 1999
				(unaudited)			(Note 1)
Assets
Current assets:
	Cash and cash equivalents			$	11,220		$	10,735
	Investments in marketable securities				66,627			—
	Accounts receivable, net of allowance for doubtful accounts of $130 at September 30, 2000 and $253 at December 31, 1999				5,197			3,576
	Other current assets				853			329
		Total current assets			83,897			14,640
Property and equipment, net of accumulated depreciation of $1,845 at September 30, 2000 and $1,042 at December 31, 1999					2,553			1,947
Deposits and other assets					137			169
Total assets				$	86,587		$	16,756
Liabilities and stockholders' equity
Current liabilities:
	Accounts payable			$	431		$	573
	Accrued payroll and related benefits				1,685			894
	Other accrued expenses				1,070			557
	Long-term debt, current portion				—			504
	Deferred revenue, current portion				13,249			6,889
		Total current liabilities			16,435			9,417
Long-term debt, less current portion					—			993
Deferred revenue, less current portion					6,356			4,704
Total liabilities					22,791			15,114
Stockholders' equity:
	Convertible preferred Series A				—			37
	Convertible preferred Series B				—			33
	Common stock				195			84
	Additional paid-in capital				85,464			18,936
	Deferred compensation				(1,829	)		(2,585	)
	Accumulated deficit				(20,045	)		(14,863	)
	Accumulated other comprehensive income (loss)				11			—
Total stockholders' equity					63,796			1,642
Total liabilities and stockholders' equity				$	86,587		$	16,756

See accompanying notes.

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Websense, Inc.

Statements of Operations

(unaudited and in thousands, except per share amounts)

				Three Months Ended						Nine Months Ended
				September 30, 2000			September 30, 1999			September 30, 2000			September 30, 1999
Revenues:
	Subscriptions			$	4,522		$	1,987		$	11,080		$	4,727
	Other products and services				221			343			581			1,204
		Total revenues			4,743			2,330			11,661			5,931
Cost of revenues:
	Subscriptions				493			309			1,434			702
	Other products and services				187			258			529			915
		Total cost of revenues			680			567			1,963			1,617
Gross margin					4,063			1,763			9,698			4,314
Operating expenses:
	Selling and marketing				3,116			1,574			8,800			4,121
	Research and development				1,544			1,110			4,602			2,535
	General and administrative				920			937			2,387			2,788
	Amortization of stock-based compensation				429			647			1,571			1,212
		Total operating expenses			6,009			4,268			17,360			10,656
Loss from operations					(1,946	)		(2,505	)		(7,662	)		(6,342	)
Interest income, net					1,157			174			2,480			108
Net loss				$	(789	)	$	(2,331	)	$	(5,182	)	$	(6,234	)
Basic and diluted net loss per share				$	(0.04	)	$	(0.29	)	$	(0.32	)	$	(0.84	)
Basic and diluted common shares					19,527			8,126			15,977			7,436

See accompanying notes.

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Websense, Inc.
Statement of Stockholders' Equity
(unaudited and in thousands)

				Convertible Preferred Series A					Convertible Preferred Series B
														Common Stock
																			Additional paid-in capital			Deferred compensation			Accumulated deficit			Accumulated other comprehensive income (loss)			Total stockholders' equity
				Shares		Amount			Shares		Amount			Shares		Amount
Balance at December 31, 1999				3,704		$	37		3,333		$	33		8,358		$	84		$	18,936		$	(2,585	)	$	(14,863	)	$	—		$	1,642
	Issuance of common stock, net of offering costs of $6,281			—			—		—			—		4,000			40			65,680			—			—			—			65,720
	Conversion of preferred stock to common stock			(3,704	)		(37	)	(3,333	)		(33	)	7,037			70			—			—			—			—			—
	Issuance of common stock upon exercise of options			—			—		—			—		80			—			17			—			—			—			17
	Issuance of common stock upon exercise of warrant			—			—		—			—		55			1			16			—			—			—			17
	Deferred compensation (net of forfeitures)			—			—		—			—		—			—			815			(815	)		—			—			—
	Amortization of deferred compensation			—			—		—			—		—			—			—			1,571			—			—			1,571
	Unrealized gain on securities available for sale			—			—		—			—		—			—			—			—			—			11			11
	Net loss			—			—		—			—		—			—			—			—			(5,182	)		—			(5,182	)
Balance at September 30, 2000				—		$	—		—		$	—		19,529		$	195		$	85,464		$	(1,829	)	$	(20,045	)	$	11		$	63,796

See accompanying notes.

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Websense, Inc.

Statements of Cash Flows

(unaudited and in thousands)

				Nine Months Ended September 30,
				2000			1999
Operating activities:
Net loss				$	(5,182	)	$	(6,234	)
Adjustments to reconcile net loss to net cash provided by operating activities:
	Depreciation				759			379
	Issuance of common stock options and warrants for services				—			81
	Deferred revenue				8,012			4,921
	Amortization of deferred compensation				1,571			1,212
Changes in operating assets and liabilities:
	Accounts receivable				(1,621	)		(1,388	)
	Deposits and other assets				(492	)		(121	)
	Accounts payable				(142	)		1,057
	Accrued payroll and related benefits				791			386
	Other accrued expenses				513			94
Net cash provided by operating activities					4,209			387
Investing activities:
Purchase of equipment					(1,365	)		(1,367	)
Purchase of marketable securities					(66,616	)		—
Net cash used in investing activities					(67,981	)		(1,367	)
Financing activities:
Borrowings (repayments) on notes payable					(1,497	)		168
Proceeds from issuance of preferred stock					—			9,876
Proceeds from issuance of common stock					65,754			265
Net cash provided by financing activities					64,257			10,309
Increase in cash and cash equivalents					485			9,329
Cash and cash equivalents at beginning of period					10,735			1,753
Cash and cash equivalents at end of period				$	11,220		$	11,082
Supplemental disclosures of cash flow information:
Interest paid				$	52		$	38

See accompanying notes.

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WEBSENSE, INC.

NOTES TO FINANCIAL STATEMENTS

1.  Basis of Presentation

    The accompanying unaudited financial statements have been prepared in conformity with generally accepted accounting principles for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information or footnote disclosures normally included in complete financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the statements include all adjustments necessary, which are of a normal and recurring nature, for the fair presentation of our financial position and of the results for the interim periods presented.

    These financial statements should be read in conjunction with the audited financial statements and notes thereto for the year ended December 31, 1999, included in Websense, Inc.'s Registration Statement on Form S-1 reported to the Securities and Exchange Commission. Operating results for the nine months ended September 30, 2000 are not necessarily indicative of the results which may be expected for any other interim period or for the year ending December 31, 2000. The balance sheet at December 31, 1999 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

    Certain reclassifications have been made to conform prior year's data to the current period presentation.

2.  Initial Public Offering

    On March 28, 2000, we completed our initial public offering, IPO, for the sale of 4,000,000 shares of common stock at a price to the public of $18 per share, which resulted in net proceeds of $65.7 million after payment of the underwriters' commissions and deductions of offering expenses. Simultaneous with the closing of the initial public offering, all of the convertible preferred stock was automatically converted into an aggregate of 7,037,036 shares of common stock.

3.  Net Loss Per Share

    We compute net loss per share in accordance with SFAS No. 128, Earnings Per Share. Under the provisions of SFAS No. 128, basic net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing the net income for the period by the weighted average number of common and common equivalent shares outstanding during the period. Diluted earnings per share are required to be calculated to include the potentially dilutive effect of the conversion of outstanding stock options. Because we have a net loss for the periods presented the inclusion of outstanding stock options would be anti-dilutive and therefore the weighted average shares used to calculate both basic and diluted loss per share are the same.

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4.  Amortization of Deferred Compensation

    For the three and nine month periods ended September 30, 2000 and 1999, we recorded amortization of deferred compensation. The allocation of the expense by operating expense category is as follows:

5.  Recently Issued Accounting Standards

    In December 1999, the SEC issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements." SAB 101 summarizes certain of the SEC's review in applying generally accepted accounting principles to revenue recognition in financial statements. We are required to adopt SAB 101 in the fourth quarter of fiscal 2000; however, we do not expect the adoption of SAB 101 to have any effect on our operations or financial position.

    In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards for derivative instruments on the Company's balance sheet at fair value. The FASB has subsequently delayed implementation of the standard for the financial years beginning after June 15, 2000. We expect to adopt SFAS 133 effective October 2000. We do not anticipate that the adoption of SFAS 133 will have a material impact on our financial position or results of operations.

    In March 2000, the FASB issued FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation". We were required to adopt FIN 44 effective July 1, 2000 with respect to certain provisions applicable to new awards, exchanges of awards in a business combination, modifications to outstanding awards, and changes in grantee status that occur on or after that date. FIN 44 addresses practice issues related to the application of APB Opinion No. 25, "Accounting for Stock Issued to Employees". We do not anticipate that the adoption of FIN 44 will have a material impact on our financial position or results of operations.

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

    From time to time we have made and may continue to make "forward looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. This report on Form 10-Q may contain forward looking statements. These statements, which represent our expectations or beliefs concerning various future events, include but are not limited to statements concerning the following:

	•		anticipated trends in revenue;
	•		growth opportunities in domestic and international markets;
	•		expected trends in operating expenses;
	•		anticipated cash and capital requirements; and
	•		intentions regarding investment of excess cash

    Actual results may differ materially from results anticipated in such forward looking statements. We assume no obligation to update any forward looking statements to reflect events or circumstances arising after the date hereof.

    Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made under the caption "Risks and Uncertainties" included herein and other reports and filings made with the Securities and Exchange Commission.

Overview

    We provide employee Internet management, or EIM, solutions that enable businesses to monitor, report and manage how their employees use the Internet. Our Websense Enterprise solution supports an organization's efforts to improve employee productivity, conserve network bandwidth and mitigate potential legal liability. We were founded in 1994 as NetPartners Internet Solutions, a reseller of computer network security solutions and related services. In 1996, we released our first software product, Websense Internet Screening System. Since that time, we have refocused our business on developing and selling employee Internet management solutions, and no longer focus on software resale and service business.

    In 1999, we changed our name to Websense, Inc. and completed our change in business strategy. In the same year, we expanded our senior management team, raised approximately $9.9 million in a private round of financing and further strengthened indirect sales channels and business relationships. In December 1999, we released version 4.0 a redesigned version of Websense Enterprise, our most recent version was released in June 2000. We currently derive a substantial majority of our revenues from subscriptions to this solution and expect this trend to continue in the future. When a purchase decision is made, customers enter into a subscription agreement, which is generally 12, 24 or 36 months in duration and for a fixed number of users. Upon entering into the subscription agreement, we promptly invoice customers for their subscriptions. Generally, payment is due for the full term of the subscription within 30 days of the invoice. We recognize revenue on a straight-line basis over the term of the subscription agreement. We record amounts billed to customers in excess of recognizable revenue as deferred revenue on our balance sheet. Upon expiration of the subscription, customers who wish to resubscribe must do so at our then current rates to continue using Websense Enterprise. Our revenue is significantly influenced by subscription renewals, and a decrease in subscription renewals could negatively impact our revenue.

    We also derive revenues from professional services for the implementation of our solution and from resale of hardware and software. We recognize revenues for these services and products upon their completion or delivery. These revenues declined significantly in the first nine months of 2000 due

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to the shift in business strategy. We expect these revenues to continue to decline as a percent of total revenues for the foreseeable future.

    In the first nine months of 2000, we derived 31 percent of revenues from international sales compared to 25 percent in the first nine months of 1999. We are continuing to expand our international operations, particularly in selected countries in the European and Asia Pacific markets, because we believe international markets represent a significant growth opportunity.

    We currently sell solutions through indirect (78 percent of revenue) and direct (22 percent of revenue) channels; however, our strategy is to increasingly rely on indirect sales channels. Domestically, we sell solutions through more than 500 Value Added Resellers, or VARs, and through our direct sales force. Internationally, we distribute Websense Enterprise through more than 125 distributors and resellers in over 75 countries who resell our solution through VARs and their resellers. In addition, we leverage the sales and marketing capabilities of the original equipment manufacturers, or OEMs, and other key providers of complementary hardware and software products.

    Because we derive revenues from subscription fees, we do not recognize the entire amount of subscription fees received in the month the subscription agreements are executed. However, we recognize operating expenses as they are incurred. Operating expenses have continued to increase as compared to prior periods due to expanded selling and marketing efforts and investments in administrative infrastructure to support subscription sales that we will recognize as revenue in subsequent periods.

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Results of Operations

Three months ended September 30, 2000 compared to the three months ended September 30, 1999

    The following table sets forth, as a percentage of total revenues, certain income data for the period indicated.

Revenues

    Subscriptions.  Subscription revenue increased $2.5 million, or 128 percent, from $2.0 million in the third quarter of 1999 to $4.5 million in the third quarter of 2000. Subscription revenue accounted for 95 percent of total revenues in the third quarter of 2000 compared to 85 percent in the third quarter of 1999. This increase was primarily a result of the addition of new customers during the quarter as well as renewals by existing customers.

    Other products and services.  Other products and services revenue decreased $122,000, or 36 percent, from $343,000 in the third quarter of 1999 to $221,000 in the third quarter of 2000. Other products and services revenue accounted for 5 percent of revenues in the third quarter of 2000 compared to 15 percent in the third quarter of 1999. The decrease is consistent with the strategy that has transformed Websense from a network security services organization and reseller of third party security software to a provider of Websense Enterprise, a subscription-based EIM solution.

Cost of Revenues

    Cost of subscriptions.  Cost of subscriptions consists of the costs of web site review, technical support and infrastructure costs associated with maintaining our database. Cost of subscriptions

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increased $184,000, or 60 percent, from $309,000 in the third quarter of 1999 to $493,000 in the third quarter of 2000. This increase was primarily due to additional personnel added to our database group, as well as, increased allocated facilities and human resource costs in 2000. Cost of subscriptions as a percentage of total revenue was 10 percent in the third quarter of 2000 as compared to 13 percent in the third quarter of 1999.

    Cost of other products and services.  Costs of other products and services consist primarily of the cost of resale software and related hardware. Cost of other products and services decreased $71,000, or 28 percent, from $258,000 in the third quarter of 1999 to $187,000 in the third quarter of 2000. Cost of other products and services as a percentage of total revenue decreased to 4 percent in the third quarter of 2000 compared to 11 percent in the third quarter of 1999. The decrease is due to the overall decline in sales of other products and services as costs continue to reflect an overall shift in emphasis to Websense Enterprise product sales.

Gross Margin

    Gross margin was $4.1 million, or 86 percent of revenues, for the quarter ended September 30, 2000 compared to $1.8 million, or 76 percent of revenues, in the quarter ended September 30, 1999. Gross margin increased $2.3 million, or 130 percent, due to a higher percentage mix of subscription revenues, which generate a higher margin as compared to other products and services revenue.

Operating Expenses

    Selling and marketing.  Selling and marketing expenses consist primarily of salaries, commissions and benefits related to personnel engaged in selling, marketing and customer support functions, along with costs related to public relations, advertising, promotions and travel. Selling and marketing expenses increased $1.5 million, or 98 percent, to $3.1 million in the third quarter of 2000, from $1.6 million in the same period in 1999. The increase in selling and marketing expenses in the third quarter was primarily due to the addition of personnel domestically, our expansion into Europe and increased advertising and promotional activities. We expect selling and marketing expenses to increase as more personnel are added to support our expanding selling and marketing efforts.

    Research and development.  Research and development expenses consist primarily of salaries and benefits for software developers, contract programmers, facilities costs and equipment depreciation. Research and development expenses increased $434,000, or 39 percent, to $1.5 million in the quarter ended September 30, 2000 from $1.1 million in the same period in 1999. The increase in research and development expenses was primarily a result of increased personnel and development efforts and enhancements to Websense Enterprise.

    General and administrative.  General and administrative expenses consist primarily of salaries, benefits and related expenses for executive and administrative personnel, third party professional service fees and allocated facilities and depreciation expenses. General and administrative expenses decreased $17,000, or 2 percent, to $920,000 in the third quarter of 2000 from $937,000 in the comparable period in 1999. This decrease is due primarily to non-recurring charges which occurred in the third quarter of 1999 which consisted of employee relocation and additional allowance for doubtful accounts. We expect general and administrative expenses to increase in the future, reflecting growth in operations and increased expenses associated with being a public company.

    Amortization of deferred compensation.  We recognized $429,000 of deferred compensation expense in the third quarter of 2000, compared to $647,000 in the comparable quarter in 1999 relating to the amortization of deferred compensation, a decrease of $218,000, or 34 percent. The decrease in the amortization expense is due to the accelerated method of amortization used.

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Interest Income (Expense), Net

    Net interest income increased $983,000, or 565 percent, to $1.2 million from $174,000 in the third quarter of 1999. The increase is primarily due to interest earned from the investment of our IPO proceeds.

Net Loss

    Net loss decreased $1.5 million, or 66 percent, to $789,000 (or $0.04 loss per share) from $2.3 million (or $0.29 loss per share) in the third quarter of 1999. This decrease was due to a combination of an increase in gross margin of $2.3 million, or 130 percent, and an increase in interest income of $983,000, offset by an increase in operating expenses of $1.7 million, or 41 percent.

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Nine months ended September 30, 2000 compared to the nine months ended September 30, 1999

    The following table sets forth, as a percentage of total revenues, certain income data for the period indicated.

Revenue

    Subscriptions.  Subscription revenue increased $6.4 million, or 134 percent, from $4.7 million for the nine months ended September 30, 1999 to $11.1 million in the first nine months of 2000. This increase was primarily a result of the addition of new customers during the quarter as well as renewals by existing customers. Subscription revenue accounted for 95 percent of total revenues in the first nine months of 2000 compared to 80 percent in the first nine months of 1999.

    Other products and services.  Other products and services revenue decreased $623,000, or 52 percent, from $1.2 million in the nine months ended September 30, 1999 to $581,000 in the first nine months of 2000. Other products and services revenue accounted for 5 percent of revenues in the first nine months of 2000 compared to 20 percent in the first nine months of 1999. The decrease is consistent with the strategy that has transformed Websense from a network security services organization and reseller of third party security software to a provider of Websense Enterprise, a subscription-based EIM solution.

Cost of Revenues

    Cost of subscriptions.  Cost of subscriptions consists of the costs of web site review, technical support and infrastructure costs associated with maintaining our database. Cost of subscriptions increased $732,000, or 104 percent, from $702,000 in the nine months ended September 30, 1999 to

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$1.4 million in the nine months ended September 30, 2000. This increase was primarily due to additional personnel added and automation tools developed by our database group, as well as, increased allocated facilities and human resource costs in 2000. Cost of subscriptions as a percentage of total revenue was 12 percent in the first nine months of 2000 compared to 12 percent in the first nine months of 1999.

    Cost of other products and services.  Costs of other products and services consist primarily of the cost of resale software and related hardware. Cost of other products and services decreased $386,000, or 42 percent, from $915,000 in the nine months ended September 30, 1999 to $529,000 in the nine months ended September 30, 2000. Cost of other products and services as a percentage of total revenue decreased to 5 percent in the first nine months of 2000 compared to 15 percent in the first nine months of 1999. These costs have decreased due to the shift in focus away from reselling hardware and software.

Gross Margin

    Gross margin was $9.7 million, or 83 percent of revenues, for the nine months ended September 30, 2000 compared to $4.3 million, or 73 percent of revenues, in the nine months ended September 30, 1999. Gross margin increased $5.4 million, or 125 percent, due to a higher percentage mix of subscription revenues, which generate a higher margin as compared to other products and services revenue.

Operating Expenses

    Selling and marketing.  Selling and marketing expenses increased $4.7 million, or 114 percent, to $8.8 million in the nine months ended September 30, 2000, from $4.1 million in the same period in 1999. The increase in selling and marketing expenses in the first nine months of 2000 was primarily due to the addition of personnel, the expansion into Europe and increased advertising and promotional activities. We expect selling and marketing expenses to increase as more personnel are added to support our expanding selling and marketing efforts.

    Research and development.  Research and development expenses increased $2.1 million, or 82 percent, to $4.6 million in the nine months ended September 30, 2000 from $2.5 million in the same period in 1999. The increase in research and development expenses was primarily a result of increased personnel and development efforts and enhancements to Websense Enterprise.

    General and administrative.  General and administrative expenses decreased $401,000, or 14 percent, to $2.4 million in the nine months ended September 30, 2000 from $2.8 million in the comparable period in 1999. The decrease in general and administrative expenses in the first nine months of 2000 is primarily due to the expanded allocation of expenses to other departments and to non-recurring charges in the first quarter of 1999 which consisted of an additional allowance for doubtful accounts and compensation expenses for consultants. We expect general and administrative expenses to increase in the future, reflecting growth in operations and increased expenses associated with being a public company.

    Amortization of deferred compensation.  We recognized $1.6 million of deferred compensation expense in the first nine months of 2000, compared to $1.2 million in the comparable period in 1999 relating to the amortization of deferred compensation, an increase of $359,000, or 30 percent. The increase in the amortization expense is primarily due to the large number of option grants which occurred after March 1999 for which deferred compensation was recorded as well as deferred compensation recorded for options issued in the first quarter of 2000.

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Interest Income (Expense), Net

    Net interest income increased $2.4 million, or 2,196 percent, from $108,000 in the first nine months of 1999 to $2.5 million in the comparable period in 2000. The increase over the first nine months of 1999 is due to the proceeds from the IPO being invested in March 2000.

Net Loss

    Net loss decreased $1.1 million, or 17 percent, from $6.2 million (or $0.84 loss per share) in the first nine months of 1999 to $5.2 million (or $0.32 loss per share) in the same period in 2000. This decrease was due to a combination of an increase in gross margin of $5.4 million, or 125 percent, an increase in interest income of $2.4 million, offset by an increase in operating expenses of $6.7 million, or 63 percent.

Liquidity and Capital Resources

    From our inception through March 2000, we financed our operations primarily through the sale of preferred equity securities. In total, we raised approximately $15.5 million, net of fees and expenses, through the sale of preferred equity securities. In March 2000, we closed our initial public offering with proceeds, net of underwriting fees and offering expenses, of approximately $65.7 million. In the past, we have also utilized available financing for the purchase of capital equipment.

    As of September 30, 2000, we had cash and cash equivalents of $11.2 million and investments in marketable securities of $66.6 million and an accumulated deficit of $20.0 million.

    Net cash provided by operating activities was $4.2 million in the nine months ended September 30, 2000 compared to $387,000 in the nine months ended September 30, 1999. The relative increase in cash provided by operating activities is primarily due to interest earnings on our cash invested and an increase in our subscriptions (which are initially recorded as deferred revenue).

    Net cash used in investing activities was $68.0 million in the nine months ended September 30, 2000 compared to $1.4 million in the nine months ended September 30, 1999. The relative increase in cash used in investing activities is primarily due to purchases of marketable securities.

    Net cash provided by financing activities was $64.3 million in the nine months ended September 30, 2000 compared to $10.3 million in the nine months ended September 30, 1999. This increase was primarily due to the completion in March 2000 of our initial public offering. We also repaid our outstanding equipment financing loans in the second quarter of 2000.

    In June of 2000 we entered into a loan and security agreement with a bank for a credit facility of $1.5 million. At September 30, 2000 we had $1.0 million available for drawing under this facility and $500,000 set aside for existing or future letters of credit. We have operating lease commitments of $1.5 million expiring in 2002 and $111,000 expiring in 2003.

    We believe that our cash and cash equivalents balances, investments in marketable securities and funds available under our existing credit facilities will be sufficient to satisfy our cash requirements for at least the next 12 months. We intend to continue to invest our cash in excess of current operating requirements in interest bearing, investment-grade securities. If existing cash is insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities or to obtain a larger credit facility. The sale of additional equity or convertible debt securities would result in additional dilution to our shareholders. Additional debt would result in increased expenses and could result in covenants that would restrict our operations. We have not made arrangements to obtain additional financing and there is no assurance that financing, if required, will be available in amounts or on terms acceptable to us, if at all.

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Risks and Uncertainties

    You should carefully consider the following information in addition to other information in this report before you decide to purchase our common stock. The risks and uncertainties described below are those that we currently deem to be material and that we believe are specific to our company and our industry. If any of these or other risks actually occurs the trading price of our common stock could decline, and you may lose all or part of your investment.

We have a history of losses and, because we expect our operating expenses to increase in the future, we may never become profitable.

    We have experienced net losses in each of the last 15 fiscal quarters, and as of September 30, 2000, we had an accumulated deficit of $20.0 million. We incurred net losses of $5.6 million for the year ended December 31, 1998 and $9.3 million for the year ended December 31, 1999. We expect to continue to incur significant net losses for the foreseeable future. While we are unable to predict accurately our future operating expenses, we currently expect these expenses to increase substantially, as we, among other things:

	•		expand our domestic and international selling and marketing activities;
	•		increase our research and development efforts to upgrade our existing products and develop  new products and technologies;
	•		develop and expand our proprietary database and systems;
	•		upgrade our operational and financial systems, procedures and controls;
	•		hire additional personnel, including additional engineers and other technical staff; and
	•		assume the responsibilities of being a public company.

    We will need to significantly increase our revenues to achieve and maintain profitability. If we fail to increase revenues from subscription fees to Websense Enterprise, we will continue to experience losses indefinitely. We may not be able to achieve or maintain profitability. We also may fail to accurately estimate and assess our increased operating expenses as we grow. If our operating expenses exceed our expectations, our financial performance will be adversely affected, which could cause the price of our common stock to decline.

We are an early-stage company with an unproven business model, which makes it difficult to evaluate our current business and future prospects.

    We have only a limited operating history upon which to base an evaluation of our current business and future prospects. We began offering our employee Internet management software in September 1996, but only since May 1998, when we released our first version of Websense Enterprise as a significant enhancement to our original product, have we directed a majority of our focus on this market. We introduced the most recent version of Websense Enterprise in June 2000. As a result, the revenue and income potential of our business and our market are unproven. In addition, we have very limited historical data with respect to subscription renewals because we sell subscriptions that range from one to three years in length and have only been selling Websense Enterprise for less than two and one-half years. Further, because of our limited operating history and because the market for employee Internet management products is relatively new and rapidly evolving, we have limited insight into trends that may emerge and affect our business. We may make errors in predicting and reacting to relevant business trends, which could harm our business. Before investing, you should consider an investment in our stock in light of the risks, uncertainties and difficulties frequently encountered by early-stage companies in new and rapidly evolving markets such as ours. We may not be able to

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successfully address any or all of these risks. Failure to adequately do so could cause our business, results of operations and financial condition to suffer.

Because we expect to derive substantially all of our future revenue from subscription fees for Websense Enterprise, any failure of this product to satisfy customer demands or to achieve more widespread market acceptance will seriously harm our business.

    Substantially all of our revenues come from subscriptions for Websense Enterprise, and we expect this trend will continue for the foreseeable future. Subscription revenues accounted for approximately 95 percent of our total revenues through the first nine months of 2000, 83 percent of our total revenues as of December 31, 1999 and approximately 36 percent as of December 31, 1998. As a result, if for any reason revenues from Websense Enterprise decline or do not grow as rapidly as we anticipate, our operating results and our business will be significantly impaired. If Websense Enterprise fails to meet the needs of our target customers, or if it does not compare favorably in price and performance to competing products, our growth will be limited. We cannot assure you that Websense Enterprise will achieve continued market acceptance. Our future financial performance also will depend, in part, on our ability to diversify our offerings by successfully developing, introducing and gaining customer acceptance of new products and enhanced versions of Websense Enterprise. We cannot assure you, however, that we will be successful in achieving market acceptance of any new products that we develop or of enhanced versions of Websense Enterprise. Any failure or delay in diversifying our existing offerings could harm our business, results of operations and financial condition.

The market for employee Internet management products is emerging, and if we are not successful in promoting awareness of the need for Websense Enterprise and of our Websense brand, our growth may be limited.

    Based on our experience with potential customers, we believe that many corporations are unaware of the existence or scope of problems caused by employee misuse of the Internet. In addition, there may be a time-limited opportunity to achieve and maintain a significant share of the market for employee Internet management products due in part to the emerging nature of this market and the substantial resources available to our existing and potential competitors. We intend to commit approximately $3.0 million of our marketing communications resources in 2000 to promote awareness of the problems caused by employee misuse of Internet access in the workplace, but we cannot assure you that we will be successful in this effort. If employers do not recognize or acknowledge these problems, then the market for Websense Enterprise may develop more slowly than we expect, which could adversely affect our operating results. Developing and maintaining awareness of our Websense brand is critical to achieving widespread acceptance of our existing and future employee Internet management products. Furthermore, we believe that the importance of brand recognition will increase as competition in our market develops. Successful promotion of our Websense brand will depend largely on the effectiveness of our marketing efforts and on our ability to develop reliable and useful products at competitive prices. If we fail to successfully promote our Websense brand, or if our expenses to promote and maintain our Websense brand are greater than anticipated, our results of operations and financial condition could suffer.

We must develop and expand our indirect sales channels to increase revenue and improve our operating results.

    We currently sell our products both indirectly and directly; however, we intend to rely increasingly on our indirect sales channels. We depend on our indirect sales channels, including value-added resellers, distributors, original equipment manufacturers and Internet service providers, to offer Websense Enterprise to a larger customer base than we can reach through our direct sales efforts. We will need to expand our existing relationships and enter into new relationships to increase our current

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and future market share and revenue. We cannot assure you that we will be able to maintain and expand our existing relationships or enter into new relationships, or that any new relationships will be available on commercially reasonable terms. If we are unable to maintain and expand our existing relationships or enter into new relationships, we would lose customer introductions and co-marketing benefits and our operating results could suffer.

Our reliance on indirect sales channels could result in reduced revenue growth because we have little control over our value-added resellers, distributors and original equipment manufacturers.

    Our indirect sales channels accounted for approximately 78 percent of our total revenues in the first nine months of 2000 and 71 percent in 1999. We anticipate that sales from our various indirect sales channels, including value-added resellers, distributors, original equipment manufacturers, Internet service providers and others, will account for an increasing percentage of our total revenues in future periods. None of these parties is obligated to continue selling our products or to make any purchases from us. Our ability to generate increased revenue depends significantly upon the ability and willingness of our indirect sales channels to market and sell our products to organizations worldwide. If they are unsuccessful in their efforts, our operating results will suffer. We cannot control the level of effort these parties expend or the extent to which any of them will be successful in marketing and selling our products. Many of our indirect sales channels also market and sell products that compete with Websense Enterprise. We may not be able to prevent these parties from devoting greater resources to support our competitors' products.

We face increasing competition from better established companies that may have significantly greater resources, which could prevent us from increasing revenue or achieving profitability.

    The market for our products is intensely competitive and is likely to become even more so in the future. Increased competition could result in pricing pressures, reduced sales, reduced margins or the failure of Websense Enterprise to achieve or maintain more widespread market acceptance, any of which would have a material adverse effect on our business, results of operations and financial condition. Our current principal competitors include:

	•		companies offering network filtering products, such as JSB Software Technologies plc., N2H2 Incorporated, Secure Computing Corporation and Symantec Corporation;
	•		companies offering network reporting products, such as Telemate Net Software, Inc. and WebTrends Corporation; and
	•		companies offering client-based software filtering products, such as The Learning Company and Log-On Data Corporation.

    We also face current and potential competition from vendors of Internet servers, operating systems and networking hardware, many of which now, or may in the future, develop and/or bundle employee Internet management products with their products. We also compete against, and expect increased competition from, traditional network management software developers and Web management service providers. Many of our current and potential competitors enjoy substantial competitive advantages, such as:

	•		greater name recognition and larger marketing budgets and resources;
	•		established marketing relationships and access to larger customer bases; and
	•		substantially greater financial, technical and other resources.

    As a result, they may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or customer requirements. For all of the foregoing reasons, we may not be able to compete successfully against our current and future competitors.

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Our future growth depends on our existing customers renewing and purchasing additional subscriptions to Websense Enterprise.

    Our future success depends on achieving substantial revenue from customer renewals for subscriptions to Websense Enterprise. Subscriptions for Websense Enterprise typically have a duration of 12, 24 or 36 months. Our customers have no obligation to renew their subscriptions upon expiration. We cannot assure you that we will generate significant revenue from renewals. In order to maintain our revenues we must continue to sell renewal subscriptions.

    Our future success also depends on our ability to sell subscriptions to existing customers for additional employees within their respective organizations. We believe that approximately 17 percent of our customers' employees are covered by Websense Enterprise. As a result, to increase our revenues we must sell our existing customers additional subscriptions for Websense Enterprise to get greater coverage of their workforces. This may require increasingly sophisticated sales efforts targeting senior management and other management personnel associated with our customers' Internet infrastructure.

Our database categories and our process for classifying web sites within those categories are subjective, and we may not be able to categorize web sites in accordance with our customers' expectations.

    We may not succeed in accurately categorizing Internet content to meet our customers' expectations. We rely upon a combination of automated filtering technology and human review to categorize Web sites in our proprietary database. Our customers may not agree with our determinations that particular Web sites should be included or not included in specific categories of our database. In addition, it is possible that our filtering processes may place objectionable material in categories that are generally unrestricted by our users' Internet access policies, which could result in employees having access to such material in the workplace. Any miscategorization could result in customer dissatisfaction and harm our reputation. Furthermore, we select our categories based on Web site content we believe employers want to manage. We may not now, or in the future, succeed in properly identifying the categories of Web site content that employers want to manage. Any failure to effectively categorize and filter Web sites according to our customers' expectations will impair the growth of our business and our efforts to increase brand acceptance.

Our database may fail to keep pace with the rapid growth and technological change of the Internet.

    The success of Websense Enterprise depends on the breadth and accuracy of our database. Although our database currently catalogs more than 1.5 million web sites, it contains only a fraction of the material available on the Internet. In addition, the total number of web sites is growing rapidly, and we expect this rapid growth rate to continue in the future. We cannot assure you that our database and database technologies will be able to keep pace with the growth in the number of web sites, especially the growing number of web sites containing foreign languages. Further, the ongoing evolution of the Internet will require us to continually improve the functionality, features and reliability of our database. Because Websense Enterprise can only manage access to web sites included in our database, if our database does not contain a meaningful portion of relevant web sites, the effectiveness of Websense Enterprise will be significantly diminished. Any failure of our database to keep pace with the rapid growth and technological change of the Internet will impair the market acceptance of Websense Enterprise, which in turn will harm our business, results of operations and financial condition.

Our recent growth has strained our existing personnel and infrastructure resources, and if we are unable to implement appropriate controls and procedures to manage our growth, we may not be able to successfully implement our business plan.

    We are currently experiencing a period of rapid growth in our operations, which has placed, and will continue to place, a significant strain on our management, administrative, operational and financial

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infrastructure. Our future success will depend in part upon the ability of our senior management to manage growth effectively. This will require us to hire and train additional personnel to manage our expanding operations. In addition, we will be required to continue to improve our operational, financial and management controls and our reporting systems and procedures. If we fail to successfully manage our growth, we will be unable to execute our business plan.

If we acquire any companies or technologies in the future, they could prove difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our operating results.

    We may acquire or make investments in complementary companies, services and technologies in the future. We have not made any acquisitions or investments to date, and therefore our ability as an organization to make acquisitions or investments is unproven.

    Acquisitions and investments involve numerous risks, including:

	•		difficulties in integrating operations, technologies, services and personnel;
	•		diversion of financial and management resources from existing operations;
	•		risk of entering new markets;
	•		potential loss of key employees; and
	•		inability to generate sufficient revenues to offset acquisition or investment costs.

    In addition, if we finance acquisitions by issuing convertible debt or equity securities, our existing stockholders may be diluted which could affect the market price of our stock. As a result, if we fail to properly evaluate and execute acquisitions or investments, our business and prospects may be seriously harmed.

We are dependent on our management team, and the loss of any key member of this team may prevent us from implementing our business plan in a timely manner.

    Our success depends largely upon the continued services of our executive officers and other key management and development personnel. In particular, we rely on John B. Carrington, our President, Chief Executive Officer and Chairman. We are also substantially dependent on the continued service of our existing engineering personnel because of the complexity of our products and technologies. We do not have employment agreements with a majority of our executive officers, key management or development personnel and, therefore, they could terminate their employment with us at any time without penalty. We do not maintain key person life insurance policies on any of our employees. The loss of one or more of our key employees could seriously harm our business, results of operations and financial condition. We cannot assure you that in such an event we would be able to recruit personnel to replace these individuals in a timely manner, or at all, on acceptable terms.

Our management team was only recently formed, and our success depends on its ability to work together effectively.

    We hired Mr. Carrington in May 1999 and Douglas C. Wride, our Chief Financial Officer, in June 1999. In addition, a majority of our management team has joined us in the last 24 months. Our future success depends on the integration of this management team and its ability to work together effectively. If our management team fails to work together effectively, our business could be harmed.

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Because competition for our target employees is intense, we may not be able to attract and retain the highly skilled employees we need to support our planned growth.

    To execute our growth plan, we must attract and retain highly qualified personnel. We need to hire additional personnel in virtually all operational areas, including selling and marketing, research and development, operations and technical support, customer service and administration. Competition for these personnel is intense, especially for engineers with high levels of experience in designing and developing software and Internet-related products. We cannot assure you that we will be successful in attracting and retaining qualified personnel. We have from time to time in the past experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. Many of the companies with which we compete for experienced personnel have greater resources than we have. If we fail to attract new personnel or retain and motivate our current personnel, our business and future growth prospects could be severely harmed.

Sales to customers outside the United States have accounted for a significant portion of our revenue, and we expect this trend to continue, which exposes us to risks inherent in international sales.

    We market and sell our products outside the United States through value-added resellers, distributors and other resellers. International sales represented approximately 31 percent of our total revenues in the first nine months of 2000 and 21 percent in the year ended December 31, 1999. As a key component of our business strategy, we intend to expand our international sales. In addition to the risks associated with our domestic sales, our international sales are subject to the following risks:

	•		dependence on foreign distributors and their sales channels;
	•		the ability of our Websense Enterprise products to properly categorize and filter Web sites containing foreign languages;
	•		laws and business practices favoring foreign competitors;
	•		compliance with multiple, conflicting and changing governmental laws and regulations, including tax laws and regulations;
	•		longer accounts receivable payment cycles and other collection difficulties; and
	•		regional economic and political conditions.

    Such factors could have a material adverse effect on our future international sales. Any reduction in international sales, or our failure to further develop our international distribution channels, could have a material adverse effect on our business, results of operations and financial condition. Our international revenue is currently denominated in U.S. dollars. As a result, fluctuations in the value of the U.S. dollar and foreign currencies may make Websense Enterprise more expensive for international customers, which could harm our business. We do not currently engage in currency hedging activities to limit the risk of exchange rate fluctuation.

Our quarterly operating results may fluctuate significantly, and these fluctuations may cause our stock price to fall.

    Our quarterly operating results have varied significantly in the past, and will likely vary in the future as the result of fluctuations in our operating expenses. We expect that our operating expenses will increase substantially in the future as we expand our selling and marketing activities, increase our research and development efforts and hire additional personnel. In addition, our operating expenses

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historically have fluctuated, and may continue to fluctuate in the future, as the result of the factors described below and elsewhere in this quarterly report:

	•		concentration of marketing expenses for activities such as trade shows and advertising campaigns;
	•		a concentration of general and administrative expenses, such as recruiting expenses and professional services fees; and
	•		a concentration of research and development costs.

    As a result, it is possible that in some future periods, our results of operations may be below the expectations of current or potential investors. If this occurs, the price of our common stock may decline.

Because we recognize revenue from subscriptions for Websense Enterprise ratably over the term of the subscription, downturns in sales may not be immediately reflected in our revenues.

    We expect that a substantial majority of our future revenues will come from subscriptions to Websense Enterprise. Upon execution of a subscription agreement, we invoice our customers for the full term of the subscription agreement. We then recognize revenue from customers over the terms of their subscription agreements which generally have a duration of 12, 24 or 36 months. As a result, a majority of revenues we report in each quarter is deferred revenue from subscription agreements entered into and paid for during previous quarters. Because of this deferred revenue, the revenues we report in any quarter or series of quarters may mask significant downturns in sales and the market acceptance of Websense Enterprise.

Any failure to protect our intellectual property rights could impair our ability to protect our proprietary technology and establish our Websense brand.

    Intellectual property is critical to our success, and we rely upon trademark, copyright and trade secret laws in the United States and other jurisdictions as well as confidentiality procedures and contractual provisions to protect our proprietary technology and our Websense brand. Any of our trademarks may be challenged by others or invalidated through administrative process or litigation. We currently have no issued patents and may be unable to obtain patent protection in the future. In addition, any issued patents may not provide us with any competitive advantages, or may be challenged by third parties. Furthermore, legal standards relating to the validity, enforceability and scope of protection of intellectual property rights are uncertain. Effective patent, trademark, copyright and trade secret protection may not be available to us in every country in which our products are available. The laws of some foreign countries may not be as protective of intellectual property rights as United States laws, and mechanisms for enforcement of intellectual property rights may be inadequate. As a result, we cannot assure you that our means of protecting our proprietary technology and brands will be adequate. Furthermore, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property. Any such infringement or misappropriation could have a material adverse effect on our business, results of operations and financial condition.

We may be sued by third parties for alleged infringement of their proprietary rights.

    The software and Internet industries are characterized by the existence of a large number of patents, trademarks and copyrights and by frequent litigation based on allegations of patent infringement or other violations of intellectual property rights. As the number of entrants into our market increases, the possibility of an intellectual property claim against us grows. Our technologies and products may not be able to withstand any third-party claims or rights against their use. Any

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intellectual property claims, with or without merit, could be time-consuming and expensive to litigate or settle, and could divert management attention from executing our business plan.

We may not be able to develop acceptable new products or enhancements to our existing products at a rate required by our rapidly changing market.

    Our future success depends on our ability to develop new products or enhancements to our existing products that keep pace with rapid technological developments and that address the changing needs of our customers. Although Websense Enterprise is designed to operate with a variety of network hardware and software platforms, we will need to continuously modify and enhance Websense Enterprise to keep pace with changes in Internet-related hardware, software, communication, browser and database technologies. We may not be successful in either developing such products or timely introducing them to the market. In addition, uncertainties about the timing and nature of new network platforms or technologies, or modifications to existing platforms or technologies, could increase our research and development expenses. The failure of our products to operate effectively with the existing and future network platforms and technologies will limit or reduce the market for our products, result in customer dissatisfaction and seriously harm our business, results of operations and financial condition.

Other vendors may develop products similar to ours for incorporation into their hardware or software, and thereby reduce demand for Websense Enterprise.

    In the future, vendors of Internet-related hardware and software may enhance their products or develop separate products that include functions that are currently provided by Websense Enterprise. If employee Internet management functions become standard features of Internet-related hardware or software, the demand for Websense Enterprise will decrease. Furthermore, even if Websense Enterprise provides greater functionality and is more effective than the products offered by vendors of Internet-related hardware or software, potential customers might accept this limited functionality in lieu of purchasing our Websense Enterprise.

Our systems may be vulnerable to security risks or service disruptions that could harm our business.

    Our servers are vulnerable to physical or electronic break-ins and service disruptions, which could lead to interruptions, delays, loss of data or the inability to process customer requests. Such events could be very expensive to remedy, could damage our reputation and could discourage existing and potential customers from using our products. We may experience break-ins in the future. Any such events could substantially harm our business, results of operations and financial condition.

Because our products are complex and are deployed in a wide variety of complex network environments, they may have errors or defects that users identify after deployment, which could harm our reputation and our business.

    Products as complex as ours frequently contain undetected errors when first introduced or when new versions or enhancements are released. We have from time to time found errors in versions of Websense Enterprise, and we may find such errors in the future. The occurrence of errors could adversely affect sales of our products, divert the attention of engineering personnel from our product development efforts and cause significant customer relations problems.

Evolving regulation of the Internet may affect us adversely.

    As Internet commerce continues to evolve, increasing regulation by federal, state or foreign agencies becomes more likely. Such regulation is likely in the areas of user privacy, pricing, content and quality of products and services. Taxation of Internet use or other charges imposed by government

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agencies or by private organizations for accessing the Internet may also be imposed. Laws and regulations applying to the solicitation, collection or processing of personal or consumer information could affect our activities. Furthermore, any regulation imposing fees for Internet use could result in a decline in the use of the Internet and the viability of Internet commerce, which could have a material adverse effect on our business, results of operations and financial condition.

The success of our business depends on the continued growth and acceptance of the Internet as a business tool.

    Expansion in the sales of Websense Enterprise depends on the continued acceptance of the Internet as a communications and commerce platform for enterprises. The Internet may not prove to be a viable commercial medium due to inadequate development of the necessary infrastructure, such as a reliable network backbone, or timely development of complementary products, such as high-speed modems. Additionally, the Internet could lose its viability as a business tool due to delays in the development or adoption of new standards and protocols to handle increased demands of Internet activity, security, reliability, cost, ease-of-use, accessibility, and quality-of-service. If the Internet does not continue to become a widespread communications medium and commercial platform, the demand for Websense Enterprise could be significantly reduced, which could have a material adverse effect on our business, results of operations and financial condition.

Our products create risks of potential negative publicity and legal liability.

    Because customers rely on Websense Enterprise to provide employee Internet management, any significant defects or errors in our products may result in negative publicity or legal claims. Negative publicity or legal claims could seriously harm our business, results of operations and financial condition. In addition, Websense Enterprise's capability to report Internet data retrieval requests and the workstations from which they originated may result in negative publicity or legal claims based on potential privacy violations.

Our executive officers, directors and principal stockholders own a large percentage of our voting stock and could delay or prevent a change in our corporate control or other matters requiring stockholder approval, even if favored by our other stockholders.

    Our executive officers, directors and principal stockholders, and their respective affiliates, beneficially own approximately 75 percent of our outstanding common stock. These stockholders, if acting together, would be able to control substantially all matters requiring approval by our stockholders, including the election of all directors and approval of significant corporate transactions.

Because our operating expenses exceed our cash flow from operations, we may need to raise additional funds in the future, which funds may not be available on acceptable terms or at all.

    We expect that our operating expenses will increase substantially over at least the next 12 months. In addition, we may experience a material decrease in liquidity due to unforeseen capital requirements or other events and uncertainties. As a result, we may need to raise additional funds, and such funds may not be available on favorable terms, if at all. If we cannot raise funds on acceptable terms, we may not be able to develop or enhance our software applications or database, execute on our business plan, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements. This may seriously harm our business, results of operations and financial condition.

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We may seek to raise additional funds, and additional funding may be dilutive to stockholders or impose operational restrictions.

    An additional equity financing may be dilutive to our stockholders and debt financing, if available, may involve restrictive covenants, which may limit our operating flexibility. If additional funds are raised through the issuance of equity securities, the percentage of ownership of our stockholders will be reduced. These stockholders may experience additional dilution in net book value per share and any additional equity securities may have rights, preferences and privileges senior to those of the holders of our common stock.

Our common stock may not develop an active, liquid trading market.

    We completed our initial public offering in March 2000. Prior to this offering, there was no public market for our common stock. We cannot predict whether an active trading market in our common stock will develop or how liquid that market may become.

The market price of our common stock is likely to be highly volatile and subject to wide fluctuations.

    The market price of our common stock is likely to be highly volatile and could be subject to wide fluctuations in response to a number of factors that are beyond our control, including:

	•		announcements of technological innovations or new products or services by our competitors;
	•		demand for Websense Enterprise, including fluctuations in subscription renewals;
	•		fluctuations in revenues from our indirect sales channels;
	•		changes in the pricing policies of our competitors; and
	•		changes in government regulations.

    In addition, the market price of our common stock is likely to be highly volatile and could be subject to wide fluctuations in response to:

	•		announcements of technological innovations or new products or services by us;
	•		changes in our pricing policies;
	•		quarterly variations in our operating expenses; and
	•		our technological capabilities to accommodate the future growth in our operations or our customers.

    Further, the stock market has experienced significant price and volume fluctuations that have particularly affected the market price of the stock of many Internet-related companies, and that often have been unrelated or disproportionate to the operating performance of these companies. A number of publicly traded Internet-related companies have current market prices below their initial public offering prices. Market fluctuations such as these may seriously harm the market price of our common stock. In the past, securities class action suits have been filed following periods of market volatility in the price of a company's securities. If such an action was instituted, we would incur substantial costs and a diversion of management attention and resources, which would seriously harm our business, results of operations and financial condition.

It may be difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders.

    Some provisions of our certificate of incorporation and bylaws, as well as some provisions of Delaware law, may discourage, delay or prevent third parties from acquiring us, even if doing so would be beneficial to our stockholders. For example, our certificate of incorporation provides for a classified

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board, with each board member serving a staggered three-year term. It also provides that stockholders may not fill board vacancies, call stockholder meetings or act by written consent. Our bylaws further provide that advance written notice is required prior to stockholder proposals. Each of these provisions makes it more difficult for stockholders to obtain control of our board or initiate actions that are opposed by the then current board. Additionally, we have authorized preferred stock that is undesignated, making it possible for the board to issue preferred stock with voting or other rights and preferences that could impede the success of any attempted change of control. Delaware law also could make it more difficult for a third party to acquire us. Section 203 of the Delaware General Corporation Law may have an anti-takeover effect with respect to transactions not approved in advance by our board, including discouraging attempts that might result in a premium over the market price of the shares of common stock held by our stockholders

Future sales of our common stock may cause our stock price to decline.

    The market price of our common stock could decline as a result of sales by our existing stockholders of a large number of shares of our common stock in the market or the perception that such sales could occur. These sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.

We do not intend to pay dividends.

    Since we terminated our election to be treated as an "S" corporation in January 1998, we have not declared or paid any cash dividends on our common stock. We currently intend to retain any future cash flows from operations to fund growth and, therefore, do not expect to pay any dividends in the foreseeable future.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

    We are exposed to changes in interest rates primarily from our investments in cash equivalents and marketable securities. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments at September 30, 2000.

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Part II—Other Information

Item 1.  Legal Proceedings

    We are currently not a party to any litigation that could have a material adverse effect on our results of operations, financial position or business.

Item 2.  Changes in Securities and Use of Proceeds

    (a) Not applicable.

    (b) Not applicable.

    (c) Not applicable.

    (d) On March 28, 2000, we completed our IPO for the sale of 4,000,000 shares of common stock at a price to the public of $18 per share, which resulted in net proceeds of $65.7 million after payment of the underwriters' commissions and deductions of offering expenses. Subsequent to our IPO, a portion of the offering proceeds were used to repay the $1.4 million balance of our fixed term loan agreements with financial institutions. The remaining proceeds have conformed with our intended use outlined in the prospectus. We currently have approximately $64.3 million remaining from our IPO.

Item 3.  Defaults upon Senior Securities

    None.

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

    None.

Item 5.  Other Information

    Our President and Chief Executive Officer, John B. Carrington, and our Vice President and Chief Financial Officer, Douglas C. Wride, have each informed us that, in order to diversify their investment portfolios while avoiding conflicts of interest or the appearance of any such conflict that might arise from their positions with the company, they have established written plans in accordance with SEC Rule 10b5-1 for gradually liquidating a portion of their holdings of our common stock. In particular, we have been notified that Mr. Carrington intends to sell 6,057 shares of stock per week and that Mr. Wride intends to sell 2,000 shares of stock per week during a period commencing in November 2000 and ending in November 2001.

Item 6.  Exhibits and Reports on Form 8-K

(a)

Exhibits

3.1		Amended and Restated Certificate of Incorporation(1)
3.2		Restated Bylaws(1)
27.1		Financial Data Schedule

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(1)	Incorporated by reference to Exhibits 3.2 and 3.4 filed with our Registration Statement on Form S-1 (Registration No. 333-95619) on March 28, 2000.
(b)	Reports on Form 8-K
	No reports on Form 8-K were filed by the Registrant during the quarter ended September 30, 2000.

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SIGNATURES

    In accordance with the requirements of the Securities Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

		WEBSENSE, INC.
Date: November 14, 2000		By:	/s/ JOHN B. CARRINGTON    John B. Carrington Chairman of the Board, President, and Chief Executive Officer
		By:	/s/ DOUGLAS C. WRIDE    Douglas C. Wride Chief Financial Officer

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QuickLinks

Websense, Inc. Table of Contents

Part I—Financial Information
Item 1. Financial Statements (unaudited)

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

Risks and Uncertainties
Item 3. Quantitative and Qualitative Disclosures about Market Risk

Part II—Other Information
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K

SIGNATURES

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